Chap.

1: OVERVIEW OF INVESTMENT
ANALYSIS
• Definition: • Objectives of Investment Analysis
• Investment Analysis is the process of evaluating 1. Maximizing wealth using the available resources
an investment for profitability and risk involving an ie if one has invested shares in a company, what
examination and assessment of economic and is the return on investment.
market trends, earning prospects, earning ratios
and various other indicators and factors to 2. Maximizing profits- major objective of business.
determine the suitable investment strategies. 3. Minimizing risks- a chance of future loss which
• When making investment decisions, investors may can be foreseen- put a policy in place.
consider a range of options ranging from a small 4. Liquidity-Be able to settle obligations when they
business to the investment a large scale corporate fall due.
projects.
5. Hedging against inflation
• Thus investment analysis could also mean the
process of judging an investment for income, risk
and resale value
 FINANCIAL MANAGEMENT
• Definition:
• Financial Management refers to the efficient and
effective management of the money (funds) in
such a manner as to accomplish the objectives of
the organization.
• It is a top management’s operational activity of a
business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient
operation.(Joseph Massie)
• Objectives of Financial Management
1. Maximizing wealth using the available resources
ie if one has invested shares in a company, what
is the return on investment.
2. Maximizing profits- major objective of business.
3. Minimizing risks- a chance of future loss which
can be foreseen- put a policy in place.
4. Liquidity-Be able to settle obligations when they
fall due.
5. Flexibility- Ability to look at alternative sources
eg bank overdraft to pay workers.
6. Financial control- set targets, monitor
performance, compare and correct deviations
FINANCIAL MANAGEMENT
DECISIONS:
1. Investment decision:
- It means investing in long term assets which
will generate money for you in future eg
buildings, land, vehicles, shares etc.
- These are important because they involve
huge sums of money, decisions are not easy to
reverse and you may acquire assets that may
not help you compete favorably.
2. Financing decisions:
- This is where you are going to get money
from and decisions include- how much do you
need, when do you need it, on what terms,
which source ie bank loan, issue of shares,
sale of assets etc.
- It is important to make correct decisions
because some involve costs such as interest
and risk of loosing mortgage.
3
FINANCIAL MGT DECISIONS Cont’d
3. Asset management decisions
(Working capital management) • Profitability is the ability to get adequate returns to
shareholders ie decrease cash and invest in assets

Level of liquidity
• It means having less investments in current assets
& profitability such as bank, cash etc.
Liquidity

• Liquidity is the ability to settle obligations as they

Optimum
fall due ie the money you have, the more liquid you
are at the expense of profitability.

Profitability
• The Finance Manager should invest optimumly ie
not so much and not so little to get a return
Investment in Assets

4
 FINANCIAL MGT DECISIONS Cont’d
4. Profit Allocation:
NB. The above financing decisions are very important
for every company’s success and requires the input
of a qualified and competent Finance manager who is
-This involves distributing profits equitably ie part of top management
give shareholders as well as maintaining some
for organizational expansion

5
Functions of Financial Management
( Role of Finance Manager)
1. To Forecast the financial needs of the
company to operate ie HR, Procurement,
Administration, Marketing etc.
2. To design financial securities to investors
that will raise money.
3. To issue securities to investors and raise
money.
4. To use the money to purchase real assets
required for company’s operations.
5. To ensure there is surplus from operations
6. Re- invest excess money generated so as to
create more money.( Don’t keep large
sums of money)- Investment decision
7. Pay periodic commitments on the money
raised eg interest, taxes, salaries etc.
8. Repay back the original amounts at maturity.
9. Weighing the alternative sources and
balancing between equity and debt (financial
structure)
10. Record keeping and production of routine
financial reports to assist in decision making.
11. Interaction with other departments eg IT,
marketing, production etc (good relationship)
12. Cash management- sound internal controls
6
Financial objective of organizations
• Most organizations are formed with the major
objectives of profit maximization and will ensure
sales maximization to get a return to the share
holders.
• Managers will do whatever it takes to achieve this
objective including setting targets and measuring
performance.
Why profit maximization is criticized.
1. It only looks at shareholders yet organizations
have many stake holders.
2. It encourages creative accounting ie presenting
financial information that will enable other stake
holders know what they want but not the real
picture or position of the business.ie doing
anything as long as it maximizes profits.
3. It does not look at risks involved in making those
profits.
4. It focuses on short term other than long term
operations of the business.
7
Other objectives of organizations
2. Wealth maximization: This is the total cash flow Solution:
that is expected from all assets of the business
discounted to get its present value/worth and its an
improvement of the profit motive of the organization.
Year 1: Year 2:
Example: PV= FV PV= 1,440,000

