Unit - 2 (Investment Decisions)

Financial Management Unit - 2

THE INVESTMENT DECISION

Introduction

An efficient allocation of capital is the most important finance function in the modern times. It involves decisions to commit the firm’s funds to the long term assets. Capital budgeting or investment decisions are of considerable importance to the firm since they tend to determine its value by influencing its growth, profitability and risk.

Capital Budgeting

The investment decisions of a firm are generally known as the capital budgeting or capital expenditure decisions. A capital budgeting decision may be defined as the firms decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. The long term assets are those that affect the firm’s operations beyond the one year period. The firm’s investment decisions would generally include expansion, acquisition, modernization and replacement of the long term assets.

Capital budgeting may also be defined as “The decision making process by which a firm evaluates the purchase of major fixed assets.”

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The term 'Capital Budgeting' is used interchangeably with capital expenditure management, capital expenditure decision, long term investment decision, management of fixed assets, etc. It may be defined as “planning, evaluation and selection of capital expenditure proposals”. Capital budgeting involves a current outlay or serves as outlays of cash resources in return for an anticipated flow of future benefits.

Lynch - "Cash budgeting consists in planning, development of available capital for the purchase of maximizing the long term profitability in the concern”.

Opportunity cost of capital

The investments should be evaluated on the basis of a criterion, which is compatible with the objective of the shareholders wealth maximization. An investment will add to the shareholders wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of capital.

In other words, the system of capital budgeting is employed to evaluate expenditure decisions which involve current outlays, but likely to produce benefits over a period of time longer than one year. These benefits may be either in the form of increased revenue or reduction in costs. Capital expenditure management therefore includes addition, disposition, modification and replacement of fixed assets. The basic features of capital budgeting are:

1. Potentially large anticipated benefits; 2. A relatively high degree of risk and3. A relatively long time period between initial outlay and anticipated returns.

Fixed assets are frequently termed as earning assets of the firm in the sense that they usually generate large return. Future sales growth is correlated with expansion of capital expenditure. It is a specialized process requiring highly sophisticated techniques and intricate forecasting for future years. Closely scrutinized capital expenditure selections result in increased sales, profits, dividends and ultimately share price value of the firm.

Importance

Capital budgeting is of paramount importance in financial decision making. Special care should be taken in making these decisions on account of the following reasons:

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1. Such decisions affect the profitability of the firm. They also have bearing on the competitive position of the enterprise. This is mainly because of the fact that they relate to fixed assets. The fixed assets represent in a sense, the true earning assets of the firm. They enable the firm to generate finished goods that can ultimately be sold for a profit. However, current assets are not generally earning assets. They provide a buffer that allows the firm to make sales and extend credit. Capital budgeting decisions determine the future destiny of the company. An opportune investment decision can yield spectacular returns. On the other hand an ill-advised and incorrect investment decision can endanger the very survival even of large sized firms. A few wrong decisions and a firm can be forced into bankruptcy. Capital budgeting is of utmost importance to avoid over-investment and under-investment in fixed assets.

2. A capital expenditure decision has its effect over a long time span and inevitably affects the company's future cost structure. To illustrate, if a particular plan has been purchased by a company to start a new product, the company commits itself to a sizable amount of fixed assets in terms of supervisors, salary, insurance, rent of buildings and so on. If the investment in future turns out to be unsuccessful or yields less profit than anticipated, the firm will have to bear the burden of fixed costs unless it writes off the investment completely. In short, a firm's future costs, break-even point, sales and profits will all be determined by the firm's selection of assets i.e., capital budgeting.

Long term investment decisions are more difficult to take because:

Decision extends to a series of years and beyond the current accounting period;

Uncertainties of future and Higher degree of risk

3. Capital investment decision once made is not easily reversible without much financial loss to the firm. It is because there may be no market for second hand plant and equipment and their conversion to other uses may not be financially feasible.

4. Capital investment involves cost and the majority of the firms have scarce capital resource. This underlines the need for thoughtful, wise and correct investment decisions as an incorrect decision would not only result in losses but also prevent the firm from earning profits from other investments which could not be undertaken for want of funds.

