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CH - 1.Nature and Introduction of Investment Decision.

An efficient allocation of capital is the most important finance function in the

modern items. It involves decisions to commit the firms funds to the long
term assets. Capital budgeting or investment decisions are of considerable
importance to the firm since they tend to determine its value by influencing its
growth, profitability and risk.

The investment decisions of a firm are generally known as the capital

budgeting, or capital expenditure decisions. A capital budgeting decision may
be define as the firms decisions to invest its current funds most efficiently in
the long term assets in anticipation of an expected flow of benefits over a
series of years.

The long term assets are those that affect the firms operations beyond the one
year period. The firms investment decisions would generally include
expansion, acquisition, modernization and replacement of the long term asset.
Sale of division or business 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 programmed have long term implications for
the firms expenditures and benefits, and therefore, they should also be
evaluated as investment decisions.

It is important to note that investment in the long term assets invariably

requires large funds to be tied up in the current assets such as inventories and
receivables. As such, investment in fixed and current assets is one single

activity.

The following are the features of investment decisions,

The exchange of current funds for future benefits.

The funds are invested in long term assets.

The future benefits will occur to the firm over a series of years.

CH - 2. Capital Budgeting Process.

Capital budgeting is the process that companies use for decision making
on capital project. The capital project lasts for longer time, usually more

than one year. As the project is usually large and has important impact
on the long term success of the business, it is crucial for the business to
make the right decision.
Capital Budgeting Process
The specific capital budgeting procedures that the manager uses depend
on the manger's level in the organization and the complexities of the
organization and the size of the projects. The typical steps in the capital
budgeting process are as follows:

Brainstorming. Investment ideas can come from anywhere, from

the top or the bottom of the organization, from any department or

functional area, or from outside the company. Generating good
investment ideas to consider is the most important step in the process
.

Project analysis. This step involves gathering the information to

forecast cash flows for each project and then evaluating the project's
profitability.

Capital budget planning. The company must organize the

profitable proposals into a coordinated whole that fits within the

company's overall strategies, and it also must consider the projects'
timing. Some projects that look good when considered in isolation
may be undesirable strategically. Because of financial and real
resource issues, the scheduling and prioritizing of projects is
important.

Performance monitoring.

In a post-audit, actual results are

compared to planned or predicted results, and any differences must

be explained. For example, how do the revenues, expenses, and cash
flows realized from an investment compare to the predictions? Postauditing capital projects is important for several reasons. First, it
helps monitor the forecasts and analysis that underlie the capital
budgeting process. Systematic errors, such as overly optimistic
forecasts, become apparent. Second, it helps improve business
operations. If sales or costs are out of line, it will focus attention on
bringing performance closer to expectations if at all possible. Finally,
monitoring and post-auditing recent capital investments will produce
concrete ideas for future investments. Managers can decide to invest
more heavily in profitable areas and scale down or cancel
investments in areas that are disappointing.
Complexity of Capital budgeting Process
The budgeting process needs the involvement of different departments
in the business. Planning for capital investments can be very complex,
often involving many persons inside and outside of the company.
Information about marketing, science, engineering, regulation, taxation,
finance, production, and behavioral issues must be systematically
gathered and evaluated.
The authority to make capital decisions depends on the size and
complexity of the project. Lower-level managers may have discretion to
make decisions that involve less than a given amount of money, or that
do not exceed a given capital budget. Larger and more complex

decisions are reserved for top management, and some are so significant
that the company's board of directors ultimately has the decision-making
authority. Like everything else, capital budgeting is a cost-benefit
exercise. At the margin, the benefits from the improved decision making
should exceed the costs of the capital budgeting effort.

CH - 3. Capital Investment Decisions.

The capital investment decisions can also be termed as capital budgeting in

finance. The purpose of the capital investment decisions includes allocation of
the firm' s capital funds most effectively in order to ensure the best return
possible.

Evaluating the projects and allocating capital depending on the requirements

of the projects are the most important aspects of capital investment decisions.

There may be various criteria for selecting the right and appropriate decision
for capital investment. For example, a firm may emphasize on the projects that
promise for the immediate return while some other firms may insist on the
projects that ensure long term growth. The major goal of capital investment
decision is to increase the value of firm by undertaking right project at right
time.

