Financial Management

Case Study-2
The Investment Detective

Submitted By:
UH20089 Kanaka Shatadal
UH20103 Ritika Mittal
UH20118 Sushmita Dikshit
UH20120 Tanvi Mishra
UH20122 Utkarsh Srivastava
Case Background

The case is on Capital Budgeting and we are supposed to play the role of a Capital-Budgeting
Analyst. We need to rank the projects and recommend the best four investments that the
company should invest in. Only quantitative aspects are to be considered for ranking projects,
there are no other criteria except that project 7 and 8 are mutually exclusive.

The initial investment of $2 million is required for every project. All investments are believed to
be of the same risk class. The weighted average cost of capital of the firm has never been
estimated. An appropriate discount rate of 10% has been assumed by analysts in the past, but
some officers have asserted that the rate should be higher.

Critical Financial Problems

Everyone invests a particular amount per annum in some financial instruments like mutual funds,
ULIPs, etc. After five, 10 years or 15 years, you'll want to redeem your investments. At that
point , we usually calculate the cash which we originally invested the maturity amount that we
received to know what proportion did we gain. But does one think this is often the proper method
to see what proportion did we gain? we'd like to understand what proportion return we got on our
investments. This needs some basic calculations.
The case basically wants us to analyse the different project ideas and understand what would be
the best method of capital budgeting.

Analysis and Interpretation

Question-1
Can you rank the projects simply by inspecting the cash flows?
Ans- Capital budgeting involves identifying the cash in ows and cash out ows which is known
as the cash flow of investing in any project.
Yes, the projects can be ranked based on the given cash flow but, to accurately assess the value
of a capital investment, other factors like the present value and the pay-back period plays a
significant role.
Rank Project Cash flow

1 3 $10,000

2 5 $4,200

3 8 $4,150

4 4 $3,561

5 1 $3,310
6 7 $2,560

7 6 $2,200

8 2 $2,165

Question-2
What criteria might you use to rank the projects? Which quantitative ranking methods are
better? Why?
Ans. ​Some of the methods that are used for capital budgeting are:

● Net present value (NPV)

● Internal rate of return (IRR)
● Payback period
● Profitability Index
● Accounting Rate of Return
1) NPV​ is known as Net Present Value, it's the difference between the present value of cash
inflows and the present value of cash outflows, and this method considers the cost of
capital of the projects. We used the NPV to pick the simplest project, if NPV greater than
or adequate to zero, so it's good to simply accept the projects, but if the NPV is negative
we should always reject the projects. This method is hottest in real world work, and most
of the managers are select the project based to the present method, if the projects are
independent with positive NPV they will accept the project, but if the projects are
mutually exclusive like project 7 and eight from the case, we select the very best positive
NPV. The disadvantage of the NPV method isn't considering the time of the projects.

Formula:
NPV = (Cash flows)/( 1+r)^t
Cash flows= Cash flows in the time period
r = Discount rate
t = time period

Advantages of Net present value method

Time value of cash:​The net present value method may be a tool for analyzing the
profitability of a specific project. It takes into consideration the value of cash . The cash
flows within the future are going to be of lesser value than the cash flows of today. And
hence the further the cash flows, the less will the worth . This is often a really important
aspect and is rightly considered under the NPV method. this enables the organisation to
match two similar projects judiciously, say a Project A with a lifetime of 3 years has
higher cash flows within the initial period and a Project B with a lifetime of 3 years has
higher cash flows within the later period, then using NPV the organisation are going to be
 ready to choose sensibly the Project A as inflows today are more valued than inflows
afterward .
Comprehensive tool: ​Net present value takes into consideration all the inflows, outflows,
period of your time , and risk involved. Therefore NPV may be a comprehensive tool
taking into consideration all aspects of the investment.
Value of investment:​The Net present value method not only states if a project are going
to be profitable or not but also gives the worth of total profits. Like within the above
example the project will gain Rs. 29879 after discounting the cash flows. The tool
quantifies the gains or losses from the investment.

Limitations of internet Present Value method

Discounting rate:​The main limitation of internet present value is that the speed of return
has got to be determined. If a better rate of return is assumed, it can show false negative
NPV, also if a lower rate of return is taken it'll show the false profitability of the project
and hence end in wrong deciding .
Different projects aren't comparable: ​NPV can't be compared to compare two projects
which aren't of an equivalent period. Because many businesses have a hard and fast
budget and sometimes have two project options, NPV can't be used for comparing the 2
projects differently within the period of your time or risk involved within the projects.
Multiple Assumptions

The NPV method also makes tons of assumptions in terms of inflows, outflows. There
could be tons of expenditure which will come to the surface if only the project actually
flies . Also, the inflows might not always be needless to say .

