|
 

|
 
 


|

 
a xnderstand the nature and importance of investment decisions.
a Distinguish between discounted cash flow (DCF) and non-
discounted cash flow (non-DCF) techniques of investment
evaluation.
a Explain the methods of calculating net present value (NPV) and
internal rate of return (IRR).
a Show the implications of net present value (NPV) and internal rate
of return (IRR).
a Describe the non-DCF evaluation criteria: payback and accounting
rate of return and discuss the reasons for their popularity in
practice and their pitfalls.
a Illustrate the computation of the discounted payback.
a Describe the merits and demerits of the DCF and Non-DCF
investment criteria.
a Compare and contract NPV and IRR and emphasise the
superiority of NPV rule.

By Akash Saxena
^
  
a èhe 


 of a firm are generally
known as the
 
 
 






a èhe firm¶s investment decisions would generally
include

ÿ ÿ 
  and




 of the long-term assets. Sale of a
division or business (

) is also as an
investment decision.
a Decisions like the change in the 
 

ÿ or an 


 
  or a


  




  
have long-
term implications for the firm¶s expenditures and
benefitsÿ and thereforeÿ they should also be
evaluated as investment decisions.

By Akash Saxena

  
a èhe exchange of current funds for future
benefits.
a èhe funds are invested in long-term assets.
a èhe future benefits will occur to the firm over
a series of years.

By Akash Saxena

  
a -rowth
a Risk
a Funding
a Irreversibility
a Complexity

By Akash Saxena
è   
a ëne classification is as follows:
a Expansion of existing business
a Expansion of new business
a Replacement and modernisation
a Yet another useful way to classify
investments is as follows:
a Mutually exclusive investments
a Independent investments
a Contingent investments

By Akash Saxena


 | 

a èhree steps are involved in the evaluation of
an investment:
a Estimation of cash flows
a Estimation of the required rate of return (the
opportunity cost of capital)
a Application of a decision rule for making the
choice

By Akash Saxena
  
a It should maximise the shareholders¶ wealth.
a It should consider all cash flows to determine the true profitability of
the project.
a It should provide for an objective and unambiguous way of
separating good projects from bad projects.
a It should help ranking of projects according to their true profitability.
a It should recognise the fact that bigger cash flows are preferable to
smaller ones and early cash flows are preferable to later ones.
a It should help to choose among mutually exclusive projects that
project which maximises the shareholders¶ wealth.
a It should be a criterion which is applicable to any conceivable
investment project independent of others.

By Akash Saxena


 | 

a r. @


  @

  
a Net Present Value (NPV)
a Internal Rate of Return (IRR)
a Profitability Index (PI)

a 2. ^


 
  
a Payback Period (PB)
a Discounted Payback Period (DPB)
a Accounting Rate of Return (ARR)

By Akash Saxena
^
 
a Cash flows of the investment project should be
forecasted based on realistic assumptions.
a Appropriate discount rate should be identified to
discount the forecasted cash flows. èhe
appropriate discount rate is the project¶s
opportunity cost of capital.
a Present value of cash flows should be
calculated using the opportunity cost of capital
as the discount rate.
a èhe project should be accepted if NPV is
positive (i.e.ÿ NPV > 0).
By Akash Saxena
^
 
a Net present value should be found out by
subtracting present value of cash outflows
from present value of cash inflows. èhe
formula for the net present value can be
written as follows:




M
`

 §    ·  ` 


             

M

`


 §  

§   

By Akash Saxena
|

 ^

a Assume that Project å costs Rs 2ÿ 00 now
and is expected to generate year-end cash
inflows of Rs 900ÿ Rs 800ÿ Rs 700ÿ Rs 600
and Rs 00 in years r through . èhe
opportunity cost of the capital may be
assumed to be r0 per cent.
    !  

^     



   
  M       
^ "
  

   M
  
!
   
   


^ "  
!   ! !M
  !
 


^ 




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By Akash Saxena
!

a Accept the project when NPV is positive
NPV > 0
a Reject the project when NPV is negative
NPV < 0
a May accept the project when NPV is zero
NPV = 0
a èhe NPV method can be used to select
between mutually exclusive projects; the one
with the higher NPV should be selected.

By Akash Saxena


  ^ 
a NPV is most acceptable investment rule for the
following reasons:
a èime value
a Measure of true profitability
a Value-additivity
a Shareholder value
a Limitations:
a Involved cash flow estimation
a Discount rate difficult to determine
a Mutually exclusive projects
a Ranking of projects

By Akash Saxena


 
a èhe internal rate of return (IRR) is the rate that
equates the investment outlay with the present
value of cash inflow received after one period.
èhis also implies that the rate of return is the
discount rate which makes NPV = 0.

