Financial management unit 2 Investment Decisions

Prepared and presented by,
N. Ganesha Pandian
MSM-MBA Financial management Ganesha Pandian

 Capital Budgeting: principles and techniques
 Nature of capital budgeting
 Identifying relevant cash flow
 Evaluation techniques: Payback period method, Accounting rate
of return, Net present value, Internal rate of return and
profitability index
 Comparison of DCF techniques
 Concept and measurement of cost of capital
 Specific cost and overall cost of capital

 Function of finance manager to determine
the composition of assets (current assets and
fixed assets)
 The manager takes financial decisions on
fixed assets – capital budgeting

 Planning the capital expenditure in
acquisition of capital/fixed assets.
 Also consider the revenue generated and the
cash inflow outlay.

 According to Charles T. Horngren: “Capital
budgeting is the long term planning for making
and financing proposed outlay”.
 Keller and Ferrara : “Capital expenditure budget
is the plans for the appropriation and
expenditure for fixed assets during the project
period”.

1. Investment – Huge fund required
2. Long term – cannot be reversed
3. Forecasting – Risk assessment to be
evaluated
4. Serious consequences – wrong decisions or
error may lead to disaster.

 To take decisions among the most profitable
among the numerous options
 Deciding to choose most profitable under
capital market constraint
 Support the growth and expansion of firm

 Substantial expenditure
 Long term implications
 Irreversible decisions
 Complexity
 Risk
 Surplus (profit to cover cost)

 Evaluating and assessing the risks in capital investments
 Time value of money adjusted
 Different sources of fund – optimizes the overall cost of
capital
 Proportion of debt and equity – facilitates capital gearing
 In tight situation – capital rationing

 Decision involves:
1. Which project a firm should involve
2. Total amount of expenditure
3. How the funds are financed

 Identification of investment proposal
 Screening of the proposals
 Evaluating the proposals
 Fixing priorities
 Final approval
 Implementing the proposal
 Follow up

 Based on Firm’s existence
1. Replacement and modernization decision –
cost reduction (old replaced with or without
considering the economic value)
2. Expansion decision
3. Diversification decision revenue
increasing decision
Contd…

 Based on decision situation
1. Mutually exclusive decision - Either this or that
2. Accept or reject decision – Project accept or
reject due to their return
3. Contingent Decision – one is related to another

1. Initial investment
2. Cash flow after taxes (CFAT)
3. Terminal cash inflows
4. Time value of money
5. Discounted rate (WACC)
6. Present value factor/ and Annuity factor table

Capital budgeting
methods
Discounted cash flow/
Time adjusted method
Traditional or non
discounting method
NPV
(Net
present
value)
Accounting /
Average
rate of
return
Pay
back
period
Internal
rate of
return
(IRR)
Profita
bility
Index
(PI)

1. Pay back period method:
Formula : Pay back period = Initial investment
CFAT
1. In case of uniform CFAT; formula applied
2. In case of differential CFAT for various years
i. Compute Cumulative CFAT
ii. Find out CFAT exceeds the initial investment
iii. Corresponding year is the pay back period

 A project had an initial investment Rs. 2,00,000.
The cash flows after tax every year of Rs. 50, 000
p. a for six years.
Compute pay back period.
Solution: Payback period = Initial investment/
CFAT = 2,00,000/50,000
Pay back period = 4 years

 A project has an initial investment Rs.
5,00,000 and the cash flow are 1,50,000 in 1st
year; 1,80,000 in 2nd year; 1,50,000 in 3rd year;
1,32,000 in 4th year and 1,20,000 in 5th year.
Next slide

Year CFAT Cumulat
ive CFAT
1 1,50,000 1,50,000
2 1,80,000 3,30,000
3 1,50,000 4,80,000
4 1,32,000 6,12,000
5 1,20,000 7,32,000
payback period = (6,12,000 – 4,80,000)/1,32,000 *12
= 3 years 1 month