Supposing company ‘A’ would like to know the wealth (1+r)n (1+0.3)2
addition that will be desired if it invested in a boda Pv = 1,440,000
boda which is expected to give them an average of
shs 1,440,000 over the next 2 years. If the current (1+0.3)
bank rate borrowing rate is 30%.
Required. Pv = 1,107,693 PV= 852,071
Discount the cash flows of this boda boda to derive Since this looks at all cash from all investment and
the wealth that will be maximized from this project. puts in consideration for time value of money, NPV
from the above project will be
1,107,693+852,071=1,959,764

8
Other objectives cont’d
(Non- Financial)
3. Corporate and social responsibility ie giving back STAKE HOLDERS:
to society where organization operates from eg
sponsoring events like MTN Marathon where - A stake holder is one who can affect or be affected by
proceeds go to cancer patients actions,objectives,policies of the organization. They
include;
4. Survival and growth ie Going concern.
1. Employees
5.Employee motivation
2. Share holders
6.Government obligation eg taxes
3. Management
7. Protecting the environment tree planting
4. Suppliers
8. Sales maximization.
5. Government
6. Competitors
7. Pressure groups- trade union, environmentalist
8. Public

9
FORMS OF BUSINESS ORGANISATIONS:
Advantages of sole proprietor:

1. Sole proprietorship 1. Cheap set up costs.

2. Reduced operating costs
2. Partnership
3. Avoids corporate tax
3. Joint ventures
4. Subject to few government regulations
4. Limited liability companies/corporations
5. All profits are taken alone- ploughed back
6. Complete secrecy in business
1. SOLE PROPRIATORSHIP Disadvantages
An un incorporated business owned by an individual 7. May fail to raise funds
and is not treated as a separate legal entity from its 8. May lack skills
owners.
9. Un limited liability-personal assets be attached
- An individual receives all profits or losses and is
liable to all obligations of the business. 10. All losses – alone.
11. No continuity in case one dies

10
Forms of business cont’d

2. Partnership: Disadvantages
- It is a relationship that exists between 2 or more
persons carrying on business in common with the
1. Un limited liability
view of making and sharing profits.
- They share profits or losses according to agreed 2. Profits are shared
terms or formula eg Ratios. 3. No secrecy in business
4. In case one works hard, proceeds are shared
Advantages 5. In case one makes a mistake all suffer
1. Share skills and talents
2. Raise more capital than a sole proprietor
3. Reduced tax liability
4. Going concern

11
Forms of business cont’d

3. Corporation/ Limited liability companies 1.
It is a separate legal entity created through state 2.
approval, treated as different from its share holders ie
can sue or be sued in their own name.
3.
Advantages
Limited liability to external debt
Going concern- live beyond life of its
founders.
Raise more capital through issue of shares

Disadvantages
4. A lot of documentation to be incorporated
5. A lot of reporting requirements- non
compliance is eminent.

12
CORPORATE GOVERNANCE:

Refers to the way a company is governed ie Principles of good corporate governance

roles/relationship between management and
directors of a company. Eg
1. Directors- responsible for corporate governance 1. Fairness- equal treatment eg share holders
of the company.
2. Accountability- obligation to give
2. Share holders – linked to directors through explanation for any actions
financial reports.
3. Transparency- openness on activities
3. Auditors – check on financial statements
4. Responsibility- act on behalf of share
4. Employees are indirectly addressed by financial
statements.
holders
Read on Role of – Executive and NEDs, Auditors, 5. Governance structure
Board chairman 6. Integrity in reporting

