Essentials of

Financial
Management

UNIT-II
Investment
Decisions
Capital budgeting involves planning and
evaluating long-term investment decisions for
projects that involve significant expenditures.

Helps in allocating financial resources to the

most profitable investment opportunities
while considering the long-term implications
Capital
on the company's financial health. Budgeting
Capital budgeting is vital as it directly
impacts the firm's future profitability, growth,
and risk management strategies.
• Maximizing Shareholder
Wealth through Capital
Budgeting
• Long-term vs. Short-term Importance of
Decision Making Capital
• Risk and Return Budgeting
Considerations in Capital
Budgeting
• Impact on Firm's Growth
and Competitive Position
1. Identification and Evaluation of
Investment Proposals
2. Techniques and Methods in Capital
Budgeting Capital
3. Risk Assessment and Mitigation in
Investment Analysis
Budgeting
4. Decision Criteria and Selection of Process
Projects
5. Post-implementation Review and
Control in Capital Budgeting
Terminologies and Concepts
 Risk-Return Tradeoff: The relationship between the level of risk and
potential return; generally, higher returns are associated with higher risks and
vice versa.
 Capital Rationing: Limiting the funds available for investment due to
constraints or budget limitations.
 Capital Expenditure: Funds used for acquiring, upgrading, or maintaining
physical assets like property, equipment, or infrastructure, typically for long-
term use.
 Incremental Cash Flows: Additional cash flows generated or incurred by a
project that differ from the existing cash flows of the company.
Terminologies and Concepts
 Mutually Exclusive Projects: Projects where choosing one option excludes
the possibility of selecting another alternative due to resource limitations.
 Discount Rate: The rate used to discount future cash flows to their present
value in order to account for the time value of money.
 Discounted Cash Flow (DCF): A valuation method that estimates the value of
an investment based on its expected future cash flows, discounted to their
present value using a specific rate.
 Opportunity Cost: The value of the best alternative forgone when a particular
investment or decision is chosen over others.
Terminologies and Concepts
 Payback Period: The time taken for the initial investment to be recovered
from the project's cash flows.
 Net Present Value (NPV): the difference between the present value of cash
inflows and outflows of an investment, considering the time value of money.
 Internal Rate of Return (IRR): The discount rate at which the net present
value of an investment becomes zero, indicating the project's potential
profitability.
 Profitability Index: A measure used to evaluate investment projects by
dividing the present value of future cash flows by the initial investment.
Techniques of
Capital
Budgeting
ARR=(Average cash inflows/Average investment)X100

OR

ARR=(Average cash inflows/Total investment)X100

Where, Accounting
Average cash inflows = Sum of all cash inflows/ No of years over which
inflows are received
rate of return
1. Decision to Accept: Project
Average investment = [(Initial cost + Installation expenses- salvage
>= Expected ARR
value) / 2] +Additional Net Working Capital + Salvage Value
2. Decision to choose over
OR
alternatives: Project with
highest ARR
Average Investment = (Book Value at Year 1 + Book Value at End of Useful
Life) / 2
In the case of annuity (consistent Cash inflows):

Payback Period = Initial investment / Cash flow Pay-back

per year period
1. Decision to Accept: Project
payback period <= Expected
maximum payback period

2. Decision to choose over

alternatives: Project with
shortest payback period
NPV = Total Present Value of Cash Inflows –
Present Value of Initial Investment
Net present
Discounting factor (Present value Factor)= value
Cost of capital of firm
1. Decision to Accept: Project
NPV >= 0

2. Decision to choose over

alternatives: Project with
largest NPV
PI = Total Present Value of Cash
Inflows/Present Value of Initial Investment
Profitability
Discounting factor (Present value Factor)= index
Cost of capital of firm
1. Decision to Accept: Project
PI >= 1

2. Decision to choose over

alternatives: Project with
largest PI
“The internal rate of return (IRR) is the discount rate at which the net present
value (NPV) on a project or investment is equal to zero, i.e. the discounted
series of cash flows are of equivalent value to the initial investment.”

Steps for calculation:

Internal
Rate of
Return
Advantage and disadvantages of the different capital budgeting
techniques

 Payback Period
Advantages
1. Simple to compute
2. Provides some information on the risk of the investment
3. Provides a crude measure of liquidity

Disadvantages
1. No concrete decision criteria to indicate whether an investment
increases the firm’s value
2. Ignores cash flows beyond the payback period
3. Ignores the time value of money
4. Ignores the risk of future cash flows
Advantage and disadvantages of the different capital budgeting
techniques

 Net Present Value

Advantages
1. Tells whether the investment will increase he firm's value
2. Considers all the cash flows
3. Considers the time value of money
4. Considers the risk of future cash flows (through the cost of capital)

Disadvantages
1. Requires an estimate of the cost of capital in order to calculate the
net present value.
2. Expressed in terms of dollars, not as a percentage.
Advantage and disadvantages of the different capital budgeting
techniques

 Profitability Index
Advantages
1. Tells whether an investment increases the firm's value
2. Considers all cash flows of the project
3. Considers the time value of money
4. Considers the risk of future cash flows (through the cost of capital)
5. Useful in ranking and selecting projects when capital is rationed

Disadvantages
1. Requires an estimate of the cost of capital in order to calculate the
profitability index
2. May not give the correct decision when used to compare mutually
exclusive projects.
Advantage and disadvantages of the different capital budgeting
techniques

 Internal Rate of Return

Advantages
1. Tells whether an investment increases the firm's value
2. Considers all cash flows of the project
3. Considers the time value of money
4. Considers the risk of future cash flows (through the cost of capital in the decision
rule)

Disadvantages
1. Requires an estimate of the cost of capital in order to make a decision
2. May not give the value-maximizing decision when used to compare mutually
exclusive projects
3. May not give the value-maximizing decision when used to choose projects when
there is capital rationing
4. Cannot be used in situations in which the sign of the cash flows of a project
change more than once during the project's life