SUMMARY

Marketing Investment Analysis:

The critical success factors for financially evaluating and effectively controlling marketing
investment decisions. Most large and very many smaller companies are now very
sophisticated in how they financially evaluate major investment decisions involving tangible
fixed assets. So far the evidence overwhelmingly indicates that companies are far less
rigorous in their financial evaluations of long term marketing investment than they are for
similar levels of expenditure involving other projects.

Indeed in many companies there is no attempt to distinguish

between short term and long term marketing expenditure in terms of the financial evaluation
techniques employed, with all marketing activities being regarded as short term, i.e. current
period, expenses in line with ‘prudent’ financial accounting conventions.

This is particularly true in the critically

important area of justifying the development and launch of new products. The initial phases
(e.g. product research and development, market research, test marketing and even pre-launch
marketing) are often allocated from a revenue budget and consequently may be controlled in
the same way as normal, regular ongoing expenditure items. In such companies, a ‘capital’
investment project would only be raised when the decision to invest in ‘real’ fixed assets,
such as a full-scale manufacturing facility, was reached.
. +, -. _,I. ._, _..‘I.,. \.) ;.
-

1
1. THE THEORY OF INVESTMENT ANALYSIS
By investment we mean here any outlay on any extraordinary project or effort quite distinct from the
normal expenditures connected with ordinary business operations. There are broadly three
investment areas in a business from this stand-point. These are la) capital expenditure, (b) new
business venture, and (c) new marketing effort.
There may be various types of business needs giving rise to an investment proposal. To define an
independent project and to recognise all feasible alternatives to it, identification of the specific need is
important. Accordingly, need may be classified as follows:
1) Expansion
2) Cost reduction
3) Loss/cost avoidance
4) Replacement
5) Employee welfare
6) Improved manufacturing methods
7) Quality assurance and good manufacturing practice
8) Pollution control

Others (for example, penetration into new markets, improving the market share, etc.)

More often than not, a project would fulfill more than one of sod needs.

After an investment proposal is made, it has to be thorough!) I evaluated. Such evaluation

requires collection, integration quantification and analysis of all feasible alternative projects relates
to the particular course of action.

It is not difficult to envisage two important components of a project the hardware and the software.
In an area development project till I software or the service aspects are more important. In the
setting up of a factory, on the other hand, the hardware elements named providing physical assets,
are more important, though there would be some software elements also in the form of providing
services and utilities.

Any project would require initially the deployment of some physical and financial resources which
would provide the basis of the stream of costs. At a later stage will accrue a stream of benefits.
Therein distinct time-lag between the stream of costs or investments and the stream of benefits
or returns. Both these streams have to be identified in the form of cash flows - both outflows and
inflows.

There are five general steps in the approach to most project analyses. These are:

1] problem/project definition;
2] recognition of all alternatives;
3] collection of all relevant data;
2
 4] qualitative and quantitative analysis;
5] presentation of results to decision - makers.

To handle the above five steps, there are broadly three areas of responsibilities,

1] Those closest to project - for collection of primary data initially and implementation
of decision finally;

2] Those responsible for data analysis and assembly of proposals;

3] Those charged with approval/disapproval of the proposal

The management accountant or project analyst is in the second area of responsibility

mentioned above.

There are various types of feasibility studies undertaken during a

Project analysis. These are:

I] technical feasibility or appraisal;

2) organisational set-up;
31 managerial competence;
4] economic analysis;
5| commercial aspects; and
6| financial feasibility.

3
2. EVALUATION OF FINANCIAL ATTRACTIVENESS OF PROJECTS

As in the case of an individual, in the case of a business also Hit means of finance are limited but
the demands for invesimei prospects are numerous. Thus a situation may arise when a Compaq has to
choose one among a number of alternative projects Profitability is generally the main criterion in
such selection, B« there may be other criteria as well; for example, need for getlin| back the money at
the earliest possible time, creation ofemploymen opportunities with emphasis more on the
discharge ol responsibilities than on profits, building up a good image of UK enterprise (which
might in turn pay back in various ways in to future), and so on.

