INVESTMENT

DECISION
UNIT III
INVESTMENT

An investment is a monetary asset purchased with the idea that the asset will provide
income in the future or can later be sold at a higher price for profit.
Investment decision is the process of making decision in capital expenditure. A
capital expenditure is an expenditure the benefits of which are expected to be
received over a period of time exceeding 1 year.
 Purchase of fixed assets like land, machinery, addition expansion or improvement
in asset, replacement of asset etc.
Definition

Also known as capital budgeting decision

Capital Budgeting Decision is the firm’s decision to invest its current funds most
efficiently in the long term asset in anticipation of an expected flow of benefits over a
series of year.
“Capital Budgeting consists in planning development of available capital for the
purpose of maximising the long term profitability of the concern.”- LYNCH
Features of Capital Budgeting

 Potentially large anticipated benefits

 Relatively high degree of risk
 Long time period between initial outlay and anticipated
return
 Irreversible
Need and Importance

 Huge investment- capital budgeting requires huge funds which are limited to the
firm. So proper planning has to be done before investing.
 Long-term- Capital investment is permanent in nature, and so risk involved is
higher.
 Irreversible- investment once made cannot be changed back without involving
huge loss.
 Growth- it has decisive influence on the growth of the firm. Unprofitable
expansion will result in heavy operating cost.
Types of Investment Decision

 Expansion or Diversification:- Related and Unrelated

Diversification.
Investment in existing or new products may also be called
revenue expansion investments.
 Replacement or Modernization:- to improve operating
efficiency and reduce cost. Also called Cost-reduction
investment.
Types of Investment Decision Cntd.

 Mutually Exclusive:- competing investment. Eg- either labour

intensive semi-automatic machine or Capital intensive fully
automatic machine.
 Independent Investment:- they serve different purposes. Eg.-
decision of buying a new vehicle and new machinery.
 Contingent investment:- dependent projects. Eg- starting a factory
in a remote backward area may necessitate building roads and
houses for employees.
Capital Budgeting Process
Project Generation ●
Identification of investment proposal
●
Screening the proposal

Project Evaluation
●
Evaluation of various Proposal

●
Fixing Priorities
Project Selection ●
Final approval

Implementing proposal
●

Project Execution Performance Review

●
 Project Evaluation Techniques

Traditional Method Modern/ Discounted cash flow

method

• Payback Period
• Average Rate of Return • Net Present Value Method
• Profitability index method
• Internal Rate of Return
1. Payback Period Method
Payback period is the time required to recover the initial investment in the
project. It is also called pay out or pay off period method.

Accept/Reject criteria:
If the actual payback period is less than the predetermined period, the project can be
accepted or it will be rejected. While comparing 2 projects the project having lower PBP
will be accepted.
Merits and Demerits

 Merits:
1) Easy to calculate.
2) It is simple to understand
3) It reduces possibility of loss due to obsolescence.
 Demerits:
1) It ignores time value of money
2) It ignores cash flows after the pay back period
3) It is one of the misleading evaluation of capital budgeting.
4) Does not consider Depreciation
Calculation

We have two different situations:-

 Equal/ Even cash inflow

 Unequal/Uneven cash inflow
A. Equal Cash Inflows

Initial Investment
PBP = Annual net Cash Inflow
EG:
A project costs Rs.50,000 and yields an annual inflow of Rs.10,000.

PBP = 50000 = 5 years.

10000
B. Uneven Cash Inflows

B
PBP = E +
C

Where,
 E = No. of years immediately preceding the year of payback
 B = Balance to be recovered
 C = Cash flow during the year of recovery
Example

A project requires a cash outlay of Rs.12,000 and generates cash inflow of Rs.2000,
Rs.4000, Rs.4000 and Rs,5000 resp.
2. Average Rate of Return (ARR)
 The average rate of return is the average annual amount of cash flow
generated over the life of an investment.

