Investment Decisions

1. Capital Budgeting or Investment Decisions

These are related to long term investment decisions or for fixed assets.

2. Types of Decisions
(A) Mutually Exclusive – Select one and rest all gets rejected
(B) Independent – Select any number of projects
(C) Complimentary – If main even accepted then associated events will also get accepted
(D) Replacement or Modernisation – Old assets are replaced with new assets
(E) Expansion – It is done to increase production capacity
(F) Diversification – It is aimed for introduction of new product
 Investment Decisions
3. Calculation of Book Profit
Particulars Amount (`)
Operating Revenue (e.g. sales etc.) -
Less: Operating cash costs -
Profit before depreciation (or Cash flow before tax) -
Less: Depreciation -
Profit before tax -
Less: Tax -
Profit after tax -
 Investment Decisions
4. Calculation of Cash Flows
Cash flows before tax = PBD
Cash flows after tax = PBD – Tax + Tax saving on loss
Cash flows after tax = PAT + Depreciation + Tax saving on loss
Cash flow after tax = Cash flow before tax (1 – t) + (Depreciation ´ t)
 Investment Decisions
5. Cash flows from sale of assets

Particulars Amount (`)

Cost of Assets -
Less: Accumulated depreciation -
Book value of assets (A) -
Sale value of assets (B) -
Profit/(loss) on sale of assets (A – B) -
Tax/(tax saving) on sale (C) -
Net cash flows from sale of assets (D = B – C) -
 Investment Decisions
6. Concept of Block of Assets
 Investment Decisions
7. Techniques of Capital Budgeting
(A) Traditional techniques:
(1) Accounting Rate of Return (ARR)
(2) Payback period (PBP)
(B) Modern Techniques
(1) Discounted Payback period
(2) Net Present Value (NPV)
(3) Profitability Index (PI)
(4) Internal Rate of Return (IRR)
(5) Modified Internal Rate of Return (MIRR)
 Investment Decisions
8.Accounting Rate of Return or Average Rate of Return (ARR)
It is the rate of return generated on the funds invested which is based on book profits.
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ARR = ×100
!"#$%&# )*"#+,-#*,

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ARR on Original investment = ×100
.$/&/*%0 )*"#+,-#*,

Where,
'!(12'!(32⋯2'!(*
Average PAT =
*

!)12!)32⋯2!)*
Average investment of Project =
*

.5#*/*&2607+/*&
Average investment of a year (AI) =
3

Average Investment of Project = ½(Cost of Project – Scrap value) + Scrap Value + WC

(in case of SLM)
 Investment Decisions
Decision Criteria of ARR
General Rule - Maximum ARR
Mutually Exclusive – Project with maximum ARR
Independent:
Project ARR > Required ARR
Project ARR < Required ARR
Project ARR = Required ARR
 Investment Decisions
9. Payback Period
It is the duration during which cost of project is recovered out of cash inflows.
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Payback period (when CFs are equal) =
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Payback period (when CFs are unequal)

- Calculate cumulative cash flows
- Calculate PBP
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Payback reciprocal =
)*/,/%0 /*"#+,-#*,
 Investment Decisions
Decision Criteria of PBP
General Rule - Minimum PBP
Mutually Exclusive – Project with minimum PBP
Independent:
Project PBP > Required PBP
Project PBP < Required PBP
Project PBP = Required PBP
 Investment Decisions
10. Time Value of Money
 Investment Decisions
Compounding Discounting
Single Amount CVF(r, n) = (1 + r)n 1
PVF(r, n) =
1+@ !

Compound Value
Present Value
= Amount ´ CVF(r, n)
= Amount ´ PVF(r, n)

Series of Same (1+@)! −1 PVAF = Sum total of PVF

CVAF(r, n) =
@
amount
or Present Value
Compound Value
Annuity = Annual amount ´ PVAF(r, n)
= Annual amount ´ CVAF(r, n)
 Investment Decisions
11. Discounted Payback Period
It is the duration during which cost of project is recovered from present value of cash inflows of the project.
Step - 1) Calculate discounted cash inflows
Step – 2) Calculate discounted payback period
Decision Criteria
General Rule - Minimum Discounted PBP
Mutually Exclusive – Project with minimum Discounted PBP
Independent:
Project Discounted PBP > Required Discounted PBP
Project Discounted PBP < Required Discounted PBP
Project Discounted PBP = Required Discounted PBP
 Investment Decisions
12. Net Present Value (NPV)
NPV = PV of cash inflows – PV of cash outflows = PVCI – PVCO
If life of project are different then decision will be based on equivalent annual NPV or equivalent annual PVCO
D'E
Equivalent Annual NPV =
'E!F 87$ G/8#

