Chapter 6

Investment Evaluation
 Understanding Investment Decision
• Also referred to as Capital Investment or Capital
Project or just Project.
• The basic characteristic of Investment evaluation is :
– Typically involves a current outlay (or current and future
outlays) of funds
– In the expectation of a stream of benefits extending far into
the future.
• However, from accounting point of view, Capital
Expenditure is the one shown as asset on the Balance
Sheet(chapter 7). This assets, except in the case of non-
depreciable asset like land, is depreciated over its life.
 What is Investment evaluation?
• Investment Evaluation refers to the process of
deciding how to allocate the firm’s scarce capital
resources (land, labor, and capital) to its various
investment alternatives.
• The process of planning for purchases of long-term
assets.
• Nature of Investment Evaluation:
Evaluating and selecting long-term investments
in:
– tangible assets
– intangible assets
 Investment Criteria

Discounting Method Non-Discounting Methods

NPV(net present value) Payback Period

Benefit-Cost Ratio (Accounting Rate of

Return )ARR
IRR(internal rate of return)

Discounted Payback
 Overview

• All of these techniques attempt to

compare the costs and benefits of a
project.
• The over-riding rule of capital budgeting is
to accept all projects for which the cost is
less than, or equal to, the benefit:
–Accept if: Cost  Benefit
–Reject if: Cost > Benefit
 1. The Payback Period Method
• The payback period measures the time that it takes to
recoup the cost of the investment.
• If the cash flows are an annuity, then we can simply divide
the cost by the annual cash flow to determine the payback
period.
• Otherwise, as in the example, we subtract the cash flows
from the cost until the remainder is zero.
• The shorter the payback period, the better to choose from.
• Generally, firms will have some maximum allowable
payback period against which all investments are compared.
• We will use the following example to
demonstrate the techniques of capital budgeting.
• Assume that your company is investigating a new
labor-saving machine that will cost $10,000. The
machine is expected to provide cost savings each
year as shown in the following timeline:
-10,000 2000 2500 3000 3500 4000

0 1 2 3 4 5

 If your required return is 12%, should this machine be

purchased?
 Note: It doesn't considers the rate of interest.
 The Payback Period: An Example
• For our example project, we will subtract
the cash flows from the initial outlay until
the entire cost is recovered:
10,000 Cumulative Payback
- 2,000 1 year
= 8,000
- 2,500 2 years
= 5,500
- 3,000 3 years
= 2,500 3 years < Payback < 4 years
 Since it will take 0.7143 years (= 2500/3500) to recover
the last 2,500, the payback period must be 3.7143 years.
Note: the return rate increase by 500 i.e 2,000-3,500
 Computation
Year Cash Flow Cumulative Net Cash Flow

0 -10,000 -10,000

1 2,000 -8,000

2 2,500 -5,500

3 3,000 -2,500

4 3,500 1,000

Hence, Payback Period lies between year 3 and 4

The example shows the drawback of payback method. The below table
shows there are two alternatives A and B in which the benefit of B is more
in the year 5 and 6 and even payback period is one year more than that of
alternative A
Year Cash flow of A Cash flow of B
0 (-100,000) (-100,000)
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 - 60,000

Payback Criterion prefers A with payback period of 3 years

over B with payback period of 4 years.
But B has very substantial cash inflows in the years 5 and 6
 2. The Discounted Payback Period
• The discounted payback period is exactly the same as
the regular payback period, except that we use the
present values of the cash flows in the calculation
• Since our required return (weight average cost of
capital, WACC) is 12%, the timeline with the PVs
looks like this:

-10,000 1785.71 1992.98 2135.34 2224.31 2269.71

0 1 2 3 4 5
 The discounted payback period is 4.82 years
 Note that the discounted payback period is always longer
than the regular payback period
 Computations
Year Cash Discounting factor @ Present Value Cumulative
Flow 12 %( P/F Will be net cash flow
noted from chart)
0 -10,000 1.000 -10,000 -10,000

1 2,000 0.893 1,786 -8214

2 2,500 0.797 1992.5 -6221.5

3 3,000 0.712 2136 -4085.5

4 3,500 0.636 2226 -1859.5

5 4,000 0.567 2268 408.5

Payback Period = 4.82 years

 Problems with Discounted Payback
• The discounted payback period solves the time
value problem, but it still ignores the cash flows
beyond the payback period.
• Therefore, you may reject projects that have
large cash flows in the outlying years that make
it very profitable.
• In other words, any measure of payback can lead
to a focus on short-run profits at the expense of
large investment.
 3. Accounting Rate of Return (ARR)
• Also called Average Rate of Return and average
accounting return
• However, in one form or other, ARR is always
defined as

