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CHAPTER ONE

1.1 INTRODUCTION
Investment decision is one of the most crucial management decisions. This
is because funds and other resources are scarce and their opportunity cost
very High.
Besides, any Investment Decision taken rightly or wrongly has lasting effect
on future growth and Development of the firm. Since most Investment
involve the commitment of substantial amount of the firm’s scarce
resources, any faulty decision may lead to substantial amount of losses. To
forestall this possibility it becomes necessary to appraise carefully the
alternate capital spending proposal and to select the one’s that promise
maximum pay-off.

INVESTMENT DECISION PROCESS

In order to ensure realistic judgment as regard the alternative capital


spending proposal, the following points must be carefully considered in the
Investment Decision Process.
(a) The problem to be solved by the Investment must be recognized and
the boundary fixed on the area of Investigation.
(b) The Objective function must be established in which you must aspire
to maximize or minimize some dependant variables such as profit, risk
and cost
(c) A search should be conducted to identify some physical constraint or
environmental factors which are likely to have effect on project
performance.
(d) After the problem formulation and search phase, the next step is the
evaluation of alternate proposal.
(e) The final stage should be to select the project that promise maximum
payoff or satisfy the objective function

INVESTMENT APPRAISAL PROCESS


There are two principal methods of Investment appraisal and these are:
(a) Non-Discounting Techniques
(b) Discounting Techniques

Non-Discounting Techniques: This is a method of Investment appraisal


which does not take in to consideration the time value of money. Under
this techniques, there are two elements of appraisal method and these are:
(i) Payback period
(ii) Accounting Rate of Return

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Discounting Techniques: This is a method of Investment appraisal that takes in
to account the time of money. The method used here are:
(i) Net Present Value (NPV)
(ii) Internal Rate of Return

1.2 STATEMENT OF PROBLEM

1. How long term goals are to be formulated


2. Identification of new Investment Opportunity
3. The controlling of Expenditure and careful monitoring of crucial aspect of project
execution
4. How to create a suitable administrative framework capable of transferring the
required information
to the decision level
5. Classifying project and recognition of economically and / or statistically depend
proposed
6. The extinction and forecasting of current and future cash flow

1.3 OBJECTIVE OF THE STUDY


• To ensure good Investment ideas are not held back
• To ensure those poor or ill-defined proposal are rejected or further
defined
• To ensure that the limited capital resources available are distributed
to wealth creating projects, which make the best contribution to
corporate goals.

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CHAPTER TWO

2.1 LITERATURE REVIEW

1. INVESTMENT
Investment can be defined as any expenditure in expectation of future
benefits. It can be divided into capital and revenue expenditure and can
be made in non-current asset or working capital.
Capital Expenditure is expenditure which results in the acquisition of
non-current asset or an improvement in their earning capacity. It is not
charged as an expense in the Income Statement, the Expenditure
appears as a non-current asset in the Balance Sheet.
Revenue Expenditure is charged to the Income Statement and is
expenditure which is incurred.
(a) For the purpose of trade of the business
(b) To maintain the existing earning capacity of non-current asset

1.1 Non-Current asset Investment and Working capital Investment.


It can be made in non-current assets or working capital.
(a) Investment in non-current assets involves a significant elapse of
time between commitment of funds and recoupment of the
Investment
(b) Investment in Working Capital arises from the need to pay out
money for resources (such as Raw materials) before it can be
recovered from sales of the finished product or service.

1.2 Investment by Commercial Sector


Investment by commercial organization might include Investment in:
• Plant and Machinery
• Research and Machinery
• Research and Development
• Advertising
• Warehouse facilities.

The overriding feature of a Commercial Sector Investment is that it is


generally based on financial consideration alone.
1.3 Investment by Non-Profit Organization
Investment by non-profit organization differs from Investment by
commercial organization for several reasons.
(a) Relatively few nonprofit organizations’ capital investments are made
with the intention of earning a financial return.

