INVESTMENT DECISION

Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices

1. Master of Business Administration BUS 2C 11 Financial Management Prepared By: Mohammed Jasir PV Asst. Professor MIIMS Contact: 9605 693 266

2. Module 2 Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices.

3. What is an Investment? In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth. In finance , an investment is a monetary asset purchased with the idea that the asset will provide income in the future or will later be sold at a higher price for a profit.

4. Investment analysis , defined as the process of evaluating an investment  for profitability and risk , ultimately has the purpose of measuring how the given investment  is a good fit for a portfolio. Investment Analysis

5. Capital Budgeting Capital budgeting is defined “as the firm’s formal process for the acquisition and investment of capital . It involves firm’s decisions to invest its current funds for addition, disposition, modification and replacement of fixed assets”. Investment in fixed assets Benefits derived in future which spreads over no: of years

6. What is Capital Budgeting ? Capital budgeting is the planning process used to determine whether an organization’s long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm’s capitalization structure.

7. Definition- Capital Budgeting “Capital budgeting is long term planning for making and financing proposed capital outlays ” - Charles T Horngreen .

8. Features Of Capital Budgeting Potentially large anticipated benefits A relatively high degree of risk Relatively long time period between the initial outlay and the anticipated return. ( Long term return/ Benefits) They are irreversible in nature

9. Need for Capital Budgeting Large investments Irreversible nature Difficulties of investment decision Long term effect on profitability To avoid over investment and under investments .

10. Methods of Capital Budgeting Traditional Methods Discounted Cash Flow Methods/ Modern Method Payback Period Accounting Rate Of Return Method Net Present Value Method Profitability Index Method Internal Rate Of Return

11. Methods of capital budgeting Traditional methods Payback period Accounting rate of return method Discounted cash flow methods/ Modern Method Net present value method Profitability index method Internal rate of return

12. Pay Back Period Method It refers to the period in which the project will generate the necessary cash to recover the initial investment. Also called “Pay Out Or Pay Off Period Method” It does not take the effect of time value of money . The selection of the project is based on the earning capacity of a project.

13. It emphasizes more on annual cash inflows, economic life of the project and original investment . It involves simple calculation, selection or rejection of the project can be made easily, results obtained is more reliable, best method for evaluating high risk projects. Under this method projects are ranked on the basis of length of payback period

14. Pay back period calculation Two different situations Equal cash inflow / Even cash inflow Unequal cash inflow / Uneven cash inflow

15. Initial Investment Annual Cash Inflow Note: Annual cash inflow is the annual earnings (Profit before depreciation and after tax) 1. Equal Cash Inflow / Even Cash Inflow Pay Back Period =

16. 2. Un Even Cash Inflow B Payback Period = 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

17. Example A project cost Rs.50,000 and yields an annual inflow of Rs.10,000. Calculate its PBP? Initial Investment Annual Cash Inflow PBP= 50,000 10,000 PBP= = 5 Years.

18. Example Un even cash inflows Determine PBP for a project which requires a cash outlay of Rs.12,000 and generates cash inflows of Rs. 2000, Rs.4000, Rs.4000 and Rs.5000 in the first, Second, third, fourth years respectively.

19. Solution – Step 1 Year Annual Cash Inflow Cumulated Cash Inflows 1 2000 2000 2 4000 6000 3 4000 10,000 4 5000 15,000

20. Upto 3 rd year the initial investment of Rs.12,000 is not recovered, only 10,000 is recovered. But in the fourth year its Rs.15,000. ie Rs.3000 more than the cost of project. We have to find Time to recover 12000 3 rd Year = 10000 (Required 2000 more ) 2000 5000 3 + B C E + Payback Period = = 3.4 Years

21. Problem - 1 Capital cost of three models of machine is Rs . 90,000 each and the estimated life is 4 years. Annual returns of each machine are given below. Decide the model of machine to be chosen on the basis of Pay back period. Year Model A Model B Model C 1 20,000 30,000 35,000 2 30,000 40,000 35,000 3 50,000 50,000 35,000 4 50,000 20,000 35,000