5. Over / under capacity: To improve timing and quality of asset acquisition, the capital expenditure decision must be carefully drawn. If the firm has

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invested too much in assets, it will incur unnecessary heavy expenditure. If it has not spent enough on fixed assets, two serious problems may arise

(i) The firm’s equipment may not be sufficiently modern to enable it to produce competitively.

(ii) If it has inadequate capacity it may lose a portion of its share of market to its rival firm. To regain lost customers it would require heavy selling expenses, price reduction, product improvement, etc.

6. Investment decision though taken by individual concerns is one of national importance because it determines employment, economic activities and economic growth.

Capital Budget Decision

Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals. Basically the firm may be confronted with three types of capital budgeting decisions.

1. Accept / Reject decision: This is the fundamental decision in capital budgeting. If the project is accepted, the firm invests in it. If the proposal is rejected the firm does not invest. In general all those proposals which yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected. By applying this criterion, all independent projects are accepted. Independent projects are projects that do not compete with one another in such a way that acceptance of one preclude the possibility of acceptance of another. Under the acceptance decision, all the independent projects that satisfy the minimum investment criteria are implemented.

2. Mutually exclusive project decision: Mutually exclusive projects are projects which compete with other projects in such a way that the acceptance of one will exclude the acceptance of other projects. The alternatives are mutually exclusive and only one may be chosen. It may be noted that the mutually exclusive project decisions are not independent of accept / reject decision. Mutually exclusive investment decisions acquire significance when more than one proposal is acceptable under the accept / reject decision. Then some techniques have to be used to determine the best one. The acceptance of 'best' alternative automatically eliminates the other alternatives.

3. Capital rationing decision: In a situation where the firm has unlimited funds, capital budgeting becomes a very simple process. In that,

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independent investment proposals yielding a return greater than some predetermined level are accepted. However, this is not the situation prevailing in most of the business firms of real world. They have fixed capital budget. A large number of investment proposals compete in these limited funds. The firm allocates funds to projects in a manner that it maximizes long run returns. Thus capital rationing refers to the situation where the firm has more acceptable investments requiring a greater amount of finance than is available with the firm. It is concerned with the selection of a group of investment proposals acceptable under the accept / reject decision. Ranking of the investment project is employed. In capital rationing, projects can be ranked on the basis of some predetermined criterion such as the rate of return .The project with highest return is ranked first and the acceptable projects are ranked thereafter.

Importance of Investment Decisions / Capital Budgeting Decisions

1. They influence the firm’s growth in the long run

2. They affect the risk of the firm

3. They involve commitment of large amount of funds

4. They are irreversible, or reversible at substantial loss

5. They are among the most difficult decisions to make

Growth: The effects of investment decisions extend into the future and have to be endured for a longer period than the consequences of the current operating expenditure. Unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm.

Risk: A long term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky.

Funding: Investment decisions generally involve large amount of funds which make it necessary for the firm to plan its investment programmes very carefully and make an advance arrangement for procuring finances internally or externally.

Irreversibility: Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. Investment decisions once made cannot be reversed or may be reversed but at a substantial loss.

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Complexity: Another important characteristic feature of capital investment decision is that it is the most difficult decision to make. Such decisions are an assessment of future events which are difficult to predict. It is really a complex problem to correctly estimate the future cash flow of an investment.

Kinds of Capital Budgeting Proposals

1. Replacement / modification of fixed assets: e.g. worn out, obsolete are replaced at appropriate time.

2. Expansion: involves an addition of capacity to existing production facilities.

3. Modernization of investment expenditure: They make it easier for a firm to reduce cost and may coincide with replacement decision.

4. Strategic investment proposal: These are capital budgeting decisions which do not assume that the return will be immediate or measured over a long period of time. Strategic investments are defensive, offensive and mixed motive decision. The vertical integration of a firm is an example of defensive investment in which a continuous source of raw materials is assumed. Horizontal combinations are offensive investments for they ensure a firm's internal and external growth respectively. Mixed motive investments are outlays on research and development programmes.

5. Diversification of business: Means operating in several markets or firm one market into another market. It may even amount to changing product lines.

6. Research and development: Where the technology is rapidly changing, research and development area is a continuous activity in any firm. Usually large sums of money are invested in research and development activities which lead to capital budgeting decisions.

