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 Nature of Investment Decisions
á The ?
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  long-term assets. Sale of a division or business
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 as an investment decision.

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therefore, they should also be evaluated as investment
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 Features of Investment Decisions
u The exchange of current funds for future
benefits.
u The funds are invested in long-term assets.
u The future benefits will occur to the firm over
a series of years.
 Investment Evaluation Criteria
u Three steps are involved in the evaluation of
an investment:
1. Estimation of cash flows
2. Estimation of the required rate of return (the
opportunity cost of capital)
3. Application of a decision rule for making the
choice
 Investment Decision Rule
á It should maximise the shareholders͛ wealth.
á It should consider all cash flows to determine the true
profitability of the project.
á It should provide for an objective and unambiguous way of
separating good projects from bad projects.
á It should help ranking of projects according to their true
profitability.
á It should recognize the fact that bigger cash flows are
preferable to smaller ones and early cash flows are
preferable to later ones.
á It should help to choose among mutually exclusive projects
that project which maximises the shareholders͛ wealth.
á It should be a criterion which is applicable to any
conceivable investment project independent of others.
 Evaluation Criteria
1. Discounted Cash Flow (DCF) Criteria
u Net Present Value (NPV)
u Internal Rate of Return (IRR)
u Profitability Index (PI)
u Discounted payback period (DPB)

2. 0on-discounted Cash Flow Criteria

u Payback Period (PB)
u Accounting Rate of Return (ARR)
 Net Present Value Method
á Cash flows of the investment project should be forecasted
based on realistic assumptions.

á Appropriate discount rate should be identified to discount

the forecasted cash flows.

á Present value of cash flows should be calculated using the

opportunity cost of capital as the discount rate.

á Net present value should be found out by subtracting

present value of cash outflows from present value of cash
inflows. The project should be accepted if NPV is positive
(i.e., NPV > 0).
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 Acceptance Rule
u Accept the project when NPV is positive NPV > 0

u Reject the project when NPV is negative NPV < 0

u May accept the project when NPV is zero NPV = 0

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 Evaluation of the NPV Method
NPV is most acceptable investment rule for the
following reasons:
á Time value
á Measure of true profitability
á Value-additivity
á Shareholder value

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á Involved cash flow estimation
á Discount rate difficult to determine
á Mutually exclusive projects
á Ranking of projects
 Question
†ulie Miller is evaluating a new project for her
firm, › et Wode ›W). She has
determined that the after-tax cash flows for the
project will be $10,000; $12,000; $15,000;
$10,000; and $7,000, respectively, for each of
the Years 1 through 5. The initial cash outlay
will be $40,000. The discount rate (k) for this
project is 13%. Should this project be
accepted?
 Questions
á Assume that the cost of capital is 6% for a project involving
a lumpsum cash outflow of Rs.8,200 and cash inflow of
Rs.2,000 per annum for 5 years. What will be the Net
Present Value ?

á Suppose we are asked to decide whether or not a new

consumer product should be launched. Based on projected
sales and costs, we expect that the cash flows over the five-
year life of the project will be Rs.2,000 in the first two
years, Rs.4,000 in the next two, and Rs.5,000 in the last
year. It will cost about Rs.10,000 to begin production. We
use a 10 % discount rate to evaluate new products. What
should we do here?
 Question
á Suppose the cash revenues from a fertilizer
business will be Rs.20,000 per year, assuming
everything goes as expected. Cash costs
(including taxes) will be Rs.14,000 per year. The
business will wind down in eight years. The plant,
property, and equipment will be worth Rs.2,000
as salvage at that time. The project costs
Rs.30,000 to launch. We use a 15 percent
discount rate on new projects such as this one. Is
this a good investment? If there are 1,000 shares
of stock outstanding, what will be the effect on
the price per share of taking this investment?
 Payback Period
á PBP is the period of time required for the cumulative expected cash
flows from an investment project to equal the initial cash outflow.

