Capital Investment Decisions
Capital Investment Decisions
Capital Investment Decisions
1. Introduction
6. Dividend Decisions:
FINANCE MANAGER
Profit and
Wealth
PROCUREMENT OF FUNDS
Maximisation
UTILISATION OF FUNDS
Payables etc.
Decisions / Financing
Capital Budgeting
Decisions
2. Explain the inter – relationship between Investment,
Financing and Dividend Decisions. RTP, M 01
a) Investment Decisions:
b) Financing Decisions:
- Proper balancing between long – term and short – term funds as
well as own funds and loan funds will help the Firm to minimize its
overall cost of capital and increase its wealth / value.
- Low cost of funds will mean higher profit margins, which can be
used for dividend distribution as well as internal financing of new
projects / growth plans.
c) Dividend Decisions:
Ie Distribution of Profits
Business Operations
resulting in Surplus ie Profit
= Returns Less Cost Retention in
Financing Decisions (ie
Business
procuring
funds from various sources at
minimum cost)
Minimum Cost
ie Internal Fund generation
3. What is Capital Budgeting? Why is it such an important
exercise? RTP
2. Importance:
c) Risk: The longer the time period of returns, the greater is the
risk / uncertainty associated with cash flows. Hence, decision
should be taken after a careful review of all available information.
Stage Procedure
Planning -Identify the various available investment
opportunities
Project Cash Flows refer to the Costs (Cash Outflows) and Benefits
(cash Inflows) associated with the Project. Since future flows are
forecasted, an element of uncertainty or probability exists in
these cash flows. The following points are to be considered in the
estimation of future Cash Flows of a project -
c) Extent of Competition,
3) Opportunity cost:
c) Social Viability:
1. Industry Information –
2. Production Process-
5. Resources/ Utilities-
- management background,
-traits as entrepreneurs,
-business or industrial experience,
6. Approaches:
Note: Adjustment in both the cash flows and the cut – off rate
should not be done.
3. Payback Reciprocal
b) The lower the payback period, the better it is, since initial
investment is recouped faster.
b) Determine the CFAT (Cash Inflows ) from the project for various
years.
per annum
A. ADVANTAGES:
B. LIMITATIONS:
Step Procedures
1 Determine the total cash outflow of the project.(Initial
Investment)
2 Determine the cash inflow after taxes (CFAT) for each
year.
3 Determine the PV factor for each year and compute
discounted CFAT (DCFAT) for each year.
Initial Investment
a) The life of the project is at least twice the payback period and
St Procedure
ep
1. Determine net investment of the project. Net investment =
Initial Investment less Salvage Value.
2 Determine the Profits After Tax (PAT) for each year. PAT =
CFAT less depreciation.
3 Determine the total PAT for N years, where N = Project life.
4 Compute average PAT per annum = total PAT of all years/ N
years
5 ARR = Average PAT per annum / Net Investment = sept 4 /
Sept 1
3. Advantages:
a) simple to understand
4. Limitations:
Ste Procedure
p
1. Determine the total cash outflow of the project and the
time periods in which they occur.
2. Compute the total discounted cash outflow = outflow X PV
factor
3. Determine the total cash inflows of the project and the time
periods in which they arise.
4. Compute the total discounted cash inflows = Inflow X PV
factor
5. Compute NVP = Discounted Cash inflows less discounted
Cash outflows (Step 4 less step 2)
6. Accept project if NPV is positive, else reject.
If Decision
NVP> 0 Accept the project. Surplus over and above the cut –
off rate is obtained.
NPV=0 Project generates cash flows at a rate just equal to
the coat of capital. Hence, it may be accepted or
rejected. This constitutes an indifference point.
NPV<0 Reject the project. The project does not provide
returns even equivalent to the cut – off rate.
Note: The NPV method will give valid results only if money can
be immediately reinvested at a rate of return equal to the firm’s
cost of capital.
22. What are the merits and demerits of the NPV method?
A.ADVANTAGES:
1. It considers the time value of money. Hence, it satisfies the
basic criterion for project evaluation.
4. Since all cash flows are converted into present value (current
rupees), different projects can be compared on NPV basis. Thus,
each project can be evaluated independent of others o its own
merit.
B. LIMITATIONS:
If Decision
PI>1 Accept the project. Surplus ever and above the cut – off
rate is obtained.
PI = 1 Project generates cash flows at a rate just equal to the
cost of capital. Hence, it may be accepted or rejected.
This constitutes an indifference point.
PI < 1 Reject the project. The project does not provide returns
even equivalent to the cut – off rate.