 Under this method avg profit after tax and depreciation is divided by
initial or avg investment. It is also called as accounting rate of return
method.
 Accept/Reject criteria:
If the actual ARR is more than the predetermined required rate, the
project can be accepted or it will be rejected. While comparing 2
projects the project having higher ARR will be accepted.
Merits and Demerits

Merits
1. It is easy to calculate and simple to understand
2. It is based on accounting information rather than cash inflow
3. It considers the total income associated with the project
Demerits
4. It ignores time value of money
5. It ignores the reinvestment potentiality of the project
6. Different methods are used for calculating accounting profit. This may be
misleading
7. Not suitable for comparing projects with different duration
Formula

(Total income/No.of years)

ARR = X 100
Initial or avg Investment
 A real estate investment is likely to generate
returns of Rs. 25,000/- in the 1st year, Rs. 30,000/-
in the 2nd year and 35,000 in 3rd year. The initial
investment is Rs.3,50,000/- with a salvage value of
Rs.50,000/-. The estimated life is 3 years.
Calculate Average Rate of Return. (10%)
An investor is considering the following 2 securities. Determine which security
should be selected based on the following information:

Particulars Project A Project B

Initial Investment 50000 60000

Annual net earnings

Year 1 5000 7000

Year 2 10000 12000
Year 3 12000 14000

Estimated life (years) 3 3

 XYZ company is looking to invest in a new machinery which
costs Rs. 4,20,000/-. An annual revnue of Rs. 2,00,000/- is
expected to be generated and an annual expense of Rs.
50,000/- will be incurred. The machine is estimated to have a
usefull life of 12 years with zero salvage value.
Calculate ARR after charging Depreciation.
3. Net Present Value
It is a DCF technique. It correctly postulates that cash flows arising at different time
periods differ in value and are comparable only when their equivalent present values
are found.
NPV considers the value of all future cash flows discounted to the present. It is the
difference between total present value of future cash inflows and outflows.

Accept/Reject criteria:
The project should be accepted if the NPV is positive. (NPV > 0). Or the project with
highest NPV.
Merits and Demerits

Merits
1. It recognises time value of money
2. It considers the total benefits arising out of the project
3. It is the best method for selecting mutually exclusive projects

Demerits
4. It is difficult to calculate and understand
5. It needs the discount factors for calculation of present value
6. Not suitable for projects having different effective life.
Formula
NPV = Net present value of all cash inflows – Total cash outflow

OR

Z1 Z2 Z3 c
NPV = 1+r (1+r)^2 (1+r)^3 …..

o Z1 – Cash flow in 1st yr

o Z2 – Cash flow in 2nd yr
o Z3 – Cash flow in 3rd yr
o R – discount rate
o C – Cash outflow
Problems

1. Nice Ltd wants to expand its business and so it is willing

to invest Rs 10,00,000.
The investment is said to bring an inflow of Rs. 100,000 in
first year, 250,000 in the second year, 350,000 in third year,
265,000 in fourth year and 415,000 in fifth year. Assuming
the discount rate to be 9%. Calculate NPV.
2. A project requires an initial investment of Rs.225,000 and is expected to generate
the following net cash inflows:
Year 1: Rs.95,000
Year 2: Rs.80,000
Year 3: Rs.60,000
Year 4: Rs.55,000
Compute net present value of the project if the minimum desired rate of return is 12%.
PV factor:
.893
.797
.712
.636
3. Consider the following 2 projects and select the best project using NPV assuming a
discounting rate of 10%:

particulars Project X Project Y

Initial Investment 20000 30000
Estimated Life 5 years 5 years
Cash inflows:
Year 1 5000 20000
Year 2 10000 10000
Year 3 10000 5000
Year 4 3000 3000
Year 5 2000 2000
Scrap Value 1000 2000
4. The following are the cash inflows and outflows of a certain project:

