INVESTMENT DECISION

TECHNIQUES FOR EVALUATING INVESTMENT PROPOSALS

1.PAYBACK PERIOD

2.AVERAGE RATE OF RETURN

3.NET PRESENT VALUE

4.PROFITABILITY INDEX

5.INTERNAL RATE OF RETURN

1.PAYBACK PERIOD

How soon you get your money back .

(a) When annual cash inflow are equal

(b) When annual cash inflows are unequal

B
Pay back period =Y+
C
Y=No of years immediately preceding the year of final recovery.
B=Balance amount still to be recovered.
C=Cash inflow during the year of final recovery.

Example: Initial Investment = 10,000 in a project

Expected future cash inflows 2000, 4000, 3000, 2000
Solution :

Calculation of Pay Back period.

Year Cash Inflows ( ) Cumulative Cash Inflows ( )

1 2000 8000
2 4000 4000
3 3000 (1000)
4 2000 (1000)
The initial investment is recovered between the 3rd and the 4th year is 3.6years
 2. AVERAGE RATE OF RETURN
This method measures the increase in profit expected to result from investment.
It is based on accounting profits and not cash flows.

Q.A project having a life of 5 year ‘ll cost rs.400000.its stream of income before depreciation and tax
is expected to be 100000, 120000, 160000, 170000, 200000 and the tax rate applicable to the firm is
40%.cal ARR
SOLUTION.
Y1 Y2 Y3 Y4 Y5
Profit before 100000 120000 160000 170000 200000
dep &tax
80000 80000 80000 80000 80000
Less:dep(tc-
sc/life)
PBT 20000 40000 80000 90000 120000
Less: tax 8000 16000 32000 36000 48000
PAT 12000 24000 48000 54000 72000

Profit = 210000/5=42000
Invst= 400000/2=200000
ARR=42000/200000*100
=21%

III. NET PRESENT VALUE

NPV= Present Value of Cash Inflows – Present Value of Cash Outflows

The discounting is done by the entity’s weighted average cost of capital.
The discounting factors is given by: 1/(1+R)N

Q.X.LTD considering two different investment proposals A & B the details are:

PARTICULARS A B
INVESTMENT COST 300000 400000
CFAT(INFLOW BEFORE
DEP & AFTER TAX)
I YEAR 120000 150000
II 120000 150000
III 100000 220000
 Suggest the most attractive proposal on the basis of NPV method constructing that the future incomes are
discounted at 12%.

SOLUTION = computation of pv. Of factor=1/(1+r) n

R=12/100=0.12; n=3

YEAR CFAT A CFAT B PV PV A PV B

1 0.893 107160 133950
120000 150000
2 0.797 95640 119550
120000 150000
3 0.712 71200 156640
100000 220000
TOTAL PV OF 274000
INFLOWS
LESS:PV OF 300000 410140
OUTFLOW
NPV (26000) 10140

Analysis: NPV is more in project B and therefore, it is accepted.