The capital investment decisions are mainly governed by the process of

ranking and identifying the capital investments of the firm. The firm needs to
decide which of the given investments will ensure the most value to the
business.

The decisions of capital investment often suffer from a number of constraints.

The amount of capital that a firm collects is limited and it brings down the
constraint on the choice of the firm over various project investments. As the
debt of the firm is increased, the debt-equity ratio of the firm also gets
increased and hence it becomes difficult for the business to raise more debts.

The decision of project ranking plays significant role in the decisions of

capital investment. Depending on the various projects the firm is having at a
certain period of time, the firms prioritize the projects. The ranking of projects
depends on how much a project will return and which project will be able to

add maximum value to the business.

There are various measures that give the estimation of the return of the firm
over various investment projects. In order to determine the value of a
particular project, three most famous methods are - IRR methods, net present
value and payback method. These methods are applied while taking decisions
on capital investment.

CH - 4. Corporate Finance - Cash Flow and NPV Applications.

Accounting Profits
Accounting profits are cash flows that include non-cash inflows/outflows such
as depreciation.
Cash Flows
Cash flows are a firm's actual cash inflows/outflows and are important in
capital budgeting.
Example: Net Cash Flows
Assume Newco has $10,000 in annual depreciation and $20,000 in accounting

net income. Because the $10,000 in annual depreciation is not an actual cash
outflow, the $20,000 in accounting net income is not the true cash flow to the
firm.
If, while all else is constant, annual depreciation were to decline by $5,000 to
$5,000, accounting net income would increase to $25,000, but actual cash
flow would remain unchanged. However, calculations of net cash flow
exclude the effects of depreciation.

Formula :For purposes of capital budgeting,

Net Cash Flow = Net Income + Depreciation
Answer: Therefore, net cash flow would be equal to $30,000 ($20,000 net
income +$10,000 depreciation) before the changes in depreciation and
$30,000 ($25,000 net income + $5,000 depreciation) after the changes in
depreciation.
Incremental Cash Flow and Capital Budgeting
Once a company makes a decision to accept a project, an incremental cash
flow is then the cash flow that is added to the firm's existing cash flow as a
result of accepting a new project.
However, in determining incremental cash flows from a new project, problems
arise, such as:
1. Sunk Costs
These are the initial outlays required to analyze a project that cannot be
recovered even if a project is accepted. As such, these costs will not affect the

future cash flows of the project and should not be considered when making
capital-budgeting decisions.
Suppose Newco is considering whether to make an addition to its current plant
to increase production. To determine if the new addition is worthwhile, Newco
hired a consulting firm for $50,000 to analyze the addition and the effect it
will have on production. The $50,000 is considered a sunk cost. If the project
is rejected, the $50,000 will still be paid, and if the project is accepted, the
$50,000 will not affect the future cash flows of the addition.

2. Opportunity Cost
This is the cost of not going forward with a project or the cash outflows that
will not be earned as a result of utilizing an asset for another alternative. For
example, the opportunity cost of Newco's new addition considered above is
the cost of the land on which Newco is considering putting the new plant
addition. As such, it should be included in the analysis of the project.

3. Externality
Additionally, in the consideration of incremental cash flows of a new project,
there may be effects on the existing operations of the company to consider,
known as "externalities". For example, the addition to Newco's plant is for the
purpose of producing a new product. It must be considered if the new product
may actually take away or add to sales of the existing product.

4. Cannibalization
This is the type of externality where the new project takes sales away from the

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existing product.

Changes in Net Working Capital

A change in net working capital is essentially the changes in current assets
minus changes in current liabilities. Within the capital-budgeting process, a
project typically adds to current assets given additional inventories or potential
increases in accounts receivables from new sales. The increases to current
assets, however, are offset by current liabilities needed to finance the new
project.

Overall, there may be change to net working capital from the new project.

If the change in net working capital is positive, the change to current

assets outweighs the change in the current liabilities.

If, however, the change in net working capital is negative, the change

to current liabilities outweighs the change in current assets.

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CH - 5. Basic principle of measuring project cash flows.

