MODULE: 2

CHAPTER: 1 UNDERSTANDING INVESTMENT DECISIONS

(CAPITAL BUDGETING DECISIONS):
Meaning, Features
Types and importance of Investment decisions
 Discounted cash flow
DPBP, NPV, PI, IRR, MIRR
 Non-discounted cash flow techniques
PBP, ARR
Capital rationing (T & N)

Capital Budgeting (strategic asset allocation) is most important issue in corporate finance.

 How firm finances its investments(capital structure)

 How it manages its short term operations(working capital decisions)
 How its allocate its capital(capital budgeting)

EXPENSE EXPENDITURE
Amount spent by a business to generate Amount invested in acquiring an asset, goods or
revenue services etc.
Eg. Advertisement expense Eg. amount on salary and wages
Expenditure incurred when cash is paid out i.e.
Revenue Expenditure (ST) and Capital Expenditure
(LT).
Capital expenditure can be also called as capital investment project or project.

For instance, truck manufacturer is considering investment in new plant, commercial bank is thinking of
an ambitious computerization programme, pharmaceutical company is evaluating a major research and
development programme.

BASIC CHARACTERISTICS:

o Current and future outlay of funds in the expectation of a stream of benefit in future
o Shown as an asset side of the balance sheet
o Represent the growing edge of business
o Capital expenditure have three distinctive features:
 Long term consequences
 Involves substantial outlays
 Difficult or expensive to reverse

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Any firm spent considerable time on capital budgeting with the involvement of top executives from
production, marketing, engineering and research and development programme. These decisions are
made by financial managers to measure profitability, growth and risk.

Most of firms have numerous opportunities before them. Some are valuable while others are not. Or else
some opportunities are more valuable while others are less significant.

CB TECHNIQUES IN IDENTIFYING INVESTMENT OPPORTUNITIES:

 CB Process
Identification of potential investment opportunity, assembling proposed investments, decision
making, preparing CB techniques and appropriations, implementation, performance review
 Project classification
Mandatory investments, replacement projects- cost reduction investments, expansion (related
diversification) project- GSFC increase its plants capacity , diversification (unrelated
diversification) project- Adani Cement, research and development projects, modernization
projects- improves efficiency reduce cost, miscellaneous projects
 Investment criteria with the objective of evaluation
o Mutually exclusive investments
o Independent investment
o Contingent investments: are dependent project; the choice of one investment necessitates
undertaking one or more investments. Eg. Kanan Devan Hills Plantation Company -2005
o Example, if a company decides to build a factory in remote area, it may have to invest in
houses, schools, roads, hospitals and many more for the employees to attract workforce.
Here, total expenditure will be treated as one single investment.
 NPV
 PI
 IRR
 MIRR
 PBP (SPBP, DPBP)
 ARR
 Investment appraisal in practice (the techniques used by firms and investors to determine
whether an investment is profit-making or not.)

DEFINE CAPITAL BUDGETING DECISION AND STATE THE FEATURES OF IT:

Capital budgeting decision is firm’s decision to invest its current funds in long term asset with most
effective way to get expected flow of benefits over a series of years.

It generally includes expansion, acquisition, modernization and replacement. For instance, sale of a
division or business (divestment) is also a investment decision. Moreover, decisions like the change in
methods of sale, an advertisement campaign, research and development programme have long term
implications for the firm’s expenditures and benefits. Therefore, they should also be considered as
investment decision.

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Three features of investment decision:

o Current funds for future benefits

o Funds invested in long term assets
o Future benefits will occur to firm over a series of years.

The firm’s value increases if the investments are more profitable and add to share holder’s wealth.

