Long term Investment

Decisions-Capital Budgeting
Module-2
Module 2 Outline
• Identify the importance and process of capital
budgeting
• Examine the methods of evaluating long term
investment projects
Investment Decisions-Capital
Budgeting
• Investment Decisions deals with firm’s decision
to invest its funds in the long term assets of
the firm in anticipation of positive cash
inflows in the coming years.
• It deals with decision to allocate and invest
money in to Long term assets of the firm.
 Where to invest funds?
 What should be the amounts that should be invested
on different proposals ?
 Re-allocation of funds when an asset no longer
generates profits
Features of Long Term Assets
• The investment amount is very high & also is in
current times
• Long term assets are going to provide return
over a series of future years
• The decision relating to investment in long term
assets is called as Capital Budgeting
Decisions /Capital Investments.
Features of Capital
Budgeting/Investment Decisions
• It involves investment of Current funds
• The Investment is made in long term assets
• The benefits from the assets are expected in
long run
• It involves the investment of large amount of
funds
• It involves high degree of risks/
uncertainty as the returns are expected over
many years
Need & Importance of Capital
Budgeting
• As Capital budgeting involves investment of
large amount of funds, they influence the firms
growth and riskiness of business
• Capital expenditure decisions are usually
irreversible in nature
• Existence of Huge risk & Un certainty
• Risk of increase in costs due to long period
taken to complete the project.
• They are most difficult decisions to take
Factors influencing investment
decision
• Availability of Funds/ Investment required
• Earnings of the Project/Profitability of Project
• Return on Capital or Pay back period
• Extra Working Capital needs of the project
• Management Outlook-Optimistic/Pessimistic
• Competitor’s Strategy
Process of Capital Budgeting
1. Project Planning
 Identifying the potential investment opportunities
 Investment opportunities having high potential of
profits for the firm are advanced to the next step of
evaluation.
 Investment opportunities having low potential or
merit of profits for the firm are rejected

2. Project Evaluation
1. Determination of proposal ‘s investments, inflows
and outflows.
2. Techniques are used to evaluate profitability of the
project
Process of Capital Budgeting-
Continued
3. Project Selection
 Projects are selected based on Risks, Return & Cost of Capital
4. Project Implementation
 The firm purchases the required assets and begins with the
implementation of the project
5. Project Control
 Here the progress of the project is monitored with help of progress
reports
 The progress reports include
 Capital expenditure reports,
 performance reports,
 comparing actual performance with planned ones.
 Taking corrective measures to rectify

6. Project Review
 Firm evaluates after the project terminates whether the project was
successful or a failure in terms of revenue generation.
 The review may provide new ideas for new proposals to be
undertaken in the future by the firm.
Capital Budgeting Techniques
• Non-discounted Cash Flow Criteria
1. Pay Back Period Method
2. Accounting Rate of Return Method
3. Profitability Index Method

• Discounted Cash Flow (DCF) Criteria

1. Net Present Value Method
2. Internal Rate of Return
3. Discounted Pay Back Period Method
4. MIRR-Modified Internal Rate of Return
Pay Back Period Method
• It is the number of years required to recover the
original cash invested in the project

• There are 2 ways to calculate the Pay Back

Period based on the type of Cash Inflows from
the project
▫ Uniform Cash Inflows or Even Cash Inflows
▫ Non-Uniform Cash Inflows or Un Even Cash
Inflows
Pay Back Period- Uniform/Even Cash
Inflows
• If the project generates constant annual cash
inflows, the payback period can be computed by
dividing the cost of investment by the annual
cash inflow.
• Pay Back Period= Initial Investment
Annual uniform Cash Inflow
Example
• Assume that a project requires an outlay of Rs
50,000 and yields annual cash inflow of
Rs12,500 for 7 years. The pay back period for the
project is calculated as follows

• Pay Back Period= Rs 50,000 = 4 Years

Rs 12,500
Pay Back Period- Non Uniform/Uneven
Cash Inflows
• In case of unequal cash inflows, the payback period
is found by adding up the annual cash inflows until
the total is equal to original cash outflow.

• PBP= Year Before Full Recovery+ Balance Cash Inflows to be Recovered

Cash Flows of the next Period
 Illustration-Investment= Rs 1,50,000
Year Annual Cash Flows Cumulative Cash
Inflows
1 Rs 30,000 Rs 30,000
2 Rs 32,000 Rs 62,000
(30,000+32,000)
3 Rs 25,000 Rs 87,000
(30,000+32,000+25,0000
)
4 Rs 38,000 Rs 1,25,000
(30,000+32,000+25,0000
+38,000)
5 Rs 40,000 Rs 1,65,000
(30,000+32,000+25,0000
+38,000+40,000)
Cash Out flows Rs 1,50,000
PBP= 4 + 25,000 = 4+ 0.625= 4.625
40,000
Acceptance rule for Pay Back Period
• Accept if PB < standard payback
• Reject if PB > standard payback
• The shorter the pay back period more better it is
for the firm.
• The firm sets up the standard pay back period
for an investment proposal
• If the payback period for the project is equal or
less than the standard pay back period set then
the project is accepted or else rejected.
• Out of 2 projects, the project with lower pay back
period will be accepted and other gets rejected
Merits & Demerits of PBP
Merits Demerits

Easy to understand and compute ·

Ignores the time value of money
and inexpensive to use.

