INVESTMENT DECISION AND RELATED PROBLEM

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

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. 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

4. 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

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

6. 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

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

8. 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

9. 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

10. 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.

11. 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

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

13. 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 =

14. 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

15. 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.

16. 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.

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

18. 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

19. 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

20. 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

21. 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 .

22. 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 It fails to consider the pattern of cash inflows

23. 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 earnings of the project of the economic life . This method 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 .

24. 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.

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

26. + Additional W/C + SV If scrap value is given Average Investment = Original investment - SV 2

27. Calculate ARR Project A Project B Investment 4,000 5,000 Expected Life 4 Years 5 Years Income shown after Depreciation and Tax Year Project A Project B 1 2000 3000 2 1500 3000 3 1500 2000 4 1000 1000 5 ------ 1000 Total Income 6000 10,000

28. 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%

29. Average income after tax and depreciation Average investment ARR = x 100 Project B Avg. Income = Total Return Expected Life 10,000 5 = 2,000 Avg. Investment = Original investment 2 5,000 2 = 2500 2,000 2,500 ARR = x 100 = 80%

30. The ARR of Project B (80%) is higher than Project A (75%) and hence Project B may be chosen

31. 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 5000 7000 2 7500 9000 3 9000 10000 4 9000 12000 5 10000 16000 Total Income 40500 54000

32. 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 .

33. 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. It consider the rate of return. This method is not suitable for comparing projects with different duration or life

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

35. 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.

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

37. 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

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

39. 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

40. Example .. Calculate NPV of the two projects and suggest. Assuming Discount rate is 10 % 40,000

41. Project A NPV = Discount Cash Inflow – Discount Cash Outflow NPV = 38174 – 40,000

42. Project B NPV = Discount Cash Inflow – Discount Cash Outflow NPV = 69,177 – 60,000

43. Present value of cash inflow Present value of cash outflow PI is equal to or more than one the proposal can be accepted 2. Profitability index method/ benefit cost ratio PI = PI = 1 Accept PI = > 1 Accept PI = <1 Reject

44. 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 calculated as 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 . It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment

45. 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)

46. 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+ P1-P2 x D IRR is that rate at which the sum of discounted cash inflow equals the sum of discounted cash outflows

47. Calculate IRR

48. Discount Factor

49. Calculation:- Actual rate of return is between 15% and 20%

50. 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+ P1-P2 x D L = 15 % P1 = 50,990 P2 = 43,900 Q = 50,000 D = 5 [20-15]

51. 50,990 – 50,000 50,990 – 43,990 990 7090 X 5 = 15+ X 5 = 15+ = 15.7 %

52. Calculate NPV, PI and IRR   Project X Project Y Investment 70,000 70,000 Cash inflow 1 10,000 50,000 cash inflow 2 20,000 40,000 Cash inflow 3 30,000 20,000 Cash inflow 4 45,000 10,000 Cash inflow 5 60,000 10,000