Long Term Investments

Long-term investments represent sizable outlays of funds,

firms typically make a variety of long-term investments,
but the most common is in fixed assets;
 Property (land), Plant & Equipment
 Capital Vs Operating Expenditure
Capital Expenditure:
An outlay of funds by the firm that is expected to produce
benefits over a period of time greater than 1 year.
Operating Expenditure:
An outlay of funds by the firm resulting in benefits
received within 1 year.
 Capital Budgeting
The process of evaluating and selecting long-term
investments that are consistent with the firm’s goal of
maximizing owners’ wealth.
Capital budgeting is the planning process used to
determine whether an organization’s make long term
investment.
 Capital Budgeting Process
The capital budgeting process
consists of five distinct but
interrelated steps:
1. Proposal generation
2. Review and analysis
3. Decision making
4. Implementation
5. Follow-up
 Independent Vs Mutually Exclusive Projects
Mutually Exclusive Projects Independent Projects
Whose compete with one another, Whose cash flows are unrelated
the acceptance of one eliminates to one another; the acceptance of
from all other. one does not eliminate the
others.
 Unlimited Funds Vs Capital Rationing
Unlimited Funds Capital Rationing
The financial situation in which a The financial situation in which
firm is able to accept all a firm has only a fixed number
independent projects that provide of dollars available for capital
an acceptable return. expenditures.
 Accept–Reject versus Ranking Approaches
Accept–Reject Approach Ranking Approach
Evaluation of capital expenditure Ranking of capital expenditure
proposals to determine whether projects on the basis of some
they meet the firm’s minimum predetermined measure, such as
acceptance criterion. the rate of return.
 Pay Back
Period

Discounted Net Present

Approaches Value (NPV)

Capital
Profitability
Budgeting
Index (PI)
Techniques

Internal Rate of
Return (IRR)

Un-discounted
Pay Back Period
Approach
 Payback Period
Amount of time required for a firm to recover its
initial investment in a project, as calculated from
cash inflows.
 In case of annuity, payback period can be found by dividing
initial investment by annual cash inflow.
 In case of mixed stream, of cash inflows, the yearly cash
inflows must be accumulated until the initial investment is
recovered.
 Payback Period
Decision Criteria
When the payback period is used to make
accept–reject decisions, the following
decision criteria apply:
 If the payback period is less than the
maximum acceptable payback period,
accept the project.
 If the payback period is greater than
the maximum acceptable payback
period, reject the project.
Payback Period
 Net Present Value (NPV)
It is found by subtracting the initial investment
(ICF) from the present value of its cash inflows
discounted at the firm’s cost of capital (r).
Formula

𝐍𝐏𝐕 = 𝐏. 𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰 − 𝐈𝐂𝐎

It is a more sophisticated capital budgeting

technique than the payback rule.
 Net Present Value (NPV)
DECISION CRITERIA
When NPV is used to make accept–
reject decisions, the decision criteria are
as follows:
 If the NPV is greater than
$0/Positive, accept the project.
 If the NPV is less than
$0/Negative, reject the project.
Net Present Value (NPV) @ cost of capital 14%
 Profitability Index
The ratio of the present value of cash inflows to the
initial cash outflow.
Formula

𝐏. 𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰
𝐏. 𝐈 =
𝐈𝐂𝐎
Also called benefit-cost ratio.
 Profitability Index
DECISION CRITERIA
 Profitability index is 1.00 or
greater, the proposal is accepted.
 Profitability index is less than 1.00,
the proposal is rejected.
Profitability Index @ cost of capital 14%
 Internal Rate of Return (IRR)
IRR is a discount rate that makes the net present
value (NPV) of all cash flows equal to zero.

P𝐕 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐈𝐧𝐟𝐥𝐨𝐰 = 𝐈𝐂𝐎

𝐍𝐏𝐕 = 𝟎
 Internal Rate of Return (IRR)
DECISION CRITERIA
When IRR is used to make accept–reject
decisions, the decision criteria are as
follows:
 If the IRR is greater than the cost
of capital, accept the project.
 If the IRR is less than the cost of
capital, reject the project.
IRR @ cost of capital 14%
 Payback Period (Discounted Approach)
Amount of time required for a firm to recover
its initial investment in a project, as
calculated from discounted cash inflows.
 In case of annuity, payback period can be found by
dividing initial investment by discounted annual
cash inflow.
 In case of mixed stream, of cash inflows, the yearly
discounted cash inflows must be accumulated until
the initial investment is recovered.
 Payback Period (Discounted Approach)
Decision Criteria
When the payback period is used to make
accept–reject decisions, the following
decision criteria apply:
 If the payback period is less than the
maximum acceptable payback period,
accept the project.
 If the payback period is greater than
the maximum acceptable payback
period, reject the project.