Year Outflows Inflows

0 200000 -
1 50000 35000
2 45000
3 65000
4 85000
5 50000

The salvage value at the end of 5 years is Rs.50000. Taking the discount rate at 10%
Calculate NPV.
4. Internal Rate of return

 IRR is the interest rate that equates the present value of expected future receipts to
the cost of investment outlay. In other words it is the interest rate which makes the
Net Present Value zero. It is also called time adjusted rate of return method or
discounted rate of return method.
 IRR is found by trial and error method.
 First we compute the present value of cash inflows from an investment, using an
arbitrarily selected interest rate. Then this is compared with the investment cost. If
the present value is higher than the cost figure, we try a higher rate. Conversely if
the present value is lower than the investment cost, a lower rate is selected.
Merits and Demerits

Merits
1. It recognises time value of money
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of required rate of return
Demerits
4. It involves complicated computational methods
5. It produces multiple rates which may be confusing
NPV Vs. IRR
 Both these methods are closely related. Both are time adjusted method and in case
of independent projects both methods will lead to same decision. However:
o NPV is calculated in terms of currency while IRR is expressed in terms of
percentage of return
o NPV calculates additional wealth while IRR does not
o IRR cannot be used for projects with changing cash flows ( initial outflow, then
inflow, then again outflow)
o IRR can lead to the belief that a project with shorter life and earlier cash inflows is
preferable to larger projects that generates more cash.
o Applying NPV using different discount rates will give different outcomes, but
IRR always gives same recommendations.
Problems

 1. Tom is considering purchasing a new machine, but he is unsure if

it’s the best use of company funds right now. The new machine costs
Rs.100,000/- and it will earn Rs.20,000, Rs.30,000, Rs.40,000 and
Rs.40,000 in the coming years.
 Calculate the rate at which there will be no loss at all to the business
even though there is no profit.
Year PVF @ 8% PVF @10% PVF @ 11%

1 0.926 0.909 0.901

2 0.857 0.826 0.812

3 0.794 0.751 0.731

4 0.735 0.683 0.659

Formula for IRR

Positive npv
IRR = Base Factor + x DP
Difference in Positive
and negative NPV

Base Factor - Positive discount rate

DP – Difference in percentage
Problem
Calculate the exact IRR for the following project:
Project Cost – 22000
Cash inflows:
Year 1 – 12000
Year 2 – 4000
Year 3 – 2000
Year 4 – 10000
You are given PF :
10% - 0.909, 0.826, 0.751, 0.683
12% - 0.893, 0.794, 0.712, 0.636
5. Profitability Index

 PI is the ratio of present value of cash inflows at the required rate of return, to
initial cash outflow of the investment. Also called Benefit-cost ratio.

PV of cash inflows
PI =
Initial cash outlay

 Accept/Reject criteria:
The proposal can be accepted when PI is more than or equal to One.
Merits and Demerits

Merits
1. It recognises time value of money
2. It analyses all cash flows in the project life.
3. It ascertains the exact rate of return of the project
Demerits
4. It is difficult to understand
5. It is difficult to calculate when two projects have different period of life.
Capital Rationing

 When multiple investment options are available but resources are limited, the
firms may have to choose the most profitable investment.

Steps in Capital Rationing:

1. Ranking projects based on any capital budgeting techniques (NPV, IRR etc.)
2. Selecting the projects in descending order of profitability until the budget
exhausts.
Types of Capital Rationing

 Soft Capital Rationing

 it is when restriction is imposed by the management. (Internal factors)

 Hard Capital Rationing

 It is when capital infusion is limited by external factors
Factors Leading to Capital Rationing

Internal Factors External Factors

• Restriction by Management • Imperfection of capital markets
• Rigidity towards free flow of capital • Govt. Regulations
• Fear about current commitments
• Fund from current operations
Advantages

 It brings in a sense of budgeting in corporates

 It prevents wastage of resources by not investing in each and every
new project.
 Only projects with higher expected returns are selected thus yielding
higher returns
 Since the company is selecting those projects where the expected
return is high, thus ensures stability for tough times as well
Disadvantages

 It may lead to selection of small projects only.

