UNIT - II

TYPES OF INVESTMENTS AND

DIS-INVESTMENTS
 INVESTMENT
• The employment of funds an assets with the
aim of earning income or capital appreciation.
• The investments has two characteristics,, they
are
a. Time
b. Risk.
• Present consumption is sacrificed to get a
return in the future. The sacrifice that has to be
borne is certain but the return in the future
may be uncertain.
• Ex:- bank is paying 8% p.a interest on Fixed
Deposits. One person investing in a business
i.e., he has to sacrify 8% interest.
• This characteristic of investment indicates the
risk factor.
• He is undertaken with a view to reap some
return from the investment.
• A person’s commitment to buy a flat or a
house for his personal use may be an
investment from his point of view. This cannot
be considered as an actual investment as it
involves sacrifice but does not yield any
financial return.
• An investment is the purchase of goods that
are not consumed today but are used in the
future to create wealth.
• In finance, an investment is a monetary asset
purchased with the idea that the asset will
provide income in the future or will be sold at
a higher price for a profit.
• Investment is a alert act of an individual or any entity
that involves deployment of money (cash) in
securities or assets issued by any financial institution
with a view to obtain the target returns over a
specified period of time.
• Target returns on an investment include:
• Increase in the value of the securities or asset, and/or
• Regular income must be available from the securities
or asset.
TYPES OF INVESTMENTS
• Investment which does not change with the
changes in income level, is called as
Autonomous or Government Investment.
• It refers to the investment made on houses,
roads, public buildings and other parts of
Infrastructure. The Government normally
makes such a type of investment.
• Investment which changes with the changes in
the income level, is called as Induced
Investment.
• At a high level of income, Consumption
expenditure increases this leads to an increase
in investment of capital goods, in order to
produce more consumer goods.
• Investment made in buying financial
instruments such as new shares, bonds,
securities, etc. is considered as a Financial
Investment.
• In financial investment, money invested for
buying of new shares and bonds as well as
debentures have a positive impact on
employment level, production and economic
growth.
• Investment made in new plant and equipment,
construction of public utilities like schools,
roads and railways, etc., is considered as Real
Investment.
• Real investment in new machine tools, plant
and equipments purchased, factory buildings,
etc. increases employment, production and
economic growth of the nation. Thus real
investment has a direct impact on employment
generation, economic growth, etc.
• Investment made with a plan in several
sectors of the economy with specific
objectives is called as Planned or Intended
Investment.
• Planned Investment can also be called as
Intended Investment because an investor
while making investment make a concrete
plan of his investmen
• Investment done without any planning is
called as an Unplanned or Unintended
Investment.

• Under this type of investment, the investor

may not consider the specific objectives while
making an investment decision.
• Gross Investment means the total amount of
money spent for creation of new capital assets
like Plant and Machinery, Factory Building, etc.

• It is the total expenditure made on new capital

assets in a period.
• Net Investment is Gross Investment less
(minus) Capital Consumption (Depreciation)
during a period of time, usually a year.
 Disinvestment
• In business, disinvestment means to sell off
certain assets such as a manufacturing plant, a
division or subsidiary, or product line.
• Disinvestment is sometimes described as the
opposite of capital expenditures.
• Ex:- A consumer products company selling off a
profitable division that no longer meets its long
range goals. The proceeds from this
disinvestment are then used to improve the
company's financial position by reducing its debt.
• The term was first used in the 1980s.
 Abandonment Definition
• Abandonment value is the equivalent cash value of a
project if it is liquidated immediately after reducing all
debts which need to be repaid.

Description: Abandonment value is also known as

liquidation value of an asset. The general rule for
deciding to discontinue the product is that if the
product’s salvage value is greater than the net present
value (NPV) of its expected cash flows, the project is
abandoned.
 Internal Rate of Return Method
• This method also known as time adjusted rate
of return, discounted cash flow, discounted
rate of return, discounted cash flow, yield
method and trial and error method.