The tools and techniques used for financial evaluation of projffl I attractiveness are somewhat
different at micro level from thoseusedH at the macro level. For example, benefit cost ratio is the mostl
common technique applied in the case of projects at the raaoj I level. Under this technique all
benefits and costs are amortise) I into annual benefits and costs, respectively, before the benefit cost I
ratio is computed. The higher the ratio, the greater will be the IJ financial justification for the project.

There are various methods and techniques of assessing the financial I justifiability of a project. These
techniques can be broadly grouped I under two sets, (a) undiscounted methods and (b) discounted I
methods.

Undiscounted methods include pay-back period calculation, benefit I cost ratio approach, working out
various return on investment (ROI) I percentages, etc. The dominant feature of all these methods is Dial
time value concept of money, on the interest element, is not considered at all under these
methods.

Interest element or time value concept of money is taken into consideration in the discounted
methods. The basic principle adopted here is the farther we move from the present, the lower I
be the value at present.

There is thus the need for adjusting both investments and returns in respect of time. Discounted
methods also ha' e various approaches, discounted pay-back period, discounted benefit-cost
approach, net present value (NPV) approach, DCF rate of TI or internal rate of return (IRR)
approach, etc. The results I at under the discounted cash flow techniques can be further refined
by adopting more sophisticated techniques like risk analysis I sensitivity studies. We shall now
discuss and illustrate these and techniques.

CASH OUTLAY (INVESTMENT

4
 Average Income

3. PAY-BACK PERIOD

The pay-back period is defined as the period (number of years and months) at the end of which
the net cash flow of a project is zero 0). In other words it is the period during which the original
investment (cash outflow) is fully paid back by the returns (cash
inflows). An example:
Year Cash Flow Rs. Lakhs

Project A Project B
0 (50) (Investment (60)
1 5 ) 20
2 10 20
3 15 20 ®0
4 20 ®0 20
5 25 20
6 30 20
The pay-back period is four years in case of Project A and three in case of Project B. Judged by
this criterion, Project B is r than Project A. This is how the relative attractiveness of a of
competing projects is to be judged under the pay-back Period approach.

The pay pack period is followed by those enterprises which are primarily interested in an early
return of the original investment ii> reduce the risk factor or to put the same money to a better
alternative use after a period of time which coincides with the pay-back period

Besides this, the pay-back method has some distinct advantages:

1] It is simple to understand and easy to calculate

2] It indicates at once an investment which is outright unacceptable (if the total

investment is not paid back during the lifetime of the project).

3] In an industry which is experiencing rapid technological changes, The pay-

back method ensures some protection against the danger ol obsolescence (since investment
decisions are based upon the lowest pay back period approach).

But the pay-back period approach suffers from some seriously limitations:

1] It does not consider the interest factor or the time

5
 value concept of money.

2] It does not consider the staggering of the return I

during the pay back period. (Two projects mi) I have the same pay back
period, but the pattern of I cash flow may be say 15+7+3 in one case audit
5+7+13 in the other).

3] It does not take into account the post pay-badl .period returns which could be
significant in soil cases.

In sum, the pay-back period method happens to be the most popular method of project
appraisal as revealed in some surveys recently conducted in the western countries.
Unfortunately, for some of unknown reasons, this method is yet to gain popularity in the
Indian trial enterprises, barring only a few houses.

4. sRETURN ON INVESTMENT (ROI)

The return on investment method is a popular method of judging acceptability of a

project. To calculate the ROI both the statement and the returns are to be worked out
with proper perspective.

Total investment usually means the net fixed assets (gross fixed is less depreciation)
plus net working capital (current assets current liabilities) relatable to a particular
project or an alternative. Returns may be either pre-tax or after-tax profit. Sometimes
after-tax cash flows are taken to be the returns. This is of course not a healthy practice -
ROI being basically an accounting concept, profit should be taken as the numerator,
whatever be the profit is defined. For example besides PBT or PAT, sometimes it' (Earnings
before interest and tax) is taken to be the returns [he purpose of ROI calculations.

An enterprise should have some minimum expectation in the form ROI percentage. This
minimum expectation is called the cut-off of investment. The projects showing ROI below
the cut-off rate automatically be excluded from consideration. And obviously, ; one with the
highest ROI rate, will be accepted when there are a number of projects competing for a
limited or scarce investible fund.

There are various approaches towards working out the ROI even the same project and,
therefore, with the same set of data.