 Merits:
1. Easy to apply and compute
2. Applicable when project is short term
3. Focus on early return and ignores future returns
4. Considers liquidity and solvency of firm
 Demerits:
1. Not taking time value of money into account
2. Biased indicator as it ignores future cash flow
3. It can’t be compared with other projects
4. Change in cash flow affect the payback period

I. Discounted payback period method:
1. Ascertain the investment and cash flow
2. Find out PV factor and compute discounted cash
flow after taxes (CFAT)
3. Ascertain cumulative discounted cash flow CFAT
exceeds initial investment
4. Corresponding to discounted CFAT is payback
period

 Formula :
post pay back profitability = post pay back profit
Initial investment * 100
Cash flow after payback period

 Rate of return computation
Pay back reciprocal = CFAT
Initial investment
= 1
payback period
It applies only when equated cash inflows every
year.

 ARR is the annualized net income earned on
the average funds invested in a project
A, In case of method on original investment :
ARR = (Average net earnings / initial investment)* 100
B, In case of method on average investment :
ARR = (Average net earnings/ Average investment) *100

 Deduct profit with tax and depreciation
 PAT (profit after tax) is calculated as average
for ‘N’Years.
 Calculate ARR by dividing earnings by
investment

 Merits:
1. Easy and simple to understand and use
2. Total earnings taken into consideration
3. Emphasis on profitability rather than liquidity
4. Calculations based on accounting data
 Demerits:
1. Ignores times value of money
2. Ignores salvage value
3. Does not consider the length of project
4. Fails to recognize the size of investment

 Project K requires an investment of Rs. 20
lakhs and yields profit after tax and
depreciation as follows:
At the end of 5thYear, the plant can be sold for
Rs. 1,60,000 CalculateARR.
Year 1 2 3 4 5
Profit after
tax and
depreciation
1,00,000 1,50,000 2,50,000 2,60,000 1,60,000

ARR = (average profit / average investment) *100
Average profit = 9,20,000 / 5 = Rs. 1,84,000
Average investment = (Original investment-scrap
value)/2
= 18,40,000/2 = 9,20,000
ARR = (1,84,000/9,20,000)*100 = 20%

 Discounting of future values by
predetermined rates
 Discount factor PV = 1/(1+r)^n
r – Discount rate
n – number of years

 Computation method:
1. Ascertain total cash inflows, outflows of the project
and time period
2. Calculate present value for cash inflow (CFAT*PV)
3. Calculate present value for outflow
4. NPV = PV cash inflow – PV cash outflow
5. Whichever project with high NPV accept the
proposal

 Merits:
1. It recognizes time value of money
2. It uses the discount rate (that is) cost of capital
3. Considers all the cash flow
4. Can compare with other projects.
 Limitations:
1. This method assumes the discount rate.
2. It may not give reliable answer in certain cases
3. Projects with the different amounts of investment cannot be
compared

 A company is considering two different
investment proposals X andY as below:
Discount rate @12% select best project (NPV)
Proposal X ProposalY
Investment
cost
1,90,000 4,00,000
CFATYear 1 80,000 1,60,000
Year 2 80,000 1,60,000
Year 3 90,000 2,4,0,000

Year CFAT X CFATY PV factor
@12%
Present
value X
Present
value
Y
1 80,000 1,60,000 0.893 71,440 1,42,880
2 80,000 1,60,000 0797 63,760 1,27,520
3 90,000 2,40,000 0.712 64,080 1,70,880
Total cash
inflow
1,99,280 4,41,280
Less:
outflow
1,90,000 4,00,000 1 1,90,000 4,00,000
NPV 9280 41280
Thus ProposalY accepted

 IRR – rate of return at which sum of discounted cash inflows equal
the sum of discounted cash outflows.
- Also called Marginal rate of return method or adjusted rate of
return method.
Computation of IRR
Two methods : I when cash flows are uniform
1. Factor calculated by formula factor = investment / cash inflow
2. Factor located in annuity table of PV for corresponding years ‘n’