Estimating cash flows the investment outlays and the cash inflows after the
project is commissioned is the most important, but also the most difficult
step in capital budgeting. Estimating cash flows process involves many people
and numerous variables.
A project which involves cash outflows followed by cash inflows comprises of
three basic components. They are,

Initial investment: Initial investment is the after-tax cash outlay on

capital expenditure and net working capital when the project is set up.

Operating cash inflows: The operating cash inflows are the after-tax

cash inflows resulting from the operations of the project during its
economic life.

Terminal cash inflow: The terminal cash inflow is the after-tax cash

flow resulting from the liquidation of the project at the end of its economic
life.

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For developing the stream of financial costs and benefits, the following
principles must be kept in mind:
1. Principle of Incremental Cash Flows
The cash flows of a project must be measured in incremental terms. To
ascertain a projects incremental cash flows, one has to look at what happens
to the cash flows of the firm with the project and without the project. The
difference between the two reflects the incremental cash flows attributable to
the project.
That is;
Project Cash Flow for year t = Cash flow for the firm with the project for year
t Cash flow for the firm without the project for year t
In estimating the incremental cash flows of a project, the following guidelines
must be borne in mind:

Consider all incidental effects

Ignore sunk costs

Include opportunity costs

Question the allocation of overhead costs

2. Principle of Long Term Funds

A project may be evaluated from various points of view: total funds point of
view, long term funds point of view, and equity point of view. The
measurement of cash flows as well as the determination of the discount rate

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for evaluating the cash flows depends on the point of view adopted. It is
generally recommended that a project may be evaluated from the point of view
of long-term funds (which are provided by equity stockholders, preference
stock-holders, debenture holders, and term-lending institutions) because the
principal focus of such evaluation is normally on the profitability of long-term
funds. This argument, though plausible, cannot be regarded as unassailable.
Nonetheless, we subscribed to the position that it is quite reasonable to view a
project from the long-term funds point of view. Hence for determining the
costs and benefits of an investment project we will raise the questions. What is
the sacrifice made by the suppliers of long term funds? What benefits accrue
to the suppliers of long-term funds? The sacrifice made by the suppliers of
long-term funds is equal to the outlays on fixed assets and net working capital
(it may be recalled that net working capital, which represents the difference
between current assets and current liabilities, is supported by long-term funds).
The benefits accruing to the suppliers of long-term funds consist of
operational cash inflows after taxes and salvage value of fixed assets and net
working capital.
3. Principle of Financing Costs Exclusion
When cash flows relating to long-term are being defined, financing costs of
long-term funds [interest on long-term debt and equity dividend] should be
excluded from the analysis. Why? The weighted average cost of capital used
for evaluating the cash flows takes into account the cost of long-term funds.
Put differently the interest and dividend payments are reflected in the
weighted average cost of capital. Hence, if interest on long term debt and

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dividend on equity capital are deducted in defining the cash flows, the cost of
long-term funds will be counted twice an error that should be carefully
guarded against.
Operationally, the exclusion of financing costs principle means that

The interest on long-term debt [referred to hereafter as just interest for

the sake of simplicity] is ignored while computing profits and taxes

thereon and

The expected dividends are deemed irrelevant in cash flow analysis.

While dividends pose no difficulty as they come only from profit after taxes,
interest needs to be handled properly. Since interest is usually deducted in the
process of arriving at profit after tax, an amount equal to interest [1 -tax rate]
should be added back to the figure of profit after tax. Thus, whether the tax
rate is applied directly to the profit before interest and tax figure or whether
the tax adjusted interest, which is simply interest [1-tax rate], is added to profit
after tax, we get the same result.
4. Principle of Post-tax
Tax payments like other payments must be properly deducted in deriving the
cash flows. Put differently cash flows must be defined in post-tax terms [It
may be noted that the cost of capital employed for evaluating the cash flow
stream is also measured in post-tax terms].
Capital budgeting is the process most companies use to authorize capital
spending on longterm projects and on other projects requiring significant

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investments of capital. Because capital is usually limited in its availability,

capital projects are individually evaluated using both quantitative analysis and
qualitative information. Most capital budgeting analysis uses cash inflows and
cash outflows rather than net income calculated using the accrual basis. Some
companies simplify the cash flow calculation to net income plus depreciation
and amortization. Others look more specifically at estimated cash inflows
from customers, reduced costs, proceeds from the sale of assets and salvage
value, and cash outflows for the capital investment, operating costs, interest,
and future repairs or overhauls of equipment.
The Cottage Gang is considering the purchase of $150,000 of equipment for
its boat rentals. The equipment is expected to last seven years and have a
$5,000 salvage value at the end of its life. The annual cash inflows are
expected to be $250,000 and the annual cash outflows are estimated to be
$200,000.

