FINANCIAL

MANAGEMENT
M O D U L E :- 2
Investment
Decision
 Syllabus – M O D U L E - 2
• Managements of Understanding Investment
Decision and Various steps involved.
• Nature of Investment Decision
• Techniques of Investment Decisions
• Discounted and Non – discounted Techniques
• Estimation of Discounted Rate (Cost of Capital)
• Basics of Risk and Return
INVESTMENT
DECISIONS
 CONTENTS
• INTRODUCTION
• MEANING AND DEFINATION OF INVESTMENT
DECISIONS
• NATURE OF INVESTMENT DECISIONS
• COMPONENTS OF INVESTMENT DECISIONS
• STEPS INVOLVED IN INVESTMENT DECISIONS
• FACTORS INFLUENCING INVESTMENT DECISIONS
• SIGNIFICANCE OF INVESTMENT DECISIONS
• PROBLEMS & DIFFICULTIES IN INVESTMENT
DECISIONS
 INTRODUCTION
• The word investment refers to the expenditure
which is required to be made in connection with the
acquisition and the development by which
management selects those investment proposal
which are worthwhile for investing available funds.
• For the purpose, management is to decide whether
or not to acquire, or add to or replace fixed assets in
the light of overall objectives of the firm.
 MEANING AND DEFINATION OF INVESTMENT
DECISIONS
• Investment Decision related to long term asset are
called capital budgeting.
• The expected benefits generally extend beyond one
year in the future.
• According to Robert N. Anthony, “The Capital
budget is essentially a list of what management
believes to be worthwhile projects for the
acquisition of new capital assets together with
estimated cost of each product.”
 NATURE OF INVESTMENT DECISIONS
• Capital Budgeting decisions involve the exchange of
current funds for the benefits to be achieved in
future.
• The future benefits are expected to be realized over
a series of years.
• The funds are invested in non – flexible and long –
term activities.
• They have a long term and significant effect on the
profitability of he concern.
• It may involved in large degree of risk. (Not
Necessary)
 COMPONENTS OF INVESTMENT DECISIONS
• Cash Outflows
• Cash Inflows
• Cut – off Rate
• Ranking the Proposals
• Risk and Uncertainty
• Non – Monetary Aspects
STEPS INVOLVED IN INVESTMENT DECISIONS
• Identification of Investment Proposals
• Screening the proposals
• Evaluation of Various Proposals
• Fixing Priorities
• Final Approval and Preparation of Capital
Expenditure Budget
• Implementing Proposal
• Performance Review
 FACTORS INFLUENCING INVESTMENT
DECISIONS
• Urgency
• Degree of Certainty
• Intangible Factors
• Legal Factors
• Availability of Funds
• Future Earnings
• Obsolescence
• Research and Development Projects
• Cost Consideration
 SIGNIFICANCE OF INVESTMENT DECISIONS
• Long – Term Effects
• Risk and Uncertainty
• Large Funds
• Corporate Image
 PROBLEMS & DIFFICULTIES IN INVESTMENT
DECISIONS
• Future Uncertainty
• Time Element
• Measurement Problem
TECHNIQUES
OF
INVESTMENT
DECISIONS
 CONTENTS
• NON DISCOUNTED CASH FLOW
METHODS
– PAY BACK PERIOD METHOD
– ACCOUTING OR AVERAGE RATE OF RETURN
(ARR)
• DISCOUNTED CASH FLOW METHODS
– NET PRESENT VALUE (NPV) METHOD
– INTERNAL RATE OF RETURN (IRR) METHOD
– PROFITABILITY INDEX (PI) METHOD
 PAY BACK PERIOD
METHOD
• INTRODUCTION
• COMPUTATION
• DECISION RULE
• ADVANTAGES
• DISADVANATAGES
 INTRODUCTION
• The payback period is defined as the number of
years required for the proposal’s cumulative cash
inflows to be equal to its cash outflows.
• In other words, the payback period is the length of
time required to recover the initial cost of the
project.
• The payback period therefore, can be looked upon
as the length of time required for a proposal to
break even on its net investment.
 COMPUTATION
• When the Annual Inflows are Equal:
– When the cash inflows being generated by a proposal
are equal per time period, the payback period can be
computed by dividing the cash outflow by the amount of
installment (inflow for a period).
– Formula Total Cash Outflow
Cash inflow per period
• When the Annual Inflows are Unequal:
– In case of Inconsistent cash flow per period then
cumulative of cash flow should be done and the have to
find the year in which year cash flow is recovered.
– Interpolation method may be used for appropriate
answer.
 DECISION RULE
• The payback period doesn’t give any clear indication
of the decision rule.
• The PB calculated for a proposal is to be compared
with some predetermined target period.
• If payback is more than the target period, then the
proposal should be rejected.
• If the different proposals are to be ranked in order
of priority, then the proposal with the shortest
payback period will be first in the priority list.
 ADVANTAGES
• Simple to Operate
• Liquidity Indication
 DISADVANTAGE
• Ignores Cash Inflows Discounting
• Equal Weightage to all Cash Flow
• Ignores salvage Value
• Method of Capital Recovery
 ACCOUTING OR
AVERAGE RATE OF
RETURN (ARR)
• INTRODUCTION
• COMPUTATION
• ADVANTAGES
• DISADVANATAGES
 INTRODUCTION
• The Capital Investment proposals are judged on
the basis of their relative profitability.
• Capital Employed and Related Income is
determined and then the average yield is
calculated.
• Such Rate is termed as Accounting or Average
Rate of Return and it is also termed as Return on
Investment.
• It is the ratio of average after tax profit to average
Investment.
 COMPUTATION

