strategic investment and financing decisons

Strategic Investment Strategic Investment & &

Financing DecisionsFinancing Decisions

UNIT - IVUNIT - IV

What is investment……..?What is investment……..?

An investment involves the outflow of cash at a An investment involves the outflow of cash at a point in time in order to obtain benefits in the point in time in order to obtain benefits in the future.future.

The inflows my be regular or irregular, but The inflows my be regular or irregular, but usually take place after the initial investment.usually take place after the initial investment.

Corporate investment involves large amounts Corporate investment involves large amounts of money so the investment decision require a of money so the investment decision require a through evaluation of proposals.through evaluation of proposals.

INVESTMENT INVESTMENT AAPPRPPRAAISISAAL L TECHNITECHNIQQUESUES

There are four commonly used techniques are four commonly used techniques for appraising capital investment projects:for appraising capital investment projects:

pay back periodpay back period

accounting rate of returnaccounting rate of return

net present valuenet present value

Internal rate of returnInternal rate of return

It is defined as “the number of years required It is defined as “the number of years required to recover the original cash outlay invested in to recover the original cash outlay invested in a project”.a project”.

Computation of Pay back period: Computation of Pay back period: The Pay The Pay back period can be calculated in two different back period can be calculated in two different situations.situations.

When annual cash inflows are equal:- When annual cash inflows are equal:- If the If the project generates constant annual cash project generates constant annual cash inflows, the payback period can be computed inflows, the payback period can be computed dividing cash outlay by the annual cash inflow. dividing cash outlay by the annual cash inflow. That is That is

PAY BACK PERIODPAY BACK PERIOD

Payback period = Payback period =

Initial Investment Initial Investment = = CoCo

Annual cash inflows CiAnnual cash inflows Ci

PAY BACK PERIODPAY BACK PERIOD

Dis-advantage of payback period:Dis-advantage of payback period:

Ignores time valve of money:-Ignores time valve of money:-It ignores the timing of the occurrence of the cash It ignores the timing of the occurrence of the cash

flows .it considers the cash flows occurring at different flows .it considers the cash flows occurring at different point of time as equal in money worth and ignores the point of time as equal in money worth and ignores the time value of money.time value of money.

Thus payback period rule, which only accounts for Thus payback period rule, which only accounts for cash flowscash flows resulting from an investment and does not resulting from an investment and does not take into account the time value of money take into account the time value of money

PAY BACK PERIODPAY BACK PERIOD

Therefore, the Therefore, the pay back period was pay back period was improved asimproved as Discounted pay back periodDiscounted pay back period Post pay backPost pay back Bailout pay backBailout pay back

Post pay back periodPost pay back period

The post payback period indicates the The post payback period indicates the returns receivable beyond the payback returns receivable beyond the payback period.period.

This method is also known as surplus This method is also known as surplus Surplus lifeSurplus life over payback period. over payback period.

These returns are called post payback These returns are called post payback profits.profits.

There are two methods to calculate the There are two methods to calculate the post pay back period. They arepost pay back period. They are

Methods of post payback period Methods of post payback period calculationcalculation

Post payback profitability indexPost payback profitability index

Pay back reciprocal methodPay back reciprocal method

Post payback profitability indexPost payback profitability index

Post payback profitability index =Post payback profitability index =

post payback profits post payback profits

* 100* 100

Investment Investment

Pay Back Reciprocal MethodPay Back Reciprocal Method

Pay back reciprocal method:Pay back reciprocal method: it is used to estimate the internal rate of it is used to estimate the internal rate of

return generated by a project.return generated by a project.

PBRM =PBRM = Annual cash inflow Annual cash inflow

Total investmentTotal investment

This can also be calculated in percentage by This can also be calculated in percentage by multiplying the above by 100multiplying the above by 100

Discounted Payback PeriodDiscounted Payback Period

A discounted payback period gives the number A discounted payback period gives the number of years it takes to break even from undertaking of years it takes to break even from undertaking the initial expenditure. the initial expenditure.

Future cash flows are considered are discounted Future cash flows are considered are discounted to time "zero." to time "zero."

This procedure is similar to a payback period; This procedure is similar to a payback period; however, the payback period only measure how however, the payback period only measure how long it take for the initial cash outflow to be paid long it take for the initial cash outflow to be paid back, ignoring the time value of money. back, ignoring the time value of money.