• It indicates the rate at which the discounted

cash inflows are equal to the discounted cash
outflow
 MODIFIED INTERNAL RATE OF RETURN

• Modified Internal Rate of Return, shortly

referred to as MIRR, is the internal rate of
return of an investment that is modified to
account for the difference between re-
investment rate and investment return.
• What is 'Modified Internal Rate Of Return - MIRR'
• Modified internal rate of return (MIRR) assumes
that positive cash flows are reinvested at the
firm's cost of capital, and the initial outlays are
financed at the firm's financing cost. By contrast,
the traditional internal rate of return
(IRR) assumes the cash flows from a project are
reinvested at the IRR. The MIRR more accurately
reflects the cost and profitability of a project.
• MIRR calculates the return on investment
based on the more practical assumption that
the cash inflows from a project shall be re-
invested at the rate of the cost of capital. As a
result, MIRR usually tends to be lower than
IRR.
• The decision rule for MIRR is very similar to
IRR, i.e. an investment should be accepted if
the MIRR is greater than the cost of capital.
• However, when evaluating multiple
investments that are mutually exclusive (i.e.
where selection of one investment would
result in the abandonment of another
investment), it is preferable to select
investments with the highest NPV rather than
the highest MIRR because NPV analysis offers
a better measure of the impact of an
investment on the wealth of the investor.
• Like IRR, MIRR should still be used to assess
the sensitivity of the proposed investments in
such cases.
• The steps to calculate the MIRR as follows:
Step 1: Calculate the Terminal Value of Cash
inflows.
Step 2: Calculate the Present Value of Cash
outflows.
Step 3: Calculate MIRR

Multiply with 100 to get the answer in %.

• Calculations of MIRR is broadly TWO TYPES. They
are.
• ONE TIME CASH OUTFLOW
• TWO/MULTIPLE CASH OUTFLOW
• Again two/multiple time cash outflows are divided
into THREE TYPES:
• 0 &1 Yr cash outflow
• 0 & Middle of the years cash outflow
• 0 & Last year cash outflow
 ONE TIME CASH OUTFLOW
Ex:- Mr. A is considering an investment of Rs.
250,000 in a startup. The cost of capital for the
investment is 13%. Following cash flows are
expected:

YEAR CASH FLOW IN

Rs.
0 (2,50,000)
1 50,000
2 1,00,000
3 2,00,000
 ONE TIME CASH OUTFLOW
Ex:- AXIS LTD is considering an investment of Rs.
1,000 in a startup. The cost of capital for the
investment is 10%. Following cash flows are
expected:

YEAR CASH FLOW IN

Rs.
0 (1,000)
1 400
2 600
3 300
 TWO TIME CASH OUTFLOW

• If “0” and “ 1 “ year cash

outflow is given.
Ex:- POLARIS LTD is considering an investment with to
the total life of 6 years and the cost of capital is
assumed at 15%. cash flows are as follows:

YEAR CASH FLOWS

0 (1,20,000)
1 (80,000)
2 20,000
3 60,000
4 80,000
5 1,00,000
6 1,20,000
Ex:- WIPRO LTD is considering an investment with to
the total life of 4 years and the cost of capital is
assumed at 10%. cash flows are as follows:

YEAR CASH FLOWS

(Rs. IN CRORES)

0 (700)
1 (300)
2 400
3 600
4 300

CALCULATE THE MIRR

0 and MIDDLE OF THE YEARS CASH OUTFLOW IS GIVEN

• If “0” and “ MIDDLE “ year

cash outflow is given.
• JIO is considering an investment with to the
total life of 4 years and the cost of capital is
assumed at 10%. cash flows are as follows:
YEAR CASH FLOWS

0 (1,00,000)
1 20,000
2 (10,000)
3 80,000
4 50,000
Ex:- POLARIS LTD is considering an investment with to
the total life of 6 years and the cost of capital is
assumed at 12%. cash flows are as follows:

YEAR CASH FLOWS

0 (2,000)
1 1,000
2 1,000
3 (4,000)
4 3,000
5 3,000
6 3,000
0 & LAST YEAR CASH OUTFLOWS
ARE GIVEN
• Assuming that the project’s cost of capital is
10% and calculate the MIRR for the following
series of cash flows:

