INVESTMENT DECISIONS

Investment decision is concerned with allocation of funds. Since financial management

deals with mobilization and development of funds, equal importance must be given to
both the functions. Funds are mobilized through long term, medium term and short term.
Medium term and long term finance must be deployed on long-term investment.

The main aim of such investment i.e. to get the proper yield from the project, so that it
can recover the cost associated with each source of funds. All theses costs must be
recovered through the judicious allocation of the available funds. This is a risky decision
to taken by the managers, so they have to forecast the anticipated profit, which is based
on several uncertainties. He has to evaluate the investment proposals in relation of their
expected returns and risk to determine whether the investment is feasible or not. The
process through which different projects are evaluated is known as “Capital Budgeting”.

Capital Budgeting is the process of making investment decision in capital expenditure. It

involves the planning and control of capital expenditure. It is the process of deciding
whether or not to commit resources to particular long-term projects whose benefits are to
be realized over a period of time.

Acc. To Charles T Horngreen

“Capital Budgeting is the long term planning for making and financing
proposed capital outlays”.
Acc. To Lynch;

“ Capital Budgeting consists in planning development of available capital

for the purpose of maximizing the long term profitability of the concern”.

From the above definition, it may be concluded that it is the process by which the
companies allocate funds to various investment projects designs to ensure profitability
and growth.

FEATURES OF CAPITAL BUDGETING

1. Exchange of funds for future benefits:

2. The future benefits are expected to be realized over a period of time.
3. The funds are invested vested in long-term activities.
4. They have a long term and significant effect on the profitability of the concern,
5. They involve huge funds.

IMPORATNCE OF CAPITAL BUDETING

1. Large Investment: Capital budgeting decision involves large investment of

funds. But the funds available with the firm are always limited and the demand for
funds far exceeds the resources. Hence it is very important for a firm to plan and
control its capital expenditure.
2. Long Term Commitment of Funds: capital expenditures involves not only
large amount of funds but also funds for long term or permanent basis. The long tern
commitments of funds increases, the financial risk involved in the investment
decision. Greater the risk involved, greater is need for careful planning of capital
expenditure i.e. Capital Budgeting.

3. Irreversible Nature: The Capital expenditure decision is of irreversible nature.

Once the decision for acquiring a permanent asset is taken, it becomes very difficult
to dispose of these assets without incurring heavy losses.

4. Long term Effect on profitability: Capital budgeting decision hane a long

term and significant effect on the profitability of a concern. Not only the present
earnings of the firm are effected by the investments in capital asserts but also the
future growth and profitability of the firm depends upon the investment decision
taken today. An unwise decision may prove disastrous and fatal to the very existence
of the concern.

5. Difficulties of investment Decisions : The long tern investment decision are

difficult to be taken because

 Decision extends to a series of years beyond the current accou7nting period.

 Uncertainties of future.
 Higher degree of risk.

6.
6. National Importance: Investment decision though taken by individual concern is
of national importance because it determines employment, economic activities and
growth.
METHODS OF CAPITAL BUDGETING

The commonly used methods are following:

Traditional Method

 Pay backs period method or pay out or pay off method

 Rate of return Method or Accounting Method

Time adjusted Method or discounted method

 Net present value method

 Internal rate of return method
I. TRADITIONAL METHOD

1. Pay back period method

It represents the period in which the total investments in permanent assts pay backs
itself. This method is based on the principal that every capital expenditures pays itself
back within a certain period out of the additional earnings generated from the capital
assets thus it measures the period of time for the original cost of a project to be
recovered from the additional earnings of the project itself.

In case of evaluation of a single project, it is adopted if it pays back itself within a

period specified by the management and if the project does not pay back itself within
the period specified by the management than it is rejected.

The payback period can be ascertained in the following manner:

1. Calculate annual net earning (profit) before depreciation and after taxes;
these are called the annual cash flows.
2. Divide the initial outlay (cost) of the project by annual cash flows, where
the project generates constant annual cash inflows.
Thus, where the project generates constant cash inflows.