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(a) When there are two or more ways of achieving the same objective
(mutually exclusive investment opportunities), a commercial
organization might prefer the option with the lowest value of cost.
(b) The cost of capital that is applied to the project cash flows by Public
Sector will not be a commercial rate of return, but one that is
determined by the Government.

The Capital Budgeting Process


Capital budgeting is the process of identifying, analyzing, selecting
investment project whose return is expected to extend beyond one year.
Capital budgeting decision normally represents the most important
decisions that an organization makes, since they commit a substantial
proportion of a firms resources to action that are likely to be irreversible.

OBJECTIVES OF CAPITAL BUDGETING


• Determining which specific Investment projects the firm should
accept:
• Determining the total amount of capital expenditure which the firm
should take and;
• Determining how this portfolio of projects should be valuated on the
basis of their estimated contribution towards the achievement of the
goals of an organization

INVESTMENT DECISION MAKING PROCESS

A typical model for investment decision making has a number of distinct


stage.
• Origination of proposal
• Project Screening
• Analysis and Acceptance
• Monitoring and Review

ORIGINATION OF PROPOSAL
Investment opportunity does not just appear out of this. They must be
created.
Any organization must therefore setup a mechanism that scan the
environment for potential opportunities and give an early warning of
future problems.
Ideas for Investment might come from those working in technical
position. Innovative ideas, such as new product lines, are more likely to
come from those in Higher level of management, given their strategic
view of the organization direction and their knowledge of the
competitive environment,
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The overriding feature of any proposal is that it should be consisted with
the organization overall strategy to achieve its objectives.

PROJECT SCREENING
Each proposal must be subjected to detailed screening to that a
qualitative evaluation of a proposal can be made, a number of key
questions such as those below might be asked before any financial
analysis is undertaken. Only if the project passes this initial screening
will more detailed financial analysis begin.

• What is the purpose of the project


• Does it fit with the organizations long term objective.
• It is a mandatory investment
• What resources are available e.g money, capital, labour
• Do we have the necessary management expertise to guide the
project to completion?
• Does the project expose the organization to unnecessary risk?
• How long will the project last end and what factors are the key to its
success
• Have ALL possible alternatives been considered

ANALYSIS AND ACCEPTANCE


STEP 1: Complete and submit standard format financial
information as a formal investment proposal.
STEP 2: Classify the project by Type
STEP 3: Carryout the financial Analysis of the project
STEP 4: Compare the outcome of the financial analysis to
predetermined acceptance criteria
STEP 5: Consider the project in the height of the capital budget for
the current and future operating period
STEP 6: Make the decision (go/no go)

MONITORING THE PROGRESS OF THE PROJECT


During the project’s progress, project control should be applied to
ensure the following
• Capital spending does not exceed the amount authorized
• The Implementation of the project is not delayed
• The anticipated benefits are eventually obtained

The first two items are probably easier to control than the third because
the control can normally be applied soon after the capital expenditure
has been authorized, whereas monitoring the benefits will spend a
longer period of time.
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INVESTMENT APPRAISAL PROCESS & TECHNIQUES
RELEVANT CASH FLOW IN INVESTMENT APPRAISAL
The cash flow that should be considered in investment appraisal are
those which arises as a consequence of the investment decision under
evaluation. Any cost incurred in the past, or any committed cost which
will be incurred regardless of whether or not an investment is
undertaken are not relevant cash flow
The annual profit from a project can be calculated as incremental
contribution earned minus any incremental fixed cost which are
additional cash item of expenditure {i.e. ignoring depreciation and so
on}
There are however, other cash flow to consider this might include the
following.
 Opportunity cost: these are cost incurred or revenue cost from
diverting existing resources from the best use.
 Tax: the extra taxation that will be payable on extra profit or the
reduction in tax arising from capital allowance or operating hosses in
any year.
 Residual value: the residual value or disposal value of equipment at
the end of its life or disposal cost

THE PAY BACK PERIOD


Payback is often used as a first screening method by this we mean that
when a capital investment project is being considered, the first question
to ask is: “how long will it take to pay back its cost?” the organization
might have a target payback and so it would reject a capital project
unless its payback period were less than a certain number of year.

