Building Economics and Value Management

Dr Sarbesh Mishra
Finance Area, NICMAR Hyderabad 500 084.

About Myself
Name Qualifications : 1. 2. 3. 4.

SARBESH MISHRA
B.Com (Hons) Post-graduate in Commerce M.Phil in Commerce Ph.D. (Commerce)

Experience

: Joined University of Delhi, as a

Lecturer in Commerce in 2001 and continued till 2005 and then joined Army Institute of Management, NOIDA as a Senior Faculty, Finance prior to current appointment at NICMAR.

Related to Time (Thoughts)

My interest is in the future because I am going to spend the rest of my life there.
Charles Franklin Kettering, Former Head-Research, General Motors

The man should never be ashamed to own that he has been in the wrong, which is but saying in other words, that he is wiser today than yesterday.
Jonathan Swift, Famous Satiric Writer, Ireland

Remember that time is money.

Benjamin Franklin, Noted Economist, USA

Contd.
You cant get caught up in things that you cant control.we cant control our selling price. We can control our cost of manufacturing. We can control our efficiencies. We can control our waste.
Steven Appleton, CEO of Micro Technology

If you dont know where youre going, it doesnt matter how you get there.
Prof. Sarbesh Mishra, NICMAR, Hyderabad

Economic Analysis
To achieve maximum profitability from the project concerned To minimise construction costs within criteria set for design, quality and space To maximise any social benefit To minimise risk and uncertainty To maximise safety, quality and public image

Processes
Preparation, which includes understanding the project, defining the clients objectives and collecting the appropriate data Analysis, which requires an interpretation of the available data and the formulation of alternative solution Evaluation, which is a combination of the assessment of the suggested alternatives and the identification of alternative solution Decision Making, which involves choosing to proceed with the course of action now identified

Importance of Investment Decision

Influence the firms growth in long-term They affect the risk of the firm They involve commitment of large volume of funds They are irreversible, or reversible at substantial loss They are among most difficult decisions to make.

Types of Capital Investment

Assets to meet regulatory, safety, health, & environmental requirement. Assets to enhance operating efficiency and/or increase revenue. Assets to enhance effectiveness. competitive

Investment Evaluation Criteria

Estimation of Cash flows.
Estimation of required rate of return (Opportunity cost of capital) Application of decision making the choice rule for

Cash Flows
Cash inflows or outflows occur at three stages of capital investment project 1. Project Initiation (For beginning operations,
Working Capital needs, Replacement of asset)

2. Project Operation

(Operating Expenditure, Addl. Working capital need, inflow of cash generated by the investment) (Cash inflows or outflows related to investments disposal, Cash inflows from the release of working capital no longer committed to the investment)

3. Final Project Disposal

Opportunity Cost
Opportunity cost is the cost incurred (sacrifice) by choosing one option over the next best alternative (which may be equally desired). Thus, opportunity cost is the cost of pursuing one choice instead of another.

The opportunity cost of capital is the expected return forgone by bypassing of other potential investment activities for a given capital. It is a rate of return that investors could earn in financial markets otherwise referred as second best alternative

Investment appraisal Techniques

Traditional Techniques Payback Period Method Accounting Rate of return Method Discounted Cash flow Technique 1. Net Present Value method (NPV) 2. Internal Rate of Return Method (IRR) 3. Profitability Index Method (PI)

Traditional Techniques
Payback Period Method Payback is the number of years required to recover the original cash outlay invested in a project. Payback =
Initial Investment Annual Average Cash Flows

Project would be accepted if its payback period is less than the maximum or standard payback period set by management.

Accounting Rate of Return (ARR)

This measures the profitability of an investment.
ARR = Average Income Average Investment

Projects with higher ARR over the minimum rate established by the management will be accepted.

DCF Techniques
It explicitly recognizes the time value of money. Cash flows arising at different time periods differ in their value and are comparable when their present values are found out. The compound interest rate is used for discounting cash flows is also called as the discount rate.

Net Present Value Method (NPV)

Cash flows of the invested projects should be forecasted based on realistic assumptions. Appropriate discount rate should identified to discount the forecasted cash flows. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. Net Present Value is found out by subtracting present value of cash inflows.

NPV Formula
n NPV = t=1 Ct (1+k)t

- C0

C1, C2 .. Represent cash inflow in year 1,2 ., k is the opportunity cost of capital C0 is the initial cost of investment n is the expected life of the investment * k is assumed to be known and is constant

Acceptance Rule
1. Accept the project when NPV is positive 2. Reject the project when NPV is negative 3. May accept the project when NPV is zero. Higher the NPV, the better it is.

IRR and PI
The internal rate of return is the rate that equates the investment outlay with the present value of cash inflow received after one year. The project shall be accepted if IRR is higher than the opportunity cost of capital.

Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

Risk Analysis as a measure of cost control

Uncertainty arises from the lack of previous experience and knowledge. Attached factors are: Date of Completion Level of capital outlay required Level of selling price Level of sales volume Level of revenue Level of Operating Costs Taxation Rules

1. 2. 3. 4. 5. 6. 7.

Probability and Expected Values

The probability of a particular outcome of an event is simply the proportion of times this outcome would occur if the events were repeated a great number of times. Expected Values It results from the multiplication of each possible outcome of an event by the probability of that outcome occurring.

Risk Adjusted Discounted Rate

The capital asset pricing model (CAPM) has provided an approach to determine project required rate of return with risk consideration. A measure of risk developed in the portfolio theory is beta (). RADR = Rf + Ri (K0 Rf) Rf = Risk free rate K0 = Cost of Capital Ri = Risk index of the project

THANK YOU