UNIT - 2

INVESTMENT DECISIONS
&
CAPITAL BUDGETING

By- Amit Kr. Arora

INVESTMENT DECISIONS
 Investment means the use of money in
the hope of making more money.

Where to invest?
When to invest?
At what extent to invest?
How to invest?
What is the purpose of investment?
CAPITAL BUDGETING
NATURE/ FEATURE OF
CAPITAL BUDGETING
 Capital budgeting plans involve a huge
investment in fixed assets.
 Preparation of capital budgeting plans involves
forecasting of several years’ profit in advance in
order to judge the profitability of projects.
 Capital expenditure once approved represents
long term investment that can not be reversed
without sustaining a loss.
 In view of the investment of large amount for a
fairly long period of time any error in the
evaluation of investment may lead to serious
consequences financially and otherwise and may
adversely affect the other further plans of the
organization.
SCOPE OF CAPITAL
BUDGETING DECISIONS

 Expansion Decisions
 Replacement Decisions:
 Buy or Lease Decisions:
 Choice of Equipment:
 Product of Process Improvement
CAPITAL BUDGETING
PROCESS

Project Project Project Project

Follow-up
Generation Evaluation Selection Execution
 CAPITAL BUDGETING
TECHNIQUES

Capital Budgeting
Techniques

Discounted Cash
Traditional
Flow
Techniques
Techniques

Pay-back Accounting
Urgency Net Present Internel Rate Terminal Profitability
Period Rate
Method Value of Return Value Index
Method of Return
PAYBACK PERIOD METHOD
 (A) In the Case of Even Cash
Inflows:
 If cash inflows from investment are
uniform throughout the life of investment,
payback period is calculated by dividing
the cost of investment with the amount
of annual cash inflow. As per formula:
 P.B.P. =
(B) In the Case of Uneven Cash
Inflows
 If cash inflows from investment are not uniform each
year, payback period will be calculated by taking
cumulative total of each year’s cash inflows and the
exact payback period will be calculated by
interpolation. Pay back period will be calculated as:
P.B.P. =

Where, E = number of years immediately

preceding the year of final recovery
B = the balance amount still to be recovered
C = cash flow during the year of final recovery
Illustration:
 A project with an outlay of Rs. 12,000 yields Rs.
2,000, Rs. 3,000, Rs. 4,000 and Rs. 6,000
respectively in the first, second, third and fourth
year, the payback period will be calculated as thus:

Year Cash-inflow CumulativeCash-in-flow

1 2,000 2,000
2 3,000 5,000
3 4,000 9,000
4 6,000 15,000
Solution:

 P.B.P. =
=
3 Years and 6 months

 Post Payback Profitability = Total

Cash Inflows – Investment Outlay
 Post Payback Profitability Index =
 Net Present Value Method
 From the following calculate the Net
Present Value of the project A. A discount
rate of 10% to be used.

.
Computation of NPV
Illustration:
 The following are the details relating to two projects:

Project X (Rs.) Project Y (Rs.)

Cost of Project 1,60,000 2,00,000
Estimated Scrap 16,000 24,000
Estimated Savings:
Ist year 20,000 40,000
2nd year 30,000 60,000
3rd year 50,000 60,000
4th year 50,000 60,000
5th year 40,000 30,000
6th year 30,000 20,000
7th year 10,000 -

Calculate Payback Period and consider which project is better.

 Question:
A company is considering the purchase of a machine.
Management does not want to purchase a machine if its
payback period is more than 3 years and its rate of return of
investment is less than 20%.
Two machines – X and Y are under consideration. Cost of each
machine is Rs. 10,000 and working life is 4 years. Scrap value
is Rs. 1,200 and Rs. 400 respectively. Annual cash inflows are
as under:

Year Machine X Machine Y

Rs. Rs.
First 2,000 3,000
Second 3,000 4,000
Third 4,000 5,000
Fourth 8,000 5,000