13
Corporate Governance cont’d
AGENCY THEORY:
- This is the relationship that exists between
management and the shareholders of the company
where managers act as agents for share holders,
using delegation powers to run the affairs of the
company in the best interest of share holders.
AGENCY PROBLEM
- A Potential conflict of interest between the agent,
share holders and creditors may arise.
- Share holders posses the right to remove directors
from office but the share holders have to take the
initiative to do so as in many companies they lack
energy to take such action.
- Another reason why managers may do their best to
improve financial performance of their company is
that often their pay is related to the size or
profitability of the company.
- Another source of conflict is attitudes towards risk
because share holders can spread his risk by
investing in many companies but manager’s
financial security depends only on that company
that employs him.
- Agency theory suggest that audited accounts of a
limited company are important source of post
decision information minimizing investor’s agency
costs in contrast to alternative approaches.
14
Agency problem cont’d

Solutions to Agency problem: • Recommendations for Corporate

1. Threat to take over
Governance
2. Threat to firing managers
3. Bonus share reward- managers 1. BOD to meet regularly
4. Profit related pay 2. Clear accepted division of responsibility.
5. Appointment of Auditors 3. Clear separation of posts of chairman and CEO.

6. Appointment of the BOD 4. Directors to be accountable to all their activities.

7. Intervention of share holders 5. EDs to have a defined term of office

6. Remuneration should be set by Remuneration
committee headed by NED

15
Financial Control

- Refers to the means by which organization’s 1. Significant investment

resources are directed, monitored and measured.
2.
- It refers to facts that show whether or not the
business has the right to control the economic
3.
aspects of the worker’s job.
- These fall under the following; 4.
5.
Method of payment-regular payment
guaranteed.
Un reimbursed expenses
Opportunity to make profit or loss.
Services available at the market.

16
Roles of Financial
Planning
Controller:
1 .Ensure correct accounting entries- with supporting
documents.
2. Establish procedures that guarantee security of
company resources/assets- custody of records.
3.Data analysis and interpretation of financial data
Financial Reporting- budgets, cash flow, balance
sheet etc.
4.Budgeting and Forecasts
5.Preparation of taxes, salaries and other deductions.
Financial
• Financial Plan is a comprehensive evaluation of an
investor’s current and future financial state by
using current known variables to predict future
cash flows, asset values and withdraw plans.
• It is an ongoing process that helps you to make
sensible decisions about money that can help you
achieve your goals in life.
17
Steps in creating a sound Financial plan

1. Establish your goals in life ie short term, 5. Implement your plan- make the changes and make
medium and long term. it happen.
2. Work out what assets and liabilities you have- 6. Monitor and review your plan at least yearly and
write them down. make adjustments where necessary.
3. Evaluate your current financial position- how
close are you to achieving your goals.
4. Develop your plan- create a ‘’route map’’ for
achieving your different goals.

18
FINANCIAL FORECASTING:

Financial Forecasting is an estimate of future

financial outcomes for the company base on past, Importance of Forecasting:
current and projected financial conditions.
1. Demonstrates the financial viability of a new
business venture
Tools used in Forecasting
2. Provides a benchmark against which to measure
1. Proforma Financial statements- previous years’ future performance.
sales figures
3. Allows you to guide your business in the right
2. Time series- trends of data collected over a long direction and take control of your cash flow.
period of time.
4. Identifies potential risks and cash shortfalls to
3. Cause-effect method eg interest rates keep the business out of trouble.
4. Executive opinion- knowledge of experts 5. Assists you to secure bank loan, investors etc.