INVESTMENT EVALUATION CRITERIA:

 Estimation of cash flows i.e. cash inflow and cash outflow

 Estimation of required rate of return (cost of capital, risk rate, discounting rate)
 Decision rule for choice

COF= INITIAL INVESTMENT + INSTALLATION CHARGES +WORKING CAPITAL

REQUIRED

CIF

YEAR EBDT/EBIT DEP/INT EBT TAX EAT DEP NCF DF DCF

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 1. PAYBACK PERIOD:
 The payback period is the time you need to recover the cost of your investment.
 It indicates the time in which an investment takes to reach the break-even point.
 The payback period shows you the time taken to recover the cost of the project.
 Account and fund managers use the payback period to determine whether to go through
with an investment.
 It is most popular and widely accepted traditional method of capital budgeting.

`Evaluation criteria:

An investment may have a short or a long payback period.

If your investment has a short payback period, you may quickly recover the cost of the
investment.
Accept the project if an investment that has a short payback period.
Shorter paybacks mean more attractive investments, while longer payback periods are less
desirable.

 First/highest rank to shortest period

 Lowest rank to longest period

ACCEPTANCE RULE:

Accept if PB< Standard payback

Reject if PB> Standard payback

CALCULATION:

The payback period is calculated by dividing the amount of the investment by the annual cash flow.
For equal cash flows:
PAYBACK PERIOD = INITIAL INVESTMENT / CASH INFLOW PER YEAR
=Co/C

For unequal cash flows:

You may calculate the payback period for unequal cash flows.
In case of that, payback period can be found out by adding up the CIFs until the total is equal to its
initial cash outlays.

TYPES:

Simple payback period (consider NCF)

Discounted payback period (consider DCF)

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MERITS:

 Some analysts favour the payback method for its simplicity.

 Easy to compute and less expensive for use
 Emphasis on liquidity
 Uses cash flow information
 Others like to use it as an additional point of reference in a capital budgeting decision
framework.

DEMERITS:
 It does not account for the time value of money. (SIMPLE PBP)
 This period does not account for what happens after payback occurs. Therefore, it ignores
(cash flows) an investment's overall profitability.
 No objective way to determine standard payback period
 No relation with wealth maximization principle

PAYBACK RECIPROCAL:

 The payback reciprocal is a crude estimate of the rate of return for a project or investment.

 The payback reciprocal is computed by dividing the digit "1" by a project's payback period
expressed in years.

 For example, if a project's payback period is 5 years, the payback reciprocal is 1 divided by 5=
0.20 = 20%.

 It is the close approximation of IRR when, life of the project is large or twice than PBP and
when PBP generates equal annual cash flows.

 The payback reciprocal overstates the true rate of return because it assumes that the annual
cash flows will continue forever. It also assumes that the annual cash flows are identical OR
similar in amount. But, these two conditions are unrealistic thus one should avoid the use of the
payback reciprocal. Instead, one can compute the internal rate of return or the net present
value because they will discount each of the actual cash amounts to reflect the time value of
money.

Calculate PBP from the followings.

1. A project has initial investment of Rs. 2,00,000 will produce cash flows after an of Rs.50,000 per
annum for six years. Compute the payback period and payback reciprocal for the project.
(Answer: 4 years, 25%)

2. A project has initial investment of Rs. 10,00,000 will produce cash flows after an of Rs.2,50,000
per annum for seven years. Compute the payback period and payback reciprocal for the project.
(Answer: 4 years, 25%)
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3. A project requires an outlay of Rs. 60,000 and yields annual cash of Rs.12,000 for seven years.
Compute the payback period and payback reciprocal for the project.
(Answer: 5 years, 20%)

4. Project Y has initial investment of Rs 5,00,000 cash down for 5 years are Rs. 150,000, Rs. 1,80,000,
Rs. 1,50,000, Rs. 1,32,000 and Rs 1,20,000. Determine payback period and payback reciprocal.
(Answer: 3.15 years, 31.75%)

5. Project D has initial outlay of Rs 20,000 cash down for 4 years are Rs. 8,000, Rs. 7,000, Rs.4,000
and Rs.3,000. Determine payback period. (Answer: 3.33 years or 3 years 4 months)

2. ACCOUNTING RATE OF RETURN ON INVESTMENT METHOD:

The accounting rate of return formula (or ARR) is used in corporate finance to calculate the potential
profitability of an investment or acquisition for a business.
The ARR formula takes the average yearly revenue generated by an asset, then divides that figure by
the initial cost. This decimal figure is then multiplied by 100 to yield the percentage rate of return.
Accounting rate of return gives a business a snapshot of the potential earning power of a particular
investment.

