Long term Investment

Decisions-Capital
Budgeting
Module-2
Module 2 Outline
• Identify the importance and process of
capital budgeting
• Examine the methods of evaluating long
term investment projects
Investment Decisions-Capital
Budgeting
• Investment Decisions deals with firm’s
decision to invest its funds in the long term
assets of the firm in anticipation of
positive cash inflows in the coming
years.
• It deals with decision to allocate and invest
money in to Long term assets of the firm.
 Where to invest funds?
 What should be the amounts that should be
invested on different proposals ?
 Re-allocation of funds when an asset no longer
generates profits
Features of Long Term Assets
• The investment amount is very high &
also is in current times
• Long term assets are going to provide
return over a series of future years
• The decision relating to investment in
long term assets is called as Capital
Budgeting Decisions /Capital
Investments.
Features of Capital
Budgeting/Investment Decisions
• It involves investment of Current funds
• The Investment is made in long term
assets
• The benefits from the assets are expected
in long run
• It involves the investment of large amount
of funds
• It involves high degree of risks/
uncertainty as the returns are expected
over many years
Need & Importance of Capital
Budgeting
• As Capital budgeting involves investment of
large amount of funds, they influence the
firms growth and riskiness of business
• Capital expenditure decisions are usually
irreversible in nature
• Existence of Huge risk & Un certainty
• Risk of increase in costs due to long
period taken to complete the project.
• They are most difficult decisions to take
Factors influencing investment
decision
• Availability of Funds/ Investment required
• Earnings of the Project/Profitability of
Project
• Return on Capital or Pay back period
• Extra Working Capital needs of the
project
• Management Outlook-
Optimistic/Pessimistic
• Competitor’s Strategy
Process of Capital Budgeting
1. Project Planning
 Identifying the potential investment
opportunities
 Investment opportunities having high potential
of profits for the firm are advanced to the next
step of evaluation.
 Investment opportunities having low potential
or merit of profits for the firm are rejected

2. Project Evaluation
1. Determination of proposal ‘s investments,
inflows and outflows.
2. Techniques are used to evaluate profitability of
the project
Process of Capital Budgeting-
Continued
3. Project Selection
 Projects are selected based on Risks, Return & Cost of Capital
4. Project Implementation
 The firm purchases the required assets and begins with the
implementation of the project
5. Project Control
 Here the progress of the project is monitored with help of
progress reports
 The progress reports include
 Capital expenditure reports,
 performance reports,
 comparing actual performance with planned ones.
 Taking corrective measures to rectify

6. Project Review
 Firm evaluates after the project terminates whether the
project was successful or a failure in terms of revenue
generation.
 The review may provide new ideas for new proposals to be
undertaken in the future by the firm.
Capital Budgeting Techniques
• Non-discounted Cash Flow Criteria
1.Pay Back Period Method
2.Accounting Rate of Return Method
3.Profitability Index Method

• Discounted Cash Flow (DCF) Criteria

1.Net Present Value Method
2.Internal Rate of Return
3.Discounted Pay Back Period Method
4.MIRR-Modified Internal Rate of Return
Pay Back Period Method
• It is the number of years required to
recover the original cash invested in the
project

• There are 2 ways to calculate the Pay Back

Period based on the type of Cash Inflows
from the project
▫ Uniform Cash Inflows or Even Cash Inflows
▫ Non-Uniform Cash Inflows or Un Even Cash
Inflows
Pay Back Period- Uniform/Even
Cash Inflows
• If the project generates constant annual
cash inflows, the payback period can be
computed by dividing the cost of
investment by the annual cash inflow.
• Pay Back Period= Initial Investment
Annual uniform
Cash Inflow
Example
• Assume that a project requires an outlay
of Rs 50,000 and yields annual cash
inflow of Rs12,500 for 7 years. The pay
back period for the project is calculated
as follows

• Pay Back Period= Rs 50,000 = 4 Years

Rs 12,500
Pay Back Period- Non
Uniform/Uneven Cash Inflows
• In case of unequal cash inflows, the payback
period is found by adding up the annual cash
inflows until the total is equal to original
cash outflow.

• PBP= Year Before Full Recovery+ Balance Cash Inflows to be

Recovered
Cash Flows of
the next Period
 Illustration-Investment= Rs
Year Annual Cash Flows Cumulative Cash
1,50,000 Inflows
1 Rs 30,000 Rs 30,000
2 Rs 32,000 Rs 62,000
(30,000+32,000)
3 Rs 25,000 Rs 87,000
(30,000+32,000+25,00
00)
4 Rs 38,000 Rs 1,25,000
(30,000+32,000+25,00
00+38,000)
5 Rs 40,000 Rs 1,65,000
(30,000+32,000+25,00
00+38,000+40,000)
Cash Out flows Rs 1,50,000
PBP= 4 + 25,000 = 4+ 0.625= 4.625
40,000
Acceptance rule for Pay Back
Period
• Accept if PB < standard payback
• Reject if PB > standard payback
• The shorter the pay back period more better it
is for the firm.
• The firm sets up the standard pay back period
for an investment proposal
• If the payback period for the project is equal or
less than the standard pay back period set then
the project is accepted or else rejected.
• Out of 2 projects, the project with lower pay
back period will be accepted and other gets
rejected
Merits & Demerits of PBP
Merits Demerits

Easy to understand and

Ignores the time value of
compute ·
money
and inexpensive to use.