Average accounting profit

ARR 
Average accounting value
 Example
Suppose we are deciding whether or not to open a
store in a new shopping mall. The required
investment in improvements is $ 500,000. The
store would have a five-year life because
everything reverts to the mall owners after that
time. The required investment would be 100 %
depreciated over five years. So the depreciation
would be $ 500,000 / 5 = $ 100,000 per year. The
tax rate is 25 %.
Table ahead shows the projected revenues and
expenses
 Computation
EBDT=earning before deprecation and tax
EBT=earning before tax NI=net income

Year 1 Year 2 Year 3 Year 4 Year 5

Revenue 433,333 450,000 266,667 200,000 133,000

Expenses 200,000 150,000 100,000 100,000 100,000

EBDT 233,333 300,000 166,667 100,000 33,000

Depreciation 100,000 100,000 100,000 100,000 100,000

EBT 133,333 200,000 66,667 -67,000

Tax @ 25 % 33,333 50,000 16,667 16750

NI 100,000 150,000 50,000 0 -50,250

 Solution

100,000  150,000  50,000  0 - 50,250

Average NI   50,250
5

500,000  0
Average of Investment   250,000
2

50,250
ARR   20%
250,000

The project is acceptable if the ARR exceeds the target ARR

 Evaluation of ARR method
• It is simple to calculate
• It is based on accounting information,
which is readily available and familiar
to businessmen.
• While it considers benefits over the
entire life of the project, it can be used
even with the limited data.
 Problems with ARR method
• ARR is not the rate of return in any meaningful
economic sense. It is just the ratio of two accounting
numbers, and is not comparable to the returns
actually offered.
• It is based upon accounting profit, not cash flow.
• It does not take into account the time value of
money.
• The ARR measure is internally inconsistent. While the
numerator represents profit belonging to equity and
preference stockholders, its denominator represents
fixed investments, which is rarely, if ever, equal to
the contributions of equity and preference
stockholders.
 4. The Net Present Value(NPV)
• The net present value (NPV) is the
difference between the present value of the
cash flows (the benefit) and the cost of the
investment (IO):
NPV  PVCF  IO

 Allprojects with NPV greater than or equal to

zero should be accepted
 PCVF=present value of cash flows.
 The NPV: An Example
Co=Initial investment (is negative always) C1=benefit for first year
c2=benefit for 2nd year etc.
r=rate of interest (12%)

• NPV is calculated by subtracting the initial outlay (cost)

from the present value of the cash flows
• Note that the discount rate is the WACC (12% in this
example)
 2000 2500 3000 3500 4000 
      10000  408.06
 112 112 112 112 112 5
 .  .  .  .  .  
1 2 3 4

 Since the NPV is positive, the project is acceptable

 Note that a positive NPV also means that the IRR is
greater than the WACC
 The Internal Rate of Return(IRR)
• Internal rate of return (IRR) is the discount rate that
equates the present value of the cash flows and the
cost of the investment
• Usually, we cannot calculate the IRR directly, instead
we must use a trial and error process
• For our example, the IRR is found by solving the
following:
• IRR=12%

2000 2500 3000 3500 4000

10,000     
1  IRR 1
1  IRR 2
1  IRR 3
1  IRR 4
1  IRR 5

 In this case, the solution is 13.45%

 Problems with the IRR
• The IRR is a popular technique primarily because
it is a percentage which is easily compared to
the WACC
• However, it suffers from a couple of flaws:
– The calculation of the IRR implicitly assumes
that the cash flows are reinvested at the IRR.
This may not always be realistic.
– Percentages can be misleading (would you
rather earn 100% on a $100 investment, or
10% on a $10,000 investment?)
 The Profitability Index(PI)
• The profitability index is the same as the NPV,
except that we divide the PVCF by the initial
outlay:
PVCF
PI 
IO
 Accept all projects with PI greater than or equal to 1.00
 For the example, the PI is:

10,408.06
PI   10408
.
10,000
 Chapter 7
Basic Concepts of Financial
Accounting
 Introduction
• In modern industry financial manager plays a
dynamic role in the development of company. But
during earlier days, financial manager used to raise
funds and managed their firm cash positions.
• In todays scenario following external factors are also
influencing
1.Techonologicl change
2.incresed corporate competition
3.flucating interest rates
4.worldwide economic uncertainty
5.flucating exchange rates
6.Tax law changes
 Financial management
• Financial management is concerned with
acquisition, financing and management
of assets with some overall goal in mind.
The decision function of financial
management are generally of three types
1.Investment decision
2.Financing decision
3.Assest management decision
 Purpose of investment
money in the business firm may be invested for the
following reasons
1.To procure land, buildings or for making expansion
of the existing plant
2.To purchase material transporting vehicles
3.For power, gas, water etc. to run the firm
4.To procure raw materials, machineries tools etc.
5.For product development ,in R&D activities
6.To expand capacity
7.To product development and diversification
8.For paying salaries and to organise business
 The Basic Accounting Equation
• Financial accounting is based upon the
accounting equation.
Assets = Liabilities + Owners' Equity
– This is a mathematical equation which must
balance.
– If assets total $300 and liabilities total $200, then
owners' equity must be $100.
 The Basic Accounting Equation
The balance sheet is an expanded expression of
the accounting equation.
Balance Sheet
Assets Liabilities and Owners’ Equity
Cash 5,000 Liabilities
Accounts receivable 7,000 Accounts payable 8,000
Inventory 10,000 Notes payable 2,000
Equipment 7,000 Total liabilities 10,000
Owners’ equity 19,000
Total assets 29,000 Total liabilities and
owners’ equity 29,000
 Assets
• Assets are valuable resources that are owned by a
firm.
– They represent probable future economic benefits and
arise as the result of past transactions or events.
– Assets are of two types 1.Fixed assets 2.current assets
– Fixed assets' requires more time to convert them into
cash.
– Fixed assets includes land building ,furniture machinery
,equipment, vehicles etc.
– Current assets' are easily converted into cash within short
period of time(1 year or less)
– Current assets include cash in hand and bank, inventories
notes and accounts receivable etc.
 Liabilities
• Liabilities are present obligations of the firm.
– They are probable future sacrifices of economic
benefits which arise as the result of past transactions
or events.
– Liabilities are of two types 1.Fixed liabilities 2.current
liabilities
– Fixed liabilities are the obligations to be paid on long
term basis(Shares, debentures etc.)
– Current liabilities are the obligations to be paid on
short term basis(rent to be paid, interest paid, taxes
etc.)
 Owners' Equity
• Owners' equity represents the owners' residual
interest in the assets of the business.
– Residual interest is another name for owners' equity.
This is the amount owed by the business to the
proprietors .Kind of fixed assets .
Equity shares ,capital ,retained profits etc.
• Yet another name for owners' equity is net assets.
– Indicates that owners' equity results when liabilities
are subtracted from assets.
Owners’ Equity = Assets – Liabilities
 What comes under fixed assets and
current assets
• Fixed assets includes(cann’t be easily converted
into cash
• Land and building ,plant and equipment
Furniture ,vehicles ,machinery etc.
• Currents assets includes(can easily converted
into cash)
• Cash in hand, cash in bank
• inventories, stocks, debtors, investments, bills
receivable, interest receivable, sundry debtors.
 What comes under fixed liabilities and
current liabilities
• Fixed liabilities are the obligations needs to be paid
on long period .
• Fixed liabilities includes long term debt, long term
loan shares, debentures, long borrowing etc.
• Current liabilities are the obligations needs to be
paid on short term basis.
• Current liabilities incudes loans, reverses
• Rent, taxes, creditors, customer advances
reverses and surplus, Depreciation, provision for
dividend etc.
• Unclaimed dividend, sundry creditors ,trade
creditors and profit and loss account.
 The Balance Sheet
• The balance sheet shows a firm's assets,
liabilities, and owner's equity at one point in
time.
• In balance sheets
Assets=Liabilities + owners equity.
– The date on the balance sheet will be a single date,
such as December 31 or June 30.
 Balance Sheet
January 31, 2000
Assets Liabilities and Owners’ Equity
Fixed assets Liabilities

Cash $ 32,500
Accounts receivable 4,400 Accounts payable $ 30,000
Prepaid rent 11,000 Unearned revenue 50
Inventory 27,800 Utilities payable 120
Equipment 27,792 Interest payable 133
Total assets $100,492 Notes payable 20,000