Note: when NPV > 0, PI will always be greater than 1. Both NPV
and PI use the same factors i.e. discounted cash inflows (A) and
discounted cash outflows (B), in the computation. NPV = A – B,
whereas PI = A / B.
4. Advantage:
5. Disadvantage:
a) In case a single large project with high profitability index is
selected, possibility of accepting several small projects which
together may have NPV then the single project is excluded.
If Decision
IRR > Accept the project. Surplus over and above the cut –off
K0 rate is obtained.
IRR = Project generates cash flows at a rate just equal to the
K0 cost of capital. Hence, it may be accepted or rejected.
This constitutes an indifference point.
IRR < Reject the project. The project does not provide returns
K0 even equivalent to the cut – off rate.
Step Procedure
1 Determine the total cash outflow of the project and the
time periods in which they occur.
2 Determine the total cash inflows of the project and the
time periods in which they arise.
3 Compute the NPV at an arbitrary discount rate, say
10%
4 Choose another discount rate and compute NPV. The
second discount Rate is chosen in such a way that one
of the NPV’s is negative and the other is positive.
Suppose, NPV is positive at 10% choose a higher
discount rate so as to get a negative NPV. In case NPV
is negative at 10%, choose a lower rate.
5 Compute the change in NPV over the two selected
discount rates.
6 On proportionate basis, compute the discount rate at
which NPV is zero.
5. Advantages:
6. Disadvantages:
Step Procedure
1 Determine the total cash outflows and inflows of the
project and the time periods in which they occur.
2 Compute terminal value of all cash flows other than the
initial investment. For this purpose, terminal value of a
cash flow = Amount of Cash flow X Re-investment
Factor, where reinvestment factor = (1+ K)n
where n = number of years balance remaining in the
project.
3 Compute total of terminal values as computed under step
2. This is taken as the “inflow” from the project, to be
compared with the “outflow” i.e. the initial investment.
4 Compute MIRR, i.e. discount rate such that PV of terminal
value = initial investment.
2. LCM method:
Step Procedure
1 Compute the initial investment of each alternative
2 Determine the project lives of each alternative
3 Determine the annuity factor relating to the project life
of each alternative
4 Compute equivalent annual investment (EAI) = initial
investment / relevant annuity factor
5 Compute CFAT per annum or cash outflows per annum,
of each alternative.
6 Compute equivalent annual benefit (EAB) = CFAT per
annum Less EAI OR Compute equivalent annual Costs
(EAC) = Cash outflows per annum + Cash outflows per
annum + EAI
7 Select project with maximum EAB or minimum EAC, as
the case may be.
(a) Generally, firms fix up maximum amount that can be invested in capital
projects, during a given period of time, say a year. This budget ceiling
imposed internally is called as Soft Capital Rationing.
(b)Projects providing relatively higher cash flows in earlier years, which can be
used for incre3asing the fund availability for other projects in those early years.
29. Do the Profitability Index (PI) and Net Present Value (NPV) criterion
of investment proposals lead to the same acceptance-rejection and ranking
decisions? In what situations will they give conflicting result?
1. Acceptance-Rejection Decision:
(b) The discount rate used in NPV and PI methods are the same.
(c) Both NPV and PI use the same factors i.e. Discounted Cash Inflow (A) and
Discounted Cash Outflows (B), in the computation. NPV=A-B, whereas
PI=A/B.
(d) When NPV>0, PI will always be greater than 1. Also when NPV<0, PI will
be less than 1.
(e) Hence, for a given project, NPV and PI method give the same Accept or
Reject decision.
Project P Q
Discounted Cash Inflows Rs.10 Lakhs Rs.5 Lakhs
1. Causes for Conflict: Higher the NPV, higher will be the IRR. However,
NPV and IRR may give conflicting result in the evaluation of different projects,
in the following situations-
(c) Outflow Patterns-i.e. when Cash Outflows arise at different point of time
during the Project Life, rather than as Initial Investment (Time 0) only.
(d) Cash Flow Disparity-when there is a huge difference between initial CFAT
and later years’ CFAT. A project with heavy initial CFAT than compared to
later years will have higher IRR and vice versa.
a) NPV represents the surplus from the project but IRR represents the point
of no surplus – no deficit.
b) NPV considers Cost of capital as constant. Under IRR, the discount rate
is determined by reverse working, by setting NPV = 0.
c) NPV aids decision – making by itself i.e., projects with positive NPV are
accepted. IRR by itself does not aid decision – making. For example, a
project with IRR = 18% will be accepted if Ko < 18%. However, the
project will be rejected if Ko = 21% (say > 18%).
f) There may be projects with negative IRR / Multiple IRR etc, if cash
outflows arise at different points of time. This leads to difficulty in
interpretation. NPV does not pose such interpretation problems.
