Indian Institute of Management

Ahmedabad





Prepared by Professor Jahar Saha, Indian Institute of Management, Ahmedabad.
1976 by the Indian Institute of Management, Ahmedabad.

IIMA/QM0024TEC
Technical Note

Capital Investment Analysis
Any Capital budgeting decision consists of four stages:
1. Listing the projects for investment i.e., identifying the alternatives,
2. For each alternative, determining the cash flows,
3. Measuring the worth, (using a suitable indicator) of each alternative project,
finally.
4. Allocating the budgeted amount and among the alternatives chosen in the light
of the (3) above.
Though extremely crucial the first and second stages requiring the technical know-how for
the estimate of present outlays, future costs and future benefits, will not be discussed in this
note. Nor shall we deal with the mathematical complexities of optimal allocation of a
limited, budget among competing projects. We will be concerned here primarily with the
measurement and comparison of the worth of investments.
In practiceThere are several measures - the ones among these are:
(1) Payback period
(2) Average return on investment
(3) Net present value
(4) Yield
The last two measures are based on the concept of time valueof money.
Each of the measure listed above has its own advantages and disadvantages. These are best
explained through the following illustrations of six investments:
Table 1
Investment
Initial
outlay Rs.
Net Cash Proceeds per year (Rs.)
Year 1 Year 2 Year 3
A 10,000 10,000 500 500
B 10,000 5,000 5,000 5,000
C 10,000 2,000 4,000 12,000
D 10,000 10,000 3,000 3,000
E 10,000 6,000 4,000 5,000
F 10,000 8,000 8,000 2,000


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1Payback Period:

This is the simplest measure for evaluating the worth of investment proposals. Payback
period as the phrase indicates, is the period in which the initial outlay is recovered in the
form of cash savings or benefits. If cash savings of benefits are the same each year, then the
payback period is obtained by dividing the initial investment by the annual savings

P = I
C
where P = payback period

C
=
annual cash benefits (i.e. Income or savings) and

I = Initial investment

When cash flows are unequal each year as in Table 1 above, the definition is used directly to
obtain P. Normally a maximum payback period is stipulated by the top management in
screening projects for investment. Investments with longer pay back periods than the
stipulated ones are rejected. To determine the priorities, investments are ranked in the
increasing order of their pay back periods. The investment with the least payback period
tops the list. Table 2 below gives the payback periods for investment listed in Table 1.
* modified from an example given by Bierman & Smidt - "Capital Budgeting".

Table 2
Investment
Pay Back
Period Ranks
A 1 1
B 2 4
C 2 1/3 6
D 1 1
E 2 4
F 1 1/4 3

The advantage of using the payback period as a measure of the worth of an investment lies
in its ease of calculation. But this case or simplicity of computation is achieved at the cost of
the discriminating abilities of this measure. For instance: Consider investments A and D.
Though they obtain identical ranks, a glance at Table 1 demonstrates 'the clear superiority of
project D over A, Similarly E is superior to B though the ranks in Table 2 fail to reveal these
differences.
This is because the payback period
(a) ignores the cash proceeds received after the payback period and
(b) ignores the time value of money.
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2 Average Return on Investment:
The average return on investment is defined as the ratio of average annual income after
depreciation from the project to the initial investment.
In computing the average return on investment, from the total income over the life of the
project, the initial investment is deducted. This net income is then divided by the number of
years of the life of the project, to obtain the average income per year. The average is then
divided by the initial investment gives the return. The computations for the six investments
of Table 1 are shown in Table 3,
Table 3
Investment
Initial
Outlay
Total
Income
Income
after
Depreciation
Average
income
after
Depreciation
Average
return on
Investment
Bank
A 10,000 11,000 1,000 333 3.33 6
B 10,000 15,000 5,000 1,667 16.67 4
C 10,000 18,000 8,000 2,667 26.67 1
D 10,000 16,000 6,000 2,000 20.00 3
E 10,000 15,000 5,000 1,667 16.67 4
F 10,000 18,000 8,000 2,667 26.67 1

This measure, unlike the payback period takes into account all the benefits generated during
the life of the investment. But it does not recognize the timings of savings i.e., it gives equal
weigh-tage to money received at various points of time. For instance, in terms of average
return on investment, investments C and F are ranked equally. But F is obviously superior to
E as it generates higher income in the initial periods. Same is the case of projects B and E. E
is superior to B.
3. Net Present Value:
Present value concept is based on the fact that Re. 1 received now is worth more than Re. 1
received one year hence. This is so because Re. 1 received today can be invested to earn
more money. When management stipulates the minimum rate ('opportunity investment rate'
or 'cost of capital') at which an investment must generate income, this rate is used to
'discount' the cash flows of the future to bring them on a comparable basis to their "present
value". For example, if the rate is 10% per year, Rs. 100 obtained a yearhence is discounted
to
100 _ 100 = Rs. 90.9.
(1+.1) 1.1
We say that the present value of Rs. 100 received 1 year hence is Rs. 90.9 when the
disocuntrate is 10%. The present value of Re. 1 obtained 1year hence, 2 year hence, 50 year
hence is tabulated in the "Tables for Capital Investment Analysis for different discounting
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rates. Using these multipliers, present values of any sums of money received at different
points of time in the future can be computed.
Table 4
Investmen
t
Present value factor (from
Tables) for 6% end of year Sum of
P.V.
(4)
Initial
Investment
(5)
N.P.V.
(4) - (5)
Rank
1
.9434
2
.8900
3
.8396
A 10,000 500 500 10,299 10,000 299 6
B 5,000 5,000 5,000 13,365 10,000 3,365 5
C 2,000 4,000 12,000 15,522 10,000 5,522 2
D 10,000 3,000 3,000 14,623 10,000 4,623 3
E 6,000 4,000 5,000 13,418 10,000 3,418 4
F 8,000 8,000 2,000 16,246 10,000 6, 346 1

Because the computations involve the discounting of future cash flows, this method is also
known as the Discounted Cash Flows (QCF) method.
Yield of an Investment
The yield of an investment also called the internal rate of return, bread even rate, etc., i.e.,
at which the NPV is zero. In other words yield is the rate which equals the present value of
the future cash benefits to the initial outlay.
To judge whether an investment is worthwhile, the yield is compared with the minimum
acceptable rate of return, determined as the cost of capital by top management. If yield is
higher than the minimum acceptable rate of return, the decision will be in favour of the
investment.
It is to be emphasized that in some situations (when in some years, cash outflows exceed
inflows) there could be more than one yield and this could lead to anamoly. Further, the
NPV and the yield, in ranking the projects may not give the same results.
Consider the following example:
Initial Investment = Rs. 100
Cash Inflow at the end of the first year = Rs. 220
Cash Outflow nt the end of the second year = Rs. 121



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The Internal rate r is determined by the equation
100 = 220 - 121
1 + r (l*r)
2

The solution is r = 8 % a nd 12%.
From (fosse considerations, NPV is preferred to yield in Judging the worth of several
inveStinsnts.
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from July 22, 2013 to December 10, 2013