19
 Chap 2:
SOURCES OF FINANCE/ FINANCING
SOURCES
1. Short term sources (W.K Finances)
- Funds are needed for different purposes in 1. Trade credit- suppliers
organizations for example investing in new 2. Accrued expenses- salaries, taxes.
business, buying fixed assets, and meeting
operational expenses. 3. Differed income- advance payments to supply goods
or services.
- There are many sources but these vary in respect
4. Bank overdraft
to purpose, cost, risk and period for which funds
could be available for use. 5. Retained profits- un distributed
- These sources are categorized two ie 6. Loans from money lenders

1. Short term and Long term. 7. Disposal of Assets

8. Hire purchase
2. Internal and External sources.
9. Debt factoring- discounting debts
10. Commercial paper
11. Sale and lease back

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FINANCING SOURCES Cont’d
2. Long term sources:(Exceed one year) 3. Internal sourcing( From within)

1. Ordinary share capital- Owners equity. 1. Retained earnings

2. Preference share capital- fixed rate of return, no
voting right etc.
2. Bonus shares- given to members instead of
dividends.
3. Debentures- long term promissory notes to pay
interest and principal on maturity. 3. Rights share- priority given to members.
4. Long term loans eg DFCU,UDB,EADB. 4. Accrued expenses
5. Retained Earnings- un distributed profits 5. Prepayments- advance payments.
6. Leasing- Finance and operating leases-lessor allows 6. Disposal of assets
leasee exclusive rights in return for lease rentals
7. Provisions- bad debts, depreciation
7. Bonds- investor lends money to a company for a long
term say 25 years, receives periodic interest until
maturity

21
FINANCING SOURCES Cont’d
4. External Sourcing: Factors to consider before borrowing:
1. Ordinary share capital 1. Size of the organization
2. Preference share capital 2. Cost of borrowing
3. Debentures 3. Risk associated
4. Bank loans 4. Terms of repayment
5. Trade credit and discounts 5. Cash inflows
6. Hire purchase 6. Period of repayment

7. Bank overdraft 7. Financial stability of the source

8. Debt factoring- discounting 8. Other attachments

9. Loans from individuals-money lenders 9. Economic factors eg inflation levels

22
FINANCING SOURCES Cont’d
Capital and Money Markets:
Difference
Role of capital mkt Authority
USE

23
Chap 3: CAPITAL BUDGETING (INVESTMENT
DECISION)
- Capital Budgeting/investment decision is the
commitment of funds into a given venture with
a purpose of generating returns in future.
- The funds can be invested in Real investment
like real estates, factory machinery, land or
Financial assets like buying bonds, shares and
money/capital market instruments like fixed
deposits.
Reasons to be careful in investment decisions
1. It shapes the type of business and industry
that the entity is in eg for a hospital it will be
different from a bank.
2. It shapes the business risk that the entity will
face – each business has unique risk.
3. It is difficult to reverse investment decision.
4. . It requires an assessment of future events
that are difficult to predict.
5. Firms commit huge amounts of money-capital
assets
24
The capital Budgeting process/stages:

1. Definition of the organizational objectives ie what 5. Selection of the most appropriate investment that
does the organization want to achieve? will add wealth to organization.
2. Generation of ideas on the possible investment ie 6. Implementation of the best idea
from friends, consultants, media, internet etc.eg
7. Monitoring and control ie compare the intended
school, supermarket, -involve many people.
goal with the achievement and make corrections in
3. Screening the investment ideas with the purpose case of deviation.
of separating the feasible from a number of
proposals- ability.
4. Evaluation of each investment idea by using
different appraisal tools to determine the most
viable- NPV,IRR,PBP,PI,ARR.
- The co assesses viability, feasibility and suitability.

25
Investment Appraisal (Evaluation)
Definition: Relevant cash flows in investment appraisal:
- This is the process of assessing or ascertaining the
viability, feasibility and suitability of the
investment. These are inflows or outflows which occur as a
result of a project. These include;
- This process starts by looking at the forecast of the
financial data for a particular investment the 1. Initial out lay.
company is interested in.
2. Expected working capital requirements.
- Only relevant financial information should be
considered ie one that can be changed if a decision 3. Relevant costs- over the useful life of a
is undertaken. project.
4. Cash in flows.
5. Profit information.

