Project Appraisal and Management

Financial Analysis
Investment Decisions

Mona Iyer
CEPT University
Ahmedabad
 Session Outline
• Investment Decisions
• Discounted Cash Flow Method
– NPV
– IRR
– PI
 Investment Decisions
When do u need to take investment
decisions?
– Starting a new project
– Expanding the existing project
– Replacement and modernization
 Investment Decisions
What are the features of Investment
Decisions?
– Current funds are allocated for future benefits
– Funds invested in long term assets
– Future benefits will occur over a long period
Why Important to take appropriate
investment decision?
– Involve commitment of large amount of funds
– Almost Irreversible decisions
– Long term Implications
 Investment Decisions
Steps Involved in Investment Evaluation
– Estimating Cash Flows
– Estimating required rate of return
– Application of Decision Rule for selecting most appropriate
investment
Investment Evaluation Criteria/ Capital Budgeting
Techniques/Investment decision Rules
• Discounted Cash Flow (DCF) Criteria
– Net Present Value
– Internal Rate of Return
– Profitability Index
• Non-Discounted Cash Flow Criteria
– Pay Back Period
– Accounting Rate of Return
 Time Value of Money
Suppose you have Rs. 100 today and you invest in some scheme with rate of return
10% per annum. Then to know cash in hand after One year your have to
compound it by compounding factor….
(C1)= 100* (1+0.1)=110
Now, assume a reverse scenario…that u know that u will have Rs. 110 cash after one
year and you want to know the present value of the same, then u will have to
discount it by discount factor (inverse of compounding factor)
Present value= 110* 1/(1+0.1)= 100

You may call C1 as Future Value (Cash Flow at year 1)

Important terms
Rate of Return/ Discount Rate /Opportunity cost of capital
Discount Factor
Present Value (Time Value of Money)
 Net Present Value (NPV)
Suppose you have to make an investment of Rs. 100 today in a project…it will give you a
cash flow if Rs. 150 after 1 year.

What is the present value of your cash flow if discount rate is 10%

PV= C1* (1/1+r)=150*(1/1+0.1) =136

Net Present Value = Present Value –Initial /required investment

=136-100=36

Thus your investment is worth more than it costs i.e it makes net contribution to value

NPV formula :

NPV=C1/(1+r)^1 + C2/(1+r)^2…… - Initial investment

OR
NPV=C0+ C1/(1+r)^1 + C2/(1+r)^2……-

Where C0 is initial outflow of money/investment and hence necessarily negative.

NPV= Discounted or present value of future cash flow - Initial investment

Net Present Value (NPV) Rule
NPV>0 Accept
NPV=0 May Accept
NPV<0 Reject
Accept project with higher NPV
Features of NPV
1. Value additivity principle applies
i.E For Project A and Project B
NPV(A+B)= NPV A + NPV B
2. Is dependent on Rate of return/discount rate
3. Is dependent on the duration of project
NPV Simulations
For different discount Rates
For different durations

Some Important Concepts

Rate of Return/Discount Rate
Opportunity Cost of Capital
• The cost of pursuing one course of action measured in terms of
forgone return offered by the most attractive alternative
investment.
Internal Rate of Return
 Internal Rate of Return (IRR)
The rate of Return which makes the Discounted Value of Cash Flow
(Present value) equal to Initial Investment

i.e. PV= C0
i.e. C0=C1/(1+r)

i.e. C1/(1+r)-C0=0
i.e. NPV = 0

Thus equation for IRR is same as NPV.

Only difference is that NPV is calculated for a given/known/assumed rate of
return whereas in IRR method rate of return ‘k’ has to be determined for
which NPV is 0
 IRR Rule
k >r (cost of capital)Accept
k=r May Accept
k < r (cost of capital) Reject

Features of IRR
1. Value additivity principle does not apply
i.E For Project A and Project B
IRR (A+B) ≠ IRR A + IRR B
2. Depends on duration of project and sequence of cash
flow
3. While comparing two investments, Higher IRR does not
indicate necessarily better investment
 Profitability Index
Ratio of Benefits to Costs
i.e. BC=PI=PV of cash flows/Initial Investment

Also some sources say

PI=NPV/Initial Investment
i.e. (PV-Investment)/Investment
i.e. (PV/Investment)- (Investment/Investment)
i.e. PI = PV/ Investment-1
PI= B/C -1
i.E B/C = PI+1

Select projects with highest PI till u run out of capital

PI based on B/C i.e present value PI based on NPV
BC>1 Accept PI>0
BC=1 May Accept PI=0
BC<1 Reject PI<0
Features of PI
1. Works well for capital rationing in one period
• Select project with higher PI till u exhaust capital
2. Breaks down when capital rationing in
more than one period
• Non-Discounted Cash Flow Method
– Pay back
– ARR
 Non-Discounted Cash Flows
Payback Period
• Most popular traditional method of evaluating investment
proposals…simple to understand …easy to calculate

• Incase of equal annual cash flows (C) payback = C0/C

• Incase of unequal cash flows the payback can be found out

by adding the cash inflows till total equals initial investment

• Acceptance Rule : Pay back cutoff generally fixed by the

project proponents/owners…is subjective
 Non-Discounted Cash Flows
Payback Period
Pay back rule Tends to give misleading answers because…..

• The payback rule ignores all the cash flows after cutoff
period regardless of the size of cash flow in the subsequent
year/s
– The cutoff should be fixed keeping in mind life of alternative
projects so that it does not end up accepting many poor short lived
projects and reject good long term projects.

• The payback rule gives equal weightage to all the cash

flows before the cutoff period
– This is taken care of in discounted payback period but still the
cashflows after the cutoff period are ignored

• Generally No rational basis for fixing the cut off period

 Non-Discounted Cash Flows
Accounting/Book Rate of Return/
Return on Investment (ROI)
• Uses Income and Investment details as available
from Accounting statements (P&L account) not
Cash Flows
• ARR or ROI= Average Income/ Average
Investments
• ARR = [sum (PADT 1 to n)/n]/ Avg Dep
Investments
 Non-Discounted Cash Flows
Accounting/Book Rate of Return/
Return on Investment (ROI)
• Acceptance Rule: Accept if ARR is higher than minimum
rate established by management.
• ARR can be misleading because
– It uses accounting profits and not cash flows
– No time value of money
Used widely for performance evaluation but not investment
criteria