ILLUSTRATION
A project costs Rs 50,000 & has a scrap value of RS 10,000. Its stream of income before
depreciation & taxes during first year through five year is RS 10,000 RS 12,000 RS 14,000
RS 16,000 & RS 20,000. Assume a 50% tax rate & depreciation on straight line basis.
Calculate the accounting rate for the project.

6
 Calculation of ROI

PERIOD 1 2 3 4 5 AVERAGE

Earnings 10,000 12,000 14,000 16,000 20,000 14,000

before dep-
& taxes

(-)dep 8,000 8,000 8,000 8,000 8,000 8,000

Net 2,000 4,000 6,000 8,000 12,000 6,400

Earnings
before
taxes

(-)Taxes at 1000 2000 3000 4000 6000 3200

50%

Net 1000 2000 3000 4000 6000 3200

Earnings
after taxes

7
Book value
of
investment:

Beginning 50,000 42,000 34,000 26,000 18,000

Ending 42,000 34,000 26,000 18,000 10,000

Average 46,000 38,000 30,000 22,000 14,000 30,000

ROI= (3200/30,000)X100=10.67%

8
5. THE DISCOUNTED CASH FLOW (DCF) TECHNIQUE IN GENERAL

Discounted Cash Flow or time adjusted return is nothing but present value of different cash flows
or returns in different future that is the future returns brought down to the equivalent pr value
level by applying suitable discount (or interest) rate Discounting is nothing but the reverse of
compounding.

Discounted cash flow technique is breakthrough in the area of project evaluation since, unlike all
other conventional methods, this technique for the first time sought to recognise and introduce
the! value concept of money or the interest factor. From the core point of view, Rs. 100 payable
today is of greater value than Rs.100 payable say, after one year, because of the interest factor
involve Assuming a 10 per cent interest rate Rs. 100 today is equivalently| Rs. 110 after one year.
Alternatively, Rs. 100 after one year may be discounted to about Rs.90 (at 10 per cent rate), which
is really the present value

If we ignore the interest factor and add up all future cash flow absolute monetary terms, it
would be fallacy of aggregation sir the addition of amounts would be from different frames of
reference. Further, on the basis of this so-called total cash flows if compare the profitability of
different projects, that comparison will not be on an apples to apples basis, but between
dissimilar Discounted cash flow techniques solves these problems

aggregation and comparison. Therefore, the relative profitability of different projects assessed
after the application of DCF technique is both correct and realistic.

As already indicated, there are various approaches in the application of the DCF technique. We
will now illustrate these.

DISCOUNTED PAY-BACK PERIOD APPROACH

If we assume a discounting rate of interest rate of 10 per cent and rework the pay back period on the
basis of the same set of data given earlier under Projects A and B, the position will be as follows

CASH FLOW
(Rs. lakhs)
Project A Project B
Year Discounting-------------------------------------------------
factor absolute present absolute present
amount value amount value
1 (50) (50) (60) (60)
.91 5 4.55 20 18.20
.82 10 8.20 20 16.40
.75 15 11.25 20 15.00
-0
.68 20 13.60 20 13.60
-0
.62 25 15.50 20 12.40
.56 30 16.80 20 11.20

9
Notes on Working:

(i) Discounting factors available from discounting tables (or

present value tables).
(ii) P V in each case = amount of cash flow x the discounting
factor
(iii) Cash flows assumed to accrue at the end of each year.

The pay-back period of the two projects as shown above are<■ years for A and 3.75 years for
B. B is therefore better thanA.1 may be noted here that under the undiscounted pay back
method also B is considered to be better than A. But on this basis the J back is four year for
A and three years for B.

DISCOUNTED BENEFIT-COST RATIO APPROACH

Following the same set of data as above, the Benefit Cost Ratio an undiscounted basis would bee
105/50 = 2.1 for Project A and in case of Project B, 120/60 = 2. On this basis, therefore, Project \
considered to be better than Project B. But if we take the w counted benefit-cost ratio
approach, the position is as follows I
Total present value of returns
Discounted benefit-cost ratio =-------------------------------1
Total investment at present value!
69.9
Project A =----= 1.398
50
86.8
Project B =----= 1.447
60

On the basis, Project B is better than Project A. The results arrived B at (1 398 and 1.447) are
also called profitability indices or profit ability factors of the respective projects.