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CH - 6. Profitability Technique For Measurement Of Cash Flow.

Payback technique
The payback measures the length of time it takes a company to recover in
cash its initial investment. This concept can also be explained as the length of
time it takes the project to generate cash equal to the investment and pay the
company back. It is calculated by dividing the capital investment by the net
annual cash flow. If the net annual cash flow is not expected to be the same,
the average of the net annual cash flows may be used.
Cash Pay-back Period =

Capital Investment
Average Annual net cash flow

For the Cottage Gang, the cash payback period is three years. It was calculated
by dividing the $150,000 capital investment by the $50,000 net annual cash
flow ($250,000 inflows $200,000 outflows)
$ 1,50,000
$ 50,000
= 3.0 Years.
The shorter the payback period, the sooner the company recovers its cash
investment. Whether a cash payback period is good or poor depends on the
company's criteria for evaluating projects. Some companies have specific
guidelines for number of years, such as two years, while others simply require
the payback period to be less than the asset's useful life.

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When net annual cash flows are different, the cumulative net annual cash
flows are used to determine the payback period. If the Turtles Co. has a project
with a cost of $150,000, and net annual cash inflows for the first seven years
of the project are: $30,000 in year one, $50,000 in year two, $55,000 in year
three, $60,000 in year four, $60,000 in year five, $60,000 in year six, and
$40,000 in year seven, then its cash payback period would be 3.25 years. See
the example that follows.

The cash payback period is easy to calculate but is actually not the only
criteria for choosing capital projects. This method ignores differences in the
timing of cash flows during the project and differences in the length of the
project. The cash flows of two projects may be the same in total but the timing
of the cash flows could be very different. For example, assume project LJM
had cash flows of $3,000, $4,000, $7,000, $1,500, and $1,500 and project
MEM had cash flows of $6,000, $5,000, $3,000, $2,000, and $1,000. Both
projects cost $14,000 and have a payback of 3.0 years, but the cash flows are

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very different. Similarly, two projects may have the same payback period
while one project lasts five years beyond the payback period and the second
one lasts only one year.

Net present value

Considering the time value of money is important when evaluating projects
with different costs, different cash flows, and different service lives.
Discounted cash flow techniques, such as the net present value method,
consider the timing and amount of cash flows. To use the net present value
method, you will need to know the cash inflows, the cash outflows, and the
company's required rate of return on its investments. The required rate of
return becomes the discount rate used in the net present value calculation. For
the following examples, it is assumed that cash flows are received at the end
of the period.
Using data for the Cottage Gang and assuming a required rate of return of
12%, the net present value is $80,452. It is calculated by discounting the
annual net cash flows and salvage value using the 12% discount factors. The
Cottage Gang has equal net cash flows of $50,000 ($250,000 cash receipt
minus $200,000 operating costs) so the present value of the net cash flows is
computed by using the present value of an annuity of 1 for seven periods.
Using a 12% discount rate, the factor is 4.5638 and the present value of the net
cash flows is $228,190. The salvage value is received only once, at the end of
the seven years (the asset's life), so its present value of $2,262 is computed

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using the Present Value of 1 table factor for seven periods and 12% discount
rate factor of .4523 times the $5,000 salvage value. The investment of
$150,000 does not need to be discounted because it is already in today's
dollars (a factor value of 1.0000). To calculate the net present value (NPV),
the investment is subtracted from the present value of the total cash inflows of
$230,452. See the examples that follow. Because the net present value (NPV)
is positive, the required rate of return has been met.