YEAR CASH FLOWS

0 -60,000
1 20,000
2 40,000
3 50,000
4 30,000
5 -15,000
IF COST OF CAPITAL & FINANCING COST IS
GIVEN WITH
SINGLE & MULTIPLE
CASH OUTFLOWS
• If both interest rates are given,
STEP 1: Calculate TV with Financing Cost %.
STEP 2: Calculate PV of Cash out flow with Cost

of Capital
STEP 3: Calculate MIRR
Ex:- POLARIS LTD is considering an investment with to
the total life of 6 years and financing cost & the cost
of capital is assumed at 12% and 15% respectively.
cash flows are as follows:
YEAR CASH FLOWS PV OF NEGATIVE FV OF
CASH FLOWS Rs. POSITIVE CFs
0 (2,000) (2,50,000) -
1 1,000 1,764.34
2 1,000 1,573.52
3 (4,000) (2,630.06)
4 3,000 3,763.20
5 3,000 3,360.00
6 3,000 3,000.00
Ex:- POLARIS LTD is considering an investment with to
the total life of 6 years and financing cost & the cost
of capital is assumed at 12% and 15% respectively.
cash flows are as follows:

PV OF NEGATIVE FV OF
CASH FLOWS Rs. POSITIVE CFs
(2,50,000) -
1,762.34
1,573.52
(2,630.06)
3,763.20
3,360.00
3,000.00
 YEAR CASH FLOWS
A Company cash 0 -12,000

flows are given it 1 4,000

2 -800
is assumed a 3 1,400
finance rate of 4 -100
12%, a 5 1,500
reinvestment rate 6 3,000

of a more realistic 7 3,200

8 3,400
8% calculate the
9 3,600
MIRR 10 3,800
 • Assuming that the project’s cost of capital is
10% and the reinvestment rate is 8%, calculate
the MIRR for the following series of cash
flows:
YEAR CASH FLOWS
0 (1,00,000)
1 20,000
2 (10,000)
3 80,000
4 50,000

1. If the reinvestment rate were 5% instead of 8%, is the project still acceptable?
2. If the reinvestment rate were 7% instead of 8%, is the project still acceptable?
 • Company N is considering two mutually
exclusive projects. The cost of capital is 12%,
and the expected reinvestment rate is 10%.
Detailed information about expected cash
flows is presented in the table below.
Cash flows at the end of relevant year, CFt

0 1 2 3 4 5
Project -Rs.20,000,000
- Rs.12,000,00 Rs.10,500,00
Rs.9,000,000 Rs.8,500,000
Y Rs.5,000,000 0 0

Project -Rs.20,000,000
Rs.11,000,00
Rs.9,000,000 Rs.7,500,000 Rs.6,000,000
-
Z 0 Rs.5,000,000
 Multiple IRRs

• Multiple IRRs occur when a project has

more than one internal rate of return. The
problem arises where a project has non-
normal cash flow (non-conventional cash
flow pattern).
• The following cash flows series
illustrate the difference between
conventional and non-conventional
pattern of cash flows.

Period 0 1 2 3 4 5
CCF -25,000 6,000 8,000 9,000 7,000 13,000
NCCF -17,000 16,000 16,000 16,000 16,000 -52,000

*CCF = CONVENTIONAL CASH FLOWS (Rs.)

*NCCF= NON-CONVENTIONAL CASH FLOWS (Rs.)
• Internal rate of return (IRR) is one of the most
commonly used capital budgeting tools.
Investment decisions are made by comparing
IRR of the project under consideration with
the hurdle rate. If the IRR is greater than the
hurdle rate, the project is accepted, otherwise
it is rejected. When there are more than two
IRRs, it is not exactly clear which IRR to
compare with the hurdle rate.
• Conventional cash flows (also called normal cash flows) is
a cash flow pattern in which cash flows change sign only
once, i.e. all net cash outflows occur at the start of the
project, followed by all net cash inflows.
• In other words, there are continuous streams of net cash
inflows or net cash outflows. Non-conventional (also called
non-normal cash flows) are cash flows that have non-
continuous streams of net cash outflows and net cash
inflows, i.e. net cash outflows may occur at the start of the
project, followed by net cash inflows, followed by further
net cash outflows.
• The following cash flows series
illustrate the difference between
conventional and non-conventional
pattern of cash flows.

Period 0 1 2 3 4 5
CCF -25,000 6,000 8,000 9,000 7,000 13,000
NCCF -17,000 16,000 16,000 16,000 16,000 -52,000

*CCF = CONVENTIONAL CASH FLOWS (Rs.)

*NCCF= NON-CONVENTIONAL CASH FLOWS (Rs.)
 Steps to be followed in Multiple IRR
• Step 1: substitute the values in the following formula

• Step 2: Assume the { 1/ (1+r)} = x and form a new

equation.