10
 The net present value (NPV) method is the classic economic method of evaluation the investment
proposals. It is one of the discounted cash flow (DCF) techniques explicitly recognized the time valu
money. It correctly postulates that cash flows arising at different time periods differ in value and ar
comparable only when their equivalent –present values-are found out. The steps involved in the NP
method are: First, an appropriate rate of interest should be selected to discount forecasted cash flow
Generally, the appropriate rate of interest is the firm’s opportunity cost of capital which is equal to
minimum rate of return expected by the investors to be earned by the firm on its investment projec
Second, the present value of investment proceeds (i.e., cash inflows) and the present value of investm
outlay (i.e., cash outflows) should be computed using opportunity cost of capital as the discounting r
If all cash outflows are made in the initial year, then their present value will be equal to the amount
cash actually spent. Third, the net present value (NPV) should be found out by subtracting the pres
value of cash inflows. Accept the project if NPV is positive (NPV >0). Thus, the NPV method is a pr
of calculating the present value of cash flows (inflows and outflows) of an investment proposal, usin
opportunity cost of capital as the appropriate discounting rate, and finding out the net present valu
subtracting the present value of cash outflows from the present value of cash inflows.

ILLUSTRATION

For Project X which initially costs Rs 2,500 and generates year-end cash inflows of Rs 900, Rs 800,
Rs 600, Rs 500 in one through five years. The opportunity cost of capital is assumed to be 10 %

Year Cash inflows Discounting PV of cash

in Rs Factor At 10% Inflows in Rs

1 900 0.9091 818

2 800 0.826 661
3 700 0.751 526
4 600 0.683 410
5 500 0.620 310
2725
Less Investment Outlay -2500
Net Present Value +225

The Net Present value for Project X can be calculated by referring to present value table, where we
appropriate discount factors. Multiplying the discount factors and cash inflows, we shall obtain the

11
present value of cash inflows. The difference between the present value of cash inflows and the initi
cash outlay will represent the net present value.

Formula to find NPV:

NPV=

Internal Rate Of Return Method (IRR)

Rate of return can be defined as one which equates investment outlay with the present value of inflo
received after one period .This also implies that the rate of return is the discount rate which makes
NPV=0 .There is no satisfactory way of defining true rate of return of a long-term asset. The intern
of return (IRR) is the best available concept. We shall see that although it is a very frequently used
concept in finance, yet at time it can be a misleading measure of investment worth.

Definition for IRR

It can be defined as that rate which equates the present value of cash inflows with the present value
cash outflows of an investment.
In other word, it is the rate at which the net present value of the investment is zero. It is called inter
rate because it depends solely on the outlay and proceeds associated with the project and not any ra
determined outside the investment. It can be determined by solving the following equation for r:

ILLUSTRATION

A project costs Rs 16000 and is expected to generate cash inflows of Rs8000, Rs7000 and Rs6000 ov
life of three years. You are required to calculate the internal rate of return of the project.

To start with, we select (arbitrarily) a rate of 20% and calculate the present value of cash inflows:

Year Cash inflow Discount factor Present value

in Rs At 20% in Rs
1 8000 0.899 6664
2 7000 0.694 4858
3 6000 0.579 3474
Less Cash outlay 14996
16000
NVP -1004

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 The Net present value indicates that this is a higher rate. Therefore, lower rates should be tried. We
18%, 16%, 14%, obtain the following results:

Year Cash Discount factor PV DF PV DF PV

inflow DF 18% 16% 14%
1 8000 0.847 6776 0.62 6896 0.877 7016
2 7000 0.718 5026 0.743 5201 0.769 5383
3 6000 0.609 3664 0.641 3846 0.675 4050
15456 15943 16449
Less Cash outlay 16000 16000 16000
NVP -544 -57 +449

When we select 15% as the trial rate we find that the net present value is + Rs 200

Year Cash inflow Discount Present

Factor at value
15%
1 8000 0.870 6960
2 7000 0.756 5295
3 6000 0.658 3948
16200
Less Cash Outlay 16200
NPV +200

The true rate of return, thus , should lie between 15-16 %.

