Presentation by

Rifa jasmin. T
Afreen
Salwa saeed NK
Fathima
Risana
Arjun

MESKALLADI COLLEGE
Long-term Investment
Decision
Capital Budgeting I:
Principles and
Techniques
Capital budgeting :
Is the process of evaluating and selecting long- term investments
that are consistent with the goal of shareholders (owners) wealth
maxim isation

Capital expenditure :
is an outlayof funds thatis expected to produce
benefits
over a period of time exceeding one year.
Relevant and Irrelevant cash outflows

Relevant cash outflows irrelevant cash outflows

1. Variable labour expenses 1. Fixed overhead expense

2. Variable material expenses 2. Sunk costs

3. Additional fi xed overhead
expenses
4. Cost of the investment
5. Marginal taxes
Cash Flow Estimates
capital budgeting cash flows have to be estimated. There
are certain ingredients of cash flow streams.

1 Tax Effect
2 Effect on other project
3 Effect of indirect Expenses
4 Effect of depreciation
Tax Effect :
It has been already observed that cash flows to be considered for purposes of
capital budgeting are net of taxes. Special consideration needs to be given to tax
effects on cash flows if the firm is incurring losses and, therefore, paying no
taxes

Effect on other projects :

Cash flow effects of the project under consideration, if it is not econo-
mically independent, on other existing projects of the firm must be
taken intoconsid-eration.
Effect of Indirect Expenses :
Another factor which merits special consideration in estimatingcash flows is
the effect of overheads. The indirect expenses/overheads are allocated to
the different products on the basis of wages paid, materials used, floor space
occupied or some other similarcommon factor.

Effect of Depreciation :
Depreciation, although a non-cash item of cost, is deductible expenditure in
determining taxable income. Depreciation provisions are prescribed by the
Companies Act for accounting purposes and by the Income Tax Act for taxation
purposes.
When Salvage Value is Zero :
In case, the salvage value of the equipment is zero, only one change is
required in spreadsheet. Enter 0 in cell B11 instead of 1,000,000. The
spreadsheet will calculate the new NPV.

The methods of appraising capital expenditure proposals can

be classified into two broad categories:

1 : Traditional

2 : Time-adjusted
1 : Traditional
1 : Average rate return

The average rate of return (ARR) method of evaluating proposed

capital ex-penditure is also known as the accounting rate of return
method. It is based upon accounting information rather than cash
flows.
2 : Pay back period method
Payback (period) method is the exact amount of time required for a
firm to recover its initial investment in a project as calculated from
cash in fl ows.

. There are two ways of calculating the PB period.

1 : Annuity
when the cash flow stream is in the nature of annuity for each
year of the project’s life, that is, CFAT are uniform. In such a situation,
the initial cost of the investment is divided by the constant annual
cash flow:
2 : Mixed stream
The second method is used when a project’s cash flows are not uniform
(mixed stream) but vary from year to year. In such a situation, PB is
calculated by the process of cumulating cash flows till the time when cu-
mul ative cash flows become equal to the original investment outlay.

2 : Time-adjusted
Discounted cash flow is a valuation method that estimates the
value of an investment based on its expected future cash
flows. DCFto estiture the w figure out theBy using a DFC
calculation, investors can estimate the profit they could make
with an investment (adjusted for the time value of money).
1 : Net present value method
The first DCF/ PV technique is the NPV. NPV may be described as
the summation of the present values of cash proceeds (CFAT) in
each year minus the summation of present values of the net cash
outflows in each year. Symbolically, the NPV for projects having
conventional cash flows would be:
If cash outflow is also expected to occur at some time other
than at initial investment (non-conventional cash flows) the
formula would be:

The decision rule for a project under NPV is to accept the

project if the NPV is positive and reject if it is negative.

(i) NPV > zero, accept, (ii) NPV < zero, reject
2 : internal rate of return method
Internal rate of return (IRR) is the discount rate that equates the present
values of cash inflows with the initial investment associated with a project,
thereby causing NPV = 0.

Assuming conventional cash flows, mathematically, the IRR is

represented by the rate, r, such that
For unconventional cash flows, the equation would be:

where
r = The internal rate of return,
CFt = Cash inflows at different time periods,
Sn = Salvage value,
Wn = Working capital adjustments and
COt = Cash outlay at different time periods
3 : Net terminal value method

The terminal value approach (TV) even more distinctly separates the
timing of the cash in flows and outflows. The assumption behind the
TV approach is that each cash in flow is reinvested in another asset at
a
certain rate of return from the moment it is received until the
termination of the project
4 : Profitability Index (PI) or Benefit-Cost Ratio (B/C)

Yet another time-adjusted capital budgeting technique is profitability index ( PI).