á Loosely, the payback is the length of time it takes to recover our

initial investment

á Business enterprises following payback period use "stipulated

payback period", which acts as a standard for screening the project.

u This method is very flawed, primarily because it ignores later year

cash flows and the present value of future cash flows.
 Payback Period
u If the project generates constant annual cash
inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow.
That is:

u Payback = Initial Investment = Co

Annual Cash Inflow C

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 the payback period can be found out by
adding up the cash inflows until the total is equal
to the initial cash outlay.
 Acceptance Rule
u The project would be accepted if its payback
period is less than the maximum or   

  period set by management.

u As a ranking method, it gives highest ranking

to the project, which has the shortest payback
period and lowest ranking to the project with
highest payback period.
 Question
u Assume that a project requires an outlay of
Rs.50,000 and yields annual cash inflow of
Rs12,500 for 7 years. The payback period for the
project will be͙.

u Suppose that a project requires a cash outlay of

Rs 20,000, and generates cash inflows of Rs
8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during
the next 4 years. What is the project͛s payback?
 Proposed Project Data
†ulie Miller is evaluating a new project for her
firm, › et Wode ›W). She has
determined that the after-tax cash flows for the
project will be $10,000; $12,000; $15,000;
$10,000; and $7,000, respectively, for each of
the Years 1 through 5. The initial cash outlay
will be $40,000.
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 Discounted Payback
u The  

 

  

  

 the sum of the discounted cash flows is
equal to the initial investment.
u Loosely speaking, Using Discounted PBP, we get
our money back, along with the interest we could
have earned elsewhere, in four years.
u If a project ever pays back on a discounted basis,
then it must have a positive NPV
u The cutoff still has to be arbitrarily set and cash
flows beyond that point are ignored.
 Profitability Index/ BCR
u PI is the ratio of the present value of cash
inflows to the present value of cash outflows.
The present values of cash flows are obtained
at a discount rate equivalent to cost of capital
u Select all projects whose profitability index is
greater than 1
u When there are mutually exclusive projects,
select the project with highest PI
 Question
u Assume that the cost of capital is 6% for a project involving a
lumpsum cash outflow of Rs.8,200 and cash inflow of Rs.2,000
per annum for 5 years. What will be the PI ?

u Suppose we are asked to decide whether or not a new

consumer product should be launched. Based on projected
sales and costs, we expect that the cash flows over the five-
year life of the project will be Rs.2,000 in the first two years,
Rs.4,000 in the next two, and Rs.5,000 in the last year. It will
cost about Rs.10,000 to begin production. We use a 10 %
discount rate to evaluate new products. What should we do
here?
Accounting Rate of Return method
u The accounting rate of return is the ratio of
the average after tax profit divided by the
average investment. The average investment
would be equal to half of the original
investment if it were depreciated constantly.

u A variation of the ARR method is to divide

average earnings after taxes by the original
cost of the project instead of the average cost.
 Question
u A project will cost Rs 40,000. Its stream of
u earnings before depreciation, interest and
taxes (EBDIT) during first year through five
years is expected to be Rs 10,000, Rs 12,000,
Rs 14,000, Rs.16,000 and Rs 20,000. Assume a
50 per cent tax rate and depreciation on
straight-line basis.
 Acceptance Rule
u This method will accept all those projects whose
ARR is higher than the minimum rate established
by the management and reject those projects
which have ARR less than the minimum rate.

u This method would rank a project as number one

if it has highest ARR and lowest rank would be
assigned to the project with lowest ARR.
 Evaluation of ARR Method

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u Simplicity
u Accounting data
u Accounting profitability

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u Cash flows ignored
u Time value ignored
u Arbitrary cut-off
 Internal Rate of Return (IRR)
IRR is the discount rate that equates the present value of
the future net cash flows from an investment project with
the project͛s initial cash outflow.
uThis also implies that the rate of return is the discount
rate which makes NPV = 0.