Annual Average Net Earnings (After Depr & Tax)

----------------------------------------------------------------- * 100
Original Investment (Average Investment)
 ADVANTAGES
• Easy to Calculate
• Considers Entire Cash flows
• Based on Financial Data
 DISADVANTAGE
• Ignores Time Value of Money
• Cost of Project cannot be determined Accurately
• Ignores Project Period
• Not suitable for Investment in Parts
 NET PRESENT VALUE
(NPV) METHOD
• INTRODUCTION
• COMPUTATION
• ADVANTAGES
• DISADVANATAGES
INTRODUCTION
COMPUTATION
 ADVANTAGES
• Recognition of Time Value of Money
• All Cash Flows Considered
• Profitability Objective Achievement
• Value Additively Principle
 DISADVANTAGE
• Difficult to Understand
• May not Provide Good Results
• Difficulty in determining Discount Rate
 INTERNAL RATE OF
RETURN (IRR) METHOD
• INTRODUCTION
• COMPUTATION
• ADVANTAGES
• DISADVANATAGES
INTRODUCTION
COMPUTATION
 ADVANTAGES
• Reorganization of Time Value of Money
• Easy to Understand
• Indicate Profitability
• Consistent with Overall Objective
 DISADVANTAGE
• Tedious Calculation
• Confusion in Multiple Rates
• Inconsistent in maximizing shareholder’s wealth
• Reinvestment of Cash Flows
• Ignore Rupees of NPV
NPV vs IRR
 PROFITABILITY
INDEX (PI) METHOD
• INTRODUCTION
• COMPUTATION
• ADVANTAGES
• DISADVANATAGES
INTRODUCTION
COMPUTATION
 ADVANTAGES
• It is consistent with the goal of maximizing the
shareholders wealth
• It uses cash flow
• It recognizes the time value of money
 DISADVANTAGE
• The main demerit of this method is that is required
detailed long term forecasts of the incremental
benefits and costs.
• It also poses difficulty in determining appropriate
discount rate.
ESTIMATION
OF
CASH FLOW
 CONTENTS
• INTRODUCTION
• PRINCIPLES FOR ESTIMATING PROJECT CASH
FLOWS
• DIFFICULTIES IN DETERMINING CASH FLOWS
• BIASES IN CASH FLOW ESTIMATION
 INTRODUCTION
• One of the most important capital budgeting tasks for
the evaluation of the project capital investments is the
estimation of the relevant cash flows for each project.
• Estimating cash flows is critical because inaccurate or
unreliable data can corrupt the entire capital
budgeting process.
• Estimating a new project’s cash flows involves great
uncertainty and may be little more than educated
guesswork.
• Those who prepare cash flow estimates should
explicitly state the assumptions underlying their
estimates.
PRINCIPLES FOR ESTIMATING PROJECT CASH FLOWS