Today most software perform the NPV analysis and assist management in deciding .
With all its limitations, the NPV method in capital budgeting is extremely useful and
hence is widely used.

2) IRR ​stands for Internal Rate of Return, it's the discount rate that forces a project’s NPV
to equal zero. We accept the project if the IRR greater than WACC(Weighted Average of
Capital Cost) and that we reject the project if it's but WACC. The disadvantage of this
method, it's assumed that the speed of return is the same for all the year of the project
which isn't correct in the real world .
For the computation of the internal rate of return, we use an equivalent formula as NPV.
To derive the IRR, an analyst has got to believe an attempt and error method and can't
use analytical methods. With automation, various software (like Microsoft Excel) is
additionally available to calculate IRR. In Excel, there's a financial function that uses
cash flows at regular intervals for calculation.
 Formula:
T
0=NPV= [ ∑ (Ct/(1 + I RR)t ) ] − C 0
t=1
​where:
Ct​=Net cash inflow during the period t
C0​=Total initial investment costs
IRR=The internal rate of return
t=The number of time periods​
The rate at which the value of investment and therefore the present value of future cash
flows match are going to be considered because the ideal rate of return. A project which
will achieve this is often a profitable project. In other words, at this rate the cash outflows
and therefore the present value of inflows are equal, making the project attractive.
IRR used for capital budgeting:
If an equivalent cost apply for various projects, then the project with the very best IRR is
going to be selected. If a corporation must choose from multiple investment options
wherein the value of investment remains constant, then IRR are going to want to rank the
projects and choose the foremost profitable one. Ideally, the IRR above the value of
capital is chosen .
In real-life scenarios, since the investment in any project is going to be huge and can have
a long-term effect, a corporation uses a mixture of varied techniques of capital budgeting
like NPV, IRR and payback period to pick the simplest project.
3) Payback period:
The payback period is that the time required to recover the initial cost of an investment.
it's the amount of years it might fancy revisit the initial investment made for a project.
Therefore, as a way of capital budgeting, the payback period is going to be wont to
compare projects and derive the amount of years it takes to urge back the initial
investment. The project with the smallest number of years usually is chosen .
Salient features of the Payback period method
● The payback period may be a simple calculation of your time for the initial
investment to return.
● It ignores the value of cash . All other techniques of capital budgeting consider
the concept of the value of cash .
● The value of cash means a rupee today is more valuable than a rupee tomorrow.
So other techniques discount the longer term inflows and reach discounted flows.
● It's utilized in combination with other techniques of capital budgeting. due to its
simplicity the payback period can't be the sole technique used for deciding the
project to be selected.

Formula
Payback Period= Total Outflows/Inflow every year
 Or
Payback Period= Initial investment/ Net Annual Cash Inflows

4) Profitability Index:
The profitability index (PI), alternatively mentioned as value investment ratio (VIR) or
profit investment ratio (PIR), describes an index that represents the connection between
the prices and benefits of a proposed project. it's calculated because the ratio between this
value of future expected cash flows and therefore the initial amount invested within the
project. a better PI means a project are going to be considered more attractive.
Key Takeaways
● The profitability index (PI) may be a measure of a project's or investment's
attractiveness.
● The PI is calculated by dividing this value of future expected cash flows by the
initial investment amount within the project.
● A PI greater than 1.0 is deemed as an honest investment, with higher values like
more attractive projects.
● Under capital constraints and mutually exclusive projects, only those with the
very best PIs should be undertaken.

The PI helps rank various projects because it lets investors quantify the worth created per
each investment unit. A profitability index of 1.0 is logically rock bottom acceptable
measure on the index, as any value less than that number would indicate that the project's
present value (PV) is a smaller amount than the initial investment. because the value of
the profitability index increases, so does the financial attractiveness of the proposed
project.

The profitability index is an appraisal technique applied to potential capital outlays. the
tactic divides the projected capital inflow by the projected capital outflow to work out the
profitability of a project. As indicated by the aforementioned formula, the profitability
index uses this value of future cash flows and therefore the initial investment to represent
the aforementioned variables.

When using the profitability index to match the desirability of projects, it's essential to
think about how the technique disregards project size. Therefore, projects with larger
cash inflows may end in lower profitability index calculations because their profit
margins aren't as high.