26
Investment Appraisal cont’d

• Irrelevant costs:
Sunk costs:
These are costs of resources already acquired which
can not be changed.
- These costs are created by a decision made in the
past and will not be changed by decisions made in
future eg
- Feasibility study
- Consultancy for future investment

27
Chap 4: INVESTMENT SELECTION TECHNIQUES
(APPRAISAL TOOLS)
• These are categorized into two ie
1. Non discounting techniques - Tools that
ignore Time Value of Money (TVM) eg Pay
back period, ARR,ROI/ROCE.
2. Discounting techniques – Those that
consider TVM eg NPV, IRR and PI
(profitability index).
1. PAY BACK PERIOD:
- This determines the time it takes for an
investment to recover its initial money
invested in a project or business (recouping).
- Given two projects which are both viable, the
one with a shorter payback period is
preferred though each investor will have their
own PBP.
- For a project with uniform cash flows, the
PBP= Initial cash out flow
Annual cash flows
28
Appraisal tools cont’d
Required:
- For projects with non- uniform cash flows, the - Assuming Mark expects this boda boda to have a
best method is to subtract the cash flows from the life span of 3 years and after which it will be sold
cash outflows until the out flows are exhausted. for shs 500,000, Compute the PBP of this boda
- Example: boda.
- If Mark purchased a boda boda today for shs 3
million for purposes of earning daily income. From - Solution:(shs 000)
analysis of the market, he has come up with the
following forecasts:
Year 1 2 3
- The rider will give him shs 10.000 per day for
6days a week. We assume the boda boda will be Cash collection 2,880 2,880 2,880
operational for 48 weeks a year as the balance is Scrap - - 500
for resting, repairs etc. 2,880 2,880 3,380
Cum.cash flows 2,880 5,760
Below Above

29
Appraisal tools cont’d

2. Assume Year 0 initial outlay is 18,000, for 5

years with cash inflow as below, compute PBP.
- From the above computation, shs 3 million
will recouped between 1st and 2nd year but to Year cash inflow Cum cash flow
be exact, 0 (18,000) -
- PBP=1 Year and 120,000 * 12 1 4,000 4,000
2,880,000 2 6,000 10,000
3 6,000 16,000
= 1 Year and 0.5 months 4 4,000 20,000
5 4,000 24,000
PBP = 1 Year and 2 weeks.

30
Appraisal tools cont’d
- From the above computation, shs 16,000 will Benefits of PBP:
be recovered at the end of year 3 but we
need shs 18,000. 1. It is easy to understand and interprete by
non finance individuals.
- Therefore,
2. It is the most commonly used appraisal
method as it can quickly eliminate
- PBP= 3Years + 2,000 = 1/2 investments that are not worth.
4,000 3. It is good for short term projects.
4. Investor knows when to recover his money.
PBP = 3 Years + 6 months 5. It can be used as an initial screening tool
before applying more advanced methods.
6. It is computed based on cash flows which
are more relevant than profit information.

31
Weakness of PBP:
1. It does not take into consideration TVM –
that money looses value with time.
2. Some investments may have a longer
period of PBP and yet they are more
profitable than shorter ones eg schools.
3. It does not look at the whole project ie
ignores cash flows after PBP.
4. It is un able to distinguish between
projects with the same PBP.
5. It may lead to excessive investments in
short term projects.
2. ACCOUNTING RATE OF RETURN
(ARR/ROI):
- This is the percentage return which takes the
average accounting profit that the investment
will generate and express it as a %ge of the
average investment made over the life of the
project.
- ARR= Average profits * 100%
Average Investment
- Where AV Profits = All profits
Life span
32
 ARR cont’d

Advantages of ARR/ROI
Av. Invest= Initial Inv + scrap value 1. It uses all available information that can be
verified through an audit process.
2 2. It can be understood in relation to the
ruling market of return.
3. Looks at the entire project life.
4. Simple and quick calculation.
5. It involves familiar concept of percentage
return. Eg ROCE

33
 ARR Cont’d:

Limitations of ARR: Or,

1. It ignores TVM. ARR=Average annual profit ie BIT but after Depn
2. Uses profit information that can be forged. Initial Capital
Note:
- Compare the answer obtained with s given
RRR to make a recommendation.
ARR= Estimated Average Profit *100%
Estimated Average Investment
Where,
- Av pft= All inflows/No of years.
- Av. Invest=Initial + scrap