1. Expansion of existing business

2. Expansion of new business

3. Replacement and modernization

4. Expansion and Diversification: Generally expanding the firm’s capacity to produce more output will accommodate high operational efficiency.

Related expansion / diversification: A company may add capacity to its existing product lines to expand existing operations.

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Unrelated diversification: A firm may expand its activities in a new business. Expansion of a new business requires investment in new products and a new kind of production activity within the firm.

Revenue expansion investments: Sometimes a company acquires existing firms to expand its business. In either case, the firm makes investment in the expectation of additional revenue.

Replacement and Modernization: The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Cost savings will reflect in the increased profits, but the firm’s revenue may remain unchanged. Assets become outdated and obsolete with technological changes. The firm must decide to replace those assets with new assets that operate more economically.

If a certain company changes form semi-automatic equipment to fully automatic drying equipment, it is an example of modernization and replacement. These are also called cost reduction investment.

Mutually exclusive investments: Mutually exclusive investments serve the same purpose and compete with each other. If one investment is undertaken, others will have to be excluded. A company may, for example, either use a labour intensive production method or capital intensive production method choosing capital intensive production method will preclude labour intensive production method.

Independent investments: Independent investments serve different purposes and do not compete with each other. Depending on their profitability and availability of funds, the company can undertake both investments.

For example, Mahindra & Mahindra can manufacture two wheelers as well as four wheelers.

Contingent Investments: Contingent investments are dependent projects the choice of one investment necessitates undertaking one or more other investments.

For example, if a company decides to build a factory in a remote, backward area, it may have to invest in houses, roads, hospitals, schools etc. for employees to attract the work force.

Investment Decision Process

The allocation of investible funds to different long term assets is known as capital budgeting decisions. Capital budgeting is a complex process which may be divided into five broad phases.

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1. Project generation

2. Project evaluation

3. Project selection

4. Project implementation

5. Controlling and review

1. Project generation: The planning phase of a firm’s capital budgeting process is concerned with the circulation of its broad investment strategy and the generation and preliminary screening project proposals.

The investments strategy of the firm delineates the broad areas or types of investments the firm plans to undertake. This provides the framework which shapes and guides the identification of individual project opportunities.

2. Project evaluation: If the preliminary screening suggests that the project is prima facie worthwhile, a detailed analysis of the marketing technical, financial, economic and ecological aspects is undertaken. The questions and issues raised in such a detailed analysis are described in the following section.

The focus of this phase of capital budgeting is on gathering, preparing and summarizing relevant information about various project proposals which are being considered for inclusion in the capital budget. Based on the information developed in this analysis, the stream of costs and benefits associated with the project can be defined.

3. Project selection: Selection follows an often overlaps, analysis. It addresses the questions. Is the project worthwhile? A wide range of appraisal criteria have been suggested to judge to worthwhile of a project. They are divided into two broad categories: Non-discounting criteria and Discounting criteria.

The principle in non-discounting criteria is the payback period and the accounting rate of return.

The key discounting criteria are the net present value, the internal rate of return and profitability index.

To apply the various appraisal criteria suitable cut off values have to be specified. These are essentially a function for the fix of financing and the level of project risk while the former can be defined with relative case; the latter truly tests the liability of the project evaluation.

4. Project implementation:

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The implementation phase for an industrial project which involves setting up of manufacturing facilities consists of several stages.

Stage Concerned with

Project and engineering design

Site probing and prospecting, preparation of blue prints and plant designs, plant engineering selection of specific machines and equipment.

Negotiation and contracting

Negotiating and drawing up of legal contracts with respect to project financing, acquisition of technology, supply of machinery and know-how and marketing arrangements.

Construction Site preparation, construction of buildings and civil work, erection and installation of machinery and equipment.

Training Training of engineers, technicians and workers.

Plant commissioning Startup of the plant.

5. Project Review: Once the project is commissioned the review phase has to be set in motion. Performance review should be done periodically to compare actual performance with projected performance. A feedback device, it is useful in several ways,

1. It throws light on how realistic were the assumptions underlying the project.

2. It provides a documented long of experience that is highly valuable in future decision making.

3. It suggests corrective action to be taken in the light of the actual performance.

Steps involved in Feasibility study

The available capital must be used in a manner which is consistent with the overall socio economic objectives. This becomes more difficult when there are several competing projects, each giving a rate of return higher than the minimum cut off rate.

