INVESTMENT VALUATION AND ITS IMPOTANCE & RETURN ON INVESTMENT Traditional Technique !

A" PA# $AC% PERIOD The pay back period is also one of the derivative of the flows. It is a simple technique and does not employ the discount cash flow techniques. It simple measures the time within which the initial investment of the project would or can be recovered based on the cash accruals generated by the project. IIIu tration on &a' (ac) &eriod A project has an initial outlay of Rs. 1 lakhs and it is e!pected that the project would generate cash accruals as per the following. #ear A-ount R " In La)h 1st 1 nd 0 03 1rd 1 th 2 13 3th 1 th 4 03 5th 03 6th 03 7th 0 It is required to estimate the pay back period of the project. It may be seen from the above figures that the company will generate cash accruals of Rs. 1 lakhs by the end of the fourth year. Thus the project would pay back the initial investment within a period of four years. There can be cases where the pay back period may not be in e!act number of years. In these kinds of situation the e!trapolation can be done to find out the fraction of years within which the project will generate cash accruals to repay the project"s initial outlay. A*era+e Rate o, Return Method" The Average Rate of Return #ARR$ method is also known as %Accounting Rate of Return &ethod' or %(inancial )tatement &ethod' or %Return on Investment &ethod' or *nadjusted Rate of Return &ethod.' It attempts to measures the rate of return on investment on the basis of the accounting information contained in the financial statements. +ormally, a minimum #cut-off$ rate of return is determined and fi!ed by the firms which constitutes the accept . reject criterion. /roject e!pected to give a return below this rate are rejected, otherwise accepted. In case of several alternative investment proposals, projects with higher ARR would be preferred to those having lower ARR. There are two possible interpretations of investment i. ii. The original cost of investment, and Average investment.

Average investment takes into consideration that the original investment in an asset diminishes from year to year over its life because of recovering capital cost by way of depreciation charges assuming that the straight line method is used for charging depreciation. In this case the average investment over the lifetime of the asset is half the depreciable part plus the whole of the non-depreciable part #i.e. scrap value$ of the cost of asset. a$ Net Pre ent *alue .NPV Method"/! The +et /resent 8alue is the difference between the total present value of future cash inflows and the total present value of cash outflow. This is the best and scientific method used for evaluating the capital investment proposals. *nder this method, cash inflows and cash outflows associated with each project are worked out. The present values of these cash inflows and outflows are calculated at the rate of return acceptable to the management. This rate of return is considering as the cut-off rate and it is generally determined on the basis of cost of capital suitable adjusted to allow for the risk element involved in the project. In case of mutually e!clusive project, the projects, whose +/8 is higher will be selected. The +et /resent 8alue method considers the time value of money concept. It considers the cash inflows over the entire life of a project. It also considers the total benefits arising out of proposal over its life. It is useful for selection of mutually e!clusive projects. 9owever, the accuracy of this method depends on the authenticity of the discounting rate for calculating the present values. There is a lot of difference of opinion regarding the method of calculation. This method may not give satisfactory result when two projects having different effective life are being compared. b$ Pro,ita(ilit' Inde0! The +/8 can be used to decide the criteria whether to :Accept" or Reject the proposal. In case the +/8 is positive the project is accepted, otherwise not. 9ence, the present value of cash inflows should be more than the present value of cash outflow for the project. The project is accepted if +/8 is positive and it is rejected if the +/8 is negative. 9owever, if the two projects have different investment and different periods, then it is difficult to use +/8 method. *nder such circumstances the profitability Inde! is used. The profitability Inde! is calculated as under. /resent 8alue of cash Inflows /rofitability Inde! ; /resent 8alue of cash <utflows The project having higher profitability Inde! #/I$ can be selected using this technique. c$ Internal Rate o, Return! Internal Rate of return is that rate of return at which the sum of discounted cash inflows is equal to the sum of discounted cash outflows. In other words, IRR is the discount rate at which the aggregate present value of cash inflows is equal to the aggregate present value of cash outflow. Thus the net present value becomes =ero at the Internal Rate of Return. The discount rate depends on the initial outlay and cash inflows of the project under

consideration. Therefore, it is called as Internal Rate of Return. The IRR is then compared with the required rate of return i.e. cut-off rate and decision for investment is taken on that basis. If the IRR is higher than required rate of return then the project is accepted and if IRR is lower than the required rate of return, the project is rejected because it is not profitability. The IRR considers the time value of money. It also considers the cash flows over the entire life of project or investment. It does not use the cost of capital to determine the present value, it itself provides a rate of return indicative of the profitability of the investment proposal. It also leads to increase in share prices and to ma!imi=e shareholder"s wealth as in case of +/8, method. 9owever, calculation of IRR is a time consuming method, project selected on the basis of IRR may not be profitable. 1"2 Investment Rs.1 >stimated life 1 yrs. Ta! rate 3 ? @ear /rofit before depreciation #Rs.$ 1 2 0 4 1 3 2 3

