INDUSTRIAL ECONOMICS/UNITIII/GSS/MIT

UNIT III
Factors affecting investment decision Degree of certainty Emotional and intangible factors Legal factors Availability of funds Future earning Cost consideration Methods of calculating capital expenditures

The following are the various methods of calculating the investment decisions.
1. PAY-BACK PERIOD METHOD/ANNUAL EQUIVALENT METHOD It represents the period in which the total investment in a project is reserved by way of return from the project. a. when annual cash flows are even: Pay-back period= original investment annual cash flows b. when annual cash flows are uneven: (i)Calculate annual cash inflows-earnings after tax before depreciation. (ii)Find the cumulative values of the annual cash inflows. (iii)Locate from the cumulative values the pay-back period. Advantages: It does not take into account the cash inflows earned after the pay-back period. Does not consider time value of money. Difficult to determine the minimum acceptable pay-back period. Full life of the asset is not considered under the pay-back period. 2. AVERAGE RATE OF RETURN METHOD (ARR)/RATE OF RETURN METHOD Average profits after tax and after depreciation are calculated and then it is divided by the total original investment (or) average investment of the project. ARR= average profits after depreciation and taxes Original investment *100(or)average investment Average investment may be calculated by the following formula, Average investment=value of investment in beginning +value of investment at end of the project life is 0 we take of original investment as average investment. Advantages:

INDUSTRIAL ECONOMICS/UNITIII/GSS/MIT It is very simple to understand and easy to calculate. It uses the entire earning of a project. This method is based upon the well known concepts of profit. Disadvantages: It ignores time value of money (interest factor). It does not take considerations real cash flows of the project. This method cannot be applied to a situation where investment in project is to be made in part. DISCOUNTED CASH FLOW METHODS/ MODERN METHODS The discounted cash flow methods take into account the profitability by way of cash inflows and the time value of money. a. Net present value method b. Internal rate of return method. c. Profitability index method. 3. NET PRESENT VALUE METHOD/ PRESENT WORTH METHOD Determine the cut-off the rate that should be selected as minimum required rate of return. Normally for this purpose, the cost of capital is considered to be minimum required rate of return. This rate is called discounting rate. The difference between the total present value of the future cash inflows & the cost of investment is net present value (or) excess present value. NPV (or) EPV = total present value of the investment Tlr = A1 + A2 + A3
2 future

cash inflows-cost of original

+. + An (1+r)n

(1+r) (1+r) (1+r)3

4. INTERNAL RATE OF RETURN (IRR)/ FUTURE WORTH METHOD: IRR is the rate at which the sum of discounted cash inflow equals the sum of discounted cash flows. Present value of cash flow Cash flow 5. PROFITABILITY INDEX: = 1

INDUSTRIAL ECONOMICS/UNITIII/GSS/MIT

Profitability index is the ratio of total present value of the future cash inflows to original investment. Profitability index = total present value of future cash inflows Cost of original investment Advantages: They recognize the time value of money. They consider the cash inflows of the projects then the net profits. They consider the cash inflows over the entire life of the project. They take into consideration the objective of maximum profitability. More difficult to understand and operate. It is not easy to determine an appropriate discount rate. Not give good results while comparing projects with unequal investments of funds.

Disadvantages: