INVESTMENT EVALUATION TECHNIQUES

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INVESTMENT EVALUATION TECHNIQUES

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Capital investment involves a cash outflow in the immediate future in anticipation of returns at a

future date .The Planning and control of capital expenditure is termed as Capital budgeting.Capital

Budgeting is the art of finding assets that are worth more than they cost to achieve a predetermined

goal i.e., optimising the wealth of a business enterprise.

Capital investment involves a cash outflow in the immediate future in anticipation of returns at a

future date.

A capital investment decision involves a largely irreversible commitment of resources that is

generally subject to significant degree of risk. Such decisions have for reading efforts on an

enterprises profitability and flexibility over the long-term. Acceptance of non-viable propos-als acts

as a drag on the resources of an enterprise and may eventually lead to bankrupcy.

For making a rational decision regarding the capital investment proposals, the decision maker needs

some techniques to convert the cash outflows and cash inflows of a project into mean-ingful

yardsticks which can measure the economic worthiness of projects.

Accounting Profit

for Project Evuluation

Return (ARR)

(b) Earnings per share (EPS)

(b) Internal Rate of Return

(IRR)

(c) Net Terminal Value

(d) Profitability Index

(e) Discounted payback

period

The basic element of this method is to calculate the recovery time, by yearwise accumulation of cash

inflows (inclusive of depreciation) until the cash inflows equal the amount of the original investment.

The time taken to recover such original investment is the payback period for the project.

Merits :

(1) No assumptions about future interest rates.

(2) In case of uncertainty in future, this method is most appropriate.

(3) A company is compelled to invest in projects with shortest payback period, if capital is a

constraint.

(4) It is an indication for the prospective investors specifying the payback period of their

investments.

(5) Ranking projects as per their payback period may be useful to firms undergoing liquidity

constraints.

Demerits :

(1) Cash generation beyond payback period is ignored.

(2) The timing of returns and the cost of capital is not considered.

(3) The traditional payback method does not consider the salvage value of an investment.

(4) Percentage Return on the capital invested is not measured.

(5) Projects with long payback periods are characteristically those involved in long-term

planning, which are ignored in this approach.

Accounting Rate of Return

This method measures the increase in profit expected to result from investment.

ARR

Average or Initial Investment

100

Average Investment

Where, Average Investment =

Merits

(1) This method considers all the years in the life of the project.

(2) It is based upon profits and not concerned with cash flows.

(3) Quick decision can be taken when a number of capital investment proposals are being

considered.

Demerits

(1) Time Value of Money is not considered.

(2) It is biased against short-term projects.

(3) The ARR is not an indicator of acceptance or rejection, unless the rates are compared with the

arbitrary management target.

(4) It fails to measure the rate of return on a project even if there are uniform cash flows.

Net Present Value (NPV) Method

= Present Value of Cash Inflows Present Value of Cash Outflows

The discounting is done by the entitiys weighted average cost of capital.

1

The dicounting factors is given by :

Where

(1 i)n

n = no. of years over which discounting is made.As Project A has a higher Net

Present Value, it has to be taken up.

Merits

(1) It recognises the Time Value of Money.

(2) It considers total benifits during the entire life of the Project.

(3) This is applicable in case of mutually exclusive Projects.

(4) Since it is based on the assumptions of cash flows, it helps in determining Shareholders Wealth.

Demerits

(1)

(2)

(3)

(4)

Desired rate of return may vary from time to time due to changes in cost of capital.

This Method is not effective when there is disparity in economic life of the projects.

More emphasis on net present values. Initial investment is not given due importance.

Internal Rate of Return is a percentage discount rate applied in capital investment desions which

brings the cost of a project and its expected future cash flows into equality, i.e., NPV is zero.

Illustration :

Project Cost

Rs. 1,10,000

Cash Inflows :

Year 1

Rs. 60,000

2

Rs. 20,000

3

Rs. 10,000

4

Rs. 50,000

Calculate the Internal Rate of Retun.

Internal Rate of Return will be calculated by the trial and error method. The cash flow is not uniform.

To have an approximate idea about such rate, we can calculate the Factor. It represent the same

relationship of investment and cash inflows in case of payback claculation :

F = I/C

Wehre F = Factor

I = Original investment

C = Average Cash inflow per annum

110,000

The factor will be located from the table P.V. of an Annuity of Rs. 1 representing number of years

corresponding to estimated useful life of the asset.

The approximate value of 3.14 is located against 10% in 4 years.

We will now apply 10% and 12% to get (+) NPV and () NPV [Which means IRR lies in between]

Year

1

2

3

4

Cash Inflows

(Rs.)

60,000

20,000

10,000

50,000

P.V. @ 10%

0.909

0.826

0.751

0.683

P.V. of Inflows

Less : Initial Investment

NPV

DCFAT

(Rs.)

54,540

16,520

7,510

34,150

1,12,720

1,10,000

2,720

P.V. @ 12%

0.893

0.797

0.712

0.636

DCFAT

(Rs.)