6. NET PRESENT VALUE (NPV)

Under this approach, a suitable discounting rate is first decided upon. Usually, this rate is equal to
more than the cost of borrowing or cost of capital for investment. Thereafter all the cash flows -
both out (investment) and in (returns) - are converted into their respective present values
applying the discounting rate. To facilitate the work discounting tables are used (which show
PV of Re 1 at different | periods and under different discounting rates). The net total present
value of all projects is then computed.

An illustration

Continuing the same example in respect of Projects A and B we may work out the NPV
(assuming as before, a discounting rate of 10 per cent and cash flows accruing only
towards the end of the respective years.)

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 CASH FLOWS (in Rs. lakhs)
PROJECT A
PROJECT B

(i)PV of (investment) (50) (60)

(ii)PV of returns (total of
all future returns, 69.9
as calculated earlier)
0
(iii) Net present value (NPV)
19.0
Ratio of NPV to PV of
0
investment NPV as percentage
0.39
of PV of investment

Let us now indicate the decision rules under NPV approach :

(i) A project showing negative NPV is to be sum

marily rejected (since it does not recover the original investment).

(ii) Criterion of project selection is the absolute NPV amount if the PV of

investments of the competing projects are around the same.

(iii) Criterion of project selection is the ratio (or percentage) of NPV to the PV of
investments for the respective projects in a situation where the PV of
investments of the competing projects are significantly different. .

Following the decision rule (iii) above, Project B is considered to better than Project A.

7. INTERNAL RATE OF RETURN (IRR) APPROACH

One of the major problems of the NPV approach is that of deciding A upon the correct
discounting rate. Needless to say. any improper decision in this respect may vitiate the
project profitability analysis, particularly in cases where different projects show \\M different
patterns of cash flows in different time periods.

This problem is obviated by a slightly more refined approach or. DCF technique. This is the
DCF rate of return (also called ■ adjusted rate of return) approach or the IRR calculation
Under this approach, the NPV of each competing project is assumed to'be ZERO and that
unique discounting rate which would make NPV = O is to be arrived at separately for each
project. The project showing § highest discounting or DCF rate or IRR is considered to be the
best.

14
The methodology of arriving at the DCF rate is initially trial m error and then use of
interpolation techniques, once the area of rate is located after two or three trials.

An Illustration

Let us continue with the same set of data for clearer understands Assume the discounting rate of
10 per cent is not given We have find the unique discounting rate in respect of each of the
projects, A and B, which would result in a zero NPV in either case.

It would be clear from the earlier workings that the DCF rate wt be higher than 10 per cent in
either case (since at 10 per cent is then are positive NPV's). Let us start with a higher rate in the
first trial for each of the two projects and come down, if necessary, in subsequent trials
Incidentally, it may be noted that higher the ratio discount we choose ,the lower will be the
present value of returns Our objective is to make it zero.

PROJECT A

Trial No 1 Trial No 2

Year Cash Discount Rate 20% Discount Rate 18%

Flow factor P.Y factor PV.
(Rs. lakhs) (Rs. lakhs) (Rs. lakhs)

1.00 (50.00)
0.83 4.15 (50) 1.00
0.69 6.90 (50.00) 1.00
0.58 8.70 (50.00)
0.48 9.60 15
0.40 10.00
0.35 10.50
5 0.85 4.25
10 0.72 7.20
15 0.61 9.15
20 0.52 10.40
25 0.44 11.00
30 0.37 11.10

PV (0.15) 3.10

From the two trials, it is apparent that the DCF rate must lie
somewhere between 18 per cent and 20 per cent. The rate may
be arrived K interpolation as follows :

NVP of low trial

DCF rate = Rate of low trial +-------------------X DiflF. in rate
NP V of low trial + deficit between
in NPV of high trials two trials

3.10
= 18% +--------------X 2%
3.10 + 0.15 = 18%+1.9%
= 19.9% (or approximately, 20%)

PROJECT B

Trial Trial
No. 1 No.2

Year 0 Cash Flow (Rs. Discount

1 lakhs) Rate 25%
2 factor
3 (60) 20 20
1.00 4 20 20 20 20 PV.
0.80 5 (R
0.64 6 s.I
0.51 ak
0.41 N.P.V hs
0 33 )
0.26
16
 (60. 0 Discount Rate23^ 0.44 8.
6. factor PV 0.36 7.
60 (Rs.Iakhs) 0.29 5.
5.
20 1 00 (6
0.81 16
(1. 0.66 13
00) 0.54 10

