UNIT-III

Unit III: Investment Decision: Basics of Capital Budgeting - Appraisal and Evaluation of Long Term Investment Proposals - Pay Back Method Accounting Rate of Return - Internal Rate of Return - Net Present Value Profitability Index. (NP)

INVESTMENT DECISION:
Determination of where, when, how, and how much capital to spend and/or debt to acquire in the pursuit of making a profit. An investment decision is often reached between an investor and his/her investment advisors. Depending on the type of brokerage account an investor has, investment managers may or may not have tremendous leeway in making decisions without consulting the investor himself/herself. Factors contributing to an investment decision include, but are not limited to: capital on hand, projects or opportunities available, general market conditions, and a specific investment strategy.

Basics of Capital Budgeting:

What is Capital
Budgeting?

Capital budgeting can be defined simply as the process of planning for projects on assets with cash flows of a period greater than one year. These projects can be classified as: Replacement decisions to maintain the business Replacement decisions for cost reduction Existing product or market expansion New products, markets or mandatory investments

Additionally, projects can also be classified as mutually exclusive or independent:

Mutually exclusive projects are potential projects that are unrelated, and any combination of those projects can be accepted. - Independent projects indicate there is only one project among all possible projects that can be accepted.
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The Importance of Capital Budgeting Capital budgeting is important for many reasons: Since projects approved via capital budgeting are long term, the firm becomes tied to the project and loses some of its flexibility during that period. When making the decision to purchase an asset, managers need to forecast the revenue over the life of that asset. Lastly, given the length of the projects, capital-budgeting decisions ultimately define the strategic plan of the company.

Appraisal and Evaluation of Long Term Investment Proposals:

1. Pay Back Method: Pay Back Period is the number of years it takes for a company to recover its original investment in a project, when net cash flow equals zero. In the calculation of the payback period, the cash flows of the project must first be estimated. The payback period is then a simple calculation. Formula: PP = years full recovery + unrecovered cost at beginning of last year cash flow in last year

The shorter the payback period of a project, the more attractive the project will be to management. In addition, management typically establishes a

maximum payback period that a potential project must meet. When two projects are compared, the project that meets the maximum payback period and has the shortest payback period is the project to be accepted. It is a simplistic measure, not taking into account the time value of money, but it is a good measure of a projects riskiness. Example: Payback Period: Assume Newco is deciding between two machines (Machine A and Machine B) in order to add capacity to its existing plant. The company estimates the cash flows for each machine to be as follows: Expected after-tax cash flows for the new machines

Year 0 1 2 3 4 5

Machine A -$5,000 500 1,000 1,000 1,500 2,500

Machine B -$2,000 500 1,500 1,000 1,500 1,500

Calculate the payback period of the two machines using the above cash flows and decide which new machine Newco should accept. Assume the maximum payback period the company establishes is five years. Solution: First it would be helpful to determine cumulative cash flow for the machine project. This is done in the following table: Figure: Cumulative cash flows for Machine A and Machine B

Year Cash Machine A Cumulative Flow Cash Machine B Cumulative Flow

0 1 Flow- -5,000 500 Cash -5,000 -4,500

2 1,000 -3,500

3 1,000 -2,500

4 1,500 -1,000

5 2,50 0 1,50 0 1,50 0 4,50 0

Flow- -2,000 500 Cash -2,000 -1,500

1,500 0

1,500 1,500

1,500 3,000

Payback period for Machine A = 4 + 1,000 = 4.67 1,500 Payback period for Machine B = 2 + 0 = 2.00 0 Both machines meet the companys maximum payback period. Machine B, however, has the shortest payback period and is the project New co should accept. Discounted Payback Period The one issue we mentioned with the payback period is that it does not take into account the time value of money, but the discounted payback period does.The discounted payback period discounts each of the estimated cash flows and then determines the payback period from those discounted flows. Example: discounted payback period Using our last example above, determine the discounted payback period for Machine A and Machine B, and determine which project Newco should accept. As calculated previously, Newcos cost of capital is 8.4%. Discounted cash flows for Machine A and Machine B

Year Cash FlowMachine A Discounted Cash Flow Cumulative Cash Flow

0 -5,000 -5,000 -5,000

1 500 461 -4,539

2 1,000 851 -3,688

3 1,000 785 -2,903

4 1,500 1,086 -1,817

2,500 1,000 1,670 -147 616 469

Cash Flow Machine B Discounted Cash Flow Cumulative Cash Flow Answer:

-2,000 -2,000 -2,000

500 461 -1,539

1,500 1,277 -262

1,500 1,178 915

1,500 1,086 2,002

1,500 1,500 1,002 3,004 925 3,928

Payback period for Machine A = 5 + 147 = 5.24 616 Payback period for Machine B = 2 + 262 = 2.22 1178 Machine A now violates managements maximum payback period of five years and should thus be rejected. Machine B meets managements maximum payback period of five years and has the shortest payback period.