53,580

15,940

7,120

31,800

1,08,440

1,10,000

(1,560)

Graphically,

For 2%, Difference = 4,280

10%

NPV 2,720

12%

(1560)

Forward Method : Taking 10%, (+) NPV

NPV at 10%

IRR = 10% + Total Difference

= 10% + 4280

2720

Difference in Rate

2%

= 10%

+ 1.27% = 11.27%

Backward Method : Taking 12%, () NPV

(1560)

IRR = 12% +

4280 2%

The decision rule for the internal rate of retern is to invest in a project if its rate of returning greater

than its cost of capital.

For independent projects and situations involving no capital rationing, then :

Situation

IRR = Cost of Capital

Signifies

The investment is expected

not to change shareholder

wealth

Decision

Indifferent between

Accepting & Rejecting

to increase shareholders

wealth

Accept

to decrease shareholders

Reject

Demerits

(i) Possibility of multiple IRR, interpretation may be difficult.

(ii) If two projects with different inflow/outflow patterns are compared, IRR will lead to peculiar

situations.

(iii) If mutually exclusive projects with different investments, a project with higher investment but

lower IRR contributes more in terms of absolute NPV and increases the shareholders wealth.

NPV-IRR Conflict

Let us consider two mutually exclusive projects A & B.

Cost of Capital

IRR

NPV

Project A

10%

13%

1,00,000

Project B

10%

11%

1,10,000

Decision

Project A

Project B

When evaluating mutually exclusive projects, the one with the highest IRR may not be the one with

the best NPV.

The conflict between NPV & IRR for the evaluation of mutually exclusive projects in due to the

reinvestment assumption :

NPV assumes cash flows reinvested at the cost of capital.

IRR assumes cash flows reinvested at the internal rate of return.

The reinvestment assumption may cause different decisions due to :

Timing difference of cash flows.

Difference in scale of operations.

Project life disparity.

Terminal Value Method

Assumption :

(1) Each cash flow is reinvested in another project at a predetermined rate of interest.

(2) Each cash inflow is reinvested elsewhere immediately after the completion of the project.

Decision-making

If the P.V. of Sum Total of the Compound reinvested cash flows is greater than the P.V. of the

outflows of the project under consideration, the project will be accepted otherwise not.

Illustration :

Original Investment

Life of the project

Cash Inflows

Cost of Capital

Rs. 40,000

4 years

Rs. 25,000 for 4 years

10% p.a.

Year-end

%

1

8

2

8

3

8

4

8

First of all, it is necessary to find out the total compounded sum which will be discounted back to the

present value.

Year

Cash Inflows

(Rs.)

Yrs. of

Investment

(Rs.)

3

2

1

0

Compounding

Factor

Total

Compounding

Sum (Rs.)

1

25,000

8

1.260

31,500

2

25,000

8

1.166

29,150

3

25,000

8

1.080

27,000

4

25,000

8

1.100

25,000

1,12,650

Present Value of the sum of compounded values by applying the discount rate @ 10%

Compounded Value of Cash Inflow

(1 i)n

Present Value =

1,12,650

(1.10)n

= 1,12,650 0.683 = 76,940/[ 0.683 being the P.V. of Re. 1 receivable after 4 years ]

Decision : The present value of reinvested cash flows, i.e., Rs. 76,940 is greater than the original cash

outlay of Rs. 40,000.

The project should be accepted as per the terminal value criterion.

Profitability Index :

P.V. of cash inflow

Profitability Index =

P.V. of cash outflow

If

P.I > 1,

project is accepted

P.I < 1,

project is rejected

The PI signifies present value of inflow per rupee of outflow. It helps to compare projects involving

different amounts of initial investments.

Illustration :

Initial investment Rs. 20 lacs. Expected annual cash flows Rs. 5 lacs for 10 years. Cost of Capital @

15%.

Calculate Profitability Index.

Solution :

Cumulative discounting factor @ 15% for 10 years = 5.019

P.V. of outflows = 6.00 5.019 = Rs. 30.114 lacs.

Profitability Index =

P.V. of Inflows

30.114

20 1.51

P.V. of Outflows

Discounted Payback Period

In Traditional Payback period, the time value of money is not considered. Under discounted payback

period, the expected future cash flows are discounted by applying the appropriate rate, i.e., the cost of

capital.

Illustration :

Initial Investment Rs. 1,00,000

Cost of Capital @ 12% p.a.

Expected Cash Inflows

Yr. 1

Rs. 25,000

Yr. 2

Rs. 50,000

Yr. 3

Rs. 75,000

Yr. 4

Rs. 1,00,000

Yr. 5

Rs. 1,50,000

Calculate Discounted Payback Period.

Solution :

Year

Cash Inflows

Discounting Factor

(Rs.)

@ 12%

1

25,000

0.8929

2

50,000

0.7972

3

75,000

0.7117

4

1,00,000

0.6355

5

1,50,000

0.5674

The recovery was made between 2nd and 3rd year.

Discounted Payback Period = 2 years +

= 2 years +

Discounted

Cash Flows (Rs.)

22,323

39,860

53,378

63,550

85,110

Cumulative

DCF (Rs.)

22,323

62,183

1,15,561

1,79,111

2,64,221

1,00,000 62,183 12

1,15,561 62,183

37817

12 = 2 years + 37817 12

53378

1,15,561 62,183

= 2 years 8

2 months.

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