34
 Example:
- Supposing ABC would like to set up a transport a) Solution:
hire services company that would require Initial
Investment in vehicles & infrastructure with shs
150 million over the next 4 years, expects
annual revenue of shs 60 million pa and Year 1 2 3 4
operating expenses of 30% of Revenue. Revenue 60m 60m 60m 60m
- Depn on MV will be on straight line at 25% & Expenses (18m) (18m) (18m) (18m)
the vehicle will be sold off after 4 years for
replacement at a Total of shs 60 million. Depn (37.5m) (37.5m) (37.5m) (37.5m)
Required Profit 4.5m 4.5m 4.5m 4.5m
a) Compute the profit of this business for this Profit on
period of 4 years and the ARR. Disposal mv - - - 60m
b) If ABC RRR was 30%, Is this a worthwhile Net profit 4.5m 4.5m 4.5m 64.5m
business?

35
 Example cont’d

b) Conclusion:
ARR= 4.5+4.5+4.5+64.5 = 19.5m
4 The investment is not viable because ARR
From (13%)is less than 30% required by the investor.

ARR= Average Profit *100

Initial cost

ARR= 19.5*100 = 13%

150

36
 DISCOUNTED CASHFLOW TECHNIQUES:

TIME VALUE OF MONEY (TVM):

- These are investment appraisal techniques - This concept refers to the fact that the value of
that take into consideration both timing of a shilling today is more than the value of a
cash flows and total profitability over a shilling tomorrow.
project’s life.
- Thus, given a future sum of money, its present
- These include; worth should be determined through a
1. Net Present Value(NPV) discounting process that is based on current
market rates eg
2. Internal Rate of Return(IRR)
- From our previous example of a boda boda,
3. Profitability Index (PI) the cash flow of the motorcycle was as follows:
- Year 1 2 3
- CF(000) 2,880 2,880 3,380

37
 TVM Cont’d

- However, to be able to earn the above cash flow,

Mark had to part with shs 3million at inception. - In using DCF techniques, all payments and receipts
- The value of the money received after I,2,3 years from capital investment are discounted to a present
can not be the same as today. To determine the value using the formula;
worth of the cash flows received over the 3
years, we shall have to look at the following - PV= FV .
factors;
(1+r)n
1. Inflation rate.
Where;
2. Ruling bank rates which shows the cost of
money. PV= Present value
FV= Future value
3. The rates on international Financial markets.
These will be used to discount future cash r= Cost of capital (interest rate)
flows to present worth. n= Period

38
 Example:
- Supposing the ruling rate of interest in COST OF CAPITAL:
Ugandan market is 30%, then we should use
that to discount the cash flows. From the - The cost of capital is used by DCF analysis is
above example, the minimum return expected by the
providers of funds.
- Year 1 PV= 2,880,000 = 2,215,385.
- It is derived from the weighted average cost
(1+.3) 1
of capital (WACC) ie
- WACC= Ke* E + Kd * D
- Year 2 PV= 2,880,000 = 1,704,142
(E+D) (D+D)
(1+.3) 2

- Year 3 PV = 3,380,000 = 1,538,462

(1+.3)3

39
COST OF CAPITAL Cont’d

NET PRESENT VALUE (NPV):

Where; - It is the discounted value of all future cash
flows from a project using the company’s cost
of capital.
WACC = weighted average cost of capital.
- It is the difference between the present value
Ke = Cost of equity (dividend) of cash inflows and the present value of cash
Kd = Cost of debt (Interest) outflows from an investment.

E = Equity(Share capital) - PV of outflows is the initial outlay which is the

amount of funds that must be spent for an
D = Debt (Loan) investment to take off.
- The NPV assesses the wealth creation
potential of an investment and is consistent
with the objective of wealth maximization.

40
 Examples of initial outlay:

1. Cost of purchase of equipment.

What is excluded in computing NPV:
2. Initial working capital.
3. Transport to site of equipment
1. Sunk costs-already incurred eg research,
4. Initial training of staff. consultancy.
5. All other relevant incidental costs.
2. Finance related costs eg interest because its
already incorporated when computing cost
Examples of Relevant costs to be included: of borrowing.
6. Capital allowance/Tax saving/ Tax incentive. 3. Depreciation and other non cash items
7. Working capital – For day today running of
because they don’t involve flow of cash.
business.
8. Inflation.