1. Average cash flow calculated
2. Factor calculated by formula factor = original
investment/ average cash flow
3. The rate ascertained by interpretation method; so
lower rate and upper rate of return found from table
4. Formula applied, IRR = Lower rate + (positive NPV
(inflow)/diff. in calculated PV (inflow)) * diff. in rate

 Merits:
1. Average cash flow calculated
2. Time value of money taken into account
3. Can be compared with other projects cutoff rates
4. Projects above cutoff rates accepted
 Limitations:
1. Computation is tedious and difficult to understand
2. NPV is more reliable than IRR for comparing
3. Results inconsistent with NPV method

 A company invest Rs. 1,00,000 in an asset of life 6 yrs
and estimated cash flow after taxes (CFAT) is Rs.
20,000 of equal amount every year. Calculate IRR
Factor value = Initial investment/ CFAT
= 1,00,000/20,000
= 5
Refer factor value PVIF table corresponding to 6 yrs.
IRR = 6%

Calculate IRR:
Initial investment = Rs. 1,20,000
Life of asset = 4 yrs
Year Cash flow
after taxes
1 30,000
2 40,000
3 60,000
4 40,000

Year CFAT PV factor
@14%
PV factor
@15%
Cash
inflow PV
14%
Cash
inflow PV
15%
1 30,000 0.877 0.869 26,310 26,070
2 40,000 0.769 0.756 30,760 30,240
3 60,000 0.674 0.657 40,440 39,420
4 40,000 0.592 0.571 23,680 22,840
Total 1,21,190 1,18,570
Cash
outflow
1,20,000 1,20,000
+ 1190 - 1430
After finding out PV factor by cumulative method and values
found in table
Contd…

Now apply formula IRR = Lower rate + (positive
NPV/diff in PV)*diff in rate
= 14+ (1190/2620) *1
= 14.45%

 Variant of NPV method – also known as benefit cost
ratio or present value index
Formula : PI = PV of cash inflows/ PV of cash outflows
Amount obtained from PI is every rupee invested in
project
- If PI is more than 1, then accept
- If PI is less than 1, then reject

 Merits:
1. Considers time value of money
2. Relatively better then NPV
3. Useful in case of investment in divisible projects
 Limitations:
1. Incase of indivisible projects
2. Cash flow changes causes results invalid

 A company needs to select from two mutually
exclusive projects X &Y discount rate = 15% and
life = 7 yrs
 Initial investment = 44,000 for X; 54,000 forY
 Cash flow (CFAT) annual = 12,000 for X; 14,500
forY
Find the profitability index

 CFAT X = 12,000 PVIFA @ 15% = 4.16
So PV CFAT = 49,920
PI for X = 49,920/44,000 = 1.135
 CFATY = 14,500 PVIFA @ 15% = 4.16 so PV
CFAT forY = 60,320
PI forY = 60,320/ 54,000 = 1.12

 Selection of combination of Investment
proposals
 Minimum amt fixes by firm to be invested on
capital proportion.

1. Risk adjusted discount method
2. Certainty – equivalent method
3. Sensitivity analysis
4. Probability Assignment
5. Standard deviation and co-efficient ofVariation
6. Decision risk analysis

 Cost of capital – “ Minimum required rate of
return, cut-off rate, hurdle rate, target rate”
Meaning :
Firm raises the long term funds 1. Debt 2.
Preference share capital 3. Equity share capital
- Paying interest, preference dividend and equity
dividend - “Cost of capital”

 According to Milton H. Spencer:Cost of capital is
the minimum rate of return which a firm requires
as a condition for undertaking an investment.
 Hamplon John J: Cost of capital is the rate of
return the firm requires from investment in order
to increase the value of the firm in the market
rate.

