:- Ved Prakash panda

Nature of Investment Decisions

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.

The firm’s investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets.

Sale of a division or business is also an investment decision.

Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm’s expenditures and benefits, and therefore, they should also be evaluated as investment decisions.

Meaning of Capital BudgetingIt is the process of evaluating and selecting long term investment decision in capital expenditure that are consistent with the goal of share holders.

Capital expenditure

It is an out lay of funds that is expected to produce benefit over a period of time, that is more than one year.

Why Capital Budgeting?

Introduction of New Product. Expansion of existing business. Replacing and Modernization of

Process. Choice between alternative project or

proposal.

Decisions in Capital Budgeting

Accept/Reject Decisions or mutually Exclusive Decisions

Capital Rationing Decisions Contingent Investment Decisions Independent Investment Decisions Replacement Decision

Features of Capital Budgeting It involves the exchange of current funds

for the benefit to be achieved in future. Future benefits are expected to be

realized over a series of years. The funds are invested in non flexible

and long term activities. It involves generally huge funds They are irreversible in nature.

Need and Importance of Capital Budgeting Large investment Long term commitment of funds Irreversible in nature Long term effect on profitability Difficulties on investment decisions

Capital Budgeting Process

Identification of investment proposals Screening the proposals Evaluation of various proposals Fixing priorities Final approval and preparation of

capital expenditure budget Implementation of proposal Performance review

Investment Evaluation Criteria Three steps are involved in the

evaluation of an investment: Estimation of cash flows Estimation of the required rate of return Application of a decision rule for making

the choice

Investment Decision Rule

It should maximise the shareholders’ wealth.

It should consider all cash flows and Time Value of Money to determine the true profitability of the project.

It should provide for an objective and unambiguous way of separating good projects from bad projects.

It should help ranking of projects according to their true profitability.

Methods of Capital Budgeting   Non-discounted Cash Flow Criteria

  Payback Period (PB)   Accounting Rate of Return (ARR)

Discounted Cash Flow (DCF) Criteria   Net Present Value (NPV)   Internal Rate of Return (IRR)   Profitability Index (PI)

Payback Period Method Payback is the number of years

required to recover the original cash outlay invested in a project.

If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. That is:

0Initial InvestmentPayback = = Annual Cash Inflow

CC

Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is:

Solution

Pay back period =50000/12500= 4 years

In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay.

Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the project’s payback?

3 years + 12 × (1,000/3,000) months3 years + 4 months

Example

A project cost rs 20 lakh and yields annually a profit of rs.3,00,000 after depreciation at 12.5% but before tax at 50%.Calculate pay back period and suggest whether it should be accepted or rejected on 6 year standard payback period.

Solution

Calculation of cash flows after tax: Profit after depreciation before tax 300000 Less: Tax at 50% 150000 Earning after tax (EAT) 150000 Add depreciation 250000 Cash flow after tax 400000 Note: Depreciation=2000000x 12.5%=250000 Pay back period=2000000/400000= 5years Decision: Project should be accepted since calculated pay back period is less

than the standard pay back period .

Acceptance Rule

The project would be accepted if its payback period is less than the maximum or standard payback period set by management.

As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.

Accounting Rate of Return Method

The accounting rate of return is the ratio of the average after-tax profit divided by the net investment.

Average rate of return =(Average annual profit/Net investment in the project) x 100

Example

A project requires an investment of Rs 5,00,000 and has a scrap value of Rs 20,000 after 5 years . It is expected to yield profit of Rs 40000,60000, 70000 ,50000 ,and 20000 during the 5 years. Calculate the average rate of return on the investment.

Total profit=40000+60000+70000 +50000 +20000 =240000

Average profit =240000/5 =48000 Net investment in the project =500000 –

20000 =480000 ARR=(48000/480000) x 100 =10%

Acceptance Rule

This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.

This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.

Net Present Value Method Cash flows of the investment project should

be forecasted based on realistic assumptions.

Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the project’s opportunity cost of capital.

The project should be accepted if NPV is positive (i.e., NPV > 0).

Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The formula for the net present value can be written as follows:

31 202 3

01

NPV(1 ) (1 ) (1 ) (1 )

NPV(1 )

nn

nt

tt

C CC C Ck k k k

CC

k

Where C1, C2 ….Cn → Cash inflows in future course of action.

K → Discount rate Co → Cash outflow

Calculating Net Present Value Assume that Project X costs Rs 2,500

now and is expected to generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 to 5. The opportunity cost of the capital may be assumed to be 10 per cent.