41
 Computation of
initial out lay:
Particulars Amount
Purchase of equipment xx
Transport of equipment to site xx
Store NR-Sunk
License fees xx
Certification from UNBS xx
Specialized trainer xx
Installation costs xx
Initial WK xx
Consultancy & Research NR- Sunk
Total initial out lay (all occur in yr 0) xx

42
 Advantages of NPV: Limitations of
NPV:

- It is not easy to be understood by non

1. It looks at the entire life time of the
project. accountants/ Financial professionals.

2. It looks at all cash flows.

3. It considers time value of money (TVM).
4. Absolute measure.

43
 Assumptions of DCF
about timing of CF:
Read on the following adjustments.
1. Cash out lay to be incurred at the 1. Tax saving.
beginning of an investment ie now year 2. Working capital
zero.
3. Inflation
2. Cash out/inflows occurring during the
course of the period are assumed to occur
at once at the end of time period eg end of
year 1,2 etc. Example on NPV- SC Company- ref
3. If a cash out lay occurs at the beginning of
the time period, it is taken to occur at the
end of the previous period.

44
 INTERNAL RATE OF RETURN (IRR):

Example:
- IRR is the discount rate that will equate the Given;
PV of in flows to the PV of out flows.
Y0 Y1 Y2 Y3 Y4
- It can be obtained by trial and error and it is
acceptable but to be more precise, an CF 1,051 246.1 348.8 586.2 355.9
interpolation method can be used Pv factor @ rate of 12%, NP V= 91m.
- Steps in obtaining IRR using interpolation - Since 12% yielded a positive NPV, we can
are; increase the disc. Rate to 25% & this will yield
1. Compute NPV using any discount rate eg the following:
from the example above (NPV) was 91m. - Yr 0 1 2 3 4
2. If the NPV obtained is positive, then the CF 1,051 246.1 348.8 586.2 355.9
higher discount rate shall be used to try and
obtain a negative NPV Pv f 25% 1 0.8 0.64 0.512 0.4096

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IRR Cont’d
Yr 0 1 2 3 4
CF 1,051 246.1 348.8 586.2 355.9 - a= Lower disc rate that gave rise to Positive
Pv f 25% 1 0.8 0.64 0.512 0.4096 NPV.
Pv (1,051) 197 223 300 146 - A = Positive NPV
NPV = (184.53) - b = Higher disc. Rate that gave rise to –ve NPV
- B = Negative NPV

3. Compute IRR using formula

- Thus,
IRR= a + A (b-a)
IRR= 12% + 91,000,000 (25%-12%)
A-B
91,000,000-184,528,000
Where;

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IRR Cont’d
IRR= 0.12+91,000,000 (0.13) Interpretation:
91,000,000 + 184,528,000 - When IRR is greater than the RRR, then the
investment will be viable because the investor can
recover all the funds invested and the reverse is
IRR= 0.12 + 91,000,000 (0.13) true if IRR is less than RRR
Advantages of IRR:
275,528,000
BODMAS
1. It calculates break-even point.

IRR= 0.12 + 0.33027 * 0.13 2. It is consistent with wealth maximization

3. It considers TVM
Disadvantages
IRR= 0.163 = 16.3%
4. A project may have many IRR
5. Cannot be used where projects starts with
initial positive cash in flow like deposits

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 PROFITABILITY INDEX (PI):
- The PI shows the cash flow generation From above example (ref IRR)
potential of every shilling invested.
- It is the ratio of the PV of cash inflows to the PI = 247+349+586+356
PV of cash outflows.
1,051
- It is used to choose the best project if all have PI = 1,538
positive NPV.
1,051
- NPV measures the wealth of all funds
invested where as PI measures the wealth
created by every shilling ie PI = 1.46
Intpn: For every shilling invested, it will generate
- PI = Total cash inflows shs 1.46. As long as PI is greater than 1, the
investment is viable because it will generate
Total cash outflows positive returns.

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