 Return at Zero risk: Projected rate of return
without risk
 Premium for business risk : also known as
operating risk
 Premium for financial risk: arising from the
capital/ cash insolvency of a firm

1. Capital budgeting decisions
2. Designing the capital structure
3. Deciding about the method of financing
4. Performance of top management
5. Other cases of decision making

 General economic conditions
 Market conditions
 Operating and financing decisions
 Amount of financing

1. Historical cost and Future cost
2. Explicit cost and Implicit cost
3. Specific cost and Overall cost
4. Average cost and Marginal cost

 Cost of Debt: returns expected by the
potential investors of debt securities of a
firm.
 The debt is tax deductible
 Two types of debt: 1. Irredeemable Debt 2.
Redeemable Debt

- Perpetual debt - not redeemable during the life time of the firm
a. Cost of Debt before tax:
K db = interest / Net proceeds = I/NP
Net proceeds can be calculated by:
1. Debt issued at par: NP = Face value – Issue expense
2. Debt issued at premium: NP = face value + securities – issue price
3. Debt issued at discount = NP = face value – Discount – issue
expenses
Contd…

 B. Cost of debt after tax (K da)
K da = k db(1 – tax rate) (or)
= (Interest – tax)/NP

 K db = Annual cost after tax / Average value of debt
Computation of Annual cost :
1. Interest - xxx
2. Add: issue expense - xxx
3. Add: Discount on issue - xxx
4. Add: premium on
redemption - xxx
5. Minus: Premium on issue of debt - xxx
Contd…

 Average value of debt = (Net proceed +
Redeemable value ) /2
 Cost of debt after tax:
K da = Kdb (1-tax rate)

 Kinley Ltd., issued 50,000 debentures with
the interest rate 10 % each Rs.100/-,
redeemable in 10 years at 10% premium.The
cost of issue was 2.5%.The company’ income
tax rate is 3.5%

 Total issue = 50,000 * 100 = 50,00,000
A, at par,
Average cost before tax
Interest = 5,00,000
Add: Issue expense
(50,00,000*2.5/100*1/10) = 12,500
Add: redemption premium
(50,00,000*10/100*1/10) = 50,000
= 5,62,500
Average cost after tax = 5,62,500 – tax
= 5,62,500 - 1,96,875 = 3,65,625
Contd…

 Average value of debt = Net proceeds +
redeemable value / 2
Net proceeds = interest – issue expenses
= 5,00,000 – 12,500 = 48,75,000
Redeemable value = 50,00,000+5,00,000 =
55,00,000
= 48,75,000 +55,00,000/ 2 = 51,87,500

Cost of Debt after tax:
K db = 5,62,000/51,87,500 *100 = 10.87%
Cost of Debt before tax:
K da= 3,65,625/51,87,500 *100 = 7.05 %

 Dividend paid – preference share holders is
the cost of preference share capital
 Two types of Preference share capital
1. Irredeemable preference share
2. Redeemable preference share
Contd…

 In India, Companies Amendment Act, 1988 prohibits
issue of irredeemable preference shares
1. Cost of Irredeemable preference share capital
Cost of preference share (kp) = Annual preference
dividend / Net proceeds
2. Cost of Redeemable preference share capital
Cost of Redeemable preference share (kp) = Annual
cost / Average value of preference share

1. Annual preference dividend xxxx
2. Add: Issue expenses xxxx
3. Add: Discount on issue xxxx
4. Add: Premium on redemption xxxx
5. Less: Premium on issue xxxx
Total : Annual cost xxxx
Average value of preference share = Net proceeds +
redemption value / 2

 ABC Ltd issued 15,000 preference share at
12% of each at Rs 100, redeemable at 10%
premium after 20 yrs.The floatation costs
were 5 %
Find out cost of preference share at par.

 Computation of average cost (p.a)
Preference dividend at 12% Rs. 1,80,000
(15,000*100 = 15,00,000)
Add: Issue cost at 5% for 20 years Rs. 3,750
(15,00,000*5/100)/20
Add: Premium@ redemption 10% Rs. 7500
(15,00,000*10/100)/20
Total Rs. 1,91,520

 AverageValue of preference share = NP+RV / 2 =
15,37,500
 Net proceeds = Dividend - Issue expenses =
14,25,000
 Redeemable value = 16,50,000
Preference share cost = 1,91,250/15,37,500 =
12.44%

