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Investment Evaluation

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.

INVESTMENT APPRAISAL TECHNIQUES

Pay back of Capital Employed

Pay back Period Method

Accounting Profit
for Project Evuluation

(a) Accounting Rate of


Return (ARR)
(b) Earnings per share (EPS)

Time Value of Money

(a) Net Present Value (NPV)


(b) Internal Rate of Return
(IRR)
(c) Net Terminal Value
(d) Profitability Index
(e) Discounted payback
period

Payback Period Method


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 Annual Pr ofit After Tax


Average or Initial Investment

100

= Average EBIT (1 t) 100


Average Investment
Where, Average Investment =

Initial Investment + Salvage Value

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

i = rate of interest per annum


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)

This is not an absolute measure.


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 (IRR)


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

Factor for the project 3.14 35,000


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)

IRR may be calculated in two ways :


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%

= 12% 0.73% = 11.27%


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

IRR > Cost of Capital

The investment is expected


to increase shareholders
wealth

Accept

IRR < Cost of Capital

The investment is expected


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.

The interest rates at which the cash inflows will be reinvested:


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.)

Rate of Int. (%)

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

Decision : The project should be accepted.


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.