Total liabilities 50,303

H.Jacobs, capital 50,189
Total liabilities and
owners’ equity $100,492
 Example on balance sheet
Example1.Following is the financial statement of
the company ACE foundry as on march 2008.
1.clearly classify them under the fixed assets
,current assets ,fixed liabilities, current liabilities
and owners equity.
2.Prepare a balance sheet for the year ending 31
march 2008.
Net fixed assets 605,000 Bills payable 220,000
Sundry debtors 275,000 Reserves 110,000
Equity share capital 120,000 Bank Balance 100,000
10% debentures 230,000 Loan 70,000
Sundry creditors 165,000
Cash in hand 220,000
Stock 825,000
provision for dividend 30,000
 Company :ACE foundry
balance sheet as on 31st march 2008
Note: Assets=liabilities+ owners equity

Assets Liabilities
Fixed assets Fixed liabilities
10%debentures 230,000
Net fixed assets 605,000 Total fixed Liabilities 230,000
Total fixed assets 605,000 Current liabilities
Current assets Sundry creditors 165,000
Bills payable 220,000
cash in hand 220,000 Reserves 110,000
sundry debtors 275,000 Loan 70,000
Provision for dividend 30,000
Stock 825,000
Total current liabilities 595,000
Bank balance 100,000 Owners Equity
Equity share capital 120,000
Total current asset 1,420,000 Total owners equity 120,000
TOTAL LIABILTIES 2,025,000
TOTAL ASSETS 2,025,000
Example 2.Prepare a balance sheet for trinity forge company for
the following data(the data given in terms of thousand(1000)

Debentures 400 Share capital 2500

Stock 650 Reserves and surplus 600
Cash and bank balance 112 Interest receivable 8
Long borrowings 80 Investments 900
Long term loan 220
Creditors 110
Customer advances 40
Loan and advances 50 Debtors 250
Land, building, plant& Provision for
Machinery 2500 dividend 50
Deprecation on above 200 Provision for
taxation 170
 Balance sheet for the trinity forge company is shown below
company: Trinity forge
Balance sheet
Assets Liabilities
Fixed liabilities:
Fixed assets: debentures 400
Long borrowing 80
Land, building, plant& Long term loan 220
Machinery 2500 Total fixed Liabilities 700
Current liabilities:
Total fixed assets 2500 Customer advances 40
Reveres and surplus 600
Current assets : Deprecation on above 208
Stock 650 Loans and advances 50
Provision for dividend 50
Cash and bank balance 112 Creditors 110
Investments 900 Provision for taxation 170
Debtors 250 Total current liabilities 1220
Owners Equity :
Interest receivable 8 share capital 2500
Total current asset 1920 Total owners equity 2500
TOTAL ASSETS 4420(Thousand) TOTAL LIABILTIES 4420(thousand)
 The Income Statement
• Only revenues and expenses appear on the
income statement.
– Students sometimes think that cash is a good
thing and should appear on the income
statement.
– Cash is an asset and so will appear on the balance
sheet.
 Income Statement
For the Month Ended January 31, 2000
Revenues
Sales $ 4,000
Service
650
Total revenue 4,650
Expenses
Cost of goods sold 2,200
Rent 1,000
Salary 700
Depreciation 208
Interest 133
Utilities 120
Total expenses 4,361
Net income $ 289
 Example on profit and loss account
or
(income statement)
Q. The following are the items of profit and loss
account for VOLTAS limited for the year ended on
march 31st 2003.you are required to arrange
them systematically and indicate
(i)Profit before taxation
(ii)Profit after taxation
 Profit and loss account for the year ended 31st march2003

ETB
Operating and administrative expenses 104,406
Depreciation 13,828
Income tax 210
Interest Paid 2595.3
Cost of sales and services 54773.9
Sales and services(revenue) 69552.9
Wealth tax 3.5
Other income 517.6
Excess provision of tax in previous years 143.0
Proposed dividend 643.8
 solution
(i)Profit before taxation=Income - Expenses
INCOME
a)Sales and service(Revenue)=69552.9
b)other income=517.6
c)Excess provision of tax in previous years=143
Total Income =a+b+c=70213.5
EXPENSES
a)Cost of sales and service =54773.9
b)Operation and administrative expenses=10440.6
c)Interest=2595.3
d)Depreciation =1382.8
Total expenses =a+b+c+d=69192.6
So (i) Profit before taxation=70213.5-69192.6=1020.9
(ii)Profit after taxation=profit before taxation-taxes-proposed dividend
Total Taxes=income tax wealth tax=210+3.5=213.5
Proposed dividend =643.8
Profit before taxation=1020.9
So
(ii) Profit after taxation(To the company) =1020.9-213.5-643.8=163.3

------- --------END--------------