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• The firm’s decision to invest its current funds most efficiently

in the long term assets in anticipation of an expected flow of

benefits over a series of years.

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.

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.

2

The exchange of current funds for future benefits.

The funds are invested in long-term assets.

The future benefits will occur to the firm over a

series of years.

3

Growth: influences rate and direction of growth.

Risk: Affects risk (fluctuations in earnings)

Funding: commitment of large amount of funds

Irreversibility

Complexity

Long term effect on profitability.

4

One classification is as follows:

◦ Expansion of existing business – revenue expansion investments

◦ Expansion of new business

◦ Replacement and modernisation – cost reduction investments

Yet another useful way to classify investments is as

follows:

◦ Mutually exclusive investments

◦ Independent investments

◦ Contingent investments (dependent)

◦ Capital rationing decisions(combination of proposals that

will yield max profits by ranking)

5

Three steps are involved in the evaluation of an

investment:

◦ Estimation of cash flows

◦ Estimation of the required rate of return (the

opportunity cost of capital)

◦ Application of a decision rule for making the choice

6

It should maximise the shareholders’ wealth.

It should consider all cash flows 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.

It should recognise the fact that bigger cash flows are preferable to

smaller ones and early cash flows are preferable to later ones.

It should help to choose among mutually exclusive projects that project

which maximises the shareholders’ wealth.

It should be a criterion which is applicable to any conceivable investment

project.

7

1. Non-discounted Cash Flow Criteria

◦ Payback Period (PB)

◦ Discounted Payback Period (DPB)

◦ Accounting Rate of Return (ARR)

2. Discounted Cash Flow (DCF) Criteria

◦ Net Present Value (NPV)

◦ Internal Rate of Return (IRR)

◦ Profitability Index (PI)

8

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:

Initial Investment C

Payback = = 0

Annual Cash Inflow C

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:

Rs 50,000

PB = = 4 years

Rs 12,000

12,500

9

Unequal cash flows: 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) months

3 years + 4 months

10

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.

11

Certain virtues:

◦ Simplicity

◦ Cost effective

◦ Short-term effects (reduces the risk of obsolescence)

◦ Risk shield

◦ Liquidity (recovery of investments)

Serious limitations:

◦ Cash flows after payback

◦ Cash flow patterns (time value of money)

◦ Cost of capital ignored

◦ Administrative difficulties (subjective)

◦ Doesn’t consider full project life. Inconsistent with

shareholder value

12

Post back period method

Post pay back profitability Index = post pay back

profits/Investment

Payback reciprocal = Annual cash flows/total

investments

Discounted payback method

◦ The present values of all inflows are cumulated in order of

time.

◦ The time period at which the cumulated PV of cash inflows

equals the PV of cash outflows is called discounted pay back

period.

13

The discounted payback period is the number of periods

taken in recovering the investment outlay on the present

value basis.

The discounted payback period still fails to consider the cash

flows occurring after the payback period.

3 DISCOUNTED PAYBACK ILLUSTRATED

Cash Flows

(Rs) Simple Discounted NPV at

C0 C1 C2 C3 C4 PB PB 10%

PVF .909 .826 .751 .683

P -4,000 3,000 1,000 1,000 1,000 2 yrs – –

PV of cash flows -4,000 2,727 826 751 683 2.6 yrs 987

Q -4,000 0 4,000 1,000 2,000 2 yrs – –

PV of cash flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421

14

The accounting rate of return is the ratio of the

average after-tax profit divided by the average

investment.

Average income

ARR =

Average investment

earnings after taxes by the original cost of the project

instead of the average cost.

16

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.

17

A firm is considering purchase of a machine. Two machines are available with

cost of 60000 Rs.net profits before tax and after depreciation are given for 5 years

Assuming tax rate of 50%. Recommend the investment decision on ARR.

YEAR Machine A Machine B

1 15000 5000

2 20000 15000

3 25000 20000

4 15000 30000

5 10000 20000

Total 85000 90000

18

YEAR Machine After tax Machine

A profits B

1 15000 7500 5000 2500

2 20000 10000 15000 7500

3 25000 12500 20000 10000

4 15000 7500 30000 15000

5 10000 5000 20000 10000

Total 85000 42500 90000 45000

19

The ARR method may claim some merits

◦ Simplicity

◦ Accounting data

◦ Accounting profitability (entire stream of income)

Serious shortcoming

◦ Cash flows ignored

◦ Time value ignored

◦ Arbitrary cut-off

20

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.

Present value of cash flows should be calculated using

the opportunity cost of capital as the discount rate.

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

NPV > 0).

21

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:

C1 C2 C3 Cn

NPV L n

C0

(1 k ) (1 k ) (1 k ) (1 k )

2 3

n

Ct

NPV C0

t 1 (1 k )

t

22

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

through 5. The opportunity cost of the capital may

be assumed to be 10 per cent.

NPV 2

3

4

5

Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF1, 0.10 ) + Rs 800(PVF2, 0.10 ) + Rs 700(PVF3, 0.10 )

+ Rs 600(PVF4, 0.10 ) + Rs 500(PVF5, 0.10 )] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225

23

Accept the project when NPV is positive

NPV > 0

Reject the project when NPV is negative

NPV < 0

May accept 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.

