Investment Decisions

Unit 3
 Capital budgeting
• Capital budgeting is the process of evaluating
and selecting long-term investments that are
consistent with the goal of shareholders
wealth maximization
• It is a long-term exercise in selection of
projects which generates returns over a
number of years in future and require huge
investment in the initial stage
 Capital Rationing
• Capital rationing is a technique of selecting the projects
that maximize the firm's value when the capital infusion is
restricted.
• Capital Rationing is a common practice in most of the
companies as they have more profitable projects available
for investment as compared to the capital available. In
theory, there is no place for capital rationing as companies
should invest in all the profitable projects.
• However, a majority of companies follow capital rationing
as a way to isolate and pick up the best projects under the
existing capital restrictions.
 Investment decision techniques
• The techniques are divided into two parts
Investment decision
technique

Non discounting Discounting

techniques techniques

1. Net present value

2. Internal rate of
1. Pay back period return
2. Accounting rate of 3. Modified internal
return rate of return
4. Discounted
payback period
5. Profitability Index
 Payback period
• It is the exact amount of time required for a firm to recover its
initial investment in a project as calculated from cash flows.
• Payback period for annual cash flows:
• PBP= Initial Investments/ annual cash flows
• It is expressed in years, months and days for this technique
cash flows after taxes are to be considered,
• Shorter the payback period better is the project.
• CFAT= PAT + Depreciation
 Advantages and Disadvantages
• Advantages:
• Simple to understand
• Easy to calculate
• Expresses the result in time period
• Disadvantages:
• It ignores time value of money
• It ignores cash flows for the entire life of
project
 Accounting rate of return/ Average rate of
return
• The ARR method is based on accounting information. There are number of
alternatives to calculate ARR. The most common used method is
• ARR=Average profit after tax/ average investment over the life of the project
*100
• Advantages:
• It is easy to understand
• Simple to compute
• Represented in percentage
• Best suited for preliminary screening
• Total benefits associated with the project are taken into account
• Disadvantages:
• It ignores time value of money
• It does not take into account cash flows
 Net present value
• The first discounting technique is NPV.
• NPV is found by subtracting a projects initial
investment from the present value of its cash
inflows discounted at the firms cost of capital
• NPV= Total PV of cash inflows-Initial investment
• If NPV is positive the project must be expected if
it is negative it must be rejected. If there are tow
or more projects with positive NPV highest NPV
should be selected
 Cont’d
• Advantages:
• Considers time value of money
• It considers total benefits arising out of a project through
out the life of the project
• It helps in achieving the objective of financial management
i.e., shareholders wealth maximization
• Disadvantages:
• Difficult to calculate
• Calculation of discount rate
 Internal rate of return
• IRR is the discount rate that equates the present values of cash inflows with initial
investments associated with the project thereby causing NPV=0
• The project would qualify to be accepted if the IRR exceeds the cut-off rate or
cost of capital.
• IRR= lower rate + (total PV @ lower rate- Initial investment)/ (total PV of lower
rate- total PV @ higher rate) * difference of rates
• Advantages:
• It takes into account time value of money
• It takes into account the total cash inflows and outflows
• It is consistent with the objective of wealth maximization
• Disadvantages:
• Tedious calculations
• Produces multiple rates which are confusing
• Under the IRR it is assumed that all cash flows are reinvested at the IRR
 Modified internal rate of return
• Procedure to calculate MIRR
• Calculate the present value of cost PVC associated with the
project, using the cost of capital as the discount rate
• Calculate the terminal value (TV)/ future value of the cash
inflows expected from the project
• Obtain MIRR by solving the following equation
• PVC= TV/ (1+MIRR)n
 Cont’d
• MIRR is superior to the regular IRR in two
ways.
• First MIRR assumes that the project cash flows
are reinvested at the cost of capital whereas
IRR assumes that the project cash flows are
reinvested at the projects own IRR
• Second The problem of multiple rates does
not exists in MIRR
 Profitability index or benefit cost ratio
• This method measures the present value of returns per rupee invested
• Profitability index = total PV of cash inflows/ total PV of cash outflows
• A project will qualify for acceptance if its PI exceeds one.
• The NPV will be positive if PI is greater than 1 and it will be negative if
PI is less than 1
• Advantages:
• Considers time value of money
• It considers total benefits arising out of a project through out the life of
the project
• Disadvantages
• Tedious work
 Discounted pay-back period
• In this method cash flows are first converted in to their
present values and then used to determine the period
required to recover the initial investment
• The lowest discounted payback project must be accepted
• The major advantage of this method is it uses time value of
money
 Cash flow for a replacement project
• Developing cash flows for a new projects or expansion
projects is straight forward
• Estimating the relevant cash flows for replacement projects is
slightly complicated because you have to determine the
incremental cash outflows and inflows in relation to the
existing project. The three components of the cash flow
streams of replacement project are defined as follows:

Cost of new assets After tax salvage value

+ realized from the old
Initial investment net working capital asset
required for the new +
asset Net working capital
required for the old
asset
 Cont’d
Operating cash inflows Operating cash
from the new assets inflows from the old
Operating cash flows
assets had it not
been replaced

After tax salvage value After tax salvage value

of the new assets of the old asset, had it
+ not been replaced
Recovery of net +
Terminal cash flow
working capital Recovery of net working
associated with the capital associated with
new assets the old asset