 Miscalculations may lead to selection of less profitable projects
 Introspective due to subjective risk and discounting factor.
1. A firm has only Rs.10 lakhs to invest in various funds. The available projects are
given below:-

Proposal Cost of Project Profitability Index

1 300000 1.46
2 100000 0.098
3 500000 2.31
4 200000 1.32
5 150000 1.25

Advise the order in which the proposals should be accepted.

2. S Ltd has Rs,10,00,000/- allocated for capital budgeting purpose.
The following proposals are ascertained with their profitability index and NPV.
Assume that the projects are indivisible and there are no alternative use of the money
allocated. Advise the company regarding selection of projects.

Project Cost PI NPV

1 300000 1.22 66000
2 150000 0.95 (-)7500
3 350000 1.20 70000
4 450000 1.18 81000
5 200000 1.20 40000
6 400000 1.05 20000
3. Equipment A has a cost of Rs.75000 and net cash flow of
Rs.20000 per year for a period of 6 years. A substitute
Equipment B would cost Rs.50000 and generate net cash
flow of Rs.14000 per year for 6 years. The required rate is
11%. Calculate NPV and IRR and suggest which equipment
should be accepted and why.
PVAF @11% - 4.231
4. ABC ltd is considering the following projects. Using discounted pay back method
suggest which is a better project.

Year Cash inflows of X Cash inflows of Y PVF @ 10%

1 5000 1000 0.909

2 4000 2000 0.826
3 3000 3000 0.751
4 1000 4000 0.683
5 -- 5000 0.621
6 -- 6000 0.564
CO 10000 8000
5. ULC co. is planning to invest in a new project. The expected cash flow and its
probability is given below. Calculate NPV @ 12%.

Year Cash Flow Probability PVF @12%

0 100000 1
1 40000 0.40
20000 0.20 0.8929
30000 0.40
2 80000 0.25
70000 0.35 0.7972
50000 0.40
3 52000 0.30
47000 0.45 0.7118
64000 0.20
4 73000 0.30
66000 0.40 0.6355
59000 0.30
 6. Excel ltd is considering expanding their business by
manufacturing and selling keyboards with an investment of
Rs.400000. The project is expected to produce 10000 keyboards
per year at an operating cost of Rs.20. per unit for the next 5
years. They are expecting to sell the keyboard @ Rs.40.
Depreciation of Rs.80000 has to be charged every year and tax @
34% has to be deducted. The expenses are to be capitalised
@10% and revenues @ 5%. Calculate the NPV for the project @
12% cost of capital.

FV @ 5% 1.0500 1.10250 1.15763 1.21551 1.27628

FV @ 10% 1.1000 1.2100 1.3310 1.4641 1.61051
PV @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674
 Calculation of Cash Inflow
Particulars Year 1 Year 2 Year 3 Year 4 Year 5

Keyboards produced 10000 10000 10000 10000 10000

Sales revenue @ 5% FV 400000 420000 441000 463050 486203

(a)
Operating cost @ 10% FV 200000 220000 242000 266200 292820
(b)
Gross profit (a-b=c) 200000 200000 199000 196850 193383

Depreciation (d) 80000 80000 80000 80000 80000

PBT (c-d=e) 120000 120000 119000 116850 113383

Tax @ 34% (f) 40800 40800 40460 39729 38549

Net profit (e-f=g) 79200 79200 78540 77121 74834

PBDAT (g+d=h) 159200 159200 158540 157121 154834

ASSIGNMENT
 From the following details, calculate the exact internal Rate of Return for each of the
projects

Particulars Project X Project Y Project Z

Initial Investment 10000 11000 12000

Cash Inflow at the end

of year:
1 500 6000 2000
2 2000 4000 3000
3 3000 - 4000
4 4000 - 4000
5 5000 3000 2000
6 (-1000) 2000 1000