DISADVANTAGES OF PAYBACK METHOD


1) It ignore the timing of cash flow with the payback period
2) It ignores the time value of money
3) Payback is unable to distinguish between projects with the same
payback period
4) The choice of any cut-off payback period by an organization is
arbitrary
5) It may lead to excessive investment in short term project
6) It takes account of the risk of the timing of cash flow but not the
variability of those cash flow
ADVANTAGES
1) It is simple to calculate & understand
2) It uses cash flow rather than accounting profit
3) It can uses as a screening device as a first stage
4) It tends to minimize both financial and business risk
5) It can be used where there is a capital rationing situation to identify
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those projects which generate additional cashflow for Investment
quickly

Illustration:
Calculate the payback period of the project below
Yr
0 100,000
1 30,000
2 50,000
3 20,000
4 10,000

Solution:
Yr
0 100,000 (100,000)
1 30,000 (70,000)
2 50,000 (20,000)
3 20,000 -
4 10,000 -

The payback period is 3years

ACCOUNTING RATE OF RETURN


ARR method also called Return on Capital Employed {ROCE} or Return
on Investment {ROI} of appraising a capital project is to estimate the
accounting rate of return that the project should yield. If it exceeds a
target rate, the project will be undertaken.
There are several different definitions of return on investment. One of
the most popular is as follows

ARR = Estimated Average Profit x 100

Estimated Average Investment

The others includes


ARR = Estimated Total Profit x 100

Estimated Initial Investment

ARR = Estimate Average Profit x 100

Estimated Initials Investment


Examples
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A coy has a target accounting rate of return of 20% and is now
considering the following project.
Capital cost of asset N 80,000
Estimated life 4yrs
Estimated profit before b4 depreciation
Yr1 N 20,000
Yr2 N 25,000
Yr3 N 35,000
Yr4 N 25,000

The capital asset would be depreciated by 25% of its cost asset year, and
will have no residual value. You are required to asses whether the project
shall be undertaken.

Solution
The annual profit after depreciation, and the mid year net book value of
the asset would be as follows
Yr Profit after Mid year ARR in the year
Depreciation Book of value
1 0 70,000 0
2 5,000 50,000 10
3 15,000 30,000 50
4 5,000 10,000 50

As the table shown, the ARR is how in the early stage of the project,
partly because of low profit in yr1 but mainly because of the Net book
value of the asset is much higher early on its life.
The project does not achieve the target ARR of 20% in its first two years,
but exceeds it in year 3 and 4 should it be undertaken?
When the accounting rate of return from a project varies from year to
year, it a=makes sense to take an overall or average view of the project’s
return. In this case, we should look at the return as a whole over the 4-
year period.

N
Total profit before depreciation over 4 years 105,000
Total profit after 4 years 25,000
Average annual profit after depreciation 6,200
Original cost of investment 80,000
Average net book value one 4 years period ( 80,000+0) = N40,000
2
ARR = 6250
40,000 = 15.6%

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The project should be undertaken because it will fail to yield the target
return of 20%

ARR AND MUTUALLY EXCLUSIVE PROJECT


Example:
Arrow Ltd wants to buy a new item of equipment which will be used to
provide a service to customer. Two models of equipment are available one
with a slightly higher capacity and greater reliability than the other. The
expected cost and profit of each item are as follows

Equipment Equipment
Item X Item Y
Capital cost 80,000 150,000
Life 5yrs 5yrs

Profit before depreciation


Yr 1 50,000 50,000
Yr 2 50,000 50,000
Yr 3 30,000 60,000
Yr 4 20,000 60,000
Yr 5 10,000 60,000
Disposable value 0 0

