You are on page 1of 13

Program : MBA

Semester : III
Subject Code : PM0012
Book Id : BKID-1238

Subject Name : Project Financing and Budgeting


Unit number : 13
Unit Title : Capital Investment Decision
Lecture Number : 13
Lecture Title : Capital Investment Decision

1
HOME CNEXT
onfidential
Unit-13 Capital Investment Decisions

Capital Investment Decisions

Objectives :

• To discuss the importance of Capital Investment techniques while


making financial decision in projects.

• To understand the various project valuation, flexibility valuation and


economic evaluation methods while taking investment decisions.

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Lecture Outline

• Introduction
• Classification of Investment Project
• Project Valuation Methods
• Flexibility Valuation
• Making Capital Investment Decisions
• Economic Evaluation of Investment Projects
• Summary
• Check your Learning
• Activity

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Introduction
Capital Investment Decision
• Defined as the money paid to purchase a capital asset or a fixed asset.
• The money invested in a business with the perceptive that the money is
used to purchase fixed assets, than using it to cover the business’ daily
working expenses.
• Involves the commitment of large sums of money that affects business over
a number of years.
• The investment decision has to be made based on the returns generated by
the investments.
• Selecting investment that improve the financial performance of the business
involves two fundamental tasks:
• Economic profitability analysis
• Financial feasibility analysis

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Classification of Investment Project


Investment projects are classified under the following categories:
• Project Size: Determines the depth of analysis to which the project is
subjected as well as the level within the company at which the project is
approved or disapproved.
• Type of benefit to the firm: The firm invests in a project only if there is
increase in cash flow, a decrease in risk, and an indirect benefit.
• Degree of dependence: The investment projects can be classified into
Mutually exclusive projects, Complementary projects and Substitute
projects.
• Degree of statistical dependence: The investment projects can be
classified based on Positive dependence, Negative dependence and
Statistical independence.
• Type of cash flow: Conventional and non conventional cash flow.

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Project Valuation Methods


The project valuation technique ensures suitable cash flow statements and
ensures proper usage of the resources.
Net Present Value Analysis (NPV)
• NPV is an analytical tool to evaluate the whether or not to invest in a
project.
• Firms invest in projects with positive NPV
Internal Rate of Return (IRR)
• It is the capital investment project’s expected rate of return.
• Firms invest in project with IRR greater than discount rate.
Weighted Average Cost of Capital (WACC)
• The discount rate or the time value of money required in converting
expected future cash flow into present value.
• Estimates the interest the firm is required to pay for each and every
rupee it finances.
6

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Project Valuation Methods


Discounted Cash Flow (DCF)
• Facilitates the evaluation process.
• Normally, every project's value is estimated by means of DCF.
• Crucial in determining the economic viability of a proposed project.
Accounting Rate of Return (ARR)
• An investment appraisal method that measures the generated profit as a
percentage of the investment.
• ARR is measured by estimating the profits before taxes and interest.
• It is easy to calculate and the percentage return is more familiar to
executives.
Payback Period (PP)
• Determines the length of time required to recover the project’s cash outlay
and the return on investment models.
• It is the time duration required to recover the initial investment committed
to a project.
• The project with the lowest payback period or equivalent to the stipulated
payback period is chosen.

n f i d e n t NEXT
PREVIOUSC oHOME ial
Unit-13 Capital Investment Decisions

Flexibility Valuation
The two most common flexibility valuation tools include:
Decision Tree Analysis (DTA):
• A tool for making decisions.
• Values flexibility by including measures and corresponding management
decisions.
• Benefits cost ratio analysis to determine the relative value of competing
projects.
Real Options Analysis (ROA):
• ROA quantitatively takes into account investment risks and the value of the
open options for budget decision-makers.
• Preferred while the value of a project is dependent on the value of some
other asset or underlying variable.

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Making Capital Investment Decisions


Finance Capital investment decisions is also termed as capital budgeting.
The capital investment decisions involve five main decisions namely:
• Objective Function
• Investment Decision
• The Financing Decision
• Dividend Decision
• Valuation

The following are the quality factors one needs to consider:


• The interaction of project and firm.
• Interaction of project and market.
• Interaction of project and macroeconomic environment.

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Economic Evaluation of Investment


Projects
The economic evaluation of investment projects stipulates a decision rule
for accepting or rejecting investment projects base on the two factors
namely:

Time Value of Money


• Time value of money is the concept of measuring the value of money
over time.
• The receipt of money is preferred sooner rather than later.

Future Value
• Future value defines the worth of money at some point in the future
of one or more investments.
• Future value is the value of an asset or cash at a specified date in the
future that is equivalent in value to a specified sum today.

10

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Summary
• Capital Investment is the money paid to purchase a capital asset or a
fixed asset.
• The investment projects can be classified based on project size, type
of benefit to the firm, dependency, statistical dependency and cash
flows.
• DCF, NPV, IRR, WACC, ARR, and PP are the various project valuation
methods.
• DTA and ROA are the two flexibility valuation methods used in
investment projects.
• Finance Capital investment decisions is also termed as capital
budgeting.
• The Economic Evaluation of Investment Projects stipulates a decision
rule for accepting or rejecting investment projects.

11

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Check Your Learning


1. Define Capital Investment
Ans. It is the money paid to purchase a capital asset or a fixed asset. The
money invested in a business with the perceptive that the
money will be used to purchase fixed assets, than using it to cover
the business’ daily working expenses. It involves the commitment
of large sums of money that affects business over a number of
years.
2. List the different types of decisions taken in investment.
Ans. There are five main decisions namely:
• Objective Function
• Investment Decision
• The Financing Decision
• Dividend Decision
• Valuation

12

PREVIOUS HOME CNEXT


onfidential
Unit-13 Capital Investment Decisions

Activity

What is the future value of Rs 10, 000 invested at 10% at the end of 1
year and what is the future value of Rs 10, 000 invested at 10% at the
end of 5 years?

13

PREVIOUS HOME Confidential