Chapter 2 Invt Decision NEW.ppt

10/3/2023
Introduction
• Investment decision refers to selecting and
acquiring the long-term and short-term assets in
which funds will be invested by the business.

Capital Budgeting Techniques
• A means of assessing whether an investment project is
worthwhile or not
• Managers are responsible for comparing and evaluating
alternative projects so as to allocate limited resources and
maximize the firm’s wealth

Project appraisal methods
Considering the time value of
money concept
Ignoring the time value of
money concept
•Net present value
•Internal rate of return
•Payback period
•Accounting rate of return

www.edbodmer.com October 23 6
Payback period
•Payback period is the period of time it takes
for a company to recover its initial investment
in a project
•The method measures the time required for a
project’s cash flow to equalize the initial
investment

Acceptance criterion
< predetermined cutoff period Accept the project
> Predetermined cutoff
period
Reject the project

A company is considering making the following mutually exclusive
Investments in the production facilities for the new products with
an Estimated useful life of four years. The cash inflow and
outflows are Listed as follows:
Project A Project B
$ $
Initial investment 900000 1000000
Cash inflow at the end of year
Year 1 700000 600000
Year 2 100000 400000
Year 3 100000 400000
Year 4 1300000 400000
Project A : 3 years Project B: 2 years
Project B takes only two years to recover its initial investment. With
The shortest payback period, the company will accept project B

Advantages of payback period
• Easy to adopt
• Facilities further evaluation
 After obtaining an acceptable payback period, the project will be
evaluated by other financial capital budgeting techniques

Disadvantages of Payback period
• Ignore the cash flows after payback period
• Adopt an arbitrary standard for the payback period
• Ignores the timing of cash flow

Accounting rate of return
• The accounting rate of return compares the average accounting profit
with the average investment cost of project
• The accounting profit can be expressed either before tax or after tax

Calculation procedures
ARR =
Average net profit per year (over the life of the project)
Average investment cost
Average net profit per year =
Total profit
No. of life of the project
Average investment cost =
Initial investment
2

In evaluating an investment project, the ARR of the project is
compared with a predetermined minimum acceptable accounting
Rate of return:
ARRs Comments
< minimum acceptable rate Reject project
= minimum acceptable rate Accept project
> minimum acceptable rate Accept project
Highest Choose highest ARR
Acceptance criterion

A company is considering whether to buy specialized machines
For a new production line. The purchase price of machinery is
$400000 and its estimated useful life is four years. There is no scrap
Value after four years
The project income statements:
Year1 Year 2 Year 3 Year 4
$ $ $ $
Revenue 310000 280000 280000 310000
Depreciation 10000 100000 100000 100000
Other expenses150000 100000 110000120000
Profit before tax 60000 80000 70000 90000
Taxation (15%) 9000 12000 10500 13500
51000 68000 59500 76500
Should the company buy the new machinery if the minimum acceptable
Rate of return is 20%?

Average net income =
51000+68000+59500+76500
4
= $63750
Average investment =
400000+0
2
= $200000
The cost of machinery is $400000 at the beginning
The cost of machinery is $0 at the end as depreciation is provided
On straight line method and there is no scrap value
ARR =
$63750
$200000 = 31.875%
Since the ARR is 31.875%, which is higher than the minimum
Acceptable rate of 20%, the company should invest in the new
machinery.

Advantages of ARR
• It is easy to understand and compute
• It avoids using gross figures. Therefore, it enables comparisons to be
made between projects with different useful lives

Disadvantages of ARR
• It ignores the time value of money
• ARR method seems to be less reliable than the NPV method.
• It adopts the accounting profit instead of cash flows calculation.
• The change of depreciation method may also alter the accounting profit

Net present value method
•Net present value (NPV) method is a process
that uses the discounted cash flow of a
project to determine whether the rate of
return on that project is equal to, higher than,
or lower than the desired rate of return
•With the NPV method, we can compare the
return on investment in capital projects with
the return on an alternative equal risk
investment in securities traded in financial
market

1. Determining the discount rate
2. Calculating the NPV:
NPV =
FV1 FV2 FV3 FVn
(1+r)1 (1+r)2 (1+r)3 (1+r)n
+ + + - I0
where FV = future value of an investment
n = no. of years
r = Rate of return available on an equivalent risk
security in the financial market
I 0= initial investment