ARR on average investments= AVERAGE NET PROFIT/ AVERAGE INVESTMENTS

ARR (return on investments) ROI= AVERAGE NET PROFIT/ORIGINAL INVESTMENT

 Average Annual Profit = Total profit (EAT) / Number of Years

 Average Investment = II+ Inst. Charges- scrap/ 2+ WC + Scrap

Evaluation criteria:

 In terms of decision making, if the ARR is equal to or greater than a company’s required rate of
return, the project is acceptable because the company will earn at least the required rate of return.
 If the ARR is less than the required rate of return, the project should be rejected.
 Therefore, the higher the ARR, the more profitable the company will become.

Accept if ARR> Minimum Rate

Reject if ARR< Minimum Rate

MERITS:

 Uses accounting data with which executives are familiar

 Easy to understand and calculate
 It measures the benefit in percentage which makes it easier to compare with other projects.

DEMERITS:

 Ignores time value of money

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  Does not use cash flows, This method is based on accounting profits rather than cash flows.
In order to maximize the wealth of shareholders, cash flows should be taken for calculation.
 No objective way to determine minimum acceptable rate of return
 This method ignores the size of investment. Sometimes ARR may be the same for different
projects but some of them may involve huge cash flows.

Calculate ARR from the followings.

1. XYZ Company is looking to invest in some new machinery to replace its current malfunctioning
one. The new machine, which costs Rs. 4,20,000 and would increase annual revenue by Rs.
2,00,000 and annual expenses by Rs. 50,000. The machine is estimated to have a useful life of
12 years and zero salvage value. Assume tax rate 50%. Find out ARR.

(Answer: 27.38%)

2. XYZ Company is considering investing in a project that requires an initial investment of

$100,000 for some machinery. There will be net inflows of $20,000 for the first two years,
$10,000 in years three and four, and $30,000 in year five. Finally, the machine has a salvage
value of $25,000. Assume tax rate 50%. Find out ARR.

(Answer: 12%)

3. NET PRESENT VALUE METHOD:

 The Net Present Value (NPV) is a method that is primarily used for financial analysis in
determining the feasibility of investment in a project or a business.
 It is the present value of future cash flows compared with the initial investments.
 An organization must take the decisions regarding the expansion of business and investment
very wisely. In such cases, the organization will take assistance of Capital Budgeting tools, one
of the most popular NPV methods and take a call on the most profitable investment.
 Net present value is a tool of Capital budgeting to analyze the profitability of a project or
investment.
 It is calculated by taking the difference between the present value of cash inflows and
present value of cash outflows over a period of time.
 As the name suggests, net present value is nothing but net off of the present value of cash
inflows and outflows by discounting the flows at a specified rate.

NPV= CIF-COF

Evaluation criteria:
NPV>0 accept
NPV<0 reject
NPV=0 indifferent (may be accepted)

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MERITS:
 Considers time value of money, based on the concept of time
 Considers all cash flows (the amount of revenues and expenditures)
 True measure of profitability
 More importance to present money value
 Satisfies the value additive principle (NPV of two or more projects can be found out.)
 Consistent with shareholder’s wealth maximization principle
 Comprehensive tool
 Value of investments

DEMERITS:
 Tedious task
 Discounting rate(higher ROR...Lower or negative NPV)

4. PROFITABILITY INDEX (PI):

The profitability index is an appraisal technique applied to potential capital outlays. The
method divides the projected capital inflow by the projected capital outflow to determine the
profitability of a project.

What Is the Profitability Index Used for?

The profitability index is used for comparison and contrast when a company has several
investments and projects it is considering undertaking. The PI is especially useful when a company
has limited resources and can't pursue all potential projects, as it can be used to prioritize which
projects to pursue first. The index can be used alongside other metrics to determine which the best
investment is.