Project appraisal may be defined as a detailed evaluation of the project to determine the technical feasibility, economic feasibility, financial feasibility and managerial competence.

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Project feasibility study or appraisal consists of the following:

1. Technical feasibility

2. Economic feasibility

3. Financial feasibility

4. Managerial competence

5. Market feasibility

1. Technical feasibility:

A project must be technically feasible. This can be judged by a detailed assessment of the following factors.

a. Technology used: The technology used has been tested and suits the local conditions. The technical study helps us to know how is available and technical collaborators are persons of good reputation.

b. Plant and equipment: The supplier of plant equipment needed for the projects are of experience and reputation. Plant layout is in accordance with the production flow programme.

2. Economic and social feasibility:

Economic feasibility analysis is also referred to as a social cost benefit analysis which is concerned with judging a project from the larger social point of view but not in monetary terms. In such an evaluation, the focus is on the social costs and benefits of a project which may often be different from the monetary costs and benefits to the firm.

a. The extent to which, the project is expected to contribute to national development.

b. The project can bring about the development in that area.

c. The project will create more employment.

d. The atmospheric and other pollutants could be contained.

3. Financial Feasibility:

Financial appraisal is done to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt and whether the proposed project will satisfy the return expectations of those who provide capital. While appraising a project financially, the following aspects should be kept in mind.

a. Cost of project: The estimates of the project should cover all items expenditure and should be realistic.

b. Sources of finance: Sources of finance contemplated by the promoters should be adequate and necessary finance should be available during

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installation. Factors to be considered while evaluating project on financial criteria:

1. Investment outlay or cost of project

2. Means of financing

3. Projected profitability

4. Break-even point

5. Cash flows of the project

6. Level of risk

4. Managerial competence:

The technical competence, administrative ability, integrity and resourcefulness of borrowing concerns top managerial personnel determines to a great extent the willingness of a financial institutional to accept a term loan proposal.

The loan application from firms having competent and honest management finds favorable considerations. It can therefore be stated that the appraisal of the managerial competence is of primary importance in the overall appraisal of a project.

5. Market feasibility:

Market appraisal is concerned with two questions.

1. What would be the aggregate demand of the proposed product/service in future?

2. What would be the market share of the project under appraisal?

In order to answer these questions a market analyst requires a wide variety of information and suitable forecasting methods.

The information required includes,

a. Past and present consumption trends, consumer behavior and preferences.

b. Past and present supply position

c. Production constraints

d. Imports and exports

e. Structure of competition

f. Cost structure and marketing policies

Capital Budgeting Techniques:

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The most important techniques used in capital budgeting are,

Traditional Methods:

1. Payback Period Method

2. Accounting Rate of Return/Average Rate of Return Method

Discounted Cash Flow Methods:

3. Net Present Value Method

4. Internal Rate of Return Method

1. Payback Period Method: Payback period method is the simplest method of evaluating investment proposals. Payback period represents the number of years required to recover the original investment. The payback period is also called payoff or payout. This period is calculated by dividing the cost of the project by the annual earnings after tax but before depreciation. Under this method project with shortest payback period will be given the highest rank and taken as best investment.

It is a traditional method of capital budgeting. It is the simplest and most widely employed quantitative method for appraising capital expenditure decisions. This method answers the question - how many years will it take for cash benefits to pay the original cost of an investment normally disregarding salvage value. Cash benefits here represent cash flow after tax (CFAT) technique to pay back the original outlay required in an investment proposal.

There are two ways of calculating the payback period. The first method can be applied when the cash flow stream is in the nature of annuity for each year of project's life, for cash flow adjusted techniques are uniform. In such a situation the initial cost of investment is divided by the constant annual cash flow. The second method is used when a project's cash flows are not

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Methods of Capital

Budgeting

Non-Discounting

Methods

Payback Method

Accounting Rate of Return (ARR)

Discounting Methods

Net Present Value (NPV)

Internal Rate of Return (IRR)


equal, but vary from year to year. In such a situation payback is calculated by the process of accumulating cash flows till the time when cumulative cash flows are equal to original investment outlay.