Discounted Payback PeriodDiscounted Payback Period

Projects that have a negative net present Projects that have a negative net present value will not have a discounted payback value will not have a discounted payback period, because the initial outlay will never period, because the initial outlay will never be fully repaid. be fully repaid.

This is in contrast to a payback period This is in contrast to a payback period where the gross inflow of future cash flows where the gross inflow of future cash flows could be greater than the initial outflow, could be greater than the initial outflow, but when the inflows are discounted, the but when the inflows are discounted, the NPV is negative. NPV is negative.

FormulaFormula

Discounted Payback period = Discounted Payback period =

Initial Investment Initial Investment

Discounted Discounted Annual cash inflows Annual cash inflows

The project which gives The project which gives a shorter is a shorter is acceptedaccepted

Bailout PaybackBailout Payback

Definition:Definition: In accounting, bailout payback period shows the In accounting, bailout payback period shows the

length of time required to repay the total initial length of time required to repay the total initial investment through investment cash flows investment through investment cash flows combined with salvage value. combined with salvage value.

The shorter the payback period, the more The shorter the payback period, the more attractive a company is.attractive a company is.

Bailout PaybackBailout Payback

That is, in the bailout payback method That is, in the bailout payback method payback period, one adds the salvage payback period, one adds the salvage value of an asset to the cash flow that value of an asset to the cash flow that asset generates to determine how long it asset generates to determine how long it will take for cash inflow to equal the will take for cash inflow to equal the cash outflowcash outflow of purchasing the asset. of purchasing the asset.

Bailout PaybackBailout Payback

The bailout payment method measures The bailout payment method measures the time that a project will take for the the time that a project will take for the cumulative cash flows from operations cumulative cash flows from operations plus the disposal value of the equipment in plus the disposal value of the equipment in a particular period to equal the initial a particular period to equal the initial investment.investment.

The bailout payback is a useful risk The bailout payback is a useful risk indicator.indicator.

Bailout PaybackBailout Payback

A way to include the A way to include the salvage valuesalvage value in the in the calculation of calculation of cash flowcash flow. That is, in the . That is, in the bailout payback method payback period, bailout payback method payback period, one adds the salvage value of an asset to one adds the salvage value of an asset to the cash flow that asset generates to the cash flow that asset generates to determine how long it will take for cash determine how long it will take for cash inflow to equal the inflow to equal the cash outflowcash outflow of of purchasing the asset.purchasing the asset.

Return On InvestmentReturn On Investment

What Does What Does Return On Return On Investment - ROIInvestment - ROI Mean? Mean?

It is also called as “average (or) accounting rate of It is also called as “average (or) accounting rate of return, or return on capital employed (or) return, or return on capital employed (or) DupontDupont SystemSystem..

A performance measure used to evaluate the efficiency A performance measure used to evaluate the efficiency

of an investment or to compare the efficiency of a of an investment or to compare the efficiency of a number of different investments. number of different investments.

To calculate ROI, the benefit (return) of an investment is To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is divided by the cost of the investment; the result is expressed as a percentage or a ratio.expressed as a percentage or a ratio.

The return on investment formulaThe return on investment formula11

In the above formula "gains from investment", In the above formula "gains from investment", refers to the proceeds obtained from selling the refers to the proceeds obtained from selling the investment of interest.investment of interest.

Return on investment is a very popular metric Return on investment is a very popular metric because of its versatility and simplicity. because of its versatility and simplicity.

That is, if an investment does not have a positive That is, if an investment does not have a positive ROI, or if there are other opportunities with a ROI, or if there are other opportunities with a higher ROI, then the investment should be not higher ROI, then the investment should be not be undertaken.be undertaken.

The return on investment formulaThe return on investment formula22

ROI = ROI =

PROFIT PROFIT ** SALESSALESSALESSALES CAPITAL EMPLOYEDCAPITAL EMPLOYED

(OR)(OR)

Net incomeNet income capital employedcapital employed

Equivalent Annual Equivalent Annual CostCost

Equivalent Annual CostEquivalent Annual Cost In finance the In finance the equivalent annual costequivalent annual cost (EAC) is (EAC) is

the cost per year of owning and operating an the cost per year of owning and operating an asset over its entire lifespan.asset over its entire lifespan.

It is used to describe how much money per year It is used to describe how much money per year an investment or asset costs the owner over the an investment or asset costs the owner over the life span of that asset.life span of that asset.