It is also known as Profit Investment Ratio (PIR), Cost-Benefit Ratio, or Value Investment Ratio
(VIR).

PI= CIF/COF

Evaluation criteria:

Generally, the higher the PI the better profitability is. A profitability index greater than 1.0 is often
considered to be a good investment, as it means that the expected return is higher than the initial
investment. When making comparisons, the project with the highest PI may be the best option.

PI>1 accept
PI<1 reject
PI=1 indifferent (may be accepted)

MERITS:

 It considers the time value of money: The profitability index takes into account the fact that
money today is worth more than the same amount of money in the future, due to the potential for
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 earning interest. This makes it a more accurate measure of investment attractiveness than
simply looking at the total expected cash flows.
 It allows for comparison of projects with different life spans: The profitability index can be used
to compare projects with different life spans, because it takes into account the present value of
future cash flows rather than just the total expected cash flows.
 It helps with decision-making under capital constraints: When a company has limited
resources and can't pursue all potential projects, the profitability index can be used to prioritize
which projects to pursue first.

DEMERITS:

 It only considers the initial investment: The profitability index only looks at the initial investment
required for a project and ignores ongoing or future investments that may be necessary. This can
make it difficult to accurately compare projects with different investment requirements.
 It doesn't consider the size of the project: The profitability index does not take into account the
size of the project, so a large project with lower profit margins may have a lower profitability
index than a smaller project with higher profit margins.
 It relies on accurate forecasting: The profitability index relies on accurate forecasting of future
cash flows and discount rates, which can be difficult to predict with certainty. If the assumptions
used in the calculation are incorrect, the resulting profitability index may not accurately reflect the
attractiveness of the project. (Bad forecasts or assumptions can make the analysis unreliable)

CALCULATE THE FOLLOWING:

1. Initial investment Rs. 40,000 and Life of an asset is 5 years. Assume tax rate of 50% at 10% of
discount rate. Calculate depreciation on straight line basis. Calculate PBP, ARR, NPV and PI.
Year EBDIT (in Rs.)
1 10,000
2 12,000
3 14,000
4 16,000
5 20,000
(Answer: SPBP 3.83 years, DPBP 4.82 years, NPV +1592, PI 1.0398, ROI 8%, ARR 16% )

2. Project F and project S has initial outlay of Rs 4,000 at the cost of capital(required rate of return) of
10% and cash inflow for 4 years which are as under.
Project F:
Rs. 3,000, Rs. 1,000, Rs.1,000 and Rs.1,000.
Project S:
Rs. 00, Rs. 4,000, Rs. 1,000 and Rs. 2,000.
Determine simple and discounted payback period, NPV and PI and evaluate the projects.
(Answer: SPBP Project F 2 years Project S 2 years, DPBP Project F 2.60 years Project S 2.93
years, NPV Project F +987 Project S +1421, PI Project F 1.25 Project S 1.36)

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 5. INTERNAL RATE OF RETURN METHOD (Trial and error
method):

 The discount rate which equates the present value of an investment’s cash inflows and outflows
is its IRR.
 IRR is the rate at which NPV will be zero.
CIF=COF

Evaluation criteria:
IRR>K accept
IRR<K reject
IRR=K indifferent (may be accepted)

Higher IRR is the indication that the project is more desirable.

MERITS:
 Considers time value of money
 Considers all cash flows (the amount of revenues and expenditures)
 True measure of profitability
 More importance to present money value
 Consistent with wealth maximization principle
DEMERITS:
 Difficulty in calculation (Tedious task)
 At time yields multiple rates
 Ignore size of the project
 Ignores future cost
 Reinvests at IRR
 Fails to indicate the correct choice between mutually exclusive projects

IRR= A + C/C-D* (B-A)

EASY STEPS TO SOLVE IRR:

(For equal cash flows)
STEP: 1 Calculate PBP= II/CIF
STEP: 2 USE TABLE 4 (Present value annuity) and find Interest Rate on the basis of nearest value of
PBP
STEP: 3 calculate NPV at both the interest rates (+,-)
STEP: 4 IRR= A + C/C-D* (B-A)
Where, A lower rate
B higher rate
C higher NPV
D lower NPV

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(For unequal cash flows)

STEP: 1 Calculate weighted average cash inflows.