ARR is measured as the average annual profit after depreciation divided


by average net book value of the asset you are required to decide which
item equipment should be selected, if any, if the coy target ARR is 30%

Solution.
Item X Item Y
Total profit before depreciation 160,000 280,000
After depreciation 80,000 130,000
Average Annual profit depreciation 16,000 26,000
(Capital cost + Disposal value)/2 40,000 75,000
ARR 40% 34.7%

Both projects would earn a return in excess of 30% but since item X would
earn a bigger ARR, it would be preferred t item Y.

DISDAVANTAGES OF ARR
1. It is based on accounting profit not cash flow
2. It takes no account the size of investment.
3. It takes no account the length of project.
4. It ignores the time value of money.
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ADVANTAGES OF ARR
1. It is a quick and simple calculation.
2. It involves a familiar concept of a percentage.
3. It look at the entire project life.

INVESTMENT APPRAISAL USING DCF METHOD


Discounted cash flow is an investment appraisal technology which takes
into account both the timing of the cash flow and also total profitable
over a project’s life.
Two important point about DCF are as follows
a. DCF looks at the cash flow of a project, not the accounting profit.
b. The timing of cash flow is taken into account by discounting them.

THE COST OF CAPITAL


The cost of capital has two aspect to it.
a. It is the cost of fund that a company raises and uses.
b. The return that investors expect to be paid for putting funds into the
company.
The cost of capital can therefore be measured by studying the returns
required by investors and used to derived discount rate for DCF analysis
and investment appraisal

The Net Present Value Method


NPV is the value obtained by discounting all cash flow and inflow of a
capital investment project by a chosen target rate of return or cost of
capital. The NPV method of Investment Appraisal is to accept Project
with positive NPV.
Dcf formula- 1
(1+r)

Example:
A coy is considering a capital Investment, where the estimated cash
flows are as follows:

YR CASHFLOW
0 ____________________________ (100,000)
1 _____________________________ 60,000
2 _____________________________ 80,000
3 _____________________________ 40,000
4 _____________________________ 30,000

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The company’s cost of capital is 15% you are required to calculate the
NPV of the project and to access whether it should be undertaken.

Solution
YR CASHFLOW DCF @ 15% PY
0 (100,000) 1:00 (100,000)
1 60,000 0.870 52,500
2 80,000 0.756 60,480
3 40,000 0.658 26,320
4 30,000 0.572 17,160
NPV 56,160

The PV of the cash Inflow exceeds the PV of cash flows by N56,160,


which means that the project will earn a DCF yield in excess of 15%. It
should therefore be undertaken

DISADVANTAGE OF NPV
(1) There is need for management to determine the appropriate cost of
capital to use. This may be particularly difficult for companies that
are not listed.
(2) It does not take Risk into consideration.
(3) The NPV method may not give satisfactory answer when the
projects being compared involve different amount of capital
invested.
ADVANTAGES OF NPV
(1) Timing of cash flow is considered.
(2) Cash flow is over the entire life of the project are taken in to
consideration

The Internal Rate of Return


The IRR method of Investment appraised is to accept projects whose
IRR (the rate at which NPV is zero) exceeds a target rate of Return. The
IRR is calculated using interpolation.
Formulae: a + +NPV
+NPV – (- NPV) (b-a) %

Where a= Lower of the two rate of return used


b= Higher of the two rate of return used
+NPV= The NPV obtained using rate a
-NPV= The rate obtained using rate b

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Example:
A company is trying to decide whether to buy a machine for N80,000
which will save cost of N20,000 per annum for 5 yrs and which will have
a resale value of N10,000 at the end of 5yrs. If it is the company’s policy
to undertake projects only if they are expected to yield Def return of 10%
or more, ascertain whether this project be undertaken.