It is an important decision enabling financial It is an important decision enabling financial analysis tool to ascertain cost per annum of analysis tool to ascertain cost per annum of owning and operating an asset or investment, owning and operating an asset or investment, based on its full life time. based on its full life time.

Equivalent Annual CostEquivalent Annual Cost This method is useful when comparing the This method is useful when comparing the

yearly cost of an investment that cover different yearly cost of an investment that cover different periods of time.periods of time.

EAC is often used as a decision making tool in capital EAC is often used as a decision making tool in capital budgeting when comparing investment projects of budgeting when comparing investment projects of unequal lifespans. unequal lifespans.

For example if project A has an expected lifetime of 7 For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present it would be improper to simply compare the net present values (NPVs) of the two projects, unless neither project values (NPVs) of the two projects, unless neither project could be repeated.could be repeated.

Equivalent Annual CostEquivalent Annual Cost

Thus, equivalent annual cost is determined by Thus, equivalent annual cost is determined by considering the base price for the asset and the considering the base price for the asset and the anticipated costs for maintenance and operation anticipated costs for maintenance and operation and dividing them by the number of years the and dividing them by the number of years the asset can be expected to be in service.asset can be expected to be in service.

The use of the EAC method implies that the The use of the EAC method implies that the project will be replaced by an identical project.project will be replaced by an identical project.

Calculation of EACCalculation of EAC

Total present value of the Total present value of the projectproject

EAC =EAC =

Pv of annuity corresponding to Pv of annuity corresponding to the life of the project at the given cost of the life of the project at the given cost of capitalcapital

TERMINAL VALUE TERMINAL VALUE METHODMETHOD

Terminal valueTerminal value

In a discounted cash flow valuation, the cash In a discounted cash flow valuation, the cash flow is projected for each year into the future for flow is projected for each year into the future for a certain number of years after which unique a certain number of years after which unique annual cash floes can not be forecasted with annual cash floes can not be forecasted with reasonable accuracy.reasonable accuracy.

At that point rather than attempting to forecast At that point rather than attempting to forecast the varying cash flow for each individual year the varying cash flow for each individual year one uses a single value representing the one uses a single value representing the discounted value of all subsequent cash flows.discounted value of all subsequent cash flows.

This single value is referred to as the terminal This single value is referred to as the terminal value. value.

Terminal value methodTerminal value method

In finance, the In finance, the terminal valueterminal value (continuing (continuing value or horizon value) of a security is the value or horizon value) of a security is the present value present value at a future point in timeat a future point in time of all of all future cash flows when we expect stable future cash flows when we expect stable growth rate forever. growth rate forever.

The terminal value is calculated in The terminal value is calculated in accordance with a stream of projected accordance with a stream of projected future free cash flows in discounted cash future free cash flows in discounted cash flow analysis. flow analysis.

Where:TV = the total amountP = the principal amountr = interest ratet = period of time

The formula to calculate terminal is the same as that for compound interest:

Single Period Capital ConstraintsSingle Period Capital Constraints The simplest capital rationing situation is one in which The simplest capital rationing situation is one in which

the expenditure constraint lasts for a single period only.the expenditure constraint lasts for a single period only. The easiest way of selecting projects, assuming thy are The easiest way of selecting projects, assuming thy are

of similar risk, for inclusion in a limited budget is to rank of similar risk, for inclusion in a limited budget is to rank them in descending order of attractiveness, then to them in descending order of attractiveness, then to accept the projects from the top of the list and work accept the projects from the top of the list and work down until the funds are exhausted.down until the funds are exhausted.

Mutually exclusive projects are handled by breaking Mutually exclusive projects are handled by breaking into a basis project and supplementary projects. into a basis project and supplementary projects.

However, there are a number of ways of ranking However, there are a number of ways of ranking projects, and these do not always give the same projects, and these do not always give the same results.results.

Multi period capital constraintMulti period capital constraint The cost of a certain investment projects may be spread The cost of a certain investment projects may be spread

over several years.over several years.

Thus, we must consider more than just a one period Thus, we must consider more than just a one period constraint, with a multi period analysis.constraint, with a multi period analysis.

multi-period models can be thought of simply as a series multi-period models can be thought of simply as a series of single-period models linked by dynamic constraints or of single-period models linked by dynamic constraints or "equations of motion" that link the periods. "equations of motion" that link the periods.

