PRESENTATION ON LONG TERM INVESTMENT TOOLS

PRESENTED BY:Shashank Mishra Sanjay Negi

Capital Budgeting Decision
Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

Capital Budgeting Decision
 Example:

Suppose our firm must decide whether to purchase a new plastic molding machine for Rs.125,000. How do we decide?  Will the machine be profitable?  Will our firm earn a high rate of return on the investment?

Decision Making in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected?

Capital Budgeting Decision
 The Ideal Evaluation Method should:

a) include cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project.

There are mainly four investment tools:-

PBP

ARR

PI

NPV

IRR

MIRR

NET PRESENT VALUE
Difference between PV of cash inflows and PV of cash outflows.

NPV =

PV of Cash Inflows - PV of Cash Outflows

DECISION:If NPV > 0 , project is accepted (Independent project) If NPV <0, project is rejected (Independent project)

If project is Mutually exclusive: Higher NPV project to be accepted.

Internal Rate Of Return (IRR)

Discounting Rate

NPV =0
PV of Cash Inflows = PV of Cash Outflows

Calculation of IRR
CF3 CFN CF1 CF2 NPV  0  CF0     ....  2 3 (1  r ) (1  r ) (1  r ) (1  r ) N
r = ? ( by trial and error method)

Acceptance Rule
For Independent Projects
If IRR > K – Then Accept If IRR < K– Then Reject

For Mutually Exclusive Projects,Select that one which has highest IRR

Characteristics of IRR

•It takes two things in consideration 1. Magnitude of cash flows 2. Timing of cash flow

Disadvantages with IRR

1. It has mathematical problem: multiple IRRs, not real solution. 2. Scale Problem. 3. Reinvestment Rate Assumption(Timing Problem) 4. It can not distinguish between investing and financing projects.

PAY BACK PERIODExample 1: Initial investment :-

time to recover invested Capital
Initial investment is recovered in the 3rd year So, Payback period = 3 years+1000*12/4000= 3years and 3 months

10000

Net cash flow (1 yr) =2000 (2nd yr) =4000 (3rd yr) =3000 (4th yr) = 4000 Example 2: Initial investment :13000 Net cash flow (1 yr) (2nd yr) (3rd yr) (4th yr) (5th yr) =2000 =4000 =3000 = 3000 =6000

Now, Payback period in this case will be 4yr +(1000/4000) i.e. ( 4 + 1000*12/6000) = 4 Yr and 2 months

CALCULATION OF BAIL OUT PERIOD

Initial investment :
Cash Flows

9000
Total Recovery

Salvage value

1st year 1000
2nd year 2000

6000
5500

7000
8500

3rd year 1000
4h year 1000

5000
3000

9000 (BOP=3yrs)
-

5th year 4000

2000

-

FACTS ABOUT PAYBACK PERIOD
•Management has to set benchmark to evaluate the project thorough this. •It does not consider Cash Flow after Payback period. •It does not fully account for the time value of money. •It does not peruse the firm’s objective of wealth maximization.

•Liquidity crunch.
•Number of projects are in queue.

Discounted Pay Back Period: Number of years taken in
recovering the investment on the present value basis.

Initial Investment = 50,000 Cost of capital =10%
Year 0 1 2 3 4 5 Cash flow -50000 25000 15000 10000 8,000 6,000 Discounted Cumulative cash Cash flow flows -50,000 ---22727.27 22727.27 12396.69 35123.97 7513.148 42637.11 5464.108 48101.22 3725.528 51826.75

50000

Discounted Pay Back period = 4 years +(50000 – 48101.22)*12= 4years +6.11 months 3725.528

Accounting Rate of Return
This is the quick estimation of project’s worth investment.

ARR =

Average Annual Profit After Tax ×100 Average or Initial Investment

Average Annual profit after Tax =

Average EBIT (1 - t)

Where, Average Investment = Initial Investment + Salvage Value

PROFITABILITY INDEX
PI = Present value of cash inflows Present Value of cash outflow

If P.I > 1, NPV is positive, project is accepted. If PI<1, NPV is negative, project is rejected.

Reinvestment Rate Assumption
Project IRR 15% C0 C1 C2 C3 k

-1000

500

460

380

10%

•NPV assumes that cash flows are reinvested at cost of capital. •IRR assumes that cash flows are reinvested at IRR.

Investing Cash flows Vs Financing Cash flows

Example: C0 Project A: -100 C1 115 IRR NPV @10% 4.55 NPV @20% -4.17 Investing Project

15%

Project B:

100

-115

15%

-4.55

4.17

Financing Project

If opportunity cost is 10% What about if it is 20% Then Project A ? OR Project B?

What is Modified Internal Rate Of Return (MIRR) ??
Rate of return which makes PV of outflows Equal to terminal value of the project.

•Assumes that all cash flows are reinvested at firm’s cost of capital.

Calculation of MIRR
Project C0
-100

C1
10

C2
60 10%

C3
80 =66

10% cost of capital is 10% Terminal Value

=12.1 =158.1 TV

PV Of Outflows (1+MIRR)N = Terminal Value of the project 100 (1+MIRR)3 = 158.1 MIRR =16.5% MIRR > COST OF CAPITAL 10%, So project will be accepted. Excel.xlsx

Why MIRR not IRR ?

•MIRR is more realistic than IRR. •NPV and MIRR both support the same project.

Question to Audience

Which is more better NPV or IRR

THANK YOU