Aepreciation #Rs$ 1 1 1 1

/rofit after depreciation #Rs.$ 1 3 2 2

Ta! B 3 ? 13 03 0 0

1"3 If the net cash outlay of an investment project is Rs.1 and annual cash inflows for 3 yrs. are Rs.7 C Rs.10 C Rs.2 C and Rs.3 respectively. Dalculate the payback period for victor ltd. 1"4 >!cel trading co. ltd. is considering the purchase of a new machine for the immediate e!pansion programme. There are three types of machine in the market for this purpose. Their details are as followsE Particular Machine A Machine $ Machine C R" R" R" Dost of machine 153 103 7 >stimated savings in scrap per year 2 53 03 >stimated saving in direct wages per year 053 4 003 Additional cost of indirect materials per year 2 >!pected saving in indirect materials per annum 1 03 Additional cost of maintenance per year 53 33 3 Additional cost of supervision 6 >stimated life of machine #yrs$ 1 4 3 Ta!ation at 2 ? of profit

@ou are required to advise the management which type of machine should be purchased on the basis of &a'(ac) &eriod 1"5 Alpha Ftd. Is producing articles mostly on hand labour and is considering to replace it by a new machine. There are two alternative models / and G of the new machine. /repare a statement of profitability showing the pay-back period from the following information. >stimated life of machine Dost of &achine >stimated savings in scrap >stimated savings in direct wages Additional cost of &aintenance Additional cost of )upervision Ignore Ta!ation and depreciation. &achine / &achine G 2 years 3 years Rs. Rs. 7, 16, 3 6 4, 6, 6 1, 1,0 1,6

1"6 The director"s Aelta India Ftd. is considering the purchase of machine to replace a machine which has been in operation for last 3 years. The details relating to available alternative machines are as followsE /articulars <ld machine +ew machine Rs. Rs. /urchase price 0 1 /ower per year 1 003 Donsumable stores per year 1 153 <ther charges per year 2 23 Hages per running hour 13 04.03 )elling price per unit 4.03 4.03 &aterial cost per unit 0.3 0.3 >stimated life of machine 1 yrs 1 yrs &achine running hrs. /er year 0 hrs 0 hrs *nits of output per hour 02 units 14 units Ta! rate 2 ? of net profit Assuming that the above sales and cost of sales hold goods for the entire economic life of the machine, suggest which of the two alternatives should be preferredC using average rate of return .ARR/. Aepreciation has to be charged according to straight-line method. 1"7 Aetermine the #1$ /ay back period and #0$ A.R.R. from the following information of a proposed project. Dost R" 3,0 ,

Annual Pro,it a,ter Ta0 and De&reciation @ear 1 0 1 2 3 Total >stimated life ; 3 years. >stimated scrap value ; Rs. 0 , 1"8

1 3 5 7 1,1

, , , , ,

1,3 ,

The ca h ,lo9 trea- ,or t9o alternati*e in*e t-ent Tata and $ata are! #ear 1 0 1 2 3 Tata .R "/ #0, , 3 , 6 , 1, , 6 , 4 , $ata .R "/ #0.1 , 6 , 4 , 6 , 4 , 6 ,

Dalculate the #1$ /ayback period, #0$ +et present value using 11? discount rate. 1": )peedage Dompany ltd. is considering a project, which costs Rs.3 .The estimated salvage value is . Ta! rate is 33?. The company uses straight-line depreciation and the proposed project has cash flows before depreciation and ta! #D(IAT$ as followsE @ear end Dash inflows #Rs$

1 13 0 03 1 03 2 0 3 13 If the cost of capital is 10?, would you recommend the acceptance of the project under internal rate of return methodJ 1"; Dhingari Ftd is currently under e!amination of a project which yield the following returns over a period of timeE @ear end Kross yield #Rs$ 1 6 0 6 1 7 2 7 3 53 The cost of the machinery to be installed works out to Rs.0 and the machine is to be depreciation at 0 ? on written down value #HA8$ basis. Income ta! rate is 3 ?. If the average cost of raising capital is 16?, would you recommend accepting the project under IRR method. 1"2< A company is considering the two mutually e!clusive projects. The finance director considers that the project with higher +/8 should be chosenC whereas the &anaging Airectors thinks that one with higher rate of return should be considering. Ioth the projects have got an useful life of 3 years and the cost of capital is 1 ?. The initial outlay is Rs. 0 lakhs. The future cash inflow form /roject L and @ are as underE

#ear 1 0 1 2 3

Pro=ect > 13, 6 , 7 , 53, 0 ,

Pro=ect # 1,16, 4 , 2 , 12, 11,

PV ?actor @ 2<A .71 .61 .53 .46 .40

PV ?actor @ 3<A .61 .47 .36 .26 .21

1ue tion 22 Dalculate the present value of annuity of Rs. 3, when discounting factor is 1 ?.

received annually for four years,

1ue tion 23 (ind the present value of the following cash flow streams. The discount rate is 1 per cant . #ear 1 0 1 2 3 Ca h StreaRs. 1 Rs. 2 Rs. 2 Rs. 2 Rs. 1

