Investment Theory & Practices: by Mr. A Hameed Shaikh

19 Nov 2014
Investment Theory & Practices

By
Mr. A Hameed Shaikh
Email [email protected]
Investment is time, energy, or matter spent in the hope of

future benefits actualized within a specified date or time
frame.
Investment Theory
Investment
In finance the purchase of a financial product or other

item of value with an expectation of favorble future
returns. In general terms, investment means the use of
money in the hope of making more money.
In business, the purchase by a producer of a physical
good, such as durable equipment or inventory , in the
hope of improving future business.
Background Knowledge
27-Nov-14
What do we know about investment appraisal
.
Investment appraisal is a business
concept which compares
expected future income to be derived from an investment with
the expenditure of incurring the investment. In non-profit
making organizations where investments are not made with
the objective of earning a return, the concept may not always
be directly applicable. In such organizations, investment
appraisal techniques may be used to compare alternative
proposals in order to provide the best value for the money
spent Bodie Zvi and Merton Robert (1998).
27-Nov-14
Investment appraisal
Investment appraisal is used to look at a potential capital

investment by a firm and measure its potential value to the
firm. There is more than one method of Investment Appraisal,
and each different method allows the potential return on the
investment to be examined in a different way Atrill Peter (2006).
4
Payback Period
Discounted payback
Net present value
Internal rate of return
Sensitivity analysis
Break-even analysis
Accounting rate of return
27-Nov-14
Investment appraisal methods
What a difference between 1 now and 1 in a

years time?
Factors change the value of money
Interest cost
Inflation
Other risks to materialise the money
27-Nov-14
Time value of money
For example: the annual interest rate is 10%, I

lend you 1 now and will get back after 1 year,
how much worth of that 1 in a years time?
? x (1+10%) = 1
? = 0.91
10% is called cost of capital; ? is called the

discount factor
The payback period is the amount of time taken

for the net cash flow resulting from an investment
to match (=), the initial cost of the investment (F9
Kaplan book ACCA.
27-Nov-14
Payback period
Formula Payback period = Initial

investment/Annual cash flow
This formula is only applicable if equal cash flows
7
Advantages
Simple to use.
Assists with cash flow
Effective when technology is fast
Changing
Disadvantages of Payback method
Ignores flows of cash over the lifetime of
the project.
Ignores total profitability.
27-Nov-14
Advantages /Disadvantages of Payback method
27-Nov-14
Payback Example - 1
27-Nov-14
Payback Example - 1
10
Year
Cash Flow
Cumulative Cash
flow
(3100)
(3100)
1000
(2100)
900
(1200)
800
(400)
500
100
500
600
Look on cumulative cash flow in end of year 3 ( 400) left to

meet initial investment and year four our cash flow is 500 so
our payback period should be three years and some months.
400/500 =0.8 years so 0.8x12 = 10 . Now payback 3 year
and 10 months.
27-Nov-14
Payback period
11
DCS
. techniques are used in calculating the net present value of a series of
cash flows. This measures the change in shareholder wealth now as a
result of accepting a project. NPV = present value of cash inflows less
present value of cash outflows .. If the NPV is positive, it means that the
cash inflows from a project will yield a return in excess of the cost of
capital, and so the project should be undertaken if the cost of capital is the
organisation's target rate of return. .. If the NPV is negative, it means that
the cash inflows from a project will yield a return below the cost of
capital, and so the project should not be undertaken if the cost of capital is
the organisation's target rate of return. .. If the NPV is exactly zero, the
cash inflows from a project will yield a return which is exactly the same as
the cost of capital, and so if the cost of capital is the organisation's target
rate of return, the project will have a neutral impact on shareholder wealth
and therefore would not be worth undertaking because of the inherent
risks in any project.
27-Nov-14
Discounted Cash Flow/NPV
12
Pros
Direct link to shareholder wealth, consider time
value of money, uses all cash flows, absolute
measure return.
27-Nov-14
NPV Pros(advantages) /Cons( disadvantages)
Cons
Difficult to explain, require a cost of capital, rather
complex.
13
Example of NPV
27-Nov-14
DF 10%
14
Year
Cash Flow
DF8%
PV
(120000)
(120000)
50000
0.926
46300
60000
0.857
51420
80000
0.794
63520
40000
0.735
29400
NPV
70640
27-Nov-14
Net Present value
15
13-15
Calculate Payback period / Net Present value ( using cheat

sheet)
Year
Cash
flow
(1900)
300
500
600
800
500
27-Nov-14
Activity
16
Payback and NPV method both useful to make any investment

decision , either going to buy new machine, new building etc.
All big organization using project appraisal to measure
cost/benefits
Helpful to measure which project is more valuable compare to
other projects
27-Nov-14
Payback/ Net Prevent value Application
17
www.opentuition.com
www.accaglobal.com
CMI Unit 5004 book
Youtube.com
Wikispaces.com / bradrc
www.cima.com
ACCA F9 book of Kaplan , BPP
27-Nov-14
Useful resource to enhance understanding in project

appraisal
18
Bodie Zvi and Merton Robert (1998) Finance first edition

pp62-65 Published by Prentice-Hall Inc New Jersey.
Atrill Peter (2006) Financial Management for decision Makers
4th edition pp60-68 Published by Pearson Education England
ACCA F9 Kaplan press
27-Nov-14
Bibliography
19
Summary . Q & A
27-Nov-14
Assignment discussion
20
Next Session.
27-Nov-14
In Next Session we are going to Learn
Internal rate of return

Sensitive analysis
Tuesday 07/08/2012
01:30 4:30
21

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19 Nov 2014

Investment Theory & Practices

Investment is time, energy, or matter spent in the hope of

In finance the purchase of a financial product or other

What do we know about investment appraisal

Investment appraisal is used to look at a potential capital

Investment appraisal methods

What a difference between 1 now and 1 in a

Time value of money

For example: the annual interest rate is 10%, I

10% is called cost of capital; ? is called the

The payback period is the amount of time taken

Formula Payback period = Initial

Advantages /Disadvantages of Payback method

Look on cumulative cash flow in end of year 3 ( 400) left to

Discounted Cash Flow/NPV

NPV Pros(advantages) /Cons( disadvantages)

Net Present value

Calculate Payback period / Net Present value ( using cheat

Payback and NPV method both useful to make any investment

Payback/ Net Prevent value Application

Useful resource to enhance understanding in project

Bodie Zvi and Merton Robert (1998) Finance first edition

In Next Session we are going to Learn

Internal rate of return

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