31. Explain the concept of “social cost – benefit analysis”. Is it relevant for
private enterprises also? RTP
1. Meaning:
a) Market prices used to measure costs and benefits in project analysis, do not
represent social values due to imperfections in market.
b) Monetary Cost Benefit Analysis fails to consider the external effects of a
project, which may be positive like development of infrastructure or negative like
pollution and imbalance in environment.
c) Taxes and subsidies are monetary costs and gains, but these are only transfer
payments from social point of view and therefore irrelevant.
Step Procedure
1 Determine the problem to be considered.
a) Social cost benefit analysis is important for private corporation also which have
a moral responsibility to undertake socially desirable projects.
b) If the private sector includes social cost benefit analysis in its project evaluation
techniques, it will ensure that it is not ignoring its own long – term interest, since
in the long – run only projects that are socially beneficial and acceptable, will
survive.
c) Methodology of social cost benefit analysis can be adopted either from the
guidelines issued by the United Nations Industrial Development Organization
(UNIDO) or the Organization of economic corporation and development (OECD).
Financial institutions e.g., IDBI, IFCI, etc even insist on social cost benefit analysis
of a private sector project before sanctioning any loan.
3. Risk Analysis
1. Financial decisions:
a) This involves identifying the source from which the finance manager
should raise the quantum of funds required by a company.
c) While estimating the revenue and costs, he must take into consideration
the inflation factor, since under inflationary conditions, expectations of
equity shareholders will rise.
2. Investment Decision:
a) While taking dividend decisions, the finance manager has to consider the
inflation factor, and ensure that the capital of the company remains intact,
even after the payment of dividend.
c) Therefore, more profits may have to be retained than what has been
retained by way of depreciation. This is more relevant in case of those
industries, where technological changes industries, where technological
changes will render the existing infrastructure redundant at a rapid pace.
1. Meaning :
b) In this analysis, each variable is fixed except one, which is changed to see the
effect on NPV or IRR. It is a study which determines how changes or errors in the
values of parameters affect the output of a model.
2. Objectives:
4. Criticisms:
2. Features:
(a) Decision point, represent by the square boxes : Point where more
than one decision can be taken
4. Step:
(d) Drawing the branch of the tree showing the decision point, chance
events and other data indicating there in the projected cash flow,
probabilities and expected payoffs.
(f) Evaluation of the project at the starting point, by the analysis of result
at each decision point by backward computation.
5. Benefits:
(b) Assumptions: the approach clearly set the implicit assumption and
calculation for all concerned with a project to see, question and revise.
(a) Decision tree analysis is applicable only to those projects with clearly
delineated stages. Not all the project can be clearly delineated for the
proposed of Decision Tree Analysis
(b) It can be applied only for project with sufficient information available
in respect of probabilities for the outcomes.
36. How would the standard deviation of the present value distribution help
in Capital Budgeting Decision ?
1. Meaning : Standard deviation is a statistical measure of dispersion, which
measure the deviation from a central number i.e the mean.
2. Applicability : Evaluation done in respect of two or more project giving the
similar cash flow
3. Purpose :
(a) It help to measure extent of the variation. Standard deviation give
deviation in value, while coefficient of variation give the extend of
deviation with reference to the central value
(b)It can be used to identify which of the project least, in tream of cash
flow
(c) If it is assumed that probability distribution is approximately normal, it
will be easy to calculate the probability of a cash budgeting generating
the NPV less than or more than the specified amount.
4. Decision: the project which have lower efficient of variation( variation per
unit ) will be preferred , if project sized are heterogeneous (different ).
2. Scenario: The two scenarios under which the Standard Deviation of a project is
computed are-(a) Case 1- Cash Flows are perfectly correlated.
3. Method of computation:
4 .Expected NPV: Expected NPV is the same if the Cash Flows are perfectly
correlated as well as when the Cash Flows are independent.
39. Write short notes on the Discount Rate or Cut-off Rate in Capital
Budgeting decisions.
4. Risk Aspect and WACC: Every project undertaken by a firm entails some risk.
Hence, Interest Rate on Government Bonds (Risk-Free Rate) cannot be used as
Cut-Off Rate for decision-making purposes.