X2%
2.00
DCF Rate = 23% +
2.00+ 1.00 = 24.33%
(or approximately, 24%)

DCF rate or IRR being higher in case of Project B. this

would I better than Project A. The fact that both unider
undiscountcd | back method and under DCF rate,
Project B in the example is i attractive, is more a
coincidence than due to an\ specific re Take the
following case, for example :

Year end... 1 2 3 4 5 6 7.. 11

Cash Flow:
Project X (40) 10 10 10 !0 10
Project Y (40) 4 8 12 16 2

PAY-BACK PERIOD DCF RATE OF RE1

Project 4 years 19%
X: 4 years 25%
Project
Y

In spite of the same pay-back period, DCF rate differs

significantly.

It would be to our advantage to tabulate and study all the

results. obtained under various methods, in respect of
Projects A and B.

Methods Project Project B

A Relative
attractiven
ess

UNDISCOUNTE 3Benefit cost ratio DISCOUNTED :

D : I Pay-back 4 Benefit cost ratio (profitability
period 2.R01 factor)
5 Pay back period
17
6Net present
value 4 vears 3 years B
(percentage on 70%, 35 67%, 57%, 33% A
investment) & 40% & 33%
7DCF rate (or 2.1 2 A
IRR)

18
8. NPV VERSUS IRR

VPV indicates the excess of the total present value of future returns over the present value of
investments IRR (or DCF rate) indicates, on the other hand, the rate at which the cash flows (at
present values), are generated in the business by a particular
project.

Both NPV and IRR iron out the differences due to interest factor or. say, higher returns in earlier
years vis-a-vis higher returns in later years (through the total returns in absolute terms may be
around the same for several projects).

Between the two, IRR or DCF rate is the more sophisticated method • a popular method as well,
since :
(a) IRR method obviates the mostly subjective decision regarding discounting rate.

(b) Whilst under NPV the main basis of companion [ is between different NPV's of different
projects under IRR or DCF rate approach a number of bases I is available, for example :

DCF rates vs current rate of return (on normal operations)!

DCF rates vs cut-off rate of the company
DCF rates Vs borrowing rate (or cost of capital)
DCF rates between different projects.
DCF rates of different projects vs. those of similar projects
of other companies.
DCF rates of different projects vs DCF rates of similar
projects undertaken in the past, (c) The results under DCF rate approach are simpler for
the man agreement to understand and appreciate.

We should, however, be very careful in applying the decision rules properly when NPV and IRR
calculations show divergent results
The rules are(a) NPV should be the basis of decision when
(i) the projects are mutually exclusive in character, and (ii) there is a capital
rationing situation.

Illustration On (ii) Above

Assume there is a capital constraint of Rs.300 and there are: projects the figures being as
follows :
Projec Investment First year NPV IRR
tt and
Cash Flow
Rs. Rs at 10% Rs %
F 100 120 9.08 20%
G 100 119 8.17 19%
H 100 112 1.81 12%
I 200 232 10.89 10%
 J 300 354 21.79 18%

Under IRR approach, F, G and H will be selected (total investment required is Rs.300). But this
would not be obviously correct. Project J should be the right selection in the case, based on NPV
results The criterion we are adopting here is maximising the total returns

(b) IRR should be a better guide when there are plenty of project situations (as it is there in a
big enterpnee) and no major capital constraints (for example, in respect of macro-
projects).

9. THE DCF TECHNIQUES - CONCLUDING OBSERVATIONS

Cash flows have to be calculated in accordance with the method explained earlier. To recapitulate, the
simple formula to be followed is estimated profit - tax + interest + book depreciation (the
depreciation debited to P/L a/c whether it be the same as or different from the tax depreciation.

The discounting factors should be taken up to four or five places of decimals from the table (not
two places as we have taken for
convenience).

Timing of cash flow is important in any DCF calculation Sometimes, investments may be
staggered over a period that may have started in the past. In such cases, all past cash flows should
be discounted forward by applying suitable discount factors to elevate them to the present value
platform.