2. Net Present Value Using the company's cost of capital, the net present value (NPV) is the sum of the discounted cash flows minus the original investment. Formula

Look Out! Projects with NPV > 0 increase stockholders return Projects with NPV < 0 decrease stockholders return Example: Net Present Value Using the cash flows in the previous examples, calculate the NPV for each machine and decide which project new co should accept. As calculated previously, New cos cost of capital is 8.4%. Answer:
NPVA = -5,000 + 500 + 1,000 + 1,000 + 1,500 + 2,500 + 1,000 = $469 (1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6 NPVB = -2,000 + 500 + 1,500 + 1,500 + 1,500 + 1,500 + 1,500 = $3,929 (1.084)1 (1.084)2 (1.084)3 (1.084)4 (1.084)5 (1.084)6

Given that both machines have NPV > 0, both projects are acceptable. However, for mutually exclusive projects, the decision rule is to choose the project with the greatest NPV. Since the NPVB > NPVA, New co should choose the project for Machine B. 3. Internal Rate of Return The internal rate of return (IRR)on a project is the rate of return at which the projects NPV equals zero. At this point, a projects cash flows are equal to the projects costs. Similar to how management must establish a maximum payback period, management must also

set what is known as a "hurdle rate", the minimum rate of return a company will accept for a project. When a project is reviewed with a hurdle rate in mind, the greater the IRR is above the hurdle rate, the greater the NPV, and conversely, the further the IRR is below the hurdle rate, the lower the NPV. Look Out! For the IRR, the decision rules are as follows: If IRR > hurdle rate, accept the project If IRR< hurdle rate, reject the project For a project to be accepted, the IRR must be greater than or equal to the hurdle rate. If a company is deciding between two projects, the project with the highest IRR is the project to be accepted. Formula

The IRR formula is quite difficult to calculate without the use of a financial calculator. Thus, a financial calculator is highly recommended to solve for a projects IRR. Otherwise trial and error must be used. Advantages and Disadvantages of the NPV and IRR Methods
While useful NPV and IRR methods are useful methods for determining whether to accept a project, both have their advantages and disadvantages.

Advantages: With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders. With the IRR method, the advantage is that it shows the return on the original money invested.

Disadvantages: With the NPV method, the disadvantage is that the project size is not measured. With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be an issue, as discussed below. The Multiple IRR Problem A multiple IRR problem occurs when cash flows during the project lifetime is negative (i.e. the project operates at a loss or the company needs to contribute more capital). This is known as a "non-normal cash flow", and such cash flows will give multiple IRRs. Why Do NPV and IRR Methods Produce Conflicting Rankings? When a project is an independent project, meaning the decision to invest in a project is independent of any other projects, both the NPV and IRR will always give the same result, either rejecting or accepting a project. While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that is, when the decision must be one project or another - these metrics do not always point you in the same direction. This is a result of the timing of cash flows for each project. In addition, conflicting results may simply occur because of the project sizes. Look Out! The timing of cash flows as well as project sizes can produce conflicting results in the NPV and IRR methods. Example: NPV and IRR Analysis Assume once again that Newco needs to purchase a new machine for its manufacturing plant. Newco has narrowed it down to two machines that

meet its criteria (Machine A and Machine B), and now it has to choose one of the machines to purchase. Further, Newco has assumed the following analysis on which to base its decision: Potential Machines for Newco

Answer: We first determine the NPV for each machine as follows: NPVA = ($5,000) + $2,768 + $2.553 = $321 NPVB = ($10,000) + $5,350 + $5,106 = $456 According to the NPV analysis alone, Machine B is the most appropriate choice for Newco to purchase. The next step is to determine the IRR for each machine using our financial calculator. The IRR for Machine A is equal to 13%, whereas the IRR for Machine B is equal to 11%. According to the IRR analysis alone, Machine A is the most appropriate choice for Newco to purchase.
The NPV and IRR analysis for these two projects give us conflicting results. This is most likely due to the timing of the cash flows for each project as

well as the size differential between the two projects. The Post-Audit's Role The post-audit process in the capital-budgeting process is quite important. In the post-audit process, an analyst examines a company's capitalbudgeting decisions to see how the actual results from the projects compare to the results the company estimated. The post-audit process gives the company a sense of not only how the projects are performing, but also how good its inputs were. If a project's actual results differed significantly in a negative direction, the post-audit process will help the company learn where it went wrong with respect to inputs so that the same mistake will not be made when analyzing future projects. 4. Profitability Index: An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as: = PV of future Cash Flows Initial Investment A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.

Let us examine finding Profitability Index or PI with an example investment proposal. Let us say we were offered a series of cash inflows at the end of each of the next four years as $500, $400, $300, and $100. And the Initial Cost Outlay for this proposal is $1,000 and the weighted average cost of capital or WACC is 12%. Profitability Index at 12%

Year 1 2 3 4

Net Cash Flows 500 400 300 1000

PVIF @ 12% Present Value 0.893 $446.50 0.797 $318.80 0.712 $213.60 0.636 $63.60 Profitability Index = 1.0425 $1,042.50/1,000

Profitability Index at 15% Year 1 2 3 4 Net Cash Flows 500 400 300 100 PVIF @ 15% 0.870 0.756 0.658 0.572 Profitability Index = 0.992 Present Value $435 $302.40 $197.40 $57.20 $992/$1,000

5. Accounting Rate of Return: A fairly simple way of gauging your return on an investment in a major project or purchase is the accounting rate of return (ARR). The formula is:

Accounting Rate of Return =

Annual Cash Inflows - Depreciation Initial Investment

For purposes of this formula, depreciation is calculated very simply, using the straight-line method: Depreciation = Cost Salvage Value Useful Life
Example: As an example of how ARR works, let's say you're looking at equipment costing $7,500 that is expected to return roughly $2,000 per year for five years. After five years you'll sell the equipment for $500. The depreciation would be ($7,500 - $500) 5, or $1,400.

ARR = $2,000 - $1,400 $7,500

= 8%

Using ARR can give you a quick estimate of the project's net profits, and can provide a basis for comparing several different projects. Under this method of analysis, returns for the project's entire useful life are considered (unlike the payback period method, which considers only the period it takes to recoup the original investment). However, the ARR method uses income data rather than cash flow and it completely ignores the time value of money. To get around this problem, you should also consider the net present value of the project, as well as its internal rate of return.