Evaluate the two proposals and suggest as to which machine

should be purchased?
 Arora Co. is considering the purchase of a
machine. Two machines, X and Y, are available
each costing Rs. 50,000 and salvage is estimated
at Rs. 3,000 and Rs. 2,000 respectively. Earnings
after taxation are expected to be as follows:
 Year Cash Flow
 Machine X Machine Y
 1 Rs. 15,000 Rs. 5,000
 2 20,000 15,000
 3 25,000 20,000
 4 15,000 30,000
 5 10,000 20,000

 Evaluate the two alternatives according to:
 a) The payback method;
 b) Unadjusted Rate of Return Method;
 c) Net Present value Method. A discount rate of
10% is to be used.
 Question:
 Rank the following investment proposals for
A&G pvt. Ltd. in order of their profitability
using (a) Payback period method, (b)
Accounting rate of return method and (c)
Present value index method (cost of capital
– 10%):
 Project Initial Outlay Annual
Cash Flow Life
 Rs. Rs. (in years)
 A 96,000 15,000 12
 B 48,000 10,000 8
 C 80,000 14,000 10
 D 40,000 9,000 8
Internal Rate of Return (IRR)
Let us consider a project where initial investment is Rs. 18,000.
The annual cash flow will be Rs. 5,600 for a period of 5
years. Calculate IRR.
Consideration other than
Profitability in Managerial
Decisions
 Urgency of the Project
 Funds Available
 Managerial Capability
 Availability of Additional Funds
 Fuller Utilization of Funds
 Future Expectations of Earnings
 Degree of Certainty of Net Income
 Risk of Obsolescence
 Maintaining Market Share
LEVERAGE ANALYSIS
Leverage is a relationship between two
interrelated variables , these may be cost,
output, sale, EBIT, EBT etc.
The variables should be interrelated
Leverage = % change in one variable
% change in other variable
LEVERAGE ANALYSIS
 Particular Amount
 Sales
 Less variable cost / Marginal cost
 Contribution (C)
 Less Fixed cost
 Earning before interest and tax and dividend (EBITD)
or Operating Profit (OP)
 Less Interest
 Earning before tax and dividend (EBTD)
 Less Tax
 Earning after tax but before dividend (EATD)
 Less Preference Dividend
 Earning available to Equity share holders
 Earning per share (EPS)
 (Earning available to Equity share holders divided by No. of Equity shares)
Types of Leverages

 OPERATING LEVERAGE

 FINANCIAL LEVERAGE

 COMPOSITE LEVERAGE /
COMBINED LEVERAGE
1) OPERATING LEVERAGE

The relationship b/w sales revenue

and EBIT is defined as operating
leverage.
If there is no F.C. the O.L. will always
equals to 1
Higher the F.C greater would be the
O.L
A high DOL is a high risk situation
FINANCIAL LEVERAGE
The relationship b/w EBIT and EPS is
defined as F.L.
F.L. exists whenever a firm has debt or
other sources of funds that carry fixed
charges.
Higher the fixed charges higher would be
the F.L.
No fixed financial liab. There will be no F.L.
Illustration : The capital structure of a
company consists of the following
securities :
10% Preference share capital
Rs. 1,00,000
Equity share capital (Rs. 10 per
share) 1,00,000
The amount of operating profit is Rs.
60,000. The company is in 50% tax
bracket.
You are required to calculate the financial
leverage of the company.
Q- A company has the following capital
structure :
Equity Share CapitalRs. 1,00,000
10% Preference share capital 1,00,000
8% Debentures 1,25,000
The present EBIT is Rs. 50,000. Calculate the
financial leverage assuming that company is
in 50% tax bracket.
Q- G.P. Ltd. has sales of Rs. 25,00,000. The
fixed costs are Rs. 4,00,000 and variable
costs are Rs. 17,00,000. The company uses
a debt of Rs.10,00,000 @ 12% p.a.
From the available data, calculate the
operating, financial and combined
leverages.
Q- A firm has sales of Rs. 20,00,000,
variable cost of Rs. 14,00,000 and fixed
costs of Rs.4,00,000 and
debt of Rs.10,00,000 at 10% rate of
interest. What are the operating, financial
and combined leverages? If the firm wants
to double the Earnings before interest
and tax, how much of a rise in sales would
be needed on a percentage basis?