Ignores cash flows occurring

Emphasizes liquidity after the
payback period.

No relation with the wealth

Uses cash flows information maximization
principle.

No objective way to determine

the
standard payback.
Accounting Rate of
Return(ARR)
• Accounting Rate of Return is also known
as Return on Investment Method(ROI)

• This method uses accounting information

revealed in the financial statements, to
measure the profitability of an investment
Accounting Rate of
Return(ARR)
The accounting rate of return is the ratio
of the average after-tax profit divided by
the average investment.

The average investment would be equal to

half of the original investment if it were
depreciated constantly.
Accounting Rate of
Return(ARR)

Average Investment= Net investment

2
Accounting Rate of
Return(ARR)
• If Machine has Salvage Value:
Accounting Rate of
Return(ARR)
• If Additional Working Capital is
introduced in the project
Acceptance Rule for ARR
method
• Accept if ARR > minimum rate(Cut off Rate)
• Reject if ARR < minimum rate(Cut off Rate)
• The calculated ARR is compared with the cut off
rate.
• Cut off Rate is the rate of return on the
investment that should be generated from a
project.
• Cut off rate is usually equal to the cost of capital
• If ARR is more than Cut off rate the project
proposal is accepted or else it is rejected
 Merits & Demerits of ARR
Merits Demerits

Uses accounting data with

Ignores the time value of
which ·
money
executives are familiar

Easy to understand and

Does not use cash flows
calculate

No objective way to determine

the
Uses cash flows information
acceptable rate of return
De-merits of ARR
• ARR ignores the original cost of
investment
Proposal X Y
Investment Capital Rs 1,00,000 Rs 2,00,000

ARR 18% 18%

• It ignores the differences in life span of

the proposals
Proposal X Y
Project Life 10 Years 8 Years

ARR 18% 18%

Net Present Value Method
• It explicitly recognizes that money receivable today has more
value than the money receivable tomorrow.

• NPV is computed by deducting the present value of cash

outflows from the present value of cash inflows

• NPV= PV of Cash Outflow- PV of Cash Inflows

• NPV Represents the excess profitability

• +NPV means the project is earning higher rate of return

than the expected return

• -NPV means the project is earning lower rate of return than

the expected return
Acceptance Rule
• Accept the project when NPV is positive NPV>0

• Reject the project when NPV is negative NPV<0

• May accept the project when NPV is zero NPV=0

• The NPV method can be used to select between

mutually exclusive projects; the one with the
higher NPV should be selected.
Net Present Value Method
Merits & Demerits of NPV
Merits Demerits

Requires estimates of cash

Considers all cash flows
flows which is a tedious task.

Requires computation of exact

True measure of profitability
cost of capital

Recognizes the time value of

Sensitive to discount rates
money

Consistent with wealth

maximization objective
Merits of NPV Method
• It is based on cash flows and recognizes
time value of money

• It considers total life of the project and

considers all cash flows

• This method can be used even when

discount rate varies from one year to
another
De-Merits of NPV Method
• It is considered to be difficult to calculate and understand

• It is difficult in estimating the Discount rate.

• It ignores the original cash outlay

Project-A Project- B
Cash Outlay 1,00,000 Rs 2,00,000

NPV(Rs) Rs 25,000 Rs 25,000

• Difficult to estimate future cash flows

• It ignores the differences in the life span of projects

Internal Rate of Return(IRR)
Method
• It is also discounted cash flow method of capital
budgeting

• It also considers Time value of Money

• IRR depends entirely on Initial cash outlay & cash

inflows from the project under consideration

• It is also known as Rate of Return method

• It is usually the rate of return that a project earns

Accept or Reject Criteria
• In case of Single project , if Internal Rate of
Return is higher than Cutoff Rate or Hurdle
Rate than the project is accepted or else
rejected

• In case of mutually exclusive project, a project

with higher IRR should be accepted and the
other has to be rejected

• If there are budget constraints, the project will

be ranked in descending order of IRR and the
project with highest IRR will be selected subject
to availability of Funds
Merits of IRR
• This method considers time value of
Money
• It considers all cash flows during the life
of project
Demerits of IRR Method
• It requires estimation of all cash inflows
which is tedious work
• It tried with different trial rates, the final
answer will be different
• Results of IRR and NPV may differ in case
of mutually exclusive projects
 Different Initial Investments
 Unequal life of Projects
 Different Pattern of Cash Flows
Profitability Index or BCR
• The ratio of the present value of the cash
inflows to the present value of the cash outflows
is profitability index or benefit-cost ratio:

• Acceptance rule
▫ Accept if PI > 1.0
▫ Reject if PI < 1.0
▫ Project may be accepted if PI = 1.0
Methods to Calculate IRR
• When Cash Inflows are Uniform
▫ First Factor has to be located using the Eqn
▫ F= Initial Investment/Avg Cash Flows
 Where F= Factor to be Located
 Original Investment
 Cash Inflow per year
• The factor value so found has to be
located in Table PVIFA.
• Check the factor value against the No of
Years mentioned in problem for which
cash flows are generated
MIRR-Modified Internal Rate
of Return
• The modified internal rate of return
(MIRR) assumes that positive cash flows
are reinvested at the firm's cost of capital.
Example
• A Problem Costs Rs 36,000 and is
expected to generate cash inflows of Rs
11,200 annually for 5 years. Calculate
the Internal Rate of Return