The document discusses various capital budgeting techniques used to evaluate investment projects. It defines investment decision as the process of making decisions regarding capital expenditures that provide benefits over multiple years. It then describes several traditional methods like payback period and average rate of return as well as modern discounted cash flow methods like net present value. Specific formulas and examples are provided to demonstrate how to calculate each technique. The document emphasizes that net present value is the best method as it considers the time value of money and total cash flows of a project.
The document discusses various capital budgeting techniques used to evaluate investment projects. It defines investment decision as the process of making decisions regarding capital expenditures that provide benefits over multiple years. It then describes several traditional methods like payback period and average rate of return as well as modern discounted cash flow methods like net present value. Specific formulas and examples are provided to demonstrate how to calculate each technique. The document emphasizes that net present value is the best method as it considers the time value of money and total cash flows of a project.
The document discusses various capital budgeting techniques used to evaluate investment projects. It defines investment decision as the process of making decisions regarding capital expenditures that provide benefits over multiple years. It then describes several traditional methods like payback period and average rate of return as well as modern discounted cash flow methods like net present value. Specific formulas and examples are provided to demonstrate how to calculate each technique. The document emphasizes that net present value is the best method as it considers the time value of money and total cash flows of a project.
The document discusses various capital budgeting techniques used to evaluate investment projects. It defines investment decision as the process of making decisions regarding capital expenditures that provide benefits over multiple years. It then describes several traditional methods like payback period and average rate of return as well as modern discounted cash flow methods like net present value. Specific formulas and examples are provided to demonstrate how to calculate each technique. The document emphasizes that net present value is the best method as it considers the time value of money and total cash flows of a project.
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INVESTMENT
DECISION UNIT III INVESTMENT
An investment is a monetary asset purchased with the idea that the asset will provide income in the future or can later be sold at a higher price for profit. Investment decision is the process of making decision in capital expenditure. A capital expenditure is an expenditure the benefits of which are expected to be received over a period of time exceeding 1 year. Purchase of fixed assets like land, machinery, addition expansion or improvement in asset, replacement of asset etc. Definition
Also known as capital budgeting decision
Capital Budgeting Decision is the firm’s decision to invest its current funds most efficiently in the long term asset in anticipation of an expected flow of benefits over a series of year. “Capital Budgeting consists in planning development of available capital for the purpose of maximising the long term profitability of the concern.”- LYNCH Features of Capital Budgeting
Potentially large anticipated benefits
Relatively high degree of risk Long time period between initial outlay and anticipated return Irreversible Need and Importance
Huge investment- capital budgeting requires huge funds which are limited to the firm. So proper planning has to be done before investing. Long-term- Capital investment is permanent in nature, and so risk involved is higher. Irreversible- investment once made cannot be changed back without involving huge loss. Growth- it has decisive influence on the growth of the firm. Unprofitable expansion will result in heavy operating cost. Types of Investment Decision
Expansion or Diversification:- Related and Unrelated
Diversification. Investment in existing or new products may also be called revenue expansion investments. Replacement or Modernization:- to improve operating efficiency and reduce cost. Also called Cost-reduction investment. Types of Investment Decision Cntd.
Mutually Exclusive:- competing investment. Eg- either labour
intensive semi-automatic machine or Capital intensive fully automatic machine. Independent Investment:- they serve different purposes. Eg.- decision of buying a new vehicle and new machinery. Contingent investment:- dependent projects. Eg- starting a factory in a remote backward area may necessitate building roads and houses for employees. Capital Budgeting Process Project Generation ● Identification of investment proposal ● Screening the proposal
Project Evaluation ● Evaluation of various Proposal
● Fixing Priorities Project Selection ● Final approval
Implementing proposal ●
Project Execution Performance Review
● Project Evaluation Techniques
Traditional Method Modern/ Discounted cash flow
method
• Payback Period • Average Rate of Return • Net Present Value Method • Profitability index method • Internal Rate of Return 1. Payback Period Method Payback period is the time required to recover the initial investment in the project. It is also called pay out or pay off period method.
Accept/Reject criteria: If the actual payback period is less than the predetermined period, the project can be accepted or it will be rejected. While comparing 2 projects the project having lower PBP will be accepted. Merits and Demerits
Merits: 1) Easy to calculate. 2) It is simple to understand 3) It reduces possibility of loss due to obsolescence. Demerits: 1) It ignores time value of money 2) It ignores cash flows after the pay back period 3) It is one of the misleading evaluation of capital budgeting. 4) Does not consider Depreciation Calculation
We have two different situations:-
Equal/ Even cash inflow
Unequal/Uneven cash inflow A. Equal Cash Inflows
Initial Investment PBP = Annual net Cash Inflow EG: A project costs Rs.50,000 and yields an annual inflow of Rs.10,000.
PBP = 50000 = 5 years.
10000 B. Uneven Cash Inflows
B PBP = E + C
Where, E = No. of years immediately preceding the year of payback B = Balance to be recovered C = Cash flow during the year of recovery Example
A project requires a cash outlay of Rs.12,000 and generates cash inflow of Rs.2000, Rs.4000, Rs.4000 and Rs,5000 resp. 2. Average Rate of Return (ARR) The average rate of return is the average annual amount of cash flow generated over the life of an investment.