Accept / Reject criterion:

The payback period can be used as a decision criterion to accept or reject an investment proposal. One application of this technique is to compare the actual payback period with a predetermined payback i.e., the payback set up by the management. If the actual payback period is less than the predetermined payback, the project will be accepted. If not, it will be rejected. Alternatively the payback can be used as a rationing method. When mutually exclusive projects are under one consideration, they may be ranked according to the length of payback period. Thus the project having the shortest payback may be assigned rank one followed in the order so that the project with longest payback might be ranked last. The term mutually exclusive refers to the proposals out of which only one can be accepted. Obviously project with shorter payback period will be selected.

Payback period = Original cost of the project

Annual cash inflow

Advantages:

1. Simple to understand and easy to calculate.

2. It reduces the chance of loss. As the project with a short payback period is preferred.

3. A firm which has shortage of funds finds this method very useful.

4. This method costs less as it requires only very little effort for its computation.

Disadvantages:

1. This method does not take into consideration the cash inflows beyond the payback period.

2. It does not consider the time value of money.

3. It gives over emphasis to liquidity.

4. The first major shortcoming of payback method is that it ignores all cash inflows after the payback period. This could be very misleading in capital budgeting valuation.

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5. Another deficiency of payback method is that it does not measure correctly even the cash flows expected to be received within the payback period as it does not differentiate between projects in terms of timing or magnitude of cash flows. It considers only the recovery period as a whole. This happens because it does not discount the future cash inflows but rather treats a rupee received from second or third year as valuable as a rupee received from first year. In other words, to the extent that payback method fails to consider the pattern of cash inflows, it ignores the time value of money.

6. Another failure of the payback method is that it does not take into consideration the entire life of the project during which cash flows are generated. As a result the project with large inflows in the later part of their lives may be rejected in favor of less profitable projects which happen to generate a larger proportion of their cash inflows in the earlier part of their lives.

7. It does not reflect all the relevant dimensions of profitability.

2. Accounting Rate of Return/Average Rate of Return Method:

This method is based on accounting profit, takes into account the earnings expected from the investment over the entire lifetime of the asset. The various projects are ranked in the order of the rate of returns. The project with the higher rate of return is accepted.

Return on investment method overcomes the deficiencies of payback period method in the sense that it considers the earnings of a project over its entire life.

1. The return on investment is estimated i.e., earnings or profits estimated from an investment proposal during its economic life, after providing for depreciation and taxes. It means net profit from estimation is as per the accounting principles.

2. The rate of return is compared with cut off rate as determined by the management. Cut off rate is the minimum rate of return on investment. It should be generated from a profit which is generally the firm's cost of capital. Cost of capital 15% - cut off rate of return = 15%. The comparison helps management to rank the various projects and select the most profitable one. If return on investment proposal is less than the cut off rate, it is rejected and accepted if it is equal or more than the cut off rate. In case of mutually exclusive alternative projects, the projects with higher rate of return are selected.

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Average annual earningsARR = X 100

Average investment

Advantages:

1. It is easy to understand and calculate.

2. It can be compared with the cutoff point of return and hence the decision to accept or reject is made easier.

3. It considers all the cash inflows during the life of the project, not like payback method.

4. It is a reliable measure because it considers net earnings.

5. The most favorable attribute of this method is its simplicity and it is easy to understand.

6. It is based on the accounting concepts of profit which are easily calculated for financial data.

7. The total benefits associated with projects are taken into account while calculating the IRR. Payback method for instance does not use the entire stream of income. This approval gives due weightage for the profitability of project.

8. Profits determined under this method after deducting depreciation and tax are as per the accounting principles which give a better basis of commission.

Disadvantages:

1. The concept of time value of money is ignored.

2. The average concept is not reliable, particularly in the times of high fluctuation in the returns.

3. The average concept dilutes the profitability of the project.

4. The method of computation of ARR is not standardized.

5. It uses accounting profits and not cash flows in appraising the projects. Accounting profits are based on arbitrary assumptions and choices and also include non-cash items. It is, therefore, inappropriate to rely on them for measuring the acceptability of the investment projects.