Ignores cash flows occurring after

Emphasizes liquidity the
payback period.

No relation with the wealth

Uses cash flows information maximization
principle.

No objective way to determine the

standard payback.
Accounting Rate of Return(ARR)
• Accounting Rate of Return is also known as
Return on Investment Method(ROI)

• This method uses accounting information

revealed in the financial statements, to measure
the profitability of an investment
Accounting Rate of Return(ARR)
The accounting rate of return is the ratio of the
average after-tax profit divided by the average
investment.

The average investment would be equal to half

of the original investment if it were depreciated
constantly.
Accounting Rate of Return(ARR)

Average Investment= Net investment

2
Accounting Rate of Return(ARR)
• If Machine has Salvage Value:
Accounting Rate of Return(ARR)
• If Additional Working Capital is introduced in
the project
Acceptance Rule for ARR method
• Accept if ARR > minimum rate(Cut off Rate)
• Reject if ARR < minimum rate(Cut off Rate)
• The calculated ARR is compared with the cut off
rate.
• Cut off Rate is the rate of return on the
investment that should be generated from a
project.
• Cut off rate is usually equal to the cost of capital
• If ARR is more than Cut off rate the project
proposal is accepted or else it is rejected
 Merits & Demerits of ARR
Merits Demerits

Uses accounting data with which ·

Ignores the time value of money
executives are familiar

Easy to understand and calculate Does not use cash flows

No objective way to determine the

Uses cash flows information acceptable rate of return
De-merits of ARR
• ARR ignores the original cost of investment
Proposal X Y
Investment Capital Rs 1,00,000 Rs 2,00,000

ARR 18% 18%

• It ignores the differences in life span of the

proposals

Proposal X Y
Project Life 10 Years 8 Years

ARR 18% 18%

Net Present Value Method
• It explicitly recognizes that money receivable today has more value
than the money receivable tomorrow.

• NPV is computed by deducting the present value of cash outflows

from the present value of cash inflows

• NPV= PV of Cash Outflow- PV of Cash Inflows

• NPV Represents the excess profitability

• +NPV means the project is earning higher rate of return than the
expected return

• -NPV means the project is earning lower rate of return than the
expected return
Acceptance Rule
• Accept the project when NPV is positive NPV>0

• Reject the project when NPV is negative NPV<0

• May accept the project when NPV is zero NPV=0

• The NPV method can be used to select between

mutually exclusive projects; the one with the
higher NPV should be selected.
Net Present Value Method
Merits & Demerits of NPV
Merits Demerits

Requires estimates of cash flows

Considers all cash flows
which is a tedious task.

Requires computation of exact

True measure of profitability
cost of capital

Recognizes the time value of

Sensitive to discount rates
money

Consistent with wealth

maximization objective
Merits of NPV Method
• It is based on cash flows and recognizes time
value of money

• It considers total life of the project and considers

all cash flows

• This method can be used even when discount

rate varies from one year to another
De-Merits of NPV Method
• It is considered to be difficult to calculate and understand

• It is difficult in estimating the Discount rate.

• It ignores the original cash outlay

Project-A Project- B
Cash Outlay 1,00,000 Rs 2,00,000

NPV(Rs) Rs 25,000 Rs 25,000

• Difficult to estimate future cash flows

• It ignores the differences in the life span of projects

Internal Rate of Return(IRR) Method
• It is also discounted cash flow method of capital
budgeting

• It also considers Time value of Money

• IRR depends entirely on Initial cash outlay & cash

inflows from the project under consideration

• It is also known as Rate of Return method

• It is usually the rate of return that a project earns

Accept or Reject Criteria
• In case of Single project , if Internal Rate of Return
is higher than Cutoff Rate or Hurdle Rate than the
project is accepted or else rejected

• In case of mutually exclusive project, a project with

higher IRR should be accepted and the other has to
be rejected

• If there are budget constraints, the project will be

ranked in descending order of IRR and the project
with highest IRR will be selected subject to
availability of Funds
Merits of IRR
• This method considers time value of Money
• It considers all cash flows during the life of
project
Demerits of IRR Method
• It requires estimation of all cash inflows which is
tedious work
• It tried with different trial rates, the final answer
will be different
• Results of IRR and NPV may differ in case of
mutually exclusive projects
 Different Initial Investments
 Unequal life of Projects
 Different Pattern of Cash Flows
Profitability Index or BCR
• The ratio of the present value of the cash inflows
to the present value of the cash outflows is
profitability index or benefit-cost ratio:

• Acceptance rule
▫ Accept if PI > 1.0
▫ Reject if PI < 1.0
▫ Project may be accepted if PI = 1.0
Methods to Calculate IRR
• When Cash Inflows are Uniform
▫ First Factor has to be located using the Eqn
▫ F= Initial Investment/Avg Cash Flows
 Where F= Factor to be Located
 Original Investment
 Cash Inflow per year
• The factor value so found has to be located in
Table PVIFA.
• Check the factor value against the No of Years
mentioned in problem for which cash flows are
generated
MIRR-Modified Internal Rate of
Return
• The modified internal rate of return (MIRR)
assumes that positive cash flows are reinvested
at the firm's cost of capital.
Example
• A Problem Costs Rs 36,000 and is expected to
generate cash inflows of Rs 11,200 annually for
5 years. Calculate the Internal Rate of Return