In all our illustrations worked out earlier, we have made a simplistic assumption that all cash flows
arise only towards the end of the year In reality, however, cash flows generate in most cases evenly
during a year Discounting tables are available for such even cash flows also. For example, 0.91 may
be the discount factor at 10 per cent for Re. 1 to be generated at the end of one year from now If it is
generated evenly throughout the year, the discounting factor at the same 10 per cent rate would be
say, 0.955.

For DCF calculation, a project may be cut off after, say, five, eight I or eight I. If this is done for
all the competing projects, the DCF I rates will not be significantly affected, though they may
have I different life spans and widely different patterns of return after tbat I 10-year period.

Lastly we may indicate here a few limitations of the DFC technique, to be borne in mind always
in its application:

(i) DCF takes care of the time value concept of I

money, but not the value of money as based on I purchasing power. Inflation
element is, therefore, I to be considered separately (say, while estimating I costs,
revenues and cash flow).

(ii) IRR results would be valid provided there is scope for reinvestment of cash flow of
returns all the time. The condition may not exist always.
 (iii) Monitoring of actual cash flow on DCF basis (to ensure that actuals conform to
earlier estimates) is almost impossible in real life business situations.

10. RISK ANALYSIS

Risk analysis is an attempt to reduce (if not eliminate) the element of risk involved in any
investment decision, which is basically, and essentially a leap into the future.

The basic data of most of the investment analyses are the sales forecasts. The actual result may
be widely different from the one anticipated if there is any error in sales forecasting and/or if
reality does not conform to the situation envisaged. If instead of a deterministic forecast, we go
by a probabilistic sales forecast, the risk element may be reduced to some extent. Needless to
say, the probabilities would only be subjective probabilities given by responsible people closest
to the proposed project. Let us consider the following situation:

PROJECT "P"
Sales Probability of DCF rate
forecast success
alternatives 0.05 30%
A 0.65 18%
B 0.30 9%
C
1.00

The weighted average DCF rate is 16 per cent (profitabilities being taken as the weight). This
gives a better and more reliable rate than any one of the three given above.

Of course, it may be argued that if the worst comes to the worst, forecast 'C may come true and
we may net a meagre 9 per cent return. But some amount of calculated business risk must
always be there, and more so in all investment decisions.

In risk analysis, the Bayesian decision model can also be used. This approach allows a flexible
detailed model to be built for a specific decision problem and uses explicit probabilities to reflect
uncertainty. Furthermore, it provides an estimate of the value of additional information in
reducing the uncertainty.
11. SENSITIVITY ANALYSIS
Sensitivity analysis is a further refinement in project profitability appraisal. The purpose is to
show:
(i) The profitability of alternative sets of estimates
For a project; and
(ii) The effect on profitability of variations in the factors involved.

Let us assume that against the estimates of three major factors of a project, variable cost may go
up or down by 10 per cent; sales forecast may differ by 20 percent and fixed cost may be up or
down by 5 per cent. Considering all such probable changes, a 'pay-off matrix' may be formed
and the degree of sensitivity worked out.

Sensitivity analysis, in essence, seeks to highlight the extent to which the original decision will remain
unchanged despite some changes in the factors involved. Assume that DCF rate of a project is
calculated to be 25 per cent and cut-off rate of the company is 15 per cent There being no other
viable alternative, a go-decision is being considered Now, it is also estimated that the sales forecast
originally taken may go down by 20 per cent and in that case the DCF rate of return is also
calculated to come down to, say. 15 pci cent. The logical conclusion would be that the go-decision
is unchanged up to 20 per cent reduction in anticipated sales and that it would probably be a 'no-go7
decision if sales are apprehended to be down by more than 20 per cent over the forecast. Following
the same approach, we may considered the effect on the DCF rate of return of increase or decrease
in variable cost and also fixed cost These have to be taken into account in sensitivity analysis and
results suitably included in the project analysis report for presentation to the decision-makers.
 CONCLUSION

The financial justification of marketing investment decisions is an essential requirement for

ensuring that these major strategic decisions, when implemented, are effective in achieving the
companies pre-set objectives.

This means that there should be a greater separation of financial reporting and management
accounting systems so that managers have the information that they need to evaluate their
decisions over the long term, and are not in any way constrained by the short term prudent
requirements of external financial reporting.