Under this method avg profit after tax and depreciation is divided by initial or avg investment. It is also called as accounting rate of return method. Accept/Reject criteria: If the actual ARR is more than the predetermined required rate, the project can be accepted or it will be rejected. While comparing 2 projects the project having higher ARR will be accepted. Merits and Demerits
Merits 1. It is easy to calculate and simple to understand 2. It is based on accounting information rather than cash inflow 3. It considers the total income associated with the project Demerits 4. It ignores time value of money 5. It ignores the reinvestment potentiality of the project 6. Different methods are used for calculating accounting profit. This may be misleading 7. Not suitable for comparing projects with different duration Formula
(Total income/No.of years)
ARR = X 100 Initial or avg Investment A real estate investment is likely to generate returns of Rs. 25,000/- in the 1st year, Rs. 30,000/- in the 2nd year and 35,000 in 3rd year. The initial investment is Rs.3,50,000/- with a salvage value of Rs.50,000/-. The estimated life is 3 years. Calculate Average Rate of Return. (10%) An investor is considering the following 2 securities. Determine which security should be selected based on the following information:
Particulars Project A Project B
Initial Investment 50000 60000
Annual net earnings
Year 1 5000 7000
Year 2 10000 12000 Year 3 12000 14000
Estimated life (years) 3 3
XYZ company is looking to invest in a new machinery which costs Rs. 4,20,000/-. An annual revnue of Rs. 2,00,000/- is expected to be generated and an annual expense of Rs. 50,000/- will be incurred. The machine is estimated to have a usefull life of 12 years with zero salvage value. Calculate ARR after charging Depreciation. 3. Net Present Value It is a DCF technique. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalent present values are found. NPV considers the value of all future cash flows discounted to the present. It is the difference between total present value of future cash inflows and outflows.
Accept/Reject criteria: The project should be accepted if the NPV is positive. (NPV > 0). Or the project with highest NPV. Merits and Demerits
Merits 1. It recognises time value of money 2. It considers the total benefits arising out of the project 3. It is the best method for selecting mutually exclusive projects
Demerits 4. It is difficult to calculate and understand 5. It needs the discount factors for calculation of present value 6. Not suitable for projects having different effective life. Formula NPV = Net present value of all cash inflows – Total cash outflow
OR
Z1 Z2 Z3 c NPV = 1+r (1+r)^2 (1+r)^3 …..
o Z1 – Cash flow in 1st yr
o Z2 – Cash flow in 2nd yr o Z3 – Cash flow in 3rd yr o R – discount rate o C – Cash outflow Problems
1. Nice Ltd wants to expand its business and so it is willing
to invest Rs 10,00,000. The investment is said to bring an inflow of Rs. 100,000 in first year, 250,000 in the second year, 350,000 in third year, 265,000 in fourth year and 415,000 in fifth year. Assuming the discount rate to be 9%. Calculate NPV. 2. A project requires an initial investment of Rs.225,000 and is expected to generate the following net cash inflows: Year 1: Rs.95,000 Year 2: Rs.80,000 Year 3: Rs.60,000 Year 4: Rs.55,000 Compute net present value of the project if the minimum desired rate of return is 12%. PV factor: .893 .797 .712 .636 3. Consider the following 2 projects and select the best project using NPV assuming a discounting rate of 10%:
particulars Project X Project Y
Initial Investment 20000 30000 Estimated Life 5 years 5 years Cash inflows: Year 1 5000 20000 Year 2 10000 10000 Year 3 10000 5000 Year 4 3000 3000 Year 5 2000 2000 Scrap Value 1000 2000 4. The following are the cash inflows and outflows of a certain project:
The salvage value at the end of 5 years is Rs.50000. Taking the discount rate at 10% Calculate NPV. 4. Internal Rate of return
IRR is the interest rate that equates the present value of expected future receipts to the cost of investment outlay. In other words it is the interest rate which makes the Net Present Value zero. It is also called time adjusted rate of return method or discounted rate of return method. IRR is found by trial and error method. First we compute the present value of cash inflows from an investment, using an arbitrarily selected interest rate. Then this is compared with the investment cost. If the present value is higher than the cost figure, we try a higher rate. Conversely if the present value is lower than the investment cost, a lower rate is selected. Merits and Demerits
Merits 1. It recognises time value of money 2. It takes into account the total cash inflow and outflow. 3. It does not use the concept of required rate of return Demerits 4. It involves complicated computational methods 5. It produces multiple rates which may be confusing NPV Vs. IRR Both these methods are closely related. Both are time adjusted method and in case of independent projects both methods will lead to same decision. However: o NPV is calculated in terms of currency while IRR is expressed in terms of percentage of return o NPV calculates additional wealth while IRR does not o IRR cannot be used for projects with changing cash flows ( initial outflow, then inflow, then again outflow) o IRR can lead to the belief that a project with shorter life and earlier cash inflows is preferable to larger projects that generates more cash. o Applying NPV using different discount rates will give different outcomes, but IRR always gives same recommendations. Problems
1. Tom is considering purchasing a new machine, but he is unsure if
it’s the best use of company funds right now. The new machine costs Rs.100,000/- and it will earn Rs.20,000, Rs.30,000, Rs.40,000 and Rs.40,000 in the coming years. Calculate the rate at which there will be no loss at all to the business even though there is no profit. Year PVF @ 8% PVF @10% PVF @ 11%
1 0.926 0.909 0.901
2 0.857 0.826 0.812
3 0.794 0.751 0.731
4 0.735 0.683 0.659
Formula for IRR
Positive npv IRR = Base Factor + x DP Difference in Positive and negative NPV
Base Factor - Positive discount rate
DP – Difference in percentage Problem Calculate the exact IRR for the following project: Project Cost – 22000 Cash inflows: Year 1 – 12000 Year 2 – 4000 Year 3 – 2000 Year 4 – 10000 You are given PF : 10% - 0.909, 0.826, 0.751, 0.683 12% - 0.893, 0.794, 0.712, 0.636 5. Profitability Index
PI is the ratio of present value of cash inflows at the required rate of return, to initial cash outflow of the investment. Also called Benefit-cost ratio.