24

NPV is most acceptable investment rule for the

following reasons:

◦ Time value

◦ Measure of true profitability

◦ Value-additivity

◦ Shareholder value

Limitations:

◦ Involved cash flow estimation

◦ Discount rate difficult to determine

◦ Mutually exclusive projects having unequal lives

◦ Ranking of projects depends upon discount rate

25

The internal rate of return (IRR) is the rate that

equates the investment outlay with the present

value of cash inflows. This also implies that the rate

of return is the discount rate which makes NPV = 0.

C1 C2 C3 Cn

C0 L

(1 r ) (1 r ) 2

(1 r ) 3

(1 r ) n

n

Ct

C0

t 1 (1 r )t

n

Ct

t 1 (1 r ) t

C0 0

26

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.

27

Level Cash Flows

◦ Let us assume that an investment would cost Rs

20,000 and provide annual cash inflow of Rs 5,430

for 6 years.

◦ The IRR of the investment can be found out as

follows:

Rs 20,000 Rs 5,430(PVAF6, r )

Rs 20,000

PVAF6, r 3.683

Rs 5,430

28

A B C D E F G H

1 N P V P r o file

D is c o u n t

2 C a s h F lo w r a te N PV

3 -2 0 0 0 0 0% 1 2 ,5 8 0

IR

4 5430 5% 7 ,5 6 1

R

5 5430 10% 3 ,6 4 9

7 5430 16% 0

8 5430 20% ( 1 ,9 4 2 )

9 5430 25% ( 3 ,9 7 4 )

F ig u r e 8 .1 N P V P r o f ile

29

Accept the project when r > k.

Reject the project when r < k.

May accept the project when r = k.

In case of independent projects, IRR and NPV rules

will give the same results if the firm has no shortage

of funds.

30

IRR method has following merits:

◦ Time value

◦ Profitability measure (considers entire income stream)

◦ Shareholder value (If IRR > opportunity cost of capital)

IRR method may suffer from:

◦ Multiple rates

◦ Mutually exclusive projects

◦ Value additivity doesnot hold.

31

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.

32

The initial cash outlay of a project is Rs 100,000 and it

can generate cash inflow of Rs 40,000, Rs 30,000,

Rs50,000 and Rs 20,000 in year 1 through 4. Assume a

10 per cent rate of discount. The PV of cash inflows at

10 per cent discount rate is:

= Rs 40,000 0.909 + Rs 30,000 0.826 + Rs 50,000 0.751 + Rs 20,000 0.68

NPV Rs 112,350 Rs 100,000 = Rs 12,350

Rs 1,12,350

PI 1.1235.

Rs 1,00,000

33

The following are the PI acceptance rules:

◦ Accept the project when PI is greater than one. PI > 1

◦ Reject the project when PI is less than one. PI < 1

◦ May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI greater

than one. PI less than means that the project’s NPV

is negative.

34

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.

35

A conventional investment has cash flows the pattern

of an initial cash outlay followed by cash inflows.

Conventional projects have only one change in the sign

of cash flows; for example, the initial outflow followed

by inflows, i.e., – + + +.

A non-conventional investment, on the other hand, has

cash outflows mingled with cash inflows throughout

the life of the project. Non-conventional investments

have more than one change in the signs of cash flows;

for example, – + + + – ++ – +.

36

Conventional Independent Projects:

In case of conventional investments, which are

economically independent of each other, NPV and

IRR methods result in same accept-or-reject decision

if the firm is not constrained for funds in accepting

all profitable projects.

37

Investment projects are said to be mutually exclusive when

only one investment could be accepted and others would

have to be excluded.

Two independent projects may also be mutually exclusive if

a financial constraint is imposed.

The NPV and IRR rules give conflicting ranking to the

projects under the following conditions:

◦ The cash flow pattern of the projects may differ. That is, the cash

flows of one project may increase over time, while those of others

may decrease or vice-versa.

◦ The cash outlays of the projects may differ.

◦ The projects may have different expected lives.

40

Cash Flows (Rs) NPV

Project C0 C1 C2 C3 at 9% IRR

M – 1,680 1,400 700 140 301 23%

N – 1,680 140 840 1,510 321 17%

41

Cash Flow (Rs) NPV

Project C0 C1 at 10% IRR

A -1,000 1,500 364 50%

B -100,000 120,000 9,080 20%

42

Cash Flows (Rs)

Project C0 C1 C2 C3 C4 C5 NPV at 10% IRR

Y – 10,000 0 0 0 0 20,120 2,495 15%

43

The IRR method is assumed to imply that the cash

flows generated by the project can be reinvested at its

internal rate of return, whereas the NPV method is

thought to assume that the cash flows are reinvested

at the opportunity cost of capital.

44

There is no problem in using NPV method when the

opportunity cost of capital varies over time.

If the opportunity cost of capital varies over time,

the use of the IRR rule creates problems, as there is

not a unique benchmark opportunity cost of capital

to compare with IRR.

46

Risk Adjusted Discount rate.

Certainty equivalent method

Sensitivity technique

Probability technique

Standard Deviation

48

Estimate the certainty equivalent cash flow in each

Year t, based on the expected cash flow and its

riskiness.

Given these certainty equivalents, discount by the risk-

free rate to obtain the project’s NPV.1

49

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