6. It does not take into account the time value of money. The timing of cash inflows and outflows is a major decision valuable in financial decision making. Accordingly benefits in the earlier years and later years cannot be

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valued at par. To that extent, the ARR method treats these benefits at par and fails to take into account the difference in the time value of money.

7. It does not differentiate between the sizes of investment regarding each project. Competing investment proposals may have the same ARR but may require different average investments.

8. This method does not take into consideration any benefits which can accrue to the firm from the sale or abandonment of equipment which is replaced by the new investment. The new investment from the point of view of correct financial decision should be measured in terms of incremental cash outflow due to new investment (i.e., new investment minus sale proceeds of existing equipment plus / minus tax adjustment). But the ARR method doesn't make any adjustment in this regard to determine the level of average investment. Investment in fixed assets is determined at their acquisition costs.

9. This method cannot be applied to a situation where investment in a project is to be made in parts.

Discounted Cash Flow / Time Adjusted Techniques

Discounted Cash Flow: Discounted cash flows are the future cash inflows reduced to their present value based on a discounting factor. The process of reducing the future cash inflows to their present value based on a discounting factor or cutoff return is called discounting.

3. Net Present Value Method:

The net present value method considers the time value of money. The cash flows of different years are valued differently and made comparable in terms of present values. The net cash inflows of various periods are discounted using required rate of return which is predetermined. Taking into conside3ration the scrap value, if the present value of as cash inflows exceeds the initial cost of the project, the project is accepted otherwise rejected. If there are two projects giving net present value, the project with the higher net present value is selected.

The cash inflow in different years are discounted (reduced) to their present value by applying the appropriate discount factor or rate and the gross or total present value of cash flows of different years are ascertained. The total present value of cash inflows are compared with present value of cash outflows (cost of project) and the net present value or the excess present value of the project and the difference between total present value of cash

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inflow and present value of cash outflow is ascertained and on this basis, the various investments proposals are ranked.

NPV = Present value of cash inflows – Investment

Merits:1. The most significant advantage is that it explicitly recognizes the time value of money, e.g., total cash flows pertaining to two machines are equal but the net present value are different because of differences of pattern of cash streams. The need for recognizing the total value of money is thus satisfied.

2. It also fulfills the second attribute of a sound method of appraisal. In that it considers the total benefits arising out of proposal over its life time.

3. It is particularly useful for selection of mutually exclusive projects.

4. This method of asset selection is instrumental for achieving the objective of financial management, which is the maximization of the shareholder's wealth. In brief the present value method is a theoretically correct technique in the selection of investment proposals.

Demerits: 1. It is difficult to calculate as well as to understand and use, in comparison with payback method or average return method.

2. The second and more serious problem associated with present value method is that it involves calculations of the required rate of return to discount the cash flows. The discount rate is the most important element used in the calculation of the present value because different discount rates will give different present values. The relative desirability of a proposal will change with the change of discount rate. The importance of the discount rate is thus obvious. But the calculation of required rate of return pursuits serious problem. The cost of capital is generally the basis of the firm's discount rate. The calculation of cost of capital is very complicated. In fact there is a difference of opinion even regarding the exact method of calculating it.

3. Another shortcoming is that it is an absolute measure. This method will accept the project which has higher present value. But it is likely that this project may also involve a larger initial outlay. Thus, in case of projects involving different outlays, the present value may not give dependable results.

4. The present value method may also give satisfactory results in case of two projects having different effective lives. The project with a shorter

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economic life is preferable, other things being equal. It may be that, a project which has a higher present value may also have a larger economic life, so that the funds will remain invested for longer period while the alternative proposal may have shorter life but smaller present value. In such situations the present value method may not reflect the true worth of alternative proposals. This method is suitable for evaluating projects whose capital outlays or costs differ significantly.

4. Internal Rate of Return Method:

The internal rate of return for an investment proposal is that discount rate which equates the present value of cash inflows with the present value of cash outflows of an investment. When compared the internal rate of return with a required rate of return, if the internal rate of return is more than required rate of return then, the project is accepted else rejected. In case of more than one project; the project with highest IRR is selected.