22. Problem - 2 Initial outlay for each of the following projects is Rs . 15,000 & standard payback is 3 years. Evaluate the projects and rank them based on payback period Year Project A Project B Project C Project D 1 5,000 3,500 2,500 8,000 2 5,000 4,000 2,500 6,000 3 5,000 4,500 2,500 6,000 4 5,000 6,000 2,500 5,000 5 5,000 6,000 2,500 5,000

23. Advantages of PBP Method Easy to understand and simple to calculate. Finding out the projects which generate the substantial cash inflows in earlier years . It is helpful in weeding out the risky projects . This method finding out the project that makes early realization of funds, this helps to enhance the liquidity. This method helps to reduce cost of calculation .

24. Disadvantages of PBP Method   Ignores all cash inflows after the Payback period. Does not considering the total benefit from the project. It ignores the time value of money . ( Cash inflows occurring different time period treat as equal.) It only find the recovery of investment, not the profitability . It ignores the scrap or salvage value of project after life

25. 2. Average Rate of Return Method (ARR) Also called Rate of return method or Accounting rate of return method Introduced to overcome the disadvantage of pay back period. It considers the all year earnings of the project. It is based on conventional accounting concepts . The rate of return is expressed as percentage of the earnings of the investment in a particular project. The profits under this method is calculated as profit after depreciation and tax of the entire life of the project .

26. This method of ARR is not commonly accepted in assessing the profitability of capital expenditure. Because the method consider the heavy cash inflow during the project period as the earnings with be averaged. The cash flow advantage derived by adopting different kinds of depreciation is also not considered in this method.

27. Calculations Average income after tax and depreciation Average investment ARR = x 100 Average Income = Total Return Expected Life or Life time Average Investment = Original investment 2

28. + Additional W/C + SV If scrap value or additional working capital is given Average Investment = Original investment - SV 2

29. Calculate ARR Project A Project B Investment 4,000 5,000 Expected Life 4 Years 4 Years Income shown after Depreciation and Tax Year Project A Project B 1 2000 3000 2 1500 3000 3 1500 2000 4 1000 1000 Total Income 6,000 9,000

30. Average income after tax and depreciation Average investment ARR = x 100 Project A Avg. Income = Total Return Expected Life 6000 4 = 1500 Avg. Investment = Original investment 2 4 000 2 = 2000 1500 2000 ARR = x 100 = 75%

31. Average income after tax and depreciation Average investment ARR = x 100 Project B Avg. Income = Total Return Expected Life 9 ,000 4 = 2,250 Avg. Investment = Original investment 2 5,000 2 = 2500 2,250 2,500 ARR = x 100 = 90%

32. The ARR of Project B (90%) is higher than Project A (75%) and hence Project B may be chosen

33. Calculate ARR Project A Project B Investment 50,000 50,000 Expected Life 5 Years 5 Years Scrap Value 7000 3000 Year Project A Project B 1 6,000 7,000 2 9,000 8,000 3 10,000 10,000 4 12,000 12,000 5 14,000 16,000 Total Income 51,000 53,000

34. Advantages Of ARR Method Simple to calculate Easy to understand based on accounting information readily available It gives importance to profitability ARR is based on accounting profit It consider all cash inflows of the project. It can be used for rank and compare two projects .

35. Disadvantages of ARR Method Ignores the time value of money Cash inflows of all years are given equal important. It uses accounting information rather than cash inflow. This method is not suitable for comparing projects with different duration or life

36. MODERN METHODS / DISCOUNTED CASH FLOW METHOD Net present value method Profitability index method Internal rate of return

37. Net present value method It recognizes the impact of time value of money. It is considered as the best method of evaluating the capital investment proposal. It is widely used in practice. The cash inflow to be received at different period of time will be discounted at a particular discount rate. The present values of the cash inflow are compared with the original investment. The difference between the two will be used for accept or reject criteria.