3. Where the annual cash inflows are unequal, the pat back period can be
found by adding up the cash inflows until the total is equal to the initial
cash outlay of project or original cost of the asset.
 Cash outlay of the project or original cost of the
asset
Payback period =
Annual cash Inflows

For e.g. A project costs Rs1, 00,000 and yields an annual cash inflow of
Rs. 20,000 for 8 years. Calculate its pay back period.

Cash outlay of the project or original cost of the asset

Pay back period =
Annual cash Inflows

= 1,00,000 = 5 years

20,000

ADVANTAGES OF PAY BACK PERIOD

1. It is simple to understand and easy to calculate.

2. It saves in cost; it requires lesser time and labor as compared to other methods of
capital budgeting.
3. This method is particularly suited to firm, which has shortage of cash or whose
liquidity position is not particularly good.
DISADVANTAGES OF PAY BACK PERIOD

1. It does not take into account the cash inflows earned after the pay back period
and hence the true profitability of the project cannot be correctly assessed.
2. It ignores the time value of money and does not consider the magnitude and
timing of cash inflows. it treats all cash flows as equal though they occur in
different time periods.
3. It does not take into consideration the cost of capital, which is very important;
factor in making sound investment decision.
4. It treats each asset individually in isolation with other asset, which is not
feasible in real practice.
5. It does not measure the true profitability of the project, as the period
considered under this method is limited to a short period only and not the full
life of the asset.

2. RATE OF RETURN METHOD

This method take into account the earnings expected from the investment over their
whole life. It is known as accounting rate if Return method for the reasons that under this
method, the accounting Concept of profit is used rather than cash inflows. According to
this method, various projects are ranked in order of the rate of earnings or rate of return.
The project with the higher rate of return is selected as compared to the one with the
lower rate of return. This method can be used to make decisions as to accepting or
rejecting a proposal. The expected return is determined and the project with a higher rate
of return than the minimum rate specified by the firm called cut-off rate, is accepted and
the one which gives a lower expected rate of return than the minimum rate is rejected.

The return in investment can be used in several ways as follows:

 a) Average rate of return method:
Under this method average profit after tax and deprecation is calculated and than it is
divided by the total capital outlay or total investment in the project.

Average Rate of return =

Total Profits (after dep. & taxes)

X 100
Net Investment in project x No. Of years of profits

OR

Average annual profit

X 100

Net investment in the Project

For e.g. A project require an investment of Rs.5,00,000 and has a scrap

value of Rs.20,000
After 5 years. It is expected to yield profits after depreciation and taxes
during the 5 years amounting to rs. 40,000. Rs. 60,000, Rs. 70,000, Rs.
50,000 and Rs.20,000. Calculate the average rate of return on the
investment.

Total profits = Rs. 40,000+60,000+70,000+50,000+20,000 = Rs.

2,40,000

Rs. 2,40,000
= Rs.48, 000
 Average Profit =
5

Net Investment in the project = Rs. 5,00,000 – 20,000(scrap value)

= Rs 4,80,000

Average annual profit

X 100

Net investment in the Project

48000
X 100 = 10%
4,80,000

b) Return per unit of investment method: This method is small

variation of the average rate of return method. In this method, the
total profit after tax and depreciation is divided by the total
investment i.e.

Total profit (after depreciation and tax)

Return Per Unit of Investment = X
100
Net investment in the project

For e.g. Continuing above e.g., the return per unit of investment shall
 2,40,000
X 100 = 50%
4,80,000

c) Return on average Investment method:

In this method the return on average investment is calculated. Using of average

investment for the purpose of return in investment is referred because the original
investment is recovered over the life of the asset on account of depreciation
charges.

Total profit after depreciation and tax

Return on average Investment = X 100

Total net Investment

ADVANTAGES OF RATE OF RETURN METHOD

1. It is very simple to understand and easy to operate.

2. This method is based upon the accounting concept of profits, it can be readily
calculated from the financial data.
3. It uses the entire earnings of the projects in calculating rate of return.