DEFINITION of 'Discounted Cash Flow - DCF'

A valuation method used to estimate the attractiveness of an investment
opportunity. Discounted cash flow (DCF) analysis uses future free cash flow
projections and discounts them (most often using the weighted average cost of
capital) to arrive at a present value, which is used to evaluate the potential for
investment. If the value arrived at through DCF analysis is higher than the
current cost of the investment, the opportunity may be a good one.
Calculated as:

Also known as
the

Discounted

Cash Flows Model.

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'Discounted Cash Flow - DCF'

There are many variations when it comes to what you can use for your cash
flows and discount rate in a DCF analysis. Despite the complexity of the
calculations involved, the purpose of DCF analysis is just to estimate the
money you'd receive from an investment and to adjust for the time value of
money.
Discounted cash flow models are powerful, but they do have shortcomings.
DCF is merely a mechanical valuation tool, which makes it subject to the
axiom "garbage in, garbage out". Small changes in inputs can result in large
changes in the value of a company. Instead of trying to project the cash flows
to infinity, terminal value techniques are often used. A simple annuity is used
to estimate the terminal value past 10 years, for example. This is done because
it is harder to come to a realistic estimate of the cash flows as time goes on.

[1]. Net Present Value.

Net present value method (also known as discounted cash flow method) is
a popular capital budgeting technique that takes into account the time value of
money. It uses net present value of the investment project as the base to
accept or reject a proposed investment in projects like purchase of new
equipment, purchase of inventory, expansion or addition of existing plant
assets and the installation of new plants etc.

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First, I would explain what is net present value and then how it is used to
analyze investment projects.
Net present value (NPV): Net present value is the difference between the
present value of cash inflows and the present value of cash outflows that occur
as a result of undertaking an investment project. It may be positive, zero or
negative. These three possibilities of net present value are briefly explained
below:
Positive NPV: If present value of cash inflows is greater than the present
value of the cash outflows, the net present value is said to be positive and the
investment proposal is considered to be acceptable.
Zero NPV: If present value of cash inflow is equal to present value of cash
outflow, the net present value is said to be zero and the investment proposal is
considered to be acceptable.
Negative NPV: If present value of cash inflow is less than present value of
cash outflow, the net present value is said to be negative and the investment
proposal is rejected.
Example 1 cash inflow project:
The management of Fine Electronics Company is considering to purchase an
equipment to be attached with the main manufacturing machine. The
equipment will cost $6,000 and will increase annual cash inflow by $2,200.
The useful life of the equipment is 6 years. After 6 years it will have no
salvage value. The management wants a 20% return on all investments.

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Required:

Compute net present value (NPV) of this investment project.

Should the equipment be purchased according to NPV analysis?

Solution:
(1)Computation of net present value:

*Value from present value of an annuity of $1 in arrears table.

(2) Purchase decision:
Yes, the equipment should be purchased because the net present value is
positive ($1,317). Having a positive net present value means the project
promises a rate of return that is higher than the minimum rate of return
required by management (20% in the above example).
In the above example, the minimum required rate of return is 20%. It means if
the equipment is not purchased and the money is invested elsewhere, the

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company would be able to earn 20% return on its investment. The minimum
required rate of return (20% in our example) is used to discount the cash
inflow to its present value and is, therefore, also known as discount rate.
Investments in assets are usually made with the intention to generate revenue
or reduce costs in future. The reduction in cost is considered equivalent to
increase in revenues and should, therefore, be treated as cash inflow in capital
budgeting computations.
The net present value method is used not only to evaluate investment projects
that generate cash inflow but also to evaluate investment projects that reduce
costs. The following example illustrates how this capital budgeting method is
used to analyze a cost reduction project:
Example 2 cost reduction project:
Smart Manufacturing Company is planning to reduce its labor costs by
automating a critical task that is currently performed manually. The
automation requires the installation of a new machine. The cost to purchase
and install a new machine is $15,000. The installation of machine can reduce
annual labor cost by $4,200. The life of the machine is 15 years. The salvage
value of the machine after fifteen years will be zero. The required rate of
return of Smart Manufacturing Company is 25%.
Should Smart Manufacturing Company purchase the machine?
Solution:
According to net present value method, Smart Manufacturing Company

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should purchase the machine because the present value of the cost savings is
greater than the present value of the initial cost to purchase and install the
machine. The computations are given below:

*Value from present value of an annuity of $1 in arrears table.