38. Cash Outflow/ Investment Future Cash Inflow/ Return Present Value

39. NPV= Discounted cash inflow - Discounted cash outflow Note1 : If only in the beginning initial investment is made, then the discounted cash outflow will be the same i.e., initial investment Note2 : Cash inflow means profit before depreciation and after tax

40. Acceptance Role If NPV is Positive value Zero Negative Value

41. Steps Involved Determine the appropriate Discount Rate Compute the present value of Total Investment ( Discounted cash outflow) Compute the present value of cash inflows ( Profit Before Depreciation and After Tax) x ( Discount Rate) 4. Minus the Value of Investment from Value of Inflow ( Discounted cash inflow- Discounted cash outflow) 5. If the NPV – ve Reject it, If NPV is + ve Accept it 6. Rank the projects and maximum positive NPV Should be chosen

42. Equation C1,C2… Cn represents net cash inflow for year 1,2….n K is the opportunity cost of capital C0 is the initial investment n is the expected life of investment

43. Example.. Calculate NPV of the two projects and suggest. Assuming Discount rate is 10 % Machine A Machine B Investment 40,000 50,000 Yearly Returns 1 12,000 25,000 2 18,000 18,000 3 7,000 12,000 4 5,000 4,000 5 4,000 4,000

44. Machine - A 12000 (1+0.1) 18000 (1+0.1) 2 + 7000 (1+0.1) 3 + 5000 (1+0.1) 4 + 4000 (1+0.1) 5 + - 40,000 NPV = NPV = 10,909 + 14,876 + 5,259 + 3415 + 2484 - 40,000 36,943 - 40,000 = - 3,057 NPV =

45. Machine - B 25000 (1+0.1) 18000 (1+0.1) 2 + 12000 (1+0.1) 3 + 4000 (1+0.1) 4 + 4000 (1+0.1) 5 + - 50,000 NPV = NPV = 22,727 + 14,876 + 9016 + 2732 + 2484 - 50,000 51835 - 50,000 = 1835 NPV =

46. NPV Machine A = - 3057 Machine B = 1835 Machine B is the best investment opportunity

47. A company is considering the purchase of new machine. Two alternative models are available. Each year cash flow is given. If the total investment of Model A is Rs . 70,000 and Model B Rs : 60,000, Which alternative company will select on the basis of NPV of two models? Year Model A Model B 1 8000 24000 2 24000 32000 3 32000 40000 4 48000 24000 5 32000 16000

48. Advantages of NPV Method It consider the time value of money Converting future cash inflows to discounted present value. Consider entire life cash inflows Objective of maximizing owner’s wealth Can be estimated and compared to take a decision. It is based on profitability and liquidity.

49. Disadvantages of NPV Method Computation is difficult It is not easy to appropriate and determine discount rate. Difficulty to estimate cash inflows due to uncertainty

50. The profitability index is an index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio . Profitability index  (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is the ratio of payoff to investment of a proposed project . 2. Profitability Index Method/ Benefit Cost Ratio

51. Present value of cash inflow Present value of cash outflow PI is equal to or more than one, the proposal can be accepted Calculation PI = PI = 1 Accept PI = > 1 Accept PI = <1 Reject

52. Calculate PI of each project and suggest the best one. Estimated discount rate is 12% Project Co C1 C2 C3 A - 4,000 4,000 2,000 B - 4,000 2,000 2,000 C - 5,000 3,000 2,000 2,000 D - 5,000 2,000 3,000 2,000

53. Advantages Of Profitability Index (PI) PI considers the time value of money. PI considers analysis all cash flows of entire life. PI makes the right in the case of different amount of cash outlay of different project. PI ascertains the exact rate of return of the project

54. Disadvantages Of Profitability Index(PI) It is difficult to understand interest rate or discount rate. It is difficult to calculate if two projects having different period of life .