5. Constant WACC: As per the Net Operating Income and Modigliani & Miller
approach to Cost of Capital, the overall cost of capital of a Firm is constant
irrespective of the level of debt-equity mix. Hence, while evaluating an investment
proposal, the financing alternative (debt-equity mix) is not considered. Overall
Cost of Capital or Discount Rate is considered constant for the Firm.
1. Risk premium model: An appropriate discount rate (RD) for a given project is a
function of the following factors-
(a) Risk Free Rate of Return [RN]: If a project with a risk is going to yield a
return lower than the Risk Free Rate of Return, the Firm would be well off by
investing its funds in the risk here security. Therefore, this is the minimum rate of
return that is expected of any other investment alternatives.
(b) Risk premium [RP]: extra return would mean extra risk. Risk premium is the
additional return that is expected for any risky investment. It comprises of the
following-
• Firm’s Normal Risk: This is an adjustment for the Firm’s normal risk. This
may arise due to its capital structure, financing policy, management risk,
nature of its constitution etc.
• Project’s Risk: This is an adjustment for the differential risk for a particular
project. Example: For a new project, whose target customers are all abroad,
the cash flows will be affected by Exchange Rate fluctuations. Hence, this
project will carry a higher risk than other existing projects, where this
exchange rate fluctuation is not a factor.
(c)Formula: Theoretically, the appropriate discount rate is the sum of the Risk
Free Rate and the Risk Free Premium. Mathematically, the relationship is
expressed as follows-
2. Inflation Adjusted Rate: Appropriate discount rate for evaluating the projects
cash flows, which are expressed in nominal terms ( i.e. the actual estimated cash
flow in money terms), should be a factor of the following-
(a) Real Rate of Return [RR]: This is the discount rate that should be applied in
respect of cash flows in a static economy, i.e. there is no inflation/deflation or cash
flows are not affected by inflation.
(b) Inflation [I]: Real Rate should be adjusted for inflation, i.e. increased by the
inflation rate to ascertain the appropriate discount rate.
(c) Formula: Theoretically, the appropriate discount rate is the sum of the Real
Discount Rate and Inflation Rate. Mathematically, the relationship is expressed as
follows-
1 + RD = (1 + RR) X (1+I)
1. Meaning: Risk Adjusted Discount Rate is the normal discount rate adjusted
upwards or downwards for the element of risk to reflect Project Risk.
4. Project Evaluation:
(c) Discount the cash flow at the RADR and identity the NPV.
(d) If the NPV is positive, the Project may be accepted, else Project is rejected.
5. Limitations:
(b) This method assumes that risk increase with time at a constant rate, which may
not be valid.
42.What are the differences between Certainty Equivalent Method and Risk
Adjusted Discount Rate Method?
(a) This is a takeoff from accounting breakeven Analysis, and considers time value
of money. Financial breakeven analysis seeks to estimate the annual cash flow
needed to make the NPV zero.
3. Limitation:
(b) If there many important variable to consider, there may give rise to a
huge number of scenario for analysis
(c) There is no clear road map to indicate how the decision –maker will used
result of the scenario analysis.
4. Best case and worst case analysis these are variant of the scenario analysis.
(a) In a best case analysis , all the input are set at the most optimistic level
(b) In the worst case analysis, input are all measure at the most pietistic
level, for computer NPV and IRR
M87, M88
Step Description
1 Define the problem or system intended to be stimulated.
2 Formulate the model intended to be used
3 Test the model and compare its behavior with the behavior of the
actual problem environment.
4 Identify and collect the data needed to test the model.
5 Run the stimulation
6 Analyze the system of the stimulation and, if desired, change the
solution that is being evaluated
7 Return the stimulation to test new solution
8 Validate the stimulation, ie increase the chances that any
interference that may be drawn about the real situation from
running the stimulation will be valid
5. Capital budgeting
d) After deriving the distributions of all the input variables i.e. mean ,
standard deviation and shape of distributions for each variable,
stimulation experiment will be performed by considering different levels
of these factors.
e) Several trial runs can be done to cover most of the possible stimulation
for analysis.
6. Benefits [N96]
b) Time and cost: A good stimulation model may be very expensive. It may
take even years to develop a usable corporate planning model.
2. Circumstances:
b) Option to abandon: if a project has abandonment value, selling off the project
on “as is where is” basis. This represents a put option (i.e. right to sell). Example:
A flat promoter may dispose of his unfinished building to an industrial house or
another flat promoter, instead of proceeding further to sell it as individual units.
4. computation:
Note: generally, the price of the option would be available, and the requirement
would be to ascertain the project worth by considering the value of option as an
alternative cash flow.