- Computation of Cost of equity capital is quite complex
- Market valueVs Book value of equity capital
1. DividendYield or Dividend price method:
Cost of equity (Ke) = D1/NP
D1= Expected dividend per share; NP = net proceeds per
share
In case equity calculated on market basis:
Cost of equity (Ke) = D1/MP

a, In case of book value: New issue of shares
Cost of equity (ke) = (D1/NP) + g
g- growth rate of dividend
b, In case of market value: existing shares
Cost of equity (ke) = (D1/MP)+g

 Method co-relate earnings of firm with market price of its shares
a, In case of book value – New issue of shares
Cost of equity (Ke) = EPS/NP
b, In case of Market value – Existing shares
Cost of equity (Ke) = EPS/MP
Assumptions:
1. EPS expected to remain constant
2. Payout is 100% (no retained earnings)
3. The Firm does not use any debt

 Yield actually realized for a period of time –
indicator for cost of equity
 Past data assumed to repeat in future
 Using D/P + g method

 Alternative to dividend based calculation of cost of equity.
 Takes risk free and risk premium into consideration
CAPM divides risks into two classes:
1.The diversifiable/ Unsystematic risk - Internal
2.The non – diversifiable/ Systematic risk - External
Non diversifiable risk ascertained by using Beta co-efficient – in
relation to market risk
Ke = Rf+ B(Rm-Rt)
Rf – Risk free return; B- measure of non diversifiable risk; Rm –
expected cost of capital of market portfolio

 Cost of retained earnings Kr = Ke(1-t)(1-b)
t -Tax rate
b- Brokerage

 Allen ltd., pays the dividend per share Rs. 4.
Market price of share Rs. 40 and expected to
grow by 10% p.a.
Calculate the cost of equity.
Cost of equity = (D/MP) + g
= (4/40*100)+10
Ke = 20%

A company assess its risk free return 12 % Beta co-
efficient = 1.75 and expected market return is
15%
Compute Cost of equity under CAPM
Solution: Ke under CAPM = 12% + [1.75(15%-12%)]
= 0.12+ 1.75(0.03) = 0.1725
= 17.25%

 Average of costs of each source of funds – given
weightage by proportion or percentage
Computation of weighted Average Cost of Capital :
Step1: Calculate specific costs (i.e) equity, preference
and debenture
Step 2: Calculate the proportion and multiply each
specific cost with its proportion
Step 3: Add all the weighted specific costs

Source of
funds
Amount Proportio
n to total
After tax
cost
Weighted
cost
Debt xxx W1 Kda Kda*w1
Preferenc
e share
xxx W2 Kp Kp *w2
Retained
earnings
xxx W3 Kr Kr*w3
Equity
share
xxx W4 Ke Ke*w4

 Cut off rate / Hurdle rate for project
evaluation
 Assessment of value of firm
 Useful in making economic value of added
calculations

 Cost of retained earnings for an additional
rupee of capital
 Cost incurred in raising new capital
 Composite Calculation

 Capital structure of a company is given below
CalculateWACC.
Type of capital Amount (Rs.) Cost of specific
capital %
Debentures 12,00,000 5%
Preference share 4,00,000 10%
Equity share 8,00,000 15%
Retained earnings 16,00,000 12%

Type of
capital
Amount
(Rs.)
Cost of
specific
capital %
Weightag
e
Weighted
Cost
Debentur
es
12,00,000 5% 12/40 =
0.3
1.5
Preferenc
e share
4,00,000 10% 4/40 = 0.1 1.0
Equity
share
8,00,000 15% 8/40 = 0.2 3.0
Retained
earnings
16,00,000 12% 16/40 =
0.4
4.8
Total 40,00,000 WACC 10.3%

Financial management unit 2 Investment Decisions

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Financial management unit 2 Investment Decisions

Similar to Financial management unit 2 Investment Decisions (20)

More from Ganesha Pandian

More from Ganesha Pandian (20)

Recently uploaded

Recently uploaded (20)

Financial management unit 2 Investment Decisions