These linking flows can incorporate any multi-period These linking flows can incorporate any multi-period phenomena: capital accumulation, growth in livestock phenomena: capital accumulation, growth in livestock herds, harvesting forests, and degradation of the herds, harvesting forests, and degradation of the environment. environment.

The development of the multi-period model proceeds in The development of the multi-period model proceeds in several stages. several stages.

With the exception of the first, each is a possible With the exception of the first, each is a possible stopping point in the construction of an operational stopping point in the construction of an operational model.model.

By breaking down the whole into a series of parts, it will By breaking down the whole into a series of parts, it will be easier to assimilate the rather substantial be easier to assimilate the rather substantial accumulation of variables and equations shown in the accumulation of variables and equations shown in the final version of the model. final version of the model.

There are a number of possible extensions, not all of There are a number of possible extensions, not all of which have been included in the discussion below. which have been included in the discussion below.

(1) Using Excel to create a basic multi-period (1) Using Excel to create a basic multi-period model model

(2) Adding capital constraints and consumption (2) Adding capital constraints and consumption variables.variables.

(3) Adding capital and labor markets to (3) Adding capital and labor markets to simulate opening the household to trade.simulate opening the household to trade.

(3) Extending the model to include a marginal (3) Extending the model to include a marginal propensity to consume income and a capital propensity to consume income and a capital market market

Mean-Variance AnalysisMean-Variance Analysis

Mean-Variance AnalysisMean-Variance Analysis

The process of portfolio selection that assumes The process of portfolio selection that assumes that every rational investor, at a given level of that every rational investor, at a given level of risk, will accept only the largest expected return. risk, will accept only the largest expected return.

More specifically, mean-variance analysis More specifically, mean-variance analysis attempts to account for risk and expected return attempts to account for risk and expected return mathematically to help the investor find a mathematically to help the investor find a portfolio with the maximum return for the portfolio with the maximum return for the minimum about of risk. minimum about of risk.

Hertz simulation modelHertz simulation model DAVID B. HERTZ DAVID B. HERTZ proposed the use of a simulation proposed the use of a simulation

model obtain the expected return and dispersion about model obtain the expected return and dispersion about this expected return for an investment proposal.this expected return for an investment proposal.

The technique is sometimes descriptively called the The technique is sometimes descriptively called the method of statistical trails.method of statistical trails.

it involves first the random selection of an outcome for it involves first the random selection of an outcome for each variable (element) of interest.each variable (element) of interest.

The combining of these outcomes with any fixed The combining of these outcomes with any fixed amounts and calculation if necessary to obtain one trail amounts and calculation if necessary to obtain one trail outcome in terms to the measure of merit.outcome in terms to the measure of merit.

The key requisite of the simulation technique is The key requisite of the simulation technique is that the outcomes of all variables of interest be that the outcomes of all variables of interest be randomly selected. (i.e., that the probability of randomly selected. (i.e., that the probability of selection of all possible outcomes be in exact selection of all possible outcomes be in exact accord with their respective probability accord with their respective probability distributions.distributions.

This is accomplished through the use of random This is accomplished through the use of random numbers and relating these numbers to the numbers and relating these numbers to the distributions of the variables.distributions of the variables.

Random numbers are numbers which Random numbers are numbers which have been generated in such a way that have been generated in such a way that there is an equal probability of any number there is an equal probability of any number appearing each time, regardless of what appearing each time, regardless of what sequence is experienced at any prior time.sequence is experienced at any prior time.

Hiller approachHiller approach

Hiller combines the assumption of mutual Hiller combines the assumption of mutual independence and perfect correlation in independence and perfect correlation in developing a model to deal with mixed developing a model to deal with mixed situations.situations.

The model enable the analysis of The model enable the analysis of investment proposal in which some of the investment proposal in which some of the expected cash flows over time are closely expected cash flows over time are closely related and others are fairly independent.related and others are fairly independent.

Hiller approachHiller approach

Two cases of such analysis are:Two cases of such analysis are: Un correlated cash flowsUn correlated cash flows Perfectly correlated cash flowsPerfectly correlated cash flows

Un correlated cash flowsUn correlated cash flows

in this case the expected net present value and in this case the expected net present value and the standard deviation of net present value the standard deviation of net present value are defined as follows:are defined as follows:

When the cash of different years are When the cash of different years are uncorrelated, the cash flow year uncorrelated, the cash flow year t t is is independent of the cash flow for year t – m.independent of the cash flow for year t – m.

Perfectly correlated cash flowsPerfectly correlated cash flows