3. Interpreting the NPV derived as follows:
NPVs Comments Reasons
<0 Reject the project The rate of return from the project is
small than the rate of return from an
equivalent risk investment
=0 Indifferent to accept
or reject the project
The rate of return from the project is
equal to the rate of return from an
equivalent risk investment
>0 Accept the project The rate of return from the project is
greater than the rate of return from
an equivalent risk investment
Highes
t
Accept the project If various project are considered, the
project with highest positive NPV
should be chosen

A company is considering making several investments in the
Production facilities for the new products with an estimated useful
Life of four years. The cash inflows and outflows are listed as follows:
Project
A B C D
$ $ $ $
Initial investment 900000 1000000 303730 1500000
Cash inflow
Year 1 120000 400000 100000 10000
Year 2 250000 400000 100000 10000
Year 3 400000 400000 100000 1000000
Year 4 1300000 400000 100000 1000000
The appropriate discount rate of these investment is 12%

Required:
(a) Calculate the NPV of each investment and determine whether
to accept it or not (assuming the company has unlimited
resources)
(b) If the company has limited resources, determine which
investment should be accepted by referring to the highest NPV

Project A
NPV =
120000 250000 400000 1300000
1.12 1.122 1.123 1.124
+ + + - 900000
= $517327 (accepting)
Project B
NPV =
40000 400000 400000 400000
1.12 1.122 1.123 1.124
+ + + - 1000000
= $214920(accepting)
(a)

Project C
NPV =
100000 100000 100000 100000
1.12 1.122 1.123 1.124
+ + + - 303730
= $0 (indifferent to accept or reject)
Project D
NPV =
10000 10000 1000000 1000000
1.12 1.122 1.123 1.124
+ + + - 1500000
= -$135801(rejecting)
(a)
(b) With limited resources, the company should only accept project A
because it generates the highest NPV

Advantages of NPV
• Consistency with the time value of money concept
• Consideration of all cash flows
• Adoption of cash flows instead of accounting profit

Internal rate of return
•The internal rate of return is the annual
percentage return achieved by a project, of
which the sum of discounted cash inflow
over the life of the project is equal to the sum
of discounted cash outflows
•If the IRR is used to determine the NPV of a
project, the NPV will be zero.
•The company will accept this project only if
the IRR is equal to or higher than the
minimum rate of return or the cost of capital

1. By trial and error, find out the discount rate
that will give a zero NPV
where FV = future value of an investment
n = no. of years
r = internal rate of return
I 0= initial investment
2. If the NPV is positive, try a higher discount
NPV =
FV1 FV2 FV3 FVn
(1+r)1 (1+r)2 (1+r)3 (1+r)n
+ + + - I0 = 0

3. After getting one positive NPV and one negative NPV, use
interpolation to find out the rate giving zero NPV
IRR = L +
P
P – N
(H – L)
Where L = Discount rate of the low trial
H = Discount rate of the high trial
P = NPV of cash flows of the low trial
N = NPV of cash flows of the high trial

4. In evaluating an investment project, the IRR is compared with the
management’s predetermined rate
IRRs Comments Reasons
< lowest acceptable level of return Reject NPV<0
= lowest acceptable level of return Accept NPV=0
> Lowest accepted level of return Accept NPV>0
Highest Accept If several project are
considered, the
highest IRR should
be chosen

A project costs $400 and produces a regular cash inflow of $200 at
the end of each of the next three years. Calculate the IRR. If the
minimum rate of return is 15 %, suggest with reason whether you
Should accept the project or not.
NPV =
$200 $200 $200
(1+r)1 (1+r)2 (1+r)3
+ + - $400 = 0
NPV =
$200 $200 $200
1.22 1.222 1.223
+ + - $400 = 8.4
Assuming the discount rate is 22%
NPV =
$200 $200 $200
1.24 1.242 1.243
+ + - $400 = -3.8
Assuming the discount rate is 24%

IRR = L +
P
P – N
(H – L)
Where L = Discount rate of the low trial
H = Discount rate of the high trial
P = NPV of cash flows of the low trial
N = NPV of cash flows of the high trial
IRR = 22% +
8.4
8.4 – (-3.8)
(24 – 22)%
= 23.38%
Since the IRR (23.38%) is higher than the minimum rate of return (15%),
The project should be accepted

Chapter 2 Invt Decision NEW.ppt

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