M `
 § ·
   
 M  `
`

 §
§  
`

 §  

 §

By Akash Saxena
|

 
a x

| : Calculating IRR by èrial
and Error
a èhe approach is to select any discount rate to
compute the present value of cash inflows. If the
calculated present value of the expected cash inflow
is lower than the present value of cash outflowsÿ a
lower rate should be tried. ën the other handÿ a
higher value should be tried if the present value of
inflows is higher than the present value of outflows.
èhis process will be repeated unless the net present
value becomes zero.

By Akash Saxena
|

 
a ·

| 
a Let us assume that an investment would cost
Rs 20ÿ000 and provide annual cash inflow of
Rs ÿ
0 for 6 years.
a èhe IRR of the investment can be found out
as follows:

^ §



M!!
 #


 § 
M!!
 



!!
 § § M!M

M

By Akash Saxena
 ^ 


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By Akash Saxena
!

a Accept the project when „ >

a Reject the project when „ <

a May accept the project when „ =

a In case of independent projectsÿ IRR and NPV
rules will give the same results if the firm has
no shortage of funds.

By Akash Saxena


  
a IRR method has following merits:
a èime value
a Profitability measure
a Acceptance rule
a Shareholder value
a IRR method may suffer from:
a Multiple rates
a Mutually exclusive projects
a Value additivity

By Akash Saxena
 

  *
a Profitability index is the ratio of the present
value of cash inflowsÿ at the required rate of
returnÿ to the initial cash outflow of the
investment

By Akash Saxena
  

  *
a èhe initial cash outlay of a project is Rs r00ÿ000
and it can generate cash inflow of Rs
0ÿ000ÿ
Rs 0ÿ000ÿ Rs 0ÿ000 and Rs 20ÿ000 in year r
through
. Assume a r0 per cent rate of
discount. èhe PV of cash inflows at r0 per cent
discount rate is:
 § 

   + M


 +  
 M
 + 

 
 

  + M
 
! +  
  + 

 !
 § 

M    
 

M 



M 
 § § 
M 




By Akash Saxena
!

a èhe following are the PI acceptance rules:
a Accept the project when PI is greater than one.
PI > r
a Reject the project when PI is less than one.
PI < r
a May accept the project when PI is equal to one.
PI = r
a èhe project with positive NPV will have PI
greater than one. PI less than means that the
project¶s NPV is negative.

By Akash Saxena


  
a It recognises the time value of money.
a It is consistent with the shareholder value
maximisation principle. A project with PI greater than
one will have positive NPV and if acceptedÿ it will
increase shareholders¶ wealth.
a In the PI methodÿ since the present value of cash
inflows is divided by the initial cash outflowÿ it is a
relative measure of a project¶s profitability.
a Like NPV methodÿ PI criterion also requires
calculation of cash flows and estimate of the discount
rate. In practiceÿ estimation of cash flows and
discount rate pose problems.

By Akash Saxena



,
a u  is the number of years required to recover the
original cash outlay invested in a project.
a If the project generates constant annual cash inflowsÿ
the payback period can be computed by dividing cash
outlay by the annual cash inflow. èhat is:
 
 |



,# #
!
|
 - |
a Assume that a project requires an outlay of Rs 0ÿ000
and yields annual cash inflow of Rs r2ÿ 00 for 7 years.
èhe payback period for the project is:
 

 # # 




By Akash Saxena



,
a x
   In case of unequal cash
inflowsÿ the payback period can be found out by
adding up the cash inflows until the total is
equal to the initial cash outlay.
a Suppose that a project requires a cash outlay of
Rs 20ÿ000ÿ and generates cash inflows of
Rs 8ÿ000; Rs 7ÿ000; Rs
ÿ000; and Rs ÿ000
during the next
years. What is the project¶s
payback?
 years + r2 × (rÿ000/ÿ000) months
 years +
months
By Akash Saxena
!

a èhe project would be accepted if its payback
period is less than the maximum or   

  period set by management.
a As a ranking methodÿ it gives highest ranking
to the projectÿ which has the shortest payback
period and lowest ranking to the project with
highest payback period.

By Akash Saxena


 


,
a Certain virtues:
a Simplicity
a Cost effective
a Short-term effects
a Risk shield
a Liquidity
a Serious limitations:
a Cash flows after payback
a Cash flows ignored
a Cash flow patterns
a Administrative difficulties
a Inconsistent with shareholder value

By Akash Saxena



, 

 


a èhe reciprocal of payback will be a close
approximation of the internal rate of return if
the following two conditions are satisfied:
a èhe life of the project is large or at least twice the
payback period.
a èhe project generates equal annual cash inflows.

