INVESTMENT DECISION THEORY

SESSION BY: PROF. FARRIDA

Pay Back Period = E + B
C
Where E = No. of yeas immediately preceding the year of payback
B = Balance to be recovered; C = Cash flow during the year of recovery of entire amt.

Model A Model B Model C

2 + 40,000 2 + 20,000 2 + 20,000
50,000 50,000 35,000

100,000 + 40,000 100,000 + 20,000 70,000 + 20,000

50,000 50,000 35,000

1,40,000 1,20,000 90,000

40,000 50,000 35,000

2.8 years 2.4 years 2.57 years

The earliest Pay Back Period is in case of Model B. Hence select Model B
Pay Back Period = E + B
C
Where E = No. of yeas immediately preceding the year of payback
B = Balance to be recovered; C = Cash flow during the year of recovery of entire amt.

Project A Project B Project C Project D

3 + 0 3 + 3,000 5 + 2,500 2 + 1,000
5,000 6,000 2,500 6,000

15,000 + 0 18,000 + 3,000 12,500 + 2,500 12,000 + 1,000

5,000 6,000 2,500 6,000

15,000 21,000 15,000 13,000

5,000 6,000 2,500 6,000

3 years 3.5 years 6 years 2.17 years

2nd rank 3rd rank 4th rank 1st rank

Formula to be used for calculating “Average Investment” if Scrap Value or Additional
Working Capital details are given:

Average Investment = Original Investment – Scrap Value + Additional Working Capital

2
 ARR = Average Income after tax & depreciation x 100.
Average Investment

Average Income = Total Returns Avg. Investment = Original Investment – Salvage Value
Expected Life 2

Project A Project B
Avg. Income = 51,000 = Rs. 10,200 Avg. Income = 53,000 = Rs. 10,600
5 5

Avg. Investment = 50,000 - 7,000 = Rs.21,500 Avg. Investment = 50,000 - 3,000 = Rs.23,500
2 2

Hence ARR = 10,200 x 100 = 47% Hence ARR = 10,600 x 100 = 45%
21,500 23,500
 NPV for Model A

NPV = C1 C2 C3 C4 C5
minus C₀
(1+k) (1+k)² (1+k)³ (1+k)⁴ (1+k)⁵

8,000 24,000 32,000 48,000 32,000

-70,000
(1+0.10) (1+0.10)² (1+0.10)³ (1+0.10)⁴ (1+0.10)⁵

8,000 24,000 32,000 48,000 32,000

-70,000
1.10 1.21 1.331 1.464 1.611

(7273 + 19,835 + 24,042 + 32,786 + 19,863) -70,000

NPV for A 103,799 - 70,000 = 33,799

 NPV for Model B

NPV = C1 C2 C3 C4 C5
minus C₀
(1+k) (1+k)² (1+k)³ (1+k)⁴ (1+k)⁵

24,000 32,000 40,000 24,000 16,000

-60,000
(1+0.10) (1+0.10)² (1+0.10)³ (1+0.10)⁴ (1+0.10)⁵

24,000 32,000 40,000 24,000 16,000

-60,000
1.10 1.21 1.331 1.464 1.611

(21,818 + 26,446 + 30,052 + 16,393 + 9,932) -60,000

104,641 - 60,000 = 44,641…….NPV of B

NPV of B is > A. Hence select Model B

NPV for Project X NPV for Project Y
C1 C2 C3 C4 C5 C1 C2 C3 C4 C5
minus C₀ minus C₀
(1+k) (1+k)² (1+k)³ (1+k)⁴ (1+k)⁵ (1+k) (1+k)² (1+k)³ (1+k)⁴ (1+k)⁵

5,000 10,000 10,000 3,000 2,000 20,000 10,000 5,000 3,000 2,000
-20,000 -30,000
(1+0.10) (1+0.10)² (1+0.10)³ (1+0.10)⁴ (1+0.10)⁵ (1+0.10) (1+0.10)² (1+0.10)³ (1+0.10)⁴ (1+0.10)⁵

5,000 10,000 10,000 3,000 2,000 20,000 10,000 5,000 3,000 2,000
-20,000 -30,000
1.10 (1.10)² (1.10)³ (1.10)⁴ (1.10)⁵ 1.10 (1.10)² (1.10)³ (1.10)⁴ (1.10)⁵

5,000 10,000 10,000 3,000 2,000 20,000 10,000 5,000 3,000 2,000
-20,000 -30,000
1.10 1.21 1.33 1.46 1.61 1.10 1.21 1.33 1.46 1.61

4545 8264 7513 2049 1242 -20,000 18182 8264 3757 2049 1242 -30,000

23614 - 20000 = 3614 NPV of Project X 33494 - 30000 = 3494 NPV of Project Y

The NPV of Project X is higher than that of Project Y. Hence Project X should be selected.
PI for
Project
A 0 4,000 2,000 = 0 4,000 2,000 = 0 + 3306 + 1504 = 4808 = 1.2
(1+0.10) (1+0.10)² (1+0.10)³ 1.1 1.21 1.33 4000

B 2000 2000 0 2000 2000 0 = 1818 + 1653 + 0 = 3471 = 0.87

(1+0.10) (1+0.10)² (1+0.10)³ = 1.1 1.21 1.33 4000

C 3000 2000 2000 = 3000 2000 2000 = 2727 + 1653 + 1504 = 5884 = 1.18
(1+0.10) (1+0.10)² (1+0.10)³ 1.1 1.21 1.33 5000

D 2000 3000 2000 = 2000 3000 2000 = 1818 + 2479 + 1504 = 5801 = 1.16
(1+0.10) (1+0.10)² (1+0.10)³ 1.1 1.21 1.33 5000

Do not accept Project B which has a Profitability Index less than 1. All other projects are acceptable
 Steps in Capital Rationing

– Rank the projects based on modern methods of

evaluation i.e. PI, NPV and IRR

– Select the projects in descending order of their

profitability, until the entire available budget is
exhausted