1ue tion 24 &r. )hah has invested Rs. 3 , on Lero! &achine on 1st Man. 0 cash income from Lero! machine in ne!t 3 years as under. #ear E ti-ated In,lo9 0 0 10,

0. 9e estimates net

0 0 0 0

1 2 3 4

13, 16, 03, 1 , . Advice him

At the end of 3th year &achine will be sold at )crap value of Rs. 3, whether his project is viable, considering interest rate of 1 ? p.a. 1ue tion 25

(inance company has introduction a scheme of investment of Rs. 2 , . The return would be Rs. 6 ,7 ,1 , 11 and 10, in the ne!t five years. The indicated rate of interest is 1 ?. Dompute the /resent 8alue of the investment and advise regarding the investment. 1ue tion 26 (ind the present value of the following cash flow if the discount rate is 1 ?. #ear 1 0 1 2 3 Ca h ?lo9 3, 2, 3, 5,3 0,3

)tate whether the investment is worthwhile if the amount of cash outflow presently is Rs. 13, . 1ue tion 27 &iss )onali is considering an investment opportunity which will give her cash inflow of Rs. 1, Rs. 1,3 , Rs. 1,0 . Rs. 1,1 N Rs. 2 respectively at the end of each of the ne!t 3 years. The initial investment is Rs. 2, . if the time, preference rate is 1 ?. )tate whether the investment is profitable or not. #/resent value factor at 1 ? are .7 71, .6042, .5311, .461 and .40 7$. 1ue tion 28 The share of Ridhi Ftd. #Rs. 1 $ was quoting at Rs. 1 0 on 1. 2.0 0 and the price rose to Rs. 110 on 1. 2.0 3. Aividends were received at 1 ? on 1 th Mune each year. Dost

of funds was 1 ?. Is it a worth-while investment, considering the time value of moneyJ #/resent value factor at 1 ? were .7 7, .604 and .531$. 1ue tion! 2: A Iond of Rs. 1, face value with a coupon of 5 percent is redeemable after 3 years at a premium of 3 percent. The required rate of return is 6?. The current market price of the bond is Rs. 72 . Hhether investment at current market price of the bond is advisableJ The present value of Re. 1 at 6? discounting rate are .7037, .6351, .5716, .513 and .46 4. 1ue tion! 2; An investment of Rs. 2 , made on 1. 2. 0 provides inflows as followsE Date Alternati*e I Alternati*e II 1. 2. 1 0 , 1 , 1. 2. 2 1 , 0 , 1. 2. 3 1 , 1 , 1. 2. 4 1 , 1 , Hhich alternative would you prefer if the investor"s e!pected return is 1 ?J Kive reason #s$ for your preference. 1ue tion 3< L@O N Do. is considering investing in a project requiring a capital outlay of Rs. 0, , . (orecast for annual income after ta! is as followsC #ear 1 0 /rofit After Ta! #Rs.$ 1, , 1, , Aepreciation is 0 ? on )traight Fine Iasis 1 6 , 2 6 , 3 2 ,

>valuate the project on the basis of +et /resent 8alue taking 12? discounting factor and advice whether L@O N Do. should invest in the project or notJ The /resent 8alue of Re. 1 at 12? discounting rate are .6550, .5473, .453 , .3701 and .3172. 1ue tion! 32 A choice is made between two projects which require an investment of Rs. 3 , and Rs. 30, respectively. They are e!pected to generate net cash flows as underE #ear Pro=ect B> Pro=ect .R "/ B# .R "/ The cost of capital of the company is 1 ?. The following are the 1 03, 1 , present value factor at 1 ? per 0 13, 10, annumE 1 1 , 16, 2 +il 03, 3 10, 6, 4 4, 2,

1ue tion 33 A te!tile company is considering two mutually e!clusive investment proposalsC their e!pected cash flows are given below. #ear Initial Investment 1 0 1 2 3 4 Pro&o al 2 3, , 1,23, 1,23, 1,23, 1,23, 1,23, Pro&o al 3 3,3 , 1, 1,1 1,1 1,3 1,4 1,3 , , , , , ,

Hhich proposal should be acceptedJ Required rate of return is 1 ?. 1ue tion! 34 A company is considering two mutually e!clusive projects. Ioth require initial investment of Rs. 3 , each and have a life of five years. The cost of capital of the company is 13?. The +et Dash inflows after ta! are given belowE

#ear 1 0 1 2 3

Pro&o al A .R "/ 13, 14, 17, 15,3 0 ,

Pro&o al $ .R "/ 0 , 16,3 14, 15,3 13,

Hhich project should be accepted as per +/8 and IRR methodsJ

1ue tion 35 A choice is to be made between two investment proposal which require an equal investment of Rs. 3, , and e!pected to generate net cash flows as underE

#ear 1 0 1 2 3 4

Pro&o al I .R "/ 0,3 , 1,3 , 1, , +il 1,0 , 4 ,

Pro&o al II .R "/ 1, , 1,0 , 1,6 , 0,3 , 6 , 2 ,

The cost of Dapital of the company is 1 ?. The following are the present value factor B 1 ? per annum.