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Equivalent Annual PVCO =
'E!F 87$ G/8#

Decision Criteria
General Rule - Maximum NPV
Mutually Exclusive – Project with maximum NPV
Independent:
NPV = + ve Accept
- ve Reject
=0 May or may not
 Investment Decisions
13. Points to Remember (PTRs)
Unless otherwise provided, following points are to be assumed:
(a) Cost of project will be incurred at beginning of the project
(b) Working capital investment will be incurred at beginning of the project
(c) Revenue cash inflows will be at the end of the respective year
(d) 100% of working capital will be realized at end of the project
(e) Sale of assets
• In case of depreciable assets, sale value = salvage or scrap value
(if scrap value not given than sale value = 0)
• In case of non-depreciable assets, sale value = cost of assets
 Investment Decisions
14. Treatment of Costs
 Investment Decisions
15. Profitability Index (PI)
It is the amount of cash inflow generated for every rupee of cash outflows.
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PI =
'E6.

Decision Criteria
General Rule - Maximum PI
Mutually Exclusive – Project with maximum PI
Independent:
PI = >1 PVCI > PVCO NPV = +ve Accept
<1 PVCI < PVCO NPV = -ve Reject
=1 PVCI = PVCO NPV = 0 May or may not
 Investment Decisions
16. Capital Rationing
Capital Rationing

(1) Calculate PI
Divisible Projects Part Investment is possible (2) Select in order of PI starting
from highest to lowest

(1) Make various combinations

possible
(2) Calculate NPV for each
Indivisible Projects Part Investment is not possible
combination
(3) Select combination having
highest NPV or benefit
 Investment Decisions
17. Internal Rate of Return (IRR)
- Calculate NPV at discount rate given in question (can start with any % given in ques.)
- If NPV is +ve, increase rate to make it -ve.
- If NPV is -ve, decrease rate to make it +ve.
GH D'E
- IRR = $% + '% − $%
(GH D'EIJH D'E)

Decision Criteria
General Rule - Maximum IRR
Mutually Exclusive – Project with maximum IRR
Independent:
IRR = > COC, Accept
< COC, Reject
= COC, May or may not
 Investment Decisions
18. NPV vs IRR
NPV is superior to IRR due to:
(a) Reinvestment rate assumption
• NPV – assume it at cost of capital
• IRR – assume it at IRR

(a) Multiple IRR can be computed with same data but it is not possible with NPV
 Investment Decisions
19. Modified Internal Rate of Return (MIRR)
It is based on compounding technique.
It assumes reinvestment of intermediate cash flows at cost of capital only.
Step – 1) Calculate total compound value of intermediate cash flows at end of project
Step – 2) Initial outflow ´ (1 + r)n = Total compound value
From above equation find r which is equal to MIRR

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Or MIRR = −1
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 Investment Decisions
Decision Criteria
General Rule - Maximum MIRR
Mutually Exclusive – Project with maximum MIRR
Independent:
MIRR = > COC, Accept
< COC, Reject
= COC, May or may not
 Investment Decisions
20. Replacement Decisions
(a) Calculate Initial cash outflows
Particulars Amount
Cost of new assets -
(-) Sale value of old assets -
(-) Tax saving on loss on sale of old assets -
(+) Tax payment on profit on sale of old assets -
(+) Increase in working capital -
(-) Decrease in working capital -
Cash Outflows -
 Investment Decisions
(b) Calculate Incremental Revenue CFs
Particulars Amount
Increase in sales -
(+) Savings in costs -
(-) Increase in costs -
Incremental PBD -
(-) Increase in Depreciation (New – Old) -
Incremental PBT -
(-) Tax -
Incremental CFs -

(c) Calculate incremental sale of assets at end and working capital realization
(d) Calculate NPV or IRR and take decision