Give weight in descending order to get equal cash flows.
STEP:
FOLLOW ALL THE STEPS OF EQUAL CASH FLOWS

Calculate IRR from the followings.

When equal cash inflows are there:

1. A firm has invested in a project worth Rs. 1,00,000 which has life span of 6 years and results in an
annual cash inflows of Rs. 20,000. (Answer: 5.47%)
2. A firm has invested in a project worth Rs. 3,00,000 which has life span of 7 years and results in an
annual cash inflows of Rs. 60,000. (Answer: 9.20%)
3. A firm has invested in a project worth Rs. 1,00,000 which has life span of 6 years and results in an
annual cash inflows of Rs. 25,000. (Answer: 12.98%)

When unequal cash inflows are there:

1. What will be IRR of the following cash flow stream?

Year Cash Flow (in $)
0 (3000)
1 9000
2 (3000)
(Answer: Rule break down)

2. What will be IRR of the following cash flow stream?

Initial investment Rs. 1,20,000 and Life of the machine is 4 years.
Year Estimated Annual Cash Flow (in Rs.)
1 30,000
2 40,000
3 60,000
4 40,000
(Answer: 14.4789%)

3. What will be IRR of the following cash flow stream?

Initial investment Rs. 1,60,000 and Life of an asset is 5 years.
Year Estimated Annual Cash Flow (in Rs.)
1 40,000
2 60,000
3 50,000
4 50,000
5 40,000
(Answer: 15.38%)

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4. What will be IRR of the following cash flow stream?
Initial investment Rs. 40,000 and Life of an asset is 6 years.
Year Estimated Annual Cash Flow (in Rs.)
1 13,000
2 8,000
3 14,000
4 12,000
5 11,000
6 15,000
(Answer: 19.73%)

5. What will be IRR of the following cash flow stream?

Initial investment Rs. 20,000 and Life of an asset is 3 years.
Year Estimated Annual Cash Flow (in Rs.)
1 7,000
2 13,000
3 12,000

(Answer: 25.20%)

6. Initial investment Rs. 1,00,000 and Life of an asset is 5 years. Calculate PBP, NPV and PI when
required rate of return is 12% and IRR @18% and @19%.
Year EBDIT (in Rs.)
1 10,000
2 12,000
3 14,000
4 16,000
5 20,000
(Answer: SPBP 3.2 years, DPBP 3.94 years, NPV +19,060, PI 1.1906, IRR 18.69% )

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 6. MODIFIED INTERNAL RATE OF RETURN METHOD (MIRR):
The MIRR is primarily used in capital budgeting to identify the viability of an investment project.

The traditional internal rate of return (IRR) assumes the cash flows from a project are reinvested at the
IRR itself. The MIRR, therefore, more accurately reflects the cost and profitability of a project. The
modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at the firm's
cost of capital and that the initial outlays are financed at the firm's financing cost.

MIRR and IRR calculations rely on the formula for NPV.

CALCULATION:

Calculating the MIRR considers three key variables: (1) the future value of positive cash flows
discounted at the reinvestment rate, (2) the present value of negative cash flows discounted at the
financing rate, and (3) the number of periods.

Mathematically, the calculation of the MIRR is expressed using the following equation:

(FV/II) 1/n-1

Where,

 FVCF – the future value of positive cash flows discounted at the reinvestment rate
 PVCF – the present value of negative cash flows discounted at the financing rate
 n – the number of periods

Evaluation criteria:

 If the MIRR of a project is higher than its expected return, an investment is considered to be
attractive. Conversely, it is not recommended to undertake a project, if its MIRR is less than the
expected return.
 In addition, the MIRR is commonly employed to compare several alternative projects that are mutually
exclusive. In such a case, the project with the highest MIRR is the most attractive.