Acceptance Rule Accept the project when NPV is positive

NPV > 0 Reject the project when NPV is negative

NPV < 0 May accept or reject the project when

NPV is zero NPV = 0 The NPV method can be used to select

between mutually exclusive projects; the one with the higher NPV should be selected.

Evaluation of the NPV Method NPV is most acceptable investment

rule for the following reasons: Time value into consideration Measures true profitability Increase shareholder’s value

Limitations: Difficulties in cash flow estimation Difficulties in determining Discount

rate

Internal Rate of Return Method

The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received in future period. This also implies that the rate of return is the discount rate which makes NPV = 0.

Where C1, C2 ….Cn → Cash inflows in future course of action.

r → Discount rate or IRR Co → Cash outflow

Calculation of IRR Uneven Cash Flows: Calculating IRR by Trial

and Error The approach is to select any discount rate

to compute the present value of cash inflows. If the calculated present value of the expected cash inflow is lower than the present value of cash outflows, a lower rate should be tried. On the other hand, a higher value should be tried if the present value of inflows is higher than the present value of outflows. This process will be repeated unless the net present value becomes zero.

Example

Ex-A project cost rs 16000 and is expected togenerate cash inflows of Rs 8000,Rs7000

Rs 6000, at the end of each year for next 3

years .Find out the IRR by using trial and error method.

IRR is the rate at which project will have a zero NPV.By taking 20% discount rate

NPV=Rs8000(PVF1,0.20) + Rs 7000(PVF 2,0.20) + RS 6000(PVF3,0.20) –Rs 16000

=(8000x0.833)+(7000 x 0.694) +(6000 x 0.579)-16000

=Rs14996 - 16000= - 1004

By taking 16% discount rate NPV=Rs8000(PVF1,0.16) + Rs 7000(PVF 2,0.16)

+ RS 6000(PVF3,0.16) –Rs 16000 =(8000x0.862)+(7000 x 0.743) +(6000 x

0.641)-16000 =Rs15943- 16000=-57

By taking 15% discount rate NPV=Rs8000(PVF1,0.15) + Rs 7000(PVF 2,0.15)

+ RS 6000(PVF3,0.16) –Rs 16000 =(8000x0.870)+(7000 x 0.756) +(6000 x

0.658)-16000 =Rs16200 - 16000= 200

The true rate of return should lie between 15 to16 % .We can find out a close approximation of the rate of return by the method of linear interpolation as follows:

PV required 16000 200 PV at lower rate 16200 257 PV at higher rate 15943

r =15%+(16%-15%)200/257 =15% +0.80%=15.8%

Acceptance Rule

Accept the project when r > k. Reject the project when r < k. May accept the project when r = k. r-IRR k-Cost of capital

Approximation of IRR

Step 1 : Find out the average annual cash inflow to get a notional annuity .

(8000+7000+6000)/3=7000 Step 2 :Divide the initial outlay with the average cash inflows 16000 /7000 =2.29 Step 3 :Now search for a value nearest to the value obtained in

step 2above in the PVIFA table For the corresponding value of n .Here it is 2.29 in 3 years row of the PVIFA table .The closet figure given in the table are 15%( and at 16% .This means that the IRR of the proposal is expected to lie between 15% and 16%.

Evaluation of IRR Method

IRR method has following merits: Time value Profitability measure shareholder value

IRR method may suffer from: Multiple IRR

Profitability Index

Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

Profitability Index The initial cash outlay of a project is Rs

100,000 and it can generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. Assume a 10 per cent rate of discount. The PI of cash inflows at 10 per cent discount rate is:

.1235.11,00,000 Rs1,12,350 RsPI

12,350 Rs=100,000 Rs112,350 RsNPV0.6820,000 Rs+0.75150,000 Rs+0.82630,000 Rs+0.90940,000 Rs=

)20,000(PVF Rs+)50,000(PVF Rs+)30,000(PVF Rs+)40,000(PVF RsPV 0.10 4,0.10 3,0.10 2,0.10 1,

Acceptance Rule

The following are the PI acceptance rules: Accept the project when PI > 1 Reject the project when PI < 1 May accept the project when PI = 1

The project with positive NPV will have PI greater than one. PI less than means that the project’s NPV is negative.

Evaluation of PI Method It recognises the time value of money. It is consistent with the shareholder value

maximisation principle. A project with PI greater than one will have positive NPV and if accepted, it will increase shareholders’ wealth.

In the PI method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a project’s profitability.

Like NPV method, PI criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.