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L. T. Investment decision
2 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Chapter Objectives
Understand the nature and importance of investment decisions.
Capital Budgeting Process
Distinguish between discounted cash flow (DCF) and non-
discounted cash flow (non-DCF) techniques of investment
Explain the methods of calculating net present value (NPV) and
internal rate of return (IRR).
Show the implications of net present value (NPV) and internal rate
of return (IRR).
Describe the non-DCF evaluation criteria: payback and accounting
rate of return and discuss the reasons for their popularity in
practice and their pitfalls.
Illustrate the computation of the discounted payback.
Describe the merits and demerits of the DCF and Non-DCF
investment criteria.
3 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Nature of Investment
The investment decisions of a firm are generally
known as the capital budgeting, or capital
expenditure decisions.
The firms investment decisions would generally
include expansion, acquisition, modernisation and
replacement of the long-term assets. Sale of a
division or business (divestment) is also as 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 firms expenditures and
benefits, and therefore, they should also be
evaluated as investment decisions.
4 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Features of Investment in
Cap.Budgeting
The exchange of current funds for future
benefits on L. T. basis
Substantial funds are invested in long-term
assets.
The future benefits will occur to the firm over
a series of years.
Difficult or expensive to reverse
5 Financial Management, Ninth Edition I M Pandey
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Importance of Capital Budgeting
Growth
Risk
Funding
Irreversibility
Complexity
Steps involved in Capital Budging
Capital Budgeting Process
Identification of Investment Projects
Investment Criteria (DCF & Non DCF)
DCF Deciding on the basis of
(a) NPV (b) Benefit Cost Ratio
(c)IRR & MIRR
Non-DCF on the basis of
(a) Pay back period & (b)Ac Rate of Ret
Investment Appraisal
6 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Capital Budgeting Process
Identification of Potential Investment
Opportunities.
Assembling of Investment proposals.
Decision Making
Preparing of Capital Budget & appropriations
Implementation
Performance Review
7 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
8 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Mandatory Investments
New or Expansion Projects
Modernization Projects Project
Replacement Projects
Diversification Project
Research & Development projects
Contingent Investment Projects
Miscellaneous Project
Identification of Inv.Projects
9 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Rules for Investment Decision
It should maximise the shareholders wealth.
It should consider all cash flows to determine the true profitability of
the project.
It should provide for an objective and unambiguous way of
separating good projects from bad projects.
It should help ranking of projects according to their true profitability.
It should recognise the fact that bigger cash flows are preferable to
smaller ones and early cash flows are preferable to later ones.
It should help to choose among mutually exclusive projects that
project which maximises the shareholders wealth.
It should be a criterion which is applicable to any conceivable
investment project independent of others.
10 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Investment Criteria
1. Discounted Cash Flow (DCF) Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)/ Benefit Cost Ratio
2. Non-discounted Cash Flow Criteria
Payback Period (PB)
Discounted Payback Period (DPB)
Accounting Rate of Return (ARR)
11 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Net Present Value Method: Steps
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 projects
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).
12 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Net Present Value Method
Net present value should be found out by
subtracting present value of cash outflows
from present value of cash inflows. The
formula for the net present value can be
written as follows:
3 1 2
0
2 3
0
1
NPV
(1 ) (1 ) (1 ) (1 )
NPV
(1 )
n
n
n
t
t
t
C C C C
C
k k k k
C
C
k
=
(
= + + + +
(
+ + + +
=
+
=
=
14 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Acceptance Rule
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV < 0
May or may not accept the project when NPV
is zero NPV = 0 (indifferent attitude)
The NPV method can be used to select
between mutually exclusive projects; the one
with the higher NPV should be selected.
Why NPV positive is a tool ?
Year Amt O/s
at the beg
of year
Ret on
O/s @
10%
Total O/s
flows
Cash
Repment
at yr end
Balance
O/s
1 2725 # 272.50 2997.50 900 2097.50
2 2097.50 209.75 2307.25 800 1507.25
3 1507.25 150.73 1657.98 700 957.98
4 957.98 95.80 1053.78 600 453.78
5 453.78 45.38 499.16 500 (0.84)*
# initial-. Outlay + NPV
15 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Considering initial outlay Rs2500/
Year Initial
amount
Ret on
O/s amt
@ 10%
Total O/s
flows
Repment Balance
1 2500 250 2750 900 1850
2 1850 185 2035 800 1235
3 1235 123.50 1358.50 700 658.50
4 658.50 65.85 724.35 600 124.35
5
* Amt Rs
124.35
363.20 is
12.45
Left after
136.80
Total repm
500
Whose
Pv= 225
(363.20)*
16 Financial Management, Ninth Edition I M Pandey
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17 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Importance of 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
Understanding Value Additivity
Value of a Firm = P.v. of all existing Proj +
NPV of all on going future projs;
When a firm undertakes a proj with +ve NPV
its value increases & visa a versa,
When firm Terminates an existing proj which
has - ve NPV, the value of the firm increases
by that amount.
In Case of Divestment:-
If D Value of the firm ( Existing + NPV) the
decision is favorable ,
18 Financial Management, Ninth Edition I M Pandey
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Contd
In case of Acquisition, If the acquisition price
is > NPV the acquiring firm is paying more
money than worth,
In case of New projects with +ve NPV the
value of the firm will increase so long actual
cash inflows are in line with expectations
otherwise it will decrease
19 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Time Varying Discount Rate
In certain cases, r may not be uniform.
--- __ Initial investment
20 Financial Management, Ninth Edition I M Pandey
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21 Financial Management, Ninth Edition I M Pandey
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Internal Rate of Return Method
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.
3 1 2
0
2 3
0
1
0
1
(1 ) (1 ) (1 ) (1 )
(1 )
0
(1 )
n
n
n
t
t
t
n
t
t
t
C C C C
C
r r r r
C
C
r
C
C
r
=
=
= + + + +
+ + + +
=
+
=
+