The technique is also known as yield on investment, marginal efficiency value of capital, marginal productivity of capital, rate of return, time adjusted rate of return and so on. Like net present value, internal rate of return method also considers the time value of money for discounting the cash streams. The basis of the discount factor however, is difficult in both cases. In the net present value method, the discount rate is the required rate of return and being a predetermined rate, usually cost of capital and its determinants are external to the proposal under consideration. The internal rate of return on the other hand is based on facts which are internal to the proposal. In other words, while arriving at the required rate of return for finding out the present value of cash flows, inflows and outflows are not considered. But the IRR depends entirely on the initial outlay and cash proceeds of project which is being evaluated for acceptance or rejection. It is therefore appropriately referred to as internal rate of return. The IRR is usually, the rate of return that a project earns. It is defined as the discount rate which equates the aggregate present value of net cash inflows (CFAT) with the aggregate present value of cash outflows of a project. In other words it is that rate which gives the net present value zero. IRR is the rate at which the total of discounted cash inflows equals the total of discounted cash outflows (the initial cost of investment). It is used where the cost of investment and its annual cash inflows are known but the rate of return or discounted rate is not known and is required to be calculated.

P1 - Q

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IRR = L + x DP1 - P2

L = Lower discount rate; P1= Present value of earnings at lower rate; P2= Present value of earnings at higher rate; Q= Actual investment; D= Difference in rate of return.

Advantages:

1. Is a theoretically correct technique to evaluate capital expenditure decision? It possesses the advantages which are offered by the NPV criterion such as; it considers the time value of money and takes into account the total cash inflows and outflows.

2. In addition, the IRR is easier to understand. Business executives and non-technical people understand the concept of IRR much more readily than they understand the concept of NPV. For instance, Business X will understand the investment proposal in a better way if it is said that the total IRR of Machine B is 21% and cost of capital is 10% instead of saying that NPV of Machine B is Rs. 15,396.

3. It itself provides a rate of return which is indicative of profitability of proposal. The cost of capital enters the calculation later on.

4. It is consistent with overall objective of maximizing shareholders wealth. According to IRR, the acceptance / rejection of a project is based on a comparison of IRR with required rate of return. The required rate of return is the minimum rate which investors expect on their investment. In other words, if the actual IRR of an investment proposal is equal to the rate expected by the investors, the share prices will remain unchanged. Since, with IRR, only such projects are accepted which have IRR of the required rate; therefore, the share prices will tend to rise. This will naturally lead of maximization of shareholders wealth.

The IRR suffers from serious limitations:

1. It involves tedious calculations. It involves complicated computation problems.

2. It produces multiple rates which can be confusing. This situation arises in the case of non-conventional projects.

3. In evaluating mutually exclusive proposals, the project with highest IRR would be picked up in exclusion of all others. However, in practice it may not turn out to be the most profitable and consistent with the objective of the firm i.e., maximization of shareholders wealth.

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4. Under IRR, it is assumed that all intermediate cash flows are reinvested at the IRR. It is rather ridiculous to think that the same firm has the ability to reinvest the cash flows at different rates. The reinvestment rate assumption under the IRR is therefore very unrealistic. Moreover it is not safe to assume always that intermediate cash flows from the project may be reinvested at all. A portion of cash inflows may be paid out as dividends, a portion may be tied up with current assets such as stock, cash, etc. Clearly, the firm will get a wrong picture of the project if it assumes that it invests the entire intermediate cash proceeds.

Net Present Value vs. Internal Rate of Return

Net Present Value Internal Rate of Return

1. NPV is expressed in terms of currency.

1. IRR is expressed in terms of percentage.

2. NPV calculates additional wealth. 2. IRR does not calculate additional wealth.

3. NPV can deal with changing cash inflows.

3. IRR method cannot be used to evaluate where the cash flows are changing (i.e. initial outlay followed by cash flows and later outlay)

4. This is an easy method which can be understood even by a layman because the NPV is expressed in terms of money.

4. A manager can better understand the concept of returns stated in percentages and find it easy to summarize and compare to the required cost of capital.