Solution:
Annual Depreciation would be 80,000 – 10,000 =N14,000
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The Return on Investment would be
20,000 –14,000 =6,000 =13.3%
½ (80,000 + 10,000) 45,000

Two third of this is 8.9% so we can start by using 9%


YR CASHFLOW DCF 9% PV
0 (80,000) 1.00 (80,000)
1-5 (20,000) 3.890 77,800
5 (10,000) 0.650 6,500
4,300

Calculate the second NPV using a Rate greater than the first.
Let’s try 12%
YR CASHFLOW DCF 12% PV
0 (80,000) 1.000 (80,000)
1-5 20,000 3.605 72,100
5 10,000 0.567 5670
2,230

IRR= a+ +NPV (b-a) %


+NPV – (- NPV)

9+ 4300 (12-9) % =10.98%


4,300+2,230

If it is company policy to undertake invested which are expected to yield


10% or more, this project would be undertaken

ADVANTAGES AND DISADVANTAGES OF IRR METHOD


The main advantage of IRR method is that the Information it provides is
more easily understood by managers.
The IRR method ignores the Relative size of Investment

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NPV AND IRR COMPARED
(a) When cash flow patterns are conventional both methods gives the
same accept or reject decision.
(b) The IRR method is more easily understood
(c) NPV is technically superior to IRR and easy to calculate
(d) IRR and accounting ROCE can be confused
(e) IRR ignores the Relative size of Investment
(f) Where cash flow patterns are non-conventional, there may be
several IRR which decision make must be aware of to avoid making
the wrong decision.
(g) The NPV is superior for ranking mutual exclusive project in order of
attractiveness.

ASSESSMENT OF DCF METHOD OF PROJECT APPRAISAL


DCF methods of appraisal have a number of advantages of other
appraisal method
• The Time Value of money is taken in to account
• The method takes account of all project cash flow
• It allows for timing of cash flow
• They are universally accepted method of calculating NPV and IRR.

PROBLEMS WITH DCF METHODS


(a) DCF method use future cash flow that may be difficult to forecast
(b) The Basic decision rule, accept all project with a positive NPV, will
not apply when the capital available for Investment is rationed
(c) The cost of capital used in DCF calculation may be difficult to
estimate
(d) The cost of capital may change over the life of an Investment

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CHAPTER THREE

3.1 STUDY POPULATION


The study population was drawn from different professionals who are
professional in their respective field and who also has investment in
different portfolio

3.2 SAMPLING METHOD AND SAMPLE SIZE


The sampling method used was random sampling techniques with a
sampling size of 10. 6 of which are male while 4 are female

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CHAPTER FOUR

4.1 DATA COLLECTION TECHNIQUES


Studies have shown there are two main methods of collecting data –
primary and secondary source, in this study we have the primary source of
data collection through the administration of questionnaire to respondents.
The primary source is reliable method of data collection in the sense that it
allows more active participation of respondent while answering the
question given to them.

4.2 METHOD OF DATA ANALYSIS


Data was analyzed using percentages

4.3 DATA ANALYSIS AND PRESENTATION

1. MALE AND FEMALE

Sex Respondent %

MALE 6 60%
FEMALE 4 40%
100

60% of the respondents are male while 40% are female.

2. AGE GROUP
Respondent %

21 – 30yrs 2 20
31 – 40yrs 4 40
41 – 50yrs 2 20
51 – 60yrs 1 10
61 Above 1 10
100

20% of the respondents are with the age group 21 – 30yrs, 40% with the
age group 31 – 40yrs, 20% with the age group 41 – 50yrs, 10% with age
group 51 – 60yrs and 10% with 61 and above.

3. PROFESSION / OCCUPATION
Respondent
Business Men 2 20%
Banker 2 20%
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Accountant 2 20%
Civil Servant 1 10%
Financial Analyst 3 30%
Other -
100%

20% of the respondents are trader, 20% of the respondents are Bankers,
20% of the respondents are Accountant, 10% of the respondent are civil
servant and 30% are Financial Analyst.