DIS ADVANTAGES OF RATE OF RETURN METHOD

1. It does not take into consideration the cash flows, which are more important
than the accounting profits.
2. It ignores the time value of money as the profits earned at different points
of time are given the equal weighs.
II. TIME ADJUSTED OR DISCOUNTED CASH
FLOWS METHODS:

The traditional methods of capital budgeting suffer from serious limitations that
give the equal weights to present and future flow of income. These does not
take into accounts the time value of money. Following are the discounted cash
flow methods:

1. NET PRESENT VALUE METHOD

This method is the modern method of evaluating the investment proposals. This
method takes into consideration the time value of money and attempts to calculate
the return in investments by introducing the factor of time element. It recognizes
the fact that a rupee earned today is more valuable earned tomorrow. The net
present value of all inflows and outflows of cash occurring during the entire life
of the project is determined separately for each year by discounting these flows by
the firm’s cost of capital.

Following are the necessary steps for adopting the net present value method of
evaluating investment proposals.

1. Determine appropriate rate of interest that should be selected as the

minimum required rate of return called discount rate.
2. Compute the present value of total investment outlay.
3. Compute the present value of total investment proceeds.
4. Calculate the net present value of each project by subtracting the present
value of cash inflows from the present value of cash outflows for each
project.
5. If the net present value is positive or zero, the proposal mat be accepted
otherwise rejected.
ADVANTAGES OF NET PRESENT VALUE

1. It recognizes the time value of money and is suitable to be applied in situations

with uniform cash outflows and cash flows at different period of time.
2. It takes into account the earnings over the entire life of the projects and the true
profitability of the investment proposal can be evaluated.
3. It takes into consideration the on\objective of maximum profitability.

DISADVANTAGES OF NET PRESENT VALUE

1. This method is more difficult to understand and operate.

2. It is not easy to determine an appropriate discount rate.
3. It may not give good results while comparing projects with unequal
lives and investment of funds.

2 INTERNAL RATE OF RETRN METHOD

It is a modern technique of capital budgeting that takes into account the time value of
money. It is also known as “time adjusted rate of return discounted cash flows” “yield
method” “trial and error yield method”

Under this method, the cash flows of the project are discounted at a suitable rate by hit
and trial method, which equates the net present value so calculated to the amount of the
investment. Under this method, since the discount rate is determined internally, this
method is called as the internal rate of return method. It can be defined as the rate of
discount at which the present value of cash inflows is equal to the present value of cash
outflows.
Steps required practicing the internal rate of return.

1. Determine the future net cash flows during the entire economic life of the
project. The cash inflows are estimated for future profits before
depreciation and after taxes.
2. Determine the rate of discount at which the value of cash inflows is equal
to the present value of cash outflows.
3. Accept the proposal if the internal rate of return is higher than or equal to
the minimum required rate of return.
4. In case of alternative proposals select the proposals with the highest rate of
return as long as the rates are higher than the cost of capital.

DETERMINATION OF INTERNAL RATE OF RETURN

1. When the annual net cash flows are equal over the life of the
assets.

Initial outlay
Present value Factor =
Annual cash Flows

2. when the annual net cash flows care Unequal over the life of the

assets.

Following are the steps

  Prepare the cash flow table using an arbitrary assumed discount rate to
discount the net cash flows to the present value.
 Find out the net present value by deducting from the present value of total
cash flows calculated in above the initial cost of the investment
 If the NPV is positive, apply higher rate of discount.
 If the higher discount rate still gives a positive NPV, increase the discount
rate further the NPV becomes become negative.
 If the NPV is negative at this higher rate, the internal rte of return must be
between these two rates.

ADVANTAGES OF INTERNAL RATE OF RETURN METHOD:

1. It takes into account the time value of money and can be usefully
applied in situations with even as well as uneven cash flows at
different periods of time.
2. It considers the profitability of the project for its entire economic
life.
3. It provides for uniform ranking of various proposals due to the %
rate of return.