Net present value method uneven cash flow:
Notice that the projects in the above examples generate equal cash inflow in
all the periods (the cost saving in example 2 has been treated as cash inflow).
Such a flow of cash is known as even cash flow. But sometimes projects do
not generate equal cash inflows in all the periods. When projects generate
different cash inflows in different periods, the flow of cash is known as
uneven cash flow. To analyze such projects the present value of the inflow of
cash is computed for each period separately. It has been illustrated in the
following example:
Example 3:

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A project requires an initial investment of $225,000 and is expected to

generate the following net cash inflows:
Year
Cash inflow

1
$95,000

2
$80,000

3
$60,000

4
$55,000

Compute net present value of the project if the minimum desired rate of return
is 12%.
Solution:
The cash inflow generated by the project is uneven. Therefore, the present
value would be computed for each year separately:

Year Present value Net cash flow Present value of cash flow
1
2
3
4

of $1 at 12%
0.893*
$
0.797
0.712
0.636

95,000
80,000
60,000
55,000

Total
Initial investment required

Net present value

84,835
63,760
42,720
34,980

226,295
225,000

1,295

*Value from present value of $1 table.

The project seems attractive because its net present value is positive.
Choosing among several alternative investment proposals:

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Sometime a company may have limited funds but several alternative

proposals. In such circumstances, if each alternative requires the same amount
of investment, the one with the highest net present value is preferred. But if
each proposal requires a different amount of investment, then proposals are
ranked using an index called present value index (or profitability index).
The proposal with the highest present value index is considered the best.
Present value index is computed using the following formula:
Formula of present value or profitability index:

Example 4:
Choose the most desirable investment proposal from the following alternatives
using profitability index method:

Present value of net cash flow

Amount required to invest
Net present value

Proposal X
$212,000
200,000

12,000

Proposal Y
$171,800
160,000

11,800

Proposal Z
$185,200
180,000

5,200

Solution:
Because each investment proposal requires a different amount of investment,
the most desirable investment can be found using present value index. Present
value index of all three proposals is computed below:
Present Value Index

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Proposal X
Proposal Y
Proposal Z

1.06
1.07
1.03

(212,000/200,000)
(171,800/160,000)
(185,200/180,000)

Proposal X has the highest net present value but is not the most desirable
investment. The present value indexes show proposal Y as the most desirable
investment because it promises to generate 1.07 present value for each dollar
invested, which is the highest among three alternatives.
Assumptions:
The net present value method is based on two assumptions. These are:

The cash generated by a project is immediately reinvested to generate a

return at a rate that is equal to the discount rate used in present value
analysis.

The inflow and outflow of cash other than initial investment occur at

the end of each period.

Advantages and Disadvantages:
The basic advantage of net present value method is that it considers the time
value of money. The disadvantage is that it is more complex than other
methods that do not consider present value of cash flows. Furthermore, it
assumes immediate reinvestment of the cash generated by investment projects.
This assumption may not always be reasonable due to changing economic
conditions.
[2]. DEFINITION of 'Profitability Index'
An index that attempts to identify the relationship between the costs and

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benefits of a proposed project through the use of a ratio calculated as:

'Profitability Index'
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.
[3]. Definition of "Internal Rate Of Return - IRR"
The discount rate often used in capital budgeting that makes the net present
value of all cash flows from a particular project equal to zero. Generally
speaking, the higher a project's internal rate of return, the more desirable it is
to undertake the project. As such, IRR can be used to rank several prospective
projects a firm is considering. Assuming all other factors are equal among the
various projects, the project with the highest IRR would probably be
considered the best and undertaken first.
IRR is sometimes referred to as "economic rate of return (ERR)."
You can think of IRR as the rate of growth a project is expected to generate.
While the actual rate of return that a given project ends up generating will
often differ from its estimated IRR rate, a project with a substantially higher
IRR value than other available options would still provide a much better
chance of strong growth.

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[4]. Discounted Payback Period.

