Unit-II

Long-term Investment Decisions

Investment Decision: Concept, nature of capital budgeting, determination of relevant cash flows, capital
budgeting techniques: Discounted cash flow (DCF) as well as Non-Discounted cash flow techniques
(Non-DCF), decision criteria and evaluation of these techniques, NPV vs IRR, Reinvestment
assumption and Modified Rate of return.
Part I: Capital Budgeting

Learning Objectives:

• Understand the nature and importance of Investment Decisions

• Discounted Cash Flow (DCF) methods of Capital Budgeting: Net
Present Value (NPV); Internal rate of return (IRR) and Profitability
Index (PI)
• NPV vs. IRR
• Non-discounted Methods of of Capital Budgeting: Payback (PB);
Discounted Payback and Accounting rate of return (ARR).
Introduction
• Investment decisions of a firm
• Capital Budgeting decision
• Features of Investment decisions :
- Current funds for future benefits
- Long-term assets
- Future benefits over a number of years
• Importance of Investment Decisions
- Influence on firm’s growth
- Risk
- Commitment of large funds
Types of Investment Decisions
• Expansion

• Diversification

• Replacement
Investment Evaluation Criteria/Steps
• Estimation of Cash Flows
• Estimation of the required rate of return
• Application of the decision rule

Investment Decision Rule

• Consider all cash flows
• Separating good projects from bad ones
• True profitability
• Bigger Cash flows are preferable to smaller ones
• Choose among mutually exclusive projects
DCF Techniques: Net Present Value (NPV)
• Cash flows are forecasted on real assumptions
• Appropriate discount rate identified
• PV of CFs is estimated using the opportunity cost of capital
• NPV= PV of cash inflows- PV of cash outflows
• Accept the project if NPV>0, reject if NPV<0, if NPV=0 (consider
other factors for decision).
Net Present Value (NPV): Example 1

NPV= Rs. 225

 Importance of Net Present Value (NPV)
• Best interest of the shareholders at the core

• Direct effect on the Total Market Value of the firm

• For example, Project X in example 1 is accepted, it will increase the

value of the firm directly by Rs. 225

• Acceptance rule
Evaluation of Net Present Value (NPV) Method: Advantages &
Limitations
Advantages:
• Time value of money
• Measure of the true profitability
• Value-additivity
• Shareholder value
Limitations:
• Cash flow estimation
• Mutually exclusive projects
• Ranking of projects
Net Present Value (NPV): Example 2
Swanson Industries has a project with the following projected cash flows:
Initial Cost, Year 0: $240,000; Cash flow year one: $25,000; Cash flow year
two: $75,000
Cash flow year three: $150,000; Cash flow year four: $150,000.
a. Using a 10% discount rate for this project and the NPV model should
this project be accepted or rejected?
b. Using a 15% discount rate?
c. Using a 20% discount rate?

a. NPV = $59,859.98 and b. NPV = $22,840.31 and

accept the project accept the project
c. NPV = -$7,939.82 and
reject the project
Net Present Value (NPV): Example 3
Net Present Value – Campbell Industries has a project with the following
projected cash flows:
Initial Cost, Year 0: $468,000; CF1: $135,000; CF2: $240,000; CF3:
$185,000; CF4: $135,000
a. Using an 8% discount rate for this project and the NPV model should
this project be accepted or rejected?
b. Using a 14% discount rate?
c. Using a 20% discount rate?

a. NPV = $108,849.31 and b. NPV = $39,893.83 and

accept the project. accept the project.
c. NPV = -$16,668.97 and
reject the project.
Net Present Value (NPV): Example 4
•Swanson Industries has four potential projects all with an initial cost of
$2,000,000. The capital budget for the year will only allow Swanson
industries to accept one of the four projects. Given the discount rates and
the future cash flows of each project, which project should they accept?
Cash Flows Project M Project N Project O Project P

