Chapter Objectives
Understand the nature and importance of investment
decisions.
Distinguish between discounted cash flow (DCF) and
non-discounted cash flow (non-DCF) techniques of
investment evaluation.
Explain the methods of calculating net present value
(NPV) and internal rate of return (IRR).
Describe the merits and demerits of the DCF and
Non-DCF investment criteria.
Compare and contract NPV and IRR and emphasise
the superiority of NPV rule.
Nature of Investment Decisions
The investment decisions of a firm are
generally known as the capital
budgeting, or capital expenditure
decisions.
A capital budgeting decision may be
defined as the firm’s decision to invest its
current funds most efficiently in the long
term assets in the anticipation of flows
of benefits over a series of years.
Nature of Investment Decisions
Contd..
The firm’s investment decisions would generally
include expansion, acquisition, modernization
and replacement of the long-term assets. Sale
of a division or business is also an investment
decision.
Decisions like the change in the methods of
sales distribution, or an advertisement
campaign or a research and development
programme have long-term implications for the
firm’s expenditures and benefits, and therefore,
they should also be evaluated as investment
decisions.
Features of Investment Decisions
The exchange of current funds for future
benefits.
The funds are invested in long-term assets.
The future benefits will occur to the firm over
a series of years.
Why Capital Budgeting is so
Important?
Involve massive investment of resources
Are not easily reversible
Have long-term implications for the firm
Involve uncertainty and risk for the firm
Any firm that does not follow the capital budgeting
process will not be maximizing shareholder wealth
and management will not be acting in the best
interests of shareholders
Types of Investment projects
Mutually Exclusive Projects: this type of
investment serve the same purpose and compete
with each other. If one investment is undertaken,
the other will have to be excluded.
Independent Projects: this investment serve
different purposes and do not compete with each
other. Depending on the profitability and
availability of the fund the firm can undertake both
investments.
Contingent projects: It is also known as
dependent projects. Projects that necessitate the
implementation of both projects. The functioning
of one project depends on the functioning of the
other project as well. i.e., they are dependent on
the acceptance of another project.
Investment Evaluation Criteria
Three steps are involved in the evaluation of
an investment:
Estimation of cash flows
Estimation of the required rate of return (the
opportunity cost of capital)
Application of a decision rule for making the
choice
Capital Budgeting techniques
1. Non Discounted techniques
(a) Pay back period
2. Discounted techniques
(b) Discounted pay back period
(c) Net present value
(d) Profitability Index
(e) Internal Rate of Return
1. Non-discounted Cash Flow Criteria
A. Payback periods: PBP for constant cash flow is
the number of years required to recover the original
cash outlay invested in a project.
If the project generates constant annual cash
inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow. That is:
Initial Investment C
Payback = = 0
Annual Cash Inflow C
Assume that a project requires an outlay of Birr
50,000 and yields annual cash inflow of Birr 12,500
for 7 years. The payback period for the project is:
PB = 50000 / 12500 = 4 years
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Contn’d
PBP for Unequal cash flows: In case of unequal cash
inflows, the payback period can be found out by adding up
the cash inflows until the total is equal to the initial cash
outlay.
Suppose that a project requires a cash outlay of Rs 20,000,
and generates cash inflows of Rs 8,000; Rs 7,000; Rs
4,000; and Rs 3,000 during the next 4 years. What is the
project’s payback?
Ans 8,000+7,000+4,000 = 19,000
In the fourth year cash inflows are 3,000, but only 1000 is
needed to recover the original outlay.
3 years + 1000/3000
PB = 3.33 years
Acceptance Rule
The project would be accepted if its payback
period is less than the maximum or standard
payback period set by management.
As a ranking method, it gives highest ranking
to the project, which has the shortest
payback period and lowest ranking to the
project with highest payback period.