One of the major disadvantages of simple payback period is that it ignores the
time value of money. To counter this limitation, an alternative procedure called
discounted payback period may be followed, which accounts for time value of
money by discounting the cash inflows of the project.
Formulas and Calculation Procedure
In discounted payback period we have to calculate the present value of each
cash inflow taking the start of the first period as zero point. For this purpose
the management has to set a suitable discount rate. The discounted cash inflow
for each period is to be calculated using the formula:
Discounted Cash Inflow =

Actual Cash Inflow

(1 + i)n

Where,
i is the discount rate;
n is the period to which the cash inflow relates.
Usually the above formula is split into two components which are actual cash
inflow and present value factor ( i.e. 1 / ( 1 + i )^n ). Thus discounted cash
flow is the product of actual cash flow and present value factor.The rest of the
procedure is similar to the calculation of simple payback period except that we
have to use the discounted cash flows as calculated above instead of actual
cash flows. The cumulative cash flow will be replaced by cumulative
discounted cash flow.
Discounted Payback Period = A +

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C
Where,
A = Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the
period A;
C = Discounted cash flow during the period after A.
Note: In the calculation of simple payback period, we could use an alternative
formula for situations where all the cash inflows were even. That formula
won't be applicable here since it is extremely unlikely that discounted cash
inflows will be even.
The calculation method is illustrated in the example below.
Decision Rule:- If the discounted payback period is less that the target period,
accept the project. Otherwise reject.
Example:- An initial investment of $2,324,000 is expected to generate
$600,000 per year for 6 years. Calculate the discounted payback period of the
investment if the discount rate is 11%.
Solution:- Step 1: Prepare a table to calculate discounted cash flow of each
period by multiplying the actual cash flows by present value factor. Create a
cumulative discounted cash flow column.
Year

Cash Flow

Present

Discounted Cash

Cumulative

no.

CF

Value

Flow

Discounted

Factor

CFPV$1

Cash Flow

PV$1=1/

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0
1
2
3
4
5
6

$ 2,324,000
600,000
600,000
600,000
600,000
600,000
600,000

(1+i)n
1.0000
0.9009
0.8116
0.7312
0.6587
0.5935
0.5346

$ 2,324,000
540,541
486,973
438,715
395,239
356,071
320,785

$ 2,324,000
1,783,459
1,296,486
857,771
462,533
106,462
214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 5.32 years

Advantages and Disadvantages
Advantage: Discounted payback period is more reliable than simple payback
period since it accounts for time value of money. It is interesting to note that if
a project has negative net present value it won't pay back the initial
investment.
Disadvantage: It ignores the cash inflows from project after the payback
period.

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CH - 7.Capital Rationing.

Capital rationing is a strategy used by organizations attempting to limit the

costs of their own investments. Typically, a company engaging in capital
rationing has made unsuccessful investments of capital in the recent past and
would like to raise the return on those investments prior to engaging in new
business.
Why Ration Capital : The main goal of capital rationing is to protect a
company from over-investing its assets. If this were to occur, the company
might continue to see low return on investment and even face a compromised
financial position. Further, this can cause a company's stock to drop.
How to Ration Capital
The main device for capital rationing is increasing the cost of capital. "Cost of
capital" is a term used to describe the cost of debt and equity, and it can be
raised or lowered based on the company's willingness to borrow money or
issue stocks. A company can increase the cost of capital by borrowing less,
thus making it more challenging to invest. The company would engage in new

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products only if the anticipated return is higher than the new cost of capital.
For example, raising the cost of capital from 10 percent to 5 percent would
demand the company see a 5 percent higher return on any future investment
than on those in the past.
What are the benefits of capital rationing?
The main benefit of capital rationing is budgeting a company's corporate
resources. When a company issues stock or borrows money, it can use these
resources for new investments. However, if the company does not see a good
return on investments, it is wasting these resources. By capital rationing,
which is the process of increasing the cost of capital, the company can make
sure it takes on fewer projects. Further, it can take on only projects for which
the anticipated return on investment is high. This will prevent the company
from over-extending its finances, which would cause a decrease in stock price
and stability.

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CH - 8. Bibliography.

Refers from the books of Advanced Financial Management.

www.slideshare.com
Refers from Investopedia Notes.
Refers from the Notes of Financial Management of M.B.A.