Year one $500,000 $600,000 $1,000,000 $300,000

Year two $500,000 $600,000 $800,000 $500,000

Year three $500,000 $600,000 $600,000 $700,000

Year four $500,000 $600,000 $400,000 $900,000

Year five $500,000 $600,000 $200,000 $1,100,000

Discount Rate 6% 9% 15% 22%

DCF Techniques: Internal Rate of Return (IRR)
• Takes into account magnitude and timing of cash flows
• Also called yield on an investment, marginal efficiency of capital, rate
of return over cost, time-adjusted rate of return
• It is also the discount rate which makes NPV=0
• Acceptance Rule: Reject the project if its IRR is lower than
The cost of capital (r<k).

Example 6: A project costs Rs. 16,000 and is expected

To generate cost inflows of Rs. 8000, Rs. 7000 and Rs. 6000
At the end of each year for next 3 years.
Evaluation of IRR Method: Advantages &
Limitations
Advantages:
• Time value of money
• Measure of the true profitability
• Acceptance rule
• Shareholder value
Limitations:
• Multiple rates
• Value additivity
• Mutually exclusive projects
DCF Techniques: Profitability Index (PI)
• Ratio of the PV of cash inflows, at the required rate of return,
to the initial cash outflow of the investment.
• PI= PV of cash inflows
Initial cash outlay
• Acceptance Rule: Reject the project when PI is less than 1.

Example 7: The initial outlay of a project is Rs. 1,00,000 and it

can generate cash inflow of Rs. 40000, Rs. 30000, Rs. 50000
and Rs. 20000 in year 1 through 4. Assume a 10% rate of
discount. Calculate PI of the project and decide whether to
accept or reject it.
Evaluation of PI: Advantages & Limitations
Advantages:
• Time value of money
• Value maximization
• Relative profitability
Limitations:
• Cash flow estimation
• Discount rate
Non-DCF Techniques: Payback
• Most popular and widely recognized
• Number of years required to recover the original cash outlay
invested in a project.
• If CFs are even, PB is computed by dividing the Initial
Investment by Annual cash inflow.
• If CFs are uneven, PB is computed by adding up the cash
flows until the total is equal to the initial CF.
• Acceptance Rule: Compare project’s payback with a pre-
determined, standard payback. The project would be accepted
if its payback period is less than the maximum or standard
payback period set by the management.
Non-DCF Techniques: Payback
Example 8: (CFs are consistent)
Assume that a project requires an outlay of Rs. 50,000 and yields
annual cash inflow of Rs. 12,500 for 7 years. Calculate the
payback period for the project.
Ans: 50000/12500 = 4 Years

Example 9: (CFs are inconsistent)

Suppose that the project requires a cash outlay of Rs. 20,000,
and generates cash inflows of Rs. 8,000; Rs 7000; Rs 4000 and
Rs. 3000 during next 4 years. What is the project’s payback?
Evaluation of PB: Advantages & Limitations
Advantages:
• Simplicity
• Cost effective
• Risk shield
• Liquidity
Limitations:
• Cash flow after payback
• Cash flow patterns
• Administrative difficulties
• Inconsistent shareholder value
Example 15:

Example 16: A project costs Rs. 20,00,000 and yields

annually a profit of Rs. 3,00,000 after depreciation @ 12½
% but before tax at 50%. Calculate the pay-back period.
Example 17: Certain projects require an initial cash outflow of Rs. 25,000 Option A The
cash inflows for 6 years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs.
3,000. Find out through pay back period which one is good?

Option B: Project require an initial cash outlay is 36,000. The cash inflows are for 6 years
as follows; 4590, 7500, 5600, 7700,9500, 6500.
A project cost is 40,000. Its stream of earnings before deprecation, interest and taxes
(EBDIT) during first year through five years is expected to be 10,000; 12,000; 14,000;
16,000; and 20,000. Assume 50 % tax and rate of deprecation is SLM.
Thank You