Understanding Investment Decisions

(Capital Budgeting Decisions)

Meaning, Features, Types and Importance of
Investment Decisions; Discounted Cash Flow
(DCF) and Non-discounted Cash Flow Techniques

Prof. Nazneen Shaikh

• The word Capital refers to be the total investment of a company of
firm in money, tangible and intangible assets.
• Whereas budgeting defined by the “Rowland and William” it may be
said to be the art of building budgets.
• Budgets are a blue print of a plan and action expressed in quantities
and manners. Investment decision is the process of making investment
decisions in capital expenditure.
• A capital expenditure may be defined as an expenditure the benefits of
which are expected to be received over period of time exceeding one
year.
• The main characteristic of a capital expenditure is that the expenditure
is incurred at one point of time whereas benefits of the expenditure are
realized at different points of time in future.
Prof. Nazneen Shaikh
Examples of capital expenditure:

1. Purchase of fixed assets such as land and building, plant and

machinery, good will, etc.
2. The expenditure relating to addition, expansion, improvement and
alteration to the fixed assets.
3. The replacement of fixed assets.
4. Research and development project.
 MEANING
The process through which different
projects are evaluated is known as
Capital capital budgeting.
Budgeting Capital budgeting is defined “as the
firm’s formal process for the
Decisions acquisition and investment of
capital. It involves firm’s decisions
to invest its current funds for
addition, disposition, modification
and replacement of fixed assets”.

Prof. Nazneen Shaikh

DEFINITION

• Capital budgeting (investment decision) as, “Capital

budgeting is long term planning for making and
financing proposed capital outlays.” Charles T.
Horngreen
• “Capital budgeting consists in planning development of
available capital for the purpose of maximizing the long
term profitability of the concern” – Lynch

Prof. Nazneen Shaikh

NEED AND IMPORTANCE OF CAPITAL BUDGETING
1. Huge investments: Capital budgeting requires huge investments of funds, but the
available funds are limited, therefore the firm before investing projects, plan are
control its capital expenditure.
2. Long-term: Capital expenditure is long-term in nature or permanent in nature.
Therefore financial risks involved in the investment decision are more. If higher
risks are involved, it needs careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed
back. Once the decision is taken for purchasing a permanent asset, it is very difficult
to dispose of those assets without involving huge losses.
4. Long-term effect: Capital budgeting not only reduces the cost but also increases
the revenue in long-term and will bring significant changes in the profit of the
company by avoiding over or more investment or under investment. Over
investments leads to be unable to utilize assets or over utilization of fixed assets.
Therefore before making the investment, it is required carefully planning and
analysis of the project thoroughly.

Prof. Nazneen Shaikh

 CAPITAL
BUDGETING
PROCESS

Prof. Nazneen Shaikh

Step 1,2: Project Generation

Step 3: Project Evaluation

Review

Step 4,5: Project Selection

Step 6: Project Execution

Prof. Nazneen Shaikh

PROJECT GENERATION

1. Identification of Investment Proposals:

The capital budgeting process begins with the identification of investment
proposals. The proposal or the idea about potential investment opportunities may
originate from the top management or may come from the rank and file worker of
any department or from any officer of the organization. The departmental head
analyses the various proposals in the light of the corporate strategies and submits
the suitable proposals to the capital expenditure planning committee in case of
large organizations or to the officers concerned with the process of long-term
decisions.
2. Screening the Proposals:
The expenditure planning committee screens the various proposals received from
different departments. The committee views these proposals from various angels to
ensure that these are in accordance with the corporate strategies or a selection
criterion‟s of the firm and also do not lead to departmental imbalances.
PROJECT EVALUATION
3. Evaluation of Various Proposals:
The next step in the capital budgeting process is to evaluate the profitability of
various proposals. There are many methods which may be used for this purpose
such as payback period method, rate of return method, net present value method,
internal rate of return method etc. All these methods of evaluating profitability of
capital investment proposals have been discussed in detail separately in the
following pages of this chapter.
It should, however, be noted that the various proposals to the evaluated may be
classified as:
(I) Independent proposals
(ii) Contingent or dependent proposals and
(iii) Mutually exclusive proposals.
PROJECT SELECTION
4. Fixing Priorities:
After evaluating various proposals, the unprofitable or uneconomic proposals
may be rejected straight ways. But it may not be possible for the firm to invest
immediately in all the acceptable proposals due to limitation of funds. Hence, it
is very essential to rank the various proposals and to establish priorities after
considering urgency, risk and profitability involved therein.
5. Final Approval and Preparation of Capital Expenditure Budget:
Proposals meeting the evaluation and other criteria are finally approved to be
included in the Capital expenditure budget. However, proposals involving
smaller investment may be decided at the lower levels for expeditious action.
The capital expenditure budget lays down the amount of estimated expenditure
to be incurred on fixed assets during the budget period.
PROJECT EXECUTION
6. Implementing Proposal:
Preparation of a capital expenditure budgeting and incorporation of a particular proposal
in the budget does not itself authorize to go ahead with the implementation of the project.
A request for authority to spend the amount should further be made to the Capital
Expenditure Committee which may like to review the profitability of the project in the
changed circumstances.
Further, while implementing the project, it is better to assign responsibilities for
completing the project within the given time frame and cost limit so as to avoid
unnecessary delays and cost over runs. Network techniques used in the project
management such as PERT and CPM can also be applied to control and monitor the
implementation of the projects.
7. Performance Review:
The last stage in the process of capital budgeting is the evaluation of the performance of
the project. The evaluation is made through post completion audit by way of comparison
of actual expenditure of the project with the budgeted one, and also by comparing the
actual return from the investment with the anticipated return. unfavorable variances, if any
should be looked into and the causes of the same are identified so that corrective action
may be taken in future.
 MANDATORY REPLACEMENT EXPANSION
INVESTMENTS PROJECTS PROJECTS

Project
Classification

DIVERSIFICATION RESEARCH AND MISCELLANEOUS

PROJECT DEVELOPMENT PROJECT
PROJECTS

Prof. Nazneen Shaikh

Methods of Capital Budgeting
Traditional
Modern Methods
Methods
Profitability
Payback Accounting
Net present Internal Rate Index /
period Rate of
Value of Return Benefit Cost
method Return
Ratio

Prof. Nazneen Shaikh

Modern DISCOUNTED
CASH FLOW

Traditional
NON-
DISCOUNTED
CASH FLOW

Prof. Nazneen Shaikh

1. Pay-Back Period Method:

• The „Pay back‟ sometimes called as pay out or pay off period method
represents the period in which the total investment in permanent assets
pays back itself.
• This method is based on the principle that every capital expenditure pays
itself back within a certain period out of the additional earnings
generated from the capital assets.
• All in all, it measures the period of time for the original cost of a project
to be recovered from the additional earnings of the project itself.
Prof. Nazneen Shaikh

Various investments are ranked according

to the length of their payback period in such a
manner that the investment with a- shorter
payback period is preferred to the one
which has longer pay back period.
Pay-Back - Decision Rule:
Period - The PBP can be used as a decision
criterion to select investment proposal.
- If the PBP is less than the maximum
Method: acceptable payback period, accept the
project.
- If the PBP is greater than the maximum
acceptable payback period, reject the
project.
Formula for Pay back Period
Pay Back Period= Cash outlay of the project/ Original Cost of the Asset
Annual Cash Inflow

If an investment of Rs. 100000 in a machine is expected to

generate cash inflow of Rs. 20,000 p.a. for 10 years. Find PBP
PBP= 100000/20000
PBP = 5 years

Prof. Nazneen Shaikh

 Particulars Project A Project B
Cost 1,00,000 1,00,000
Expected future
cash flow
Which
Year 1 50,000 1,00,000 Project is
Year 2 50,000 5,000
Year 3 1,10,000 5,000 Better to
Year 4 None None
choose?
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year
Prof. Nazneen Shaikh
Accounting Rate of Return Method (ARR)/
Average Rate of Return
• This method helps to overcome the disadvantages of the
payback period method.
• The rate of return is expressed as a percentage of the
earnings of the investment in a particular project.
• It works on the criteria that any project having ARR higher
than the minimum rate established by the management
will be considered and those below the predetermined rate
are rejected.

Prof. Nazneen Shaikh

Formula for Average/ Accounting Rate of Return

ARR= Average Annual Profit​

Initial Investment
A project is being considered that has an initial investment of 250,000 and it's forecasted to
generate revenue for the next five years. Below are the details:

Initial investment: 250,000

Expected revenue per year: 70,000
Time frame: 5 years
•ARR calculation: 70,000 (annual revenue) / 250,000 (initial cost)
•ARR = .28 or 28% (.28 * 100)

Prof. Nazneen Shaikh

 Profit after tax (A)
ARR Book value of the investment (A)

Year Book value of investment Profit after tax

1 Rs.90,000 Rs.20,000
2 80,000 22,000
3 70,000 24,000
4 60,000 26,000
5 50,000 28,000
Total 350000 120000
Average 70000 24000
ARR= 24000/70000 = .3428 =34.28%

Prof. Nazneen Shaikh

NET PRESENT
VALUE Net present value is perhaps the most
is the difference important concept of finance.
between the present
value of cash inflows
and the present value of
It is used to evaluate investment and financing
cash outflows over a decisions that involve cash flows occurring over
period of time. multiple periods.
NPV is used in capital
budgeting and
investment planning to The net present value (NPV) of a project is the
analyze the profitability sum of the present values of all the cash flows
of a projected positive as well as negative - that are expected
investment or project. to occur over the life of the project.

Prof. Nazneen Shaikh

Formula NPV
NPV=TVECF−TVIC
TVECF=Today‟s value of the ex
pected cash flows
TVIC=Today‟s value of invested
cash​
 Moris Associates is evaluating a project whose expected cash flows are as follows:
Year Cash flow (Rs. in million)
0 (23)
1. 6
2. 8
3. 9
4. 7

The cost of capital for Matrix Associates is 14 percent.