The profitability index approach measures the present value of returns per rupee
invested, while the NPV is based on the difference between the present value of
future cash in flows and the present value of cash outlays.
Capital Budgeting
II:
Additional Aspects
 NPV Vs. IRR Methods
The NPV and IRR methods would in certain situations give the same
accept-reject decision. But they may also differ in the sense that the
choice of an asset under certain circumstances may be mutually
contradictory

(i) the similarities between them, and (ii) their differences, as also the factors

. NPV and IRR: Similarities

NPV and IRR: Similarities The two methods- IRR and NPV- would give consistent results
in terms of acceptance or rejection of investment proposals in certain situations. That
is, if a project is sound, it will be indicated by both the methods. If, however, it does
not qualify for acceptance, both the methods will indicate that it should be rejected.
The situations in which the two methods will give a concurrent accept-
reject decision will be in respect of conventional and independent projects.

Conventional investment projects are projects which cash outflows are

confined to the initial period.

Independent projects are all profitable projects that can be accepted a

little bit of body text

Thus, Fig. 6.1 portrays NPV as (i) positive; (ii) zero; and (iii) negative corresponding to
three situations (a) IRR > K; (b) IRR = K; (c) IRR < K.
Figure 6.1 shows the relationship between the NPV of a project and the discount rate.
If there is no K, or discount rate is zero (a very unreal situation), NPV is maximum. As the
value of K increases, the NPV starts declining. At 12 per cent rate of discount, the NPV is
zero. This is the IRR also because by definition it is that rate of discount which reduces
the NPV to zero. Assuming cost of capital to be 8 per cent, we find that NPV is positive by
amount (a) and the project is acceptable and so is it under IRR as its value is > K (0.12 >0.08). If
we assume K to be 16 per cent, the project is unacceptable as the NPV is negative by amount (b)
and so is it under IRR as IRR < K (0.12 < 0.16). The two approaches lead to identical results with
regard to the accept-reject decision.
. NPV and IRR Methods: Differences
Thus, in the case of independent conventional investments,the NPV and IRR methods will
give concurrent results. However, in certain situationsthey will give contradictory results
such that if the NPV method finds one proposal acceptable, IRR favours another. This is so
in the case of mutually exclusive investment projects. If there are alternative courses of
action, only one can be accepted. Such alternatives aremutually exclusive.

(i) Technical
(ii) Financial

The term technical exclusiveness refers to alternatives having different profitabilities and
the selection of that alternative which is the most profitable. Thus, in the case of a
purchase or lease decision the more profitable out of the two will be selected. The mutual
exclusiveness may also be financial.
The different ranking given by the NPV and IRR methods can be illustrated
under the following heads:

1. Size-disparity problem;
2. Time-disparity problem; and
3. Unequal expected lives.

1 : Size-disparity Problem
This arises when the initial investment in projects under consideration, that is, mutually
exclusive projects, is different. The cash outlay of some projects is larger than that of
others. In such a situation, the NPV and IRR will give a different ranking.
2 . Time- disparity Problem

The mutually-exclusive proposals may differ on the basis of the pattern of cash flows
generated, although their initial investments may be the same. This may be called the time-
disparity problem. The time-disparity problem may be defined as the conflict in ranking of
proposals by the NPV and IRR methods which have different patterns of cash inflows

3 . Projects With Unequal Lives

Another situation in which the IRR and NPV methods would give a conflicting ranking to
mutually exclusive projects is when the projects have different expected lives.

There are two approaches to do this: (i) common time horizon approach and
(ii) equivalent annual value/cost approach
Net Present Value Vs. Profitability Index
The NPV and PI, as investment criteria, provide the same accept and reject decision, because
both the methods are closely related to each other. Under the PI method, the investment
proposal will be acceptable if the PI is greater than one; it will be greater than one only when
the proposal has a positive net present value.

Fallout of Capital Rationing

The firm may impose such a limit primarily for two reasons: (i) there may be a paucity of
funds and (ii) corporate managers/owners may be conservative and may not like to
invest more than a specified/stated sum in capital projects at one point of time; they
may like to accept projects with a greater margin of safety, measured by NPV.