Long term decision making.pptx
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Here are the steps to calculate the profitability index for this project: 1) Calculate the net present value (NPV) of the cash flows: Year 1: CF = Rs. 40,000; PV Factor @ 10% = 0.909; PV = Rs. 40,000 * 0.909 = Rs. 36,360 Year 2: CF = Rs. 30,000; PV Factor @ 10% = 0.826; PV = Rs. 30,000 * 0.826 = Rs. 24,780 Year 3: CF = Rs. 50,000; PV Factor @ 10% = 0.751; PV = Rs. 50,000 * 0.751 = Rs. 37,
Long term decision making.pptx
- 1. Chapter 4 Long term Decision Making By Prof. Suku Thomas Samuel Department of Management
- 2. Capital Investment Process The steps for capital investment process are as follows: 1. Identify Objectives 2. Search of Investment opportunities 3. Identify states of nature 4. List possible outcomes 5. Measure payoffs 6. Select investment projects 7. Obtain authorisation & implement projects 8. Review capital investment decisions
- 3. Time value of Money The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim. 1. Future value of money 2. Present value of money
- 5. Investment appraisal There are four widely used appraisal methods: 1. Payback period. 2. Accounting Rate of Return (ARR) 3. Internal Rate of Return (IRR) 4. Net Present Value (NPV)
- 6. Payback Period The payback period is the time a project will take to pay back the money spent on it. It is based on expected cash flows and provides a measure of liquidity and risk (the quicker that an investor can recover the initial investment the quicker they can reinvest it elsewhere and the lower the risk of this particular investment). This is the time which elapses until the invested capital is recovered. It considers cash flows only.
- 7. Payback Period The advantages of payback period are as follows: i. Simplicity ii. Improving investment conditions iii. Payback favours projects with a quick return iv. Cash flows The disadvantages of payback period are as follows: i. Project returns may be ignored ii. Time value of money iii. Lack of objectivity
- 8. Accounting rate of return (ARR) The ARR method calculates a percentage return provided by the accounting profits of the project. The ‘average annual profit’ is after depreciation. Net cash flow is normally equivalent to ‘profit before depreciation’. The ARR for a project may be compared with the company's target return and if higher the project should be accepted. Faced with a choice of mutually-exclusive investments, the project with the highest ARR should be chosen
- 9. Accounting rate of return (ARR) The advantages of ARR are as follows: i. Simple to understand: It is easily understood and easily calculated. ii. Widely used and accepted. iii. Considers the whole life of the project. The disadvantages of ARR are as follows: i. Ignores the time value of money. ii. Not a measure of absolute profitability. iii. Does not consider cash flows.
- 10. Internal Rate of Return Internal rate of return is a method of calculating an investment’s rate of return. When calculating IRR, expected cash flows for a project or investment are given and the NPV equals zero. Once the internal rate of return is determined, it is typically compared to a company’s hurdle rate or cost of capital.
- 11. Internal Rate of Return (IRR) The advantages of IRR are as follows: i. Considers the time value of money. ii. Simple to interpret. iii. Method to rank projects for profitability. The disadvantages IRR are as follows: i. Provides an incomplete picture of the future. ii. Does not account for reinvestments.
- 12. Net Present Value (NPV) Net Present Value (NPV) is the value of all future cash flows. The cash flow can be positive or negative. Form of intrinsic valuation and is used extensively across finance. Helps to determine how much an investment, project, or any series of cash flows is worth.
- 13. Net Present Value (NPV) The advantages of NPV are as follows: i. Considers the time value of money. ii. Helps to compare mutually exclusive projects. iii. Helps quick decision making process. The disadvantages NPV are as follows: i. Cannot be used to compare projects of different sizes. ii. Does not consider any hidden costs, sunk costs etc.
- 14. Capital Rationing Capital rationing occurs when insufficient funds are available to undertake all beneficial projects. Strategy used by companies or investors to limit the number of projects they take on at a time. Capital rationing is the process through which companies decide how to allocate their capital among different projects, given that their resources are not limitless. Hard capital rationing refers to restraints put on a company by outside entities, such as banks or other lenders. Soft capital rationing results from a company's own policies relating to how it wants to use its capital.
- 15. PAYBACK PERIOD • Duration required to recover amount spent in an investment. • Traditional & simple technique for application. • Has two scenarios: even cash flow & uneven cash flow. I. Even cash flow: Applied when the cash inflow is even throughout the years PBP = Intial Investment Annual cash flow
- 16. Uneven cash flow: Applied when the cash inflow is uneven throughout the years PBP = Year before the recovery of investment + Additional cash flow for recover of investment Actual Cashflow received PAYBACK PERIOD – Uneven Cashflow
- 17. PAYBACK PERIOD - Question Karnataka Soap factory is planning to buy a soap moulding machine for expansion. The management has identified 2 mutually exclusive machines which requires an investment of Rs 1,00,000 each. The following are the cash flows expected: Year Bhakti Shakti 1 30,000 25,000 2 30,000 25,000 3 30,000 25,000 4 30,000 25,000 5 30,000 25,000
- 18. PAYBACK PERIOD - Question The canteen is planning to invest in automated beverage vending machine, the management of the canteen has identified 2 machines – Ben & Zen, each costing Rs 30,000. The following are the estimated profits: Year 1 2 3 4 5 Ben 10,000 10,000 4,000 6,000 8,000 Zen 8,000 10,000 10,000 6,000 7,000
- 19. NET PRESENT VALUE (NPV) Air Waves corporation is planning to in two technology solutions that are available: 4G & 5G, costing Rs 5,00,000 & Rs 6,00,000 respectively. The estimated profits are expected to be as follows: Year 4G 5G PV 1 1,50,000 50,000 0.909 2 2,00,000 1,50,000 0.826 3 2,50,000 2,00,000 0.751 4 1,50,000 3,00,000 0.683 5 1,00,000 2,00,000 0.620
- 20. Profitability Index The initial investment of a project is Rs 1,00,000. The cash flows generated by the company for 4 years are Rs 40,000; Rs 30,000; Rs 50,000 and Rs 20,000. Calculate PI at 10% rate of discount.
Editor's Notes
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