Evaluation of Payback
Certain merits:
Simplicity
Cost effective
Short-term effects
Liquidity
Serious limitations:
Cash flows after payback is ignored
Cash flow patterns: (gives equal weight to
return in different time)
Administrative difficulties: difficult in setting
maximum acceptable period or standard
Inconsistent with shareholder value
B) Discounted Payback Period
3 DISCOUNTED PAYBACK ILLUSTRATED
Cash Flows
(Rs) Non.discounted Discounted NPV at
C0 C1 C2 C3 C4 PB PB 10%
P -4,000 3,000 1,000 1,000 1,000 2 yrs – –
PV of cash flows -4,000 2,727 826 751 683 2.6 yrs 987
Q -4,000 0 4,000 1,000 2,000 2 yrs – –
PV of cash flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421
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B) Discounted Payback Period
The discounted payback period is the number of
periods taken in recovering the investment outlay
on the present value basis.
The discounted payback period still fails to consider
the cash flows occurring after the payback period.
16q
2. Discounted Cash Flow (DCF) Criteria
A. Net Present Value Method
o The following steps should be followed in calculating NPV:-
Cash flows of the investment project should be forecasted
based on realistic assumptions.
Appropriate discount rate should be identified to discount
the forecasted cash flows. The appropriate discount rate is
the project’s opportunity cost of capital.
Present value of cash flows should be calculated using the
opportunity cost of capital as the discount rate.
The project should be accepted if NPV is positive (i.e., NPV >
0).
dss
CONT’D
Net present value should be found out by
subtracting present value of cash
outflows from present value of cash
inflows.
NPV = PV(CIF) – Initial Investment
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Calculating Net Present Value
Assume that Project X costs Rs 2,500 now
and is expected to generate year-end cash
inflows of Rs 900, Rs 800, Rs 700, Rs 600
and Rs 500 in years 1 through 5. The
opportunity cost of the capital may be
assumed to be 10 per cent. Cost of Capital
rate is 10%
Solution:
NPV = + 225.47 – Accept the Project
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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.
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Evaluation of the NPV Method
NPV is most acceptable investment rule
for the following reasons:
Time value
Measure of true profitability
Value-additivity
Shareholder value
Limitations:
Involved cash flow estimation
Discount rate difficult to determine
Mutually exclusive projects
Ranking of projects
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Profitability Index
Profitability index is the ratio of the
present value of cash inflows, at the required
rate of return, to the initial cash outflow of
the investment.
Profitability Index
The initial cash outlay of a project is Birr
100,000 and it can generate cash inflow of
Birr 40,000, 30,000, 50,000 and Rs 20,000
in year 1 through 4. Assume a 10 per cent
rate of discount. The PV of cash inflows at 10
per cent discount rate.
PI=?
Acceptance Rule
The following are the PI acceptance rules:
Accept the project when PI is greater than one.
PI > 1
Reject the project when PI is less than one.
PI < 1
May accept the project when PI is equal to one.
PI = 1
The project with positive NPV will have PI
greater than one. PI less than means that the
project’s NPV is negative.
Evaluation of PI Method
It recognises the time value of money.
It is consistent with the shareholder value
maximisation principle. A project with PI
greater than one will have positive NPV and
accepted, it will increase shareholders’ wealth.
In the PI method, since the present value of
cash inflows is divided by the initial cash
outflow, it is a relative measure of a project’s
profitability.
Like NPV method, PI criterion also requires
calculation of cash flows and estimate of the
discount rate. In practice, estimation of cash
flows and discount rate pose problems.
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Internal Rate of Return Method
(IRR)
The internal rate of return (IRR) is the rate
that equates the investment outlay with the
present value of cash inflow received after
one period. This also implies that the rate of
return is the discount rate which makes
NPV = 0.
Calculation of IRR
Uneven Cash Flows: Calculating IRR by
Trial and Error
The approach is to select any discount rate to
compute the present value of cash inflows.
If the calculated present value of the expected
cash inflow is lower than the present value of
cash outflows, a lower rate should be tried.
On the other hand, a higher value should be
tried if the present value of inflows is higher
than the present value of outflows. This
process will be repeated unless the net present
value becomes zero
Evaluation of IRR Method
IRR method has following merits:
Time value
Profitability measure
Acceptance rule
Shareholder value
IRR method may suffer from:
Multiple rates
Mutually exclusive projects
Value additivity