CF1 CF2 CFn

Co = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n
 Acceptance Rule
u Accept the project when r > k
u Reject the project when r < k
u May accept the project when r = k
 IRR Solution

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR) (1+IRR)5
4

Find the interest rate (G ) that causes the

discounted cash flows to equal $40,000.
 IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X = $1,444
.05 $4,603
 Evaluation of IRR Method
IRR method has following merits:
u Time value
u Profitability measure
u Acceptance rule
u Shareholder value

IRR method may suffer from

u Multiple rates
u Mutually exclusive projects
u Value additivity
 NPV and IRR
The NPV profile provides valuable insights:
u The IRR is the point at which the NPV=0
u The slope of NPV reflects how sensitive the project is
to discount rate changes

NPV and IRR rules lead to identical decisions under

following conditions:
u The project must be conventional
u The project must be independent
IRR - Pitfalls
u Pitfall 1 - Lending or Borrowing?
IRR cannot distinguish between lending and borrowing
so a high IRR is not always desirable

u Pitfall 2 - Mutually Exclusive Projects

IRR sometimes ignores the magnitude of the project.
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u Pitfall 3 - Multiple Rates of Return
Simple solution is to use NPV to make decision

u Pitfall 4 ʹ Differences between the short term and

long term interest rates
 Modified IRR
MIRR overcomes the shortcoming of regular IRR
The procedure for calculating MIRR is as follows:
u Calculate the PVC associated with the project, using the cost of
capital as the discount rate
u Calculate the terminal value of the cash inflows expected form
the project
u Obtain MIRR by solving the following equation
PVC = TV
(1+MIRR)^n
 Question

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 Questions
u Evaluate the project whose cash flows are as follows:
Year Cash Flows
0 -10,00,000
1 1,00,000
2 2,00,000
3 3,00,000
4 6,00,000
5 3,00,000
What is the NPV of the project if the discount rate is 12% for year
1 and rises every year by 1%
Question: You have a choice of accepting either of two 5-year
cashflow streams or lump-sum amounts given below:
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1 Rs 7,000 Rs 11,000
2 7,000 9,000
3 7,000 7,000
4 7,000 5,000
5 7,000 3,000
At time zero (t)Lump-sum amount 
Assuming 10 per cent required rate of return, which alternative (I or
II) and in which form (Cash flow or lumpsum) would you prefer
and why?
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 Question
u If an equipment costs Rs. 5,00,000 and lasts 8 years,
what should be the minimum annual cash inflow
before it is worthwhile to purchase the equipment?
Assume that the cost of capital is 10%.

u X has taken a 20-month car loan of Rs 6,00,000. The

rate of interest is 12 per cent per annum. What will be
the amount of monthly loan amortization?
 Conventional & Non-Conventional
Cash Flows
u A conventional investment has cash flows the pattern of an
initial cash outlay followed by cash inflows. Conventional
projects have only one change in the sign of cash flows; for
example, the initial outflow followed by inflows, i.e., ʹ + + +.

u A non-conventional investment, on the other hand, has cash

outflows mingled with cash inflows throughout the life of the
project. Non-conventional investments have more than one
change in the signs of cash flows; for example, ʹ + + + ʹ ++ ʹ+.
 Inflation and Capital Budgeting
u inflation is the increase in the general level of prices for all
goods and services in an economy
u nominal values are the actual amount of money making up
cash flows
u real values reflect the purchasing power of the cash flows
u real values are found by adjusting the nominal values for the
rate of inflation
u (1 + Nominal Rate) = (1 + Real Rate) * (1 + Inflation Rate)
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u if projected cash flows are in real terms, the

discount rate used should be a real rate.

u if projected cash flows are in nominal terms,

the discount rate used should be a nominal
rate.
 Ñxample: NPV in nominal and real term
u Consider the following data of a Co. launching a
new product and with 10% cost of capital

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u Assuming an inflation rate of 5% determine NPV

of the project by using both the nominal rate and
the real rate of discount
 Ñxample: NPV in nominal and real term
       
       

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u Whether we work in real or nominal doesn't matter.

u Be careful with depreciation. It is specified in the tax
code in nominal terms. Work out depreciation in
nominal terms and then convert to real terms.