5. NPV suggests larger projects which generates more cash inflows.

5. IRR suggests smaller projects with shorter life and earlier cash inflows.

6. In NPV using different discount rates will result in different recommendations.

6. In IRR method whatever the discount rate we use, it gives the same result.

Developing cash flows

Capital expenditures typically involve current and near future costs that are expected to generate benefits in the future. While measuring the costs and benefits of a capital expenditure proposal, you must bear in mind the following guidelines:

1. Focus on cash flows: Costs and benefits must be measured in terms of cash flows. Costs are cash outflows and benefits are cash inflows. Cash flows matter because they represent the purchasing power. Since accounting

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figures are based on the accrual principle, they have to be adjusted to derive the cash flows. For example, depreciation and other non-cash charges, which are deducted in computing profits from the accounting point of view, have to be added back as they do not entail cash outflows.

Estimate cash inflows on a post-tax basis. Some firms look at pre-tax cash flows and, to compensate that, apply a discount rate greater than the cost of the capital. However, there is no reliable basis for making such adjustments.

2. Consider all incidental effects: In addition to its direct cash flows, a project may have incidental effects on the rest of the firm. It may enhance the profitability of some of the existing activities of the firm as it has a complementary relationship with them or it may detract from the profitability of some of the existing activities as it has a competitive relationship with them all these must be taken into account.

3. Ignore sunk costs: Sunk costs represent past outlays that cannot be recovered and hence, are not relevant for new investment decisions.

4. Include opportunity cost: If a project requires the use of some resources already available with a firm, the opportunity cost of the resources should be charged to the project. The opportunity cost of a resource is the value of net cash flows that can be derived from it if it were put to its best alternative use.

5. Networking capital: Apart from investment in fixed assets like land, machinery, building and technical knowhow, a project also requires investment in current assets like cash receivables (debtors), and inventories. A portion of current assets is supported by non-interest bearing current liabilities accounts payable (creditors) and provisions. The difference between current assets and non-interest bearing current liabilities is the net working capital. It is financed by equity, preference and debt.

Components of Cash Flow Stream:

The cash flows stream of a project may be divided into three parts as follows:

Initial Outlay: These represent the cash outflows associated with investment in various project components.

Initial outlay = Outlay on fixed assets + Outlay on net working capital

Operational Flow: These are cash inflows expected during the operational phase of the project.

Operational flow = Profit + Depreciation – Tax

Terminal Flow: Cash flows expected from the disposal of assets when the project is terminated are referred to as terminal flows.

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Terminal flow = Post tax salvage value of fixed asset + Post tax salvage value of net working capital

Approaches for Reconciliation

The conflicts in project rankings may arise because of size disparity, time disparity and life disparity.

Size Disparity

A source of ranking conflict may be the disparity in the size of initial outlays. Such conflicts may arise mainly because NPV represents an absolute magnitude whereas the IRR is a relative measure. The resolution of conflict depends on the following circumstances of the firm.

1. If the firm has enough funds available to it at a given cost of capital, a project with bigger size is preferable as it contributes more to the NPV of the firm.

2. If the firm has limited availability of the funds and acceptance of big sized project means the rejection of some other projects, then the NPV of big project must be compared with the sum of NPV of other projects and alternative with higher NPV is to be accepted.

Time Disparity

Projects may differ with respect to the sequence of the pattern of cash inflows associated with that and such time disparities of cash inflows may lead to conflicts in ranking.

This conflict can be resolved by defining the reinvestment rates that are applicable to cash flow and calculation modified versions of NPV and IRR. This method is known as terminal value method and it involves the following two steps.

Life Disparity

In some cases the mutually exclusive alternatives have varying times and it may lead to conflict in rankings. One approach to resolve this conflict is by comparing the alternatives on the basis of their Uniform Annual Earnings (UAE) and selects the alternative with highest UAE.

The UAE of a project is equal to the project of NPV and CRF

UAE = NPV X CRF

Where capital recovery factor (CRF) is simply the inverse of the present value interest factor for annuity.

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The UAE method appears appealing because it expresses the gains from the project in an annualized form and hence renders easy comparison between projects with different expected lives.

Important Questions

1. Explain briefly about investment decision process.2. Explain about capital budgeting and its significance3. What are the different methods of capital budgeting?4. Problems…

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Documents

Unit - 2 (Investment Decisions)