55. Internal rate of return  ( IRR ) is a metric used in capital budgeting measuring the profitability of potential investments .   Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero . 3. Internal Rate Of Return (IRR)

56. Discounted Cash inflow Discounted Cash outflow Discount Rate ? IRR is that rate at which the sum of discounted cash inflow equals the sum of discounted cash outflows

57. L = Lower discount rate P1 = Present Value at lower (%) rate P2 = Present Value at higher (%) rate Q = Actual investment D = Difference in rate (%) P1 – Q IRR = L+ x D P1 - P2

58. Calculate IRR of each and suggest the best one Investment 10000 10000 10000 Year Model A Model B Model C 1 2000 3000 2000 2 3000 3000 4000 3 3000 3000 4000 4 4000 2000 5000

59. Advantages of IRR Use of time value of money. All cash flows are equally important  Uniform ranking  Maximum profitability of shareholder Not need to calculate cost of capital

60. Disadvantages of IRR To understand IRR is difficult  Not Helpful for comparing two different investment Unrealistic Assumption

61. Methods of Capital Budgeting Traditional Methods Discounted Cash Flow Methods/ Modern Method Payback Period Accounting Rate Of Return Method Net Present Value Method Profitability Index Method Internal Rate Of Return

62. Discounted Payback Period Payback period by considering time value of money. A project’s discounted payback period is the number of years it takes for the net cash flows’ present values to pay back the net investment. Shorter paybacks are better than longer paybacks.

63. Year Cash Flow 1 70,000 2 70,000 3 70,000 4 70,000 5 70,000 Example. Investment 2,00,000 Opportunity cost : 10%

64. More to Capital Budgeting

65. Earning before depreciation, interest and taxes (EBDIT) XXXXX Depreciation xxxx Earning before interest and tax (EBIT) xxxxx Tax (….%) xxx Earning before interest and after tax (EBIT(1-T) XXXX

66. Capital Rationing

67. Capital Rationing Related to Capital Budgeting Related to Investment When More investment options are available But limited resources are available (Shortage of Finance) Need to choose the best options Helps to prioritise the options based on profitability Helping to select the appropriate projects

68. Capital Rationing Capital rationing situation refers to the choice of investment proposal under financial constraints . Capital rationing is applied when a firm has a number of acceptable investment proposal but the resource available is restricted to certain extend

69. Capital Rationing providing answers to The required fund? Available Fund? How to assign the available fund?

70. Steps in Capital Rationing Ranking projects (By use of any profitability measures) (NPV,IRR,PI) Selecting projects in descanting order of profitability until the budget exhausted

71. Factors Leading to Capital Rationing Internal Factors Restriction by management Top mgt. Philosophy towards capital spending Fear about current commitments Fund from current operations Feasibility of acquiring new fund External Factors External Factors Imperfection of capital market Govt. Regulations

72. 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 sources (External Factors )

73. Advantages of capital rationing Budget No wastage Fewer projects Higher returns More stability

74. 1. Budget It introduces a sense of strict budgeting of corporate resources 2. No wastage It prevents wastage of resources by not investing in each and every new project available for investment 3. Fewer projects It ensures that less number of projects are selected by imposing capital restrictions

75. 4 . Higher returns Invest only in projects where the expected return is high, thus eliminating projects with lower returns in capital 5. More stability Since the company is selecting those projects where the expected return is high, thus ensures stability for tough times as well

76. The required initial investment and Present value of inflows in respect of 5 projects (A,B,C,D, and E) is given above. T he total funds available is Rs 13,00,000. Determine the optimal combination of projects under profitability index Project Required initial investment Present value of inflows A 2,00,000 2,20,000 B 6,00,000 7,00,000 C 1,00,000 92,000 D 4,00,000 4,90,000 E 2,00,000 2,10,000

77. Project Required initial investment Present value of inflows Profitability Index Ranking Apportioning available capital D 4,00,000 4,90,000 1.225 1 4,00,000 B 6,00,000 7,00,000 1.16667 2 6,00,000 A 2,00,000 2,20,000 1.1 3 2,00,000 E 2,00,000 2,10,000 1.05 4 1/2th of Project E C 1,00,000 92,000 0.92 5