DISADVANTAGES OF INTERNAL RATE OF RETURN METHOD:

1. It is difficult to understand.
2. This method is based upon the assumption that the earnings are reinvested at the
internal rate of return for the remaining life of the project, which is not a justified
assumption particularly when the rate of return earned by the firm is not close ton
the internal rate of return.
3. The result of NPV and IRR method may differ when the project under evaluation
differ their size.
 RISK AND UNCERTANITY IN CAPITAL BUDGETING

All the techniques of capital budgeting require the estimation of future cash inflows and
cash outflows. But due to uncertainties about the future, the estimates if demand,
production, sales cannot be exact. All these elements of uncertainty have to be taken into
account in the form of forcible risk while taking a decision on investment6b proposals.
The following two methods are suggested for accounting for risk in capital budgeting.
1. Risk adjusted cut off rate or method of varying discount rate.
2. Certainty equivalent method.

Risk adjusted cut off rate or method of varying discount rate: the simplest method foe
accounting for risk in capital budgeting is to increase the cut-off rate or the discount
factor by certain % on account of risk. The projects which are more risky and which have
greater variability in expected returns should discounted at higher rate as compared to the
projects which are less risky and are expected to have lesser variability in returns.

The greater drawback of this method is that it is not possible to determine the risk
premium rate appropriately and moreover it is the future cash flow, which is uncertain
and requires the adjustment and not the discount rate.
For e.g. The Beta Company Is considering the purchase of new
investment. Two alternatives investments are available (A and B) Rs.1,
00,000. Cash flows are expected to be as follows:

CASH FLOWS

YEAR INVESTMENT INVESTMENT

A (Rs) B(Rs)

1 40,000 50,000
2 35,000 40,000
3 25,000 30,000
4 20,000 30,000

The company has a target return on capital at 10%. Risk premium

rates are 2% and 8%. For investments A and B. which investments
should be preferred?

Solution:
 The profitability of the investments can be compared on the basis of net present
values cash inflows adjusted for risk premiums rate as follows:

Year Investment Investment

A B

Discount Cash Present Discount Cash Present

Factor@ Inflows Value Factor@ Inflows Value
10%+2% Rs. Rs. 10%+8% Rs. Rs.
= 12% = 18%

1 .893 40,000 35,720 .847 50,000 42,350

2 .797 35,000 27,895 .718 40,000 28,720
3 .712 25,000 17,800 .609 30,000 18,270
4 .635 20,000 12,700 .516 30,000 15,480

94,115 1,04,820

Investment A Investment B

Rs 94,115-1,00,000 Rs. 1,04,820-1,00,000

Net Present Value = Rs(-) 5,885 = Rs. 4,820

As even at a higher discount rate investment B gives a higher present value, investment B
Should be preferred.

3. Certainty Equivalent Method:

Another simple method of accounting foe risk n capital budgeting is to reduce the
expected cash flows by certain amounts. It can be employed by multiplying the
expected cash flows by certainty equivalent co-efficient as to convert the cash floe
to certain cash flows.
For e.g. There are two projects X and Y. each involves an investment of
Rs40,000. The expected cash flows and the certainty co-efficient are as
under:

Project X Project Y

Year Cash Inflows Certainty Cash Inflows Certainty

Coefficient Coefficient

1 25,000 .8 20,000 .9

2 20,000 .7 30,000 .8

3 20,000 .9 20,000 .7

Risk free cut off rate is 10%. Suggest which of the two projects should
be preffered?
Solution :

Calculation of cash inflows with certainty

Project X Project Y

Yea Cash Inflows Certainty Certain Cash Certainty Certain

Coefficient Cash Inflow Inflows Coefficient Cash
flow

1 25,000 .8 20,000 20,000 .9 18,000

2 20,000 .7 14,000 30,000 .8 24,000

3 20,000 .9 18,000 20,000 .7 14,000

Calculations of Present Values of cash Inflows

 Project X Project Y

Year Discount Factor Cash inflows Present Values Cash inflows Present
Value
@10% Rs. Rs. Rs. Rs.

1 .909 20,000 18,180 18,000 16,362

2 .826 14,000 11,564 24,000 19,824

3 .751 18,000 13,518 14,000 10,514

46,700

Project X Project Y

Rs 43,262-40,000 Rs 46,700-40,000
Net Present Value Rs. 3262 Rs.6700

As the Net present value of project Y is more than that of Project X, Project Y should be
preferred.