PV of cash inflows PI = Initial cash outlay
Accept/Reject criteria: The proposal can be accepted when PI is more than or equal to One. Merits and Demerits
Merits 1. It recognises time value of money 2. It analyses all cash flows in the project life. 3. It ascertains the exact rate of return of the project Demerits 4. It is difficult to understand 5. It is difficult to calculate when two projects have different period of life. Capital Rationing
When multiple investment options are available but resources are limited, the firms may have to choose the most profitable investment.
Steps in Capital Rationing:
1. Ranking projects based on any capital budgeting techniques (NPV, IRR etc.) 2. Selecting the projects in descending order of profitability until the budget exhausts. Types of Capital Rationing
Soft Capital Rationing
it is when restriction is imposed by the management. (Internal factors)
Hard Capital Rationing
It is when capital infusion is limited by external factors Factors Leading to Capital Rationing
Internal Factors External Factors
• Restriction by Management • Imperfection of capital markets • Rigidity towards free flow of capital • Govt. Regulations • Fear about current commitments • Fund from current operations Advantages
It brings in a sense of budgeting in corporates
It prevents wastage of resources by not investing in each and every new project. Only projects with higher expected returns are selected thus yielding higher returns Since the company is selecting those projects where the expected return is high, thus ensures stability for tough times as well Disadvantages
It may lead to selection of small projects only.
Miscalculations may lead to selection of less profitable projects Introspective due to subjective risk and discounting factor. 1. A firm has only Rs.10 lakhs to invest in various funds. The available projects are given below:-
Advise the order in which the proposals should be accepted.
2. S Ltd has Rs,10,00,000/- allocated for capital budgeting purpose. The following proposals are ascertained with their profitability index and NPV. Assume that the projects are indivisible and there are no alternative use of the money allocated. Advise the company regarding selection of projects.
Project Cost PI NPV
1 300000 1.22 66000 2 150000 0.95 (-)7500 3 350000 1.20 70000 4 450000 1.18 81000 5 200000 1.20 40000 6 400000 1.05 20000 3. Equipment A has a cost of Rs.75000 and net cash flow of Rs.20000 per year for a period of 6 years. A substitute Equipment B would cost Rs.50000 and generate net cash flow of Rs.14000 per year for 6 years. The required rate is 11%. Calculate NPV and IRR and suggest which equipment should be accepted and why. PVAF @11% - 4.231 4. ABC ltd is considering the following projects. Using discounted pay back method suggest which is a better project.
Year Cash inflows of X Cash inflows of Y PVF @ 10%
1 5000 1000 0.909
2 4000 2000 0.826 3 3000 3000 0.751 4 1000 4000 0.683 5 -- 5000 0.621 6 -- 6000 0.564 CO 10000 8000 5. ULC co. is planning to invest in a new project. The expected cash flow and its probability is given below. Calculate NPV @ 12%.
Year Cash Flow Probability PVF @12%
0 100000 1 1 40000 0.40 20000 0.20 0.8929 30000 0.40 2 80000 0.25 70000 0.35 0.7972 50000 0.40 3 52000 0.30 47000 0.45 0.7118 64000 0.20 4 73000 0.30 66000 0.40 0.6355 59000 0.30 6. Excel ltd is considering expanding their business by manufacturing and selling keyboards with an investment of Rs.400000. The project is expected to produce 10000 keyboards per year at an operating cost of Rs.20. per unit for the next 5 years. They are expecting to sell the keyboard @ Rs.40. Depreciation of Rs.80000 has to be charged every year and tax @ 34% has to be deducted. The expenses are to be capitalised @10% and revenues @ 5%. Calculate the NPV for the project @ 12% cost of capital.
FV @ 5% 1.0500 1.10250 1.15763 1.21551 1.27628
FV @ 10% 1.1000 1.2100 1.3310 1.4641 1.61051 PV @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674 Calculation of Cash Inflow Particulars Year 1 Year 2 Year 3 Year 4 Year 5