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 MERITS:

 MIRR improves on IRR by assuming that positive cash flows are reinvested at the firm's cost of
capital.
 MIRR is used to rank investments or projects a firm or investor may undertake.
 MIRR is designed to generate one solution, eliminating the issue of multiple IRRs.

Calculate MIRR from the followings.

1. A company made an initial investment of $1,000 for a project, expecting returns in cash worth $300,
$600, and $900 for 3 consecutive years. The cost of capital and the reinvestment rate was 12%.
Hence –

FV = 300 * (1+0.12)2 + 600 * (1+0.12)1 + 900

= (300 * 1.25) + (600* 1.12) + 900

= 375 + 672 + 900

= 1947

PV = 1000

Using Modified Internal Rate of Return formula:

= 24.87%

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2. A company invests $1,800 and evaluates the return worth $500 to be consistent for the next three
years an additional profit of $500 at the end of the third year. What is the difference between the
IRR and Modified Internal Rate of Return of the project if the Cost of capital is 10% and IRR is
12%?

FV = 500 * (1+0.10)2 + 500 * (1+0.10)1 + 1000

= 605 + 550 + 1000

= 2155

PV = 1800

= 6.18%

The difference between the IRR and Modified Internal Rate of Return is equal to = (12 – 6.18) %

= 5.82%

3. A company made an initial investment of Rs. 80,000 for a project, expecting returns in cash worth
Rs. 15,000, Rs. 20,000, Rs. 25,000, Rs. 30,000, and Rs. 35,000 for 5 consecutive years. The cost of
capital and the reinvestment rate was 12%. Calculate:

YEAR CIF FV
0 -80000
1 15000 1.573519 23602.79
2 20000 1.404928 28098.56
3 25000 1.2544 31360
4 30000 1.12 33600
5 35000 1 35000
151661.4

MIRR=(FV/II) 1/n-1

=(151661.4/80000) 1/5 -1
=(151661.4/80000) 0.2 -1
=(1.8957) 0.2 -1
=1.1361-1
=0.13*100
=13%

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CAPITAL RATIONING:
Shareholder’s wealth will maximize if company undertakes all the projects which have positive NPV.
Capital rationing is to be done when there are insufficient funds or limited resources and cannot choose
or invest all positive projects. It is to be one to choose best profitable projects.

CR has two types:

Soft CR (Internal) Hard CR (External)

Company imposes its own spending restrictions Banks won’t lend any more
Limited management skills Recession
Limited exposure to external finance Company has poor track records
Focus on profitability of small number of Poor management team
projects No asset secure loan

PROJECTS are of two types:

DIVISIBLE INDIVISIBLE
Company can invest partially Company has to invest entirely
Use PI and rank projects Select the combination of projects which
gives highest NPV

Capital rationing can allow companies to focus their capital on the areas of the business that have the
highest potential return. It can also allow them to control their growth rate, avoid over-expansion, and
overall investment portfolio.

WHEN PROJECT ARE DIVISIBLE

PROJECT COST (COF) DCFV (CIF) NPV PI RANK
1 80000 100000 20000 1.25 4
2 150000 190000 40000 1.27 3
3 70000 114000 44000 1.63 1
4 130000 200000 70000 1.54 2

BUT WE HAVE LIMIT OF RS. 300000

PROJECT COST (COF) INVESTMENT NPV
3 70000 70000 44000
4 130000 130000 70000
2 150000 100000 40000 26666.67
1 80000 NIL

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 WHEN PROJECTS ARE INDIVISIBLE (NPV)

COMBINATION 1

PROJECT COST (COF) DCFV (CIF) NPV

1 80000 100000 20000

2 150000 190000 40000

3 70000 114000 44000

TOTAL 300000 104000

COMBINATION 2

PROJECT COST (COF) DCFV (CIF) NPV

1 80000 100000 20000

3 70000 114000 44000

4 130000 200000 70000

TOTAL 280000 134000

Combination 2 should be selected as it gives highest NPV in limited funds.

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