• Step 3: based on the above equation substitute the

value in the quadratic equation and find the Multiple
Internal Rate of Return
• A quadratic equation is an equation of the
second degree, meaning it contains at least
one term that is squared. The standard form is
ax² + bx + c = 0 with a, b, and c being
constants, or numerical coefficients, and x is
an unknown variable.

 b  b2  4ac
x
2a
• From the following information find Multiple
Internal Rate of Return.

Cash Flows (in Rs.)

Project & C0 (0) C1(1) C2(2)
Year
I -1,000 4,000 -3,750
 NET PRESENT VALUE (NPV)
• NPV can be defined as present value of benefits minus
present value of costs.

• It is the process of calculating present values of inflows

using cost of capital as appropriate rate of discount and
subtract present value of cash out flows from the
present value of cash inflows and find the net present
value, which may be positive or negative.

• Positive net present value occurs when the present value

of cash inflow is higher than the present value of cash
outflows and vice versa.
4/19/18 VIJAY 57
 STEPS INVOLVED IN COMPUTATION OF NPV
• 1.Forecasting of cash inflows of the investment
project based on realistic assumptions.
• 2. Computation of cost of capital, which is
used as discounting factor for conversion of
future cash inflows into present values.
• 3. Calculation of PV cash flows using cost of
capital as discounting rate.
• 4. finding out NPV by subtracting PV of cash
out flows from PV of cash inflows.

4/19/18 VIJAY 58
 DECISION RULE:
• Acceptance or reject rule of the project
decides based on the NPV.
• ACCEPT : NPV > ZERO

• REJECT : NPV < ZERO

• CONSIDER : NPV = ZERO

4/19/18 VIJAY 59
 ADJUSTED NET PRESENT VALUE
• Adjusted present value is an investment appraisal
technique similar to net present value method.
• The adjusted NPV of a project is its NPV calculated
after making adjustments for the financing impact
of the project.
• The calculation of adjusted NPV begins with the
‘base-case’ NPV which is defined as the NPV under
the assumption that the project is all-equity
financed. Once the ‘base case’ NPV is obtained,
adjustments are made to it to reflect the impact of
the project on financing.
• Adjusted NPV = Base Case NPV + NPV of
financing decisions associated with the
project.
• Step 1: Calculate the NPV of the project
without any debt.
-Even Cash Flows (With A-4 Table Values)
-Un-Even Flows (with A-3 Table Value)
• Step 2:- Calculate the Equity Required after deducting
Issue Cost.
{Required Equity / (100 – Issue Cost)}
• Step 3:- calculate the Adjusted NPV before present
value Tax Shield.
Adjusted NPV = Base Case NPV – Issue cost
• Step 4: Calculate each year Debt outstanding, Interest,
Tax Shield and the PV of Tax Shield with Interest Rate
given. And Find the Total Present Value of Tax Shield.
• Step 5: Finally Find the Adjusted NPV with Tax Shield.
ANPV = Base Case NPV – Issue cost + Present value
of tax shield.
• Calculate the NPV for a project, which require an initial
investment of Rs.20,000 and which, involves a net cash
inflow (CFAT) of Rs.6,000 each year for 6 years. Cost of
funds 8%. what is the present value per rupee of
investment.
YEARS Net cash Discount factor Present value
inflow (Rs.) at 8% (Rs.)
1 to 6 6,000 4.623* 27,738
Total Present value of cash inflows 27,738
Less: Present Value of cash outflows 20,000
NET PRESETNT VALUE 7,738
*TABLE A-4 the present value of Annuity One Rupee
for PV of one rupee at 8%.
4/19/18 VIJAY 63
 DECISION RULE:
• Acceptance or reject rule of the project
decides based on the NPV.
• ACCEPT : NPV > ZERO

• REJECT : NPV < ZERO

• CONSIDER : NPV = ZERO

4/19/18 VIJAY 64
 IMPACT OF INFLATION ON
CAPITAL BUDGETING DECISIONS
• Inflation is the rate at which the general level
of prices for goods and services is rising and,
consequently, the purchasing power of
currency is falling.
• Net present value (NPV) is a technique that
involves estimating future net cash flows of an
investment, discounting those cash flows
using a discount rate reflecting the risk level of
the project and then subtracting the net initial
outlay from the present value of the net cash
flows. It helps in identifying whether a project
adds value or not
 Methods
• There are two ways in inflation can be accounted
for while calculating net present value:
• Nominal method: converting real cash flows to
nominal cash flows and discounting them using
nominal discount rate
• Real method: estimating real cash flows and
discounting them using real discount rate.
• The final net present value is same under both
methods.
• Under the nominal method, net cash flows in
time “t” are calculated by the following
formula:
• Nominal Cash Flows at Time t = Real Cash
Flows at Time t × (1 + Inflation Rate)t