• Separation Principle
• Identify Incremental Cash flow
• Focus on After Tax Flows
• Consistency Principle
– Investor Group
– Inflation
DIFFICULTIES IN DETERMINING CASH FLOWS
• Sunk Costs
• Opportunity Cost
• Side Effect
• Allocated Costs
 BIASES IN CASH FLOW ESTIMATION
• Overstatement of Profitability
– Intentional Over – Statement
– Lack of Experience
– Myopic Euphoria
– Capital Rationing
• Understatement of Profitability
– Salvage Values are Under Estimated
– Intangible Benefits are Ignored
– Value of Future Option is Overlooked
COST OF CAPITAL
OR

DISCOUNT RATE
 CONTENTS
• MEANING AND DEFINITION OF COST OF CAPITAL
• CHARACTERISTICS OF COST OF CAPITAL
• CLASSIFICATION OF COST OF CAPITAL
• FACTORS AFFECTING COST OF CAPITAL
• SIGNIFICANCE OF COST OF CAPITAL
• PROBLEMS IN DETERMINING OF COST OF CAPITAL
MEANING AND DEFINITION OF COST OF CAPITAL
CHARACTERISTICS OF COST OF CAPITAL
• Not a cash cost
• Minimum Rate of Return
• Consideration of Risk Premium
CLASSIFICATION OF COST OF CAPITAL
• Future Cost and Historical Cost
• Average Cost and Marginal Cost
• Implicit Cost and Explicit cost
FACTORS AFFECTING COST OF CAPITAL
• Factors the Firm cannot control
– Level of Interest Rates
– Tax Rates
• Factors the Firm can control
– Capital Structure Policy
– Dividend Policy
– Investment Policy
 SIGNIFICANCE OF COST OF CAPITAL
• Capital Budgeting Decisions
• Capital structure Decisions
• Evaluating Financial Performance
• Other Decisions
PROBLEMS IN DETERMINING OF COST OF CAPITAL
• Conceptual Controversies Regarding the
Relationship between the cost of capital and the
capital structure
• Ambiguity in different concepts of cost
• Problems in computation of cost of equity
• Problems in computation of cost of retained
earnings
• Problems in assigning weights
ESTIMATION
OF
COST OF CAPITAL
 CONTENTS
• COST OF DEBT / DEBENTURE
• COST OF PREFERENCE SHARE
• COST OF EQUITY SHARES
• COST OF RETAINED EARNING
COST OF DEBT / DEBENTURE
COST OF PREFERENCE SHARE
COST OF EQUITY SHARES
COST OF RETAINED EARNING
ESTIMATION OF
WEIGHTED
AVERAGE COST
OF CAPITAL
 CONTENTS
• MEANING OF WEIGHTED AVERAGE COST OF
CAPITAL
• STEPS TO CALCULATE WEIGHTED AVERAGE COST
OF CAPITAL
• SYSTEMS OF WEIGHTING
• MEASUREMENT OF WEIGHTED AVERAGE COST OF
CAPITAL
• ADVANTAGES OF WEIGHTED AVERAGE COST OF
CAPITAL
• DISADVANTAGES OF WEIGHTED AVERAGE COST OF
CAPITAL
MEANING OF WEIGHTED AVERAGE COST OF
CAPITAL
STEPS TO CALCULATE WEIGHTED AVERAGE COST
OF CAPITAL
SYSTEMS OF WEIGHTING
MEASUREMENT OF WEIGHTED AVERAGE COST OF
CAPITAL
ADVANTAGES OF WEIGHTED AVERAGE COST OF CAPITAL

• Straight Forward and Logical

• Builds on Individual Debt and Equity Components
• Accurate in periods of normal profits
• Accurate when the debt level is reasonable
 DISADVANTAGES OF WEIGHTED AVERAGE COST OF
CAPITAL
• Determining the weights
• Choice of Capital Structure
• Other Limitations