By Akash Saxena
 


, 
a èhe  

 

 is the number of
periods taken in recovering the investment outlay on the
present value basis.
a èhe discounted payback period still fails to consider the
cash flows occurring after the payback period.
M


   

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0 0    /  0
  
2 .
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333
333 0
333 0
 1 1
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333 3 /
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/  0
 
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By Akash Saxena
! 
 
a èhe accounting rate of return is the ratio of the
average after-tax profit divided by the average
investment. èhe average investment would be
equal to half of the original investment if it were
depreciated constantly.
!
 
!#
!
 

a A variation of the ARR method is to divide

average earnings after taxes by the original cost
of the project instead of the average cost.
By Akash Saxena
!

a èhis method will accept all those projects
whose ARR is higher than the minimum rate
established by the management and reject
those projects which have ARR less than the
minimum rate.
a èhis method would rank a project as number
one if it has highest ARR and lowest rank
would be assigned to the project with lowest
ARR.

By Akash Saxena


 ! 
a èhe ARR method may claim some merits
a Simplicity
a Accounting data

a Accounting profitability

a Serious shortcoming
a Cash flows ignored
a èime value ignored
a Arbitrary cut-off

By Akash Saxena
| 

^ 

|
 -
a A conventional investment has cash flows the
pattern of an initial cash outlay followed by cash
inflows. Conventional projects have only one
change in the sign of cash flows; for exampleÿ
the initial outflow followed by inflowsÿ
i.e.ÿ ± + + +.
a A non-conventional investmentÿ on the other
handÿ has cash outflows mingled with cash
inflows throughout the life of the project. Non-
conventional investments have more than one
change in the signs of cash flows; for exampleÿ
± + + + ± ++ ± +.
By Akash Saxena
^
a Conventional Independent Projects:
In case of conventional investmentsÿ which are
economically 

  of each otherÿ NPV
and IRR methods result in same accept-or-reject
decision  the firm is not constrained for funds in
accepting  profitable projects.

By Akash Saxena
 ^
;Lending and borrowing-type projects:
Project with initial outflow followed by inflows is
a lending type projectÿ and project with initial
inflow followed by outflows is a lending type
projectÿ Both are conventional projects.
     
!    "    
å    4 
D    4  


By Akash Saxena

 
a A project may have
both lending and
borrowing features NPV (Rs)
20
NPV Rs 6
together. IRR methodÿ 0

when used to evaluate -2 0

such non-conventional - 00

investment can yield -7 0

0 0 r00 r0 200 20
multiple internal rates Discount Rate (%)

of return because of
more than one change
of signs in cash flows.
By Akash Saxena
|

, 
 * 

a Investment projects are said to be mutually exclusive
when only one investment could be accepted and
others would have to be excluded.
a èwo independent projects may also be mutually
exclusive if a financial constraint is imposed.
a èhe NPV and IRR rules give conflicting ranking to the
projects under the following conditions:
a èhe cash flow pattern of the projects may differ. èhat isÿ the
cash flows of one project may increase over timeÿ while those
of others may decrease or  „.
a èhe cash outlays of the projects may differ.
a èhe projects may have different expected lives.

By Akash Saxena
è  |
 -

›
›› 
›  › ›
› › › › ›
››  ›
[
    


    
 

By Akash Saxena
j


 |      
 !  |  |    " 
! 

 M! 

 


 




By Akash Saxena
· j


› |

ëº
›
u 
 | | |  | | | u
  ºº›

› › ›
›
› › › › › ››› ›

› › ›
› › › › › 
›  ›
›

By Akash Saxena
 ! 
a èhe IRR method is assumed to imply that the
cash flows generated by the project can be
reinvested at its internal rate of returnÿ whereas
the NPV method is thought to assume that the
cash flows are reinvested at the opportunity
cost of capital.

By Akash Saxena
  



a èhe 

  

 (MIRR)
is the compound average annual rate that is
calculated with a reinvestment rate different
than the project¶s IRR. èhe 

 
 

 (MIRR) is the compound
average annual rate that is calculated with a
reinvestment rate different than the project¶s
IRR.

By Akash Saxena

    ||
 

a èhere is no problem in using NPV method
when the opportunity cost of capital varies
over time.
a If the opportunity cost of capital varies over
timeÿ the use of the IRR rule creates
problemsÿ as there is not a unique benchmark
opportunity cost of capital to compare with
IRR.

By Akash Saxena
^
a A conflict may arise between the two methods
if a choice between mutually exclusive projects
has to be made. Follow NPV method:

›
››
››
u


 

 
 

 




 
 

u
 
 

u



By Akash Saxena