Nominal interest rate refers to the interest rate before taking

inflation into account. the real interest rate is calculated after
taking into inflation which is called real interest rate
Ex:-Inflation adjustment using nominal cash flows
• MIND TREE is considering a project that is
expected to generate 10 Lakhs at the end of
each year for 5 years. The initial outlay required
is 25 Lakhs. A nominal discount rate of 9.2% is
appropriate for the risk level. Inflation is 5%.
• You are the company’s financial analyst. The
company’s CFO has asked you to calculate NPV
using a schedule of future nominal cash flows.
• Nominal cash flows are calculated for each
year as follows:
• Year 1 = 10 Lakhs × (1+5%)1 = 10.5 Lakhs
Year 2 = 10 Lakhs × (1+5%)2 = 11.3 Lakhs
Year 3 = 10 Lakhs × (1+5%)3 = 11.58 Lakhs
Year 4 = 10 Lakhs × (1+5%)4 = 12.16 Lakhs
Year 5 = 10 Lakhs × (1+5%)5 = 12.76 Lakhs
• These nominal cash flows are to be discounted using
nominal discount rate, which is 9.2%.
YEAR NOMINAL CASH PV DISCOUNT FACTOR PV OF CASH
FLOWS (NOMINAL FLOWSS
RATE)@9.20%
1 2 3 4=(2X3)
1 10.50 0.916 9.62
2 11.03 0.839 9.25
3 11.58 0.768 8.89
4 12.16 0.703 8.55
5 12.76 0.644 8.22
TOTAL PRESENT VALUE OF CASH INFLOWS 44.52
NET PRESENT VALUE = NET PV OF CIF – NET PV OF COF
= 44.52 – 25 = 19.52
 Inflation adjustment using real cash
flows and real discount rate
• Under the real method, we discount real cash
flows using real discount rate.
• The relationship between nominal discount rate,
real discount rate and inflation can be
rearranged as follows:
• Real discount rate
= {(1 + nominal discount rate) ÷ (1+inflation rate)} – 1
• {(1+ 9.2%) ÷ (1+5%)} – 1
= 4%
• These real cash flows are to be discounted using real
discount rate, which is 4%. (as per calculation)

YEAR REAL CASH FLOWS PV DISCOUNT FACTOR PV OF CASH

(REAL RATE)@4% FLOWSS
1 10.00 0.962 9.62
2 10.00 0.925 9.25
3 10.00 0.889 8.89
4 10.00 0.855 8.55
5 10.00 0.822 8.22
TOTAL PRESENT VALUE OF CASH INFLOWS 44.52
NET PRESENT VALUE = NET PV OF CIF – NET PV OF COF
= 44.52 – 25 = 19.52
• Now we can see that the NPV is consistent
under both methods. i.e., 19.52.

• Inflation has the following effects:

• a) Inflation will mean higher costs and higher
selling prices. It is difficult to predict the effect
of higher selling prices on demand.
A company that raises its prices by 30%,
because the general rate of inflation is 30%,
might suffer a serious fall in demand.
• b) Inflation, as it affects financing needs, is
also going to affect the cost of capital.
• c) Since fixed assets and stocks will increase in
money value, the same quantities of assets
must be financed by increasing amounts of
capital. If the future rate of inflation can be
predicted with some degree of accuracy,
management can work out how much extra
finance the company will need and take steps
to obtain it, e.g. by increasing retention of
earnings, or borrowing.
 Inflation and Capital Budgeting

Step 1: Determine the NPV when there is Inflation.

Step 2: Determine the CFAT in Inflation Situation

Step 3: Determine the Real Cash Flows (CFAT)

Step 4: Find the NPV with Real CFAT

• https://www.google.co.in/search?
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• SOURCE:
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• http://www.eng.utoledo.edu/~nkissoff/lesson
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