(i) What is the NPV of the project?

Year Cashflow Present value of future

cash flow
0 (23) -23
1 6 6/(1+.14)^1 5.263
2 8 8/(1+.14)^2 6.156
3 9 9/(1+.14)^3 6.075
4 7 7/(1+.14)^4 4.145
Prof. Nazneen Shaikh
NPV -1.361
Benefit-Cost Ratio (BRC)/ Profitability
Index
• A benefit-cost ratio (BCR) is a ratio used in a cost-benefit analysis to
summarize the overall relationship between the relative costs and
benefits of a proposed project.
• BCR can be expressed in monetary or qualitative terms.
• If a project has a BCR greater than 1.0, the project is expected to
deliver a positive net present value to a firm and its investors.
• If a project's BCR is less than 1.0, the project's costs outweigh the
benefits, and it should not be considered.

Prof. Nazneen Shaikh

Formula for Profitability Index/ Benefit cost ratio

Prof. Nazneen Shaikh

 Morris Associates is evaluating a project whose expected cash flows are as follows:
Year Cash flow (Rs. in million)
0 (23)
1. 6
2. 8
3. 9
4. 7
The cost of capital for Morris Associates is 14 percent.

(i) What is the Benefit cost ratio/ Profitability index of the project? = 21.639/23 = .94082
Which is less then 1 so project should not be consider.

Year Cashflow Present value of future

cash flow
0 (23)
1 6 6/(1+.14)^1 5.263
2 8 8/(1+.14)^2 6.156
3 9 9/(1+.14)^3 6.075
4 7 7/(1+.14)^4 4.145
Prof. Nazneen Shaikh
Total 21.639
The cash flows associated with an investment are given below:
PVFCF
85420/(1.18)^1 72389.831
Year Cash flow 103240/(1.18)^2 74145.361
0 Rs.(260,000)
128430/(1.18)^3 78166.463
1 85,420
2 103,240 92480/(1.18)^4 47700.155

3 128,430 78350/(1.18)^5
34247.507 46649.3
NPV

4 92,480
306649.3163 1.18
5 78,350 /260000
306649.3163

Calculate the benefit cost ratio of this investment, if the discount rate is 18 percent.

Prof. Nazneen Shaikh

INTERNAL RATE OF RETURN
• The internal rate of return is a metric used in financial analysis to
estimate the profitability of potential investments.
• The internal rate of return is a discount rate that makes the net
present value (NPV) of all cash flows equal to zero in a discounted
cash flow analysis.
• IRR calculations rely on the same formula as NPV does.

Prof. Nazneen Shaikh

This method is popularly known as time adjusted rate of return
method/discounted rate of return method also.
The internal rate of return is defined as the interest rate that equates
the present value of expected future receipts to the cost of the
investment outlay.
This internal rate of return is found by trial and error.

First we compute the present value of the cash-flows from an

investment, using an randomly elected interest rate.
Then we compare the present value so obtained with the investment
cost. If the present value is higher than the cost figure, we try a
higher rate of interest and go through the procedure again.
Prof. Nazneen Shaikh
Prof. Nazneen Shaikh
Prof. Nazneen Shaikh
1. Sigma Corporation is evaluating a project whose expected cash flows are as
follows:
Year Cash flow (Rs.in million)
1. - 16.0
2. 3.2
3. 4.5
4. 7.0
5. 8.4

The cost of capital for Sigma Corporation is 12 percent .

(i) What is the NPV of the project?
(ii) Profitability index
(iii) IRR
(iv) PBP / Discounted pay back period
(v) ARR
Prof. Nazneen Shaikh
(i) What is the NPV of the project?

(ii) Profitability index= Present value of future cash flow/initial investment

(iii)IRR (where NPV=o Trial and Error Method to find R)

(iv) PBP / Discounted pay back period=Cash outlay of the project/ Original Cost of the Asset
Annual Cash Inflow/ Discounted cash inflow
(v) ARR=Average Annual Profit​
Initial Investment

Prof. Nazneen Shaikh

 3.2 4.5 7.0 8.4
+ + + +
NPV = -16.0 (1.12) (1.12)2 (1.12)3 (1.12)4
2.8576 + 3.5865 + 4.984 + 5.3424
0.7705 16.7705 1.048
=
/16

Prof. Nazneen Shaikh

What is the IRR of the project?
At 12% discount rate NPV is 0.7705
Try 13%
NPV = -16 + 3.2 (0.885) + 4.5 (0.783) + 7 (0.693) + 8.4 (0.613)
= -16 + 2.832 + 3.5235 + 4.851 + 5.1492
= 0.3557 T 16.3557

Try 14%
NPV = -16 + 3.2 (0.877) + 4.5 (0.769) + 7 (0.675) + 8.4 (0.592)
= -16 + 2.8064 + 3.4605 + 4.725 + 4.9728
= -0.0353 T 15.9647
As this is very nearly zero, the IRR of the project is 14 %

Prof. Nazneen Shaikh

Prof. Nazneen Shaikh