The profitability index are often computed using the subsequent ratio:
PV=
Components of the Profitability Index
 PV of Future Cash Flows (Numerator)

The present value of future cash flows requires the implementation of the value of cash
calculations. Cash flows are discounted the acceptable number of periods to equate future
cash flows to current monetary levels. Discounting accounts for the thought that the
worth of $1 today doesn't equal the worth of $1 received in one year because money
within the present offers more earning potential via interest-bearing savings accounts,
than money yet unavailable. Cash flows received further within the future are therefore
considered to possess a lower present value than money received closer to this .

Investment Required (Denominator)

The discounted projected cash outflows represent the initial capital outlay of a project.
The initial investment required is merely the income required at the beginning of the
project. All other outlays may occur at any point within the project's life, and these are
factored into the calculation through the utilization of discounting within the numerator.
this extra capital outlays may think about benefits concerning taxation or depreciation.

Calculating and Interpreting the Profitability Index

Because profitability index calculations can't be negative, they consequently must be
converted to positive figures before they're deemed useful. Calculations greater than 1.0
indicate the longer term anticipated discounted cash inflows of the project are greater
than the anticipated discounted cash outflows. Calculations but 1.0 indicate the deficit of
the outflows is bigger than the discounted inflows, and therefore the project shouldn't be
accepted. Calculations that equal 1.0 cause situations of indifference where any gains or
losses from a project are minimal.

When using the profitability index exclusively, calculations greater than 1.0 are ranked
that support the very best calculation. When limited capital is out there , and projects are
mutually exclusive, the project with the very best profitability index is to be accepted
because it indicates the project with the foremost productive use of limited capital. The
profitability index is additionally called the benefit-cost ratio for this reason. Although
some projects end in higher net present values, those projects could also be omitted
because they do not have the very best profitability index and don't represent the
foremost beneficial usage of company assets.

5) Accounting Rate of Return

Accounting Rate of Return (ARR), also popularly known as the average rate of return
measures the expected profitability from any capital investment. ARR indicates the
profitability from investments using simple estimates which helps in evaluating capital
projects. This method divides the net income from an investment by the total amount
 invested in obtaining the ARR.Using ARR will enable the investors to decide on viability
and profitability of capital projects to be undertaken. It also helps investors analyse the
risk involved in the investments and conclude if the investment would yield enough
earnings to cover the risk level. It is one of the widely used financial ratios and comes
handy during the decision-making process when different projects have to be compared
and selected. However, ARR calculation does not consider the interest accrued, taxes,
inflation, etc., this makes it an insufficient method for huge and long-term capital
investments.
ARR= Average Accounting Profit/ Average Investment
Note:

● Average accounting profit is the arithmetic mean of the expected profit earned or to be
earned over the life of the project.
● The average investment is the sum of the beginning and ending book value of the project
divided by two. In certain cases, the initial value of the investment will also be
considered instead of average value.

If the result is equal to or greater than the desired ARR, then the project is accepted. When two
or more projects are compared, the project that has greater ARR is accepted.

Generally, ARR calculation is not only done before accepting the proposal, but it is also done
year-on-year to check on the returns from the project since ARR does not consider multi-period
variables for its calculation.

Advantages:

1) This is a simple method which uses the profit from an investment to quickly know the
return.
2) It is easy to calculate and understand the payback pattern over the economic life of the
project
3) It shows the profitability of an investment and helps to measure the current performance
of the project
4) This method enables the comparison of various projects of competitive nature
5) Small-time investors would be using this method more frequently for appraising their
investment decision
Disadvantages:
1) This method is based on accounting profits only and does not consider the cash inflows,
taxes, etc.
2) This method cannot be used where the investment in a project is made at different times
or in parts.
3) One of the main disadvantages of this method is that it ignores the time factor. Time
value of money is an important factor in deciding the viability of investment.
 4) When different projects are compared, this method does not consider the life period of
various investments and hence it may not produce the accurate results as required.
5) This method ignores the external factors and also the results are different if the same
project is analyzed using a return on investment method. Hence it is not suitable for huge
and long-term projects.

Specific Recommendations

Question -3
What is the ranking you found using quantitative methods? Does this ranking differ from
the ranking obtained by simple inspection of cash flows?

Ans. ​When we use the quantitative ranking methods, we get the result

Rank Projects

1 Project 3

2 Project 4

3 Project 8

4 Project 5

Question - 4
What kinds of real investment projects have cash flows similar to those in Exhibit 1?