4. ARE YOU AN INVESTOR

Respondent %
Yes 10 100%
No -

100% of the Respondent are investors

5. WHAT LINE OF INVESTMENT DO YOU CARRY PRESENTLY


Respondent %
Oil and Gas 4 40
Banking 4 40
Manufacturing 1 10
Mining/constructing 1 10
Other -
100

40% of the Respondent invested in Oil and Gas, 40% of the Respondent
invest in Banking, 10% in Manufacturing, 10% in Mining/Construction

6. WHAT FACTOR DO YOU CONSIDER MOST WITHIN MAKING AN


INVESTMENT DECISION
Respondent

Divided payment policy 5 50%


Share Valuation 1 10%
Name of industry 2 20%
Management 1 10%
Capital structure 1 10%
Others -

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100

50% of the respondent consider divided payment before making


investment decision, 10% consider share and valuation, 20% consider
name of industry, 10% consider management structure, 10% capital
structure.

7. DO YOU APPRAISE {CONDUCT DUE DILIGENCE} INVESTMENT


OPPORTUNITY BEFORE MAKING AN INVESTMENT DECISION
Respondent

Yes 7 70%
No 3 30%
100

70% of the respondents appraise investment opportunity before making


decision, while 30% do not

8. WHAT PARAMETERS DO YOU USE IN YOUR INVESTMENT


APPRAISAL BEFORE INVESTING.
Respondent %

Pay back 1 10%


ARR 1 10%
NPV 4 40%
IRR 1 10%
Cost of Capital 3 30%
Other -
100

100% users payback 10% uses ARR, 40% uses NPV, 10% uses IRR and
30% uses cost of capital.

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CHAPTER FIVE
SUMMARY, CONCLUSION AND RECOMMENDATION
5.1 SUMMARY
This study examines investment decision and the appraisal process using
professional that has small companies they managed which also has
investment in different portfolio.
Investment decisions are long term corporate finance decision
relating to fixed assets and capital structures decisions are based on several
inter-related criteria
1) Corporate management seeks to maximize the value of firm by
investment in project which yields a positive Net present value when valued
using an appropriate discount rate.
2) These projects must also be financed appropriately
3) If no such opportunities exist, maximizing shareholders value dictates
that management must return excess cash to shareholders
5.2 CONCLUSION
Each project’s value will be estimated using a discounted cash flow
valuation and the opportunity with the highest value as measured by the
resultant Net present value will be selected. This requires estimating the
size and timing of all the incremental cash flows resulting from the project.
The NPV is greatly affected by the Discount Rate, thus, identifying the
proper discount rate is critical to making appropriate decision. The
discount rate is the minimum acceptable return on investment. The
discount rate should reflect the riskness of the investment, typically
measured by volatility of cash flow and must take into account the
financing mix.
In conjunction with NPV, there are several other measures used as
(secondary) selection criteria in corporation finance. These are visible from
DCF and include discounted pay back period, internal rate of return,
equivalent annuity, capital efficiency, discounted pay back period and
return on investment.
5.3 RECOMMENDATION
Based on the findings, the following principles have been put forward for
adoption:
1) Individual companies must allocate resources between competing
opportunity {project}
2) Making this capital allocation requires estimating the value of each
opportunity or project, which is a function of size, timing and prediction of
future cash flow
3) Management must also attempt to match the financing mix to the asset
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being financed as closely as possible in term of both timing and cash flow.

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Adeniji .A. A.(2008), An Insight Management Accounting


3rd Lag, eltoda Venture

Broking ton R.K {1998}, Financial Management, London, DP


Publication Ltd; (Fourth Edition)

Lautech MBA 1st 3rd semester study


Pack, 2010

ACCA study pack, Bpp learning media, 2008

Institution of financial and investment analyst,


Nigeria (IFIAN) Training manual, 2009.

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