Investment decision

INDEX
SR.NO PARTICULARS PAGE NO
1. INTRODUCTION TO INVESTMENT 6
2 CAPITAL BUDGETING 9
3 CASH FLOW, INFLOW, OUTFLOW 16
4 TECHINQUES OF EVALUATION 23
5 PROBLEMS WITH SOLUTIONS 36
6 CONCLUSION 43
7 BIBLIOGRAPHY 44

Chapter 1: INTRODUCTION TO INVESTMENT
Meaning of investment:
An asset or item that is purchased with the hope that it will generate income or
appreciate in the future is called investment. In an economic sense, an investment
is the purchase of goods that are not consumed today but are used in the future to
create wealth. In finance, an investment is a monetary asset purchased with the
idea that the asset will provide income in the future or appreciate and be sold at a
higher price.
Meaning of Investment decision:
Determination of where, when, how, and how much capital to spend and/or debt to
acquire in the pursuit of making a profit. An investment decision is often reached
between an investor and his/her investment advisors. Factors contributing to an
investment decision include, but are not limited to: capital on hand, projects or
opportunities available, general market conditions, and a specific investment
strategy.

Investment Decisions are the decisions wherein the decisions are made to deploy /
invest funds in asset / investment instrument with objective to earn either valuation
increase of returns in form of %.
Target returns on an investment include:
i. Increase in the value of the securities or asset, and/or
ii. Regular income must be available from the securities or asset.
Types of Investment:
1. Autonomous Investment
2. Induced Investment
3. Financial Investment
4. Real Investment
5. Gross Investment
6. Net Investment
Cost of Capital:
Cost of capital may be defined as the company's cost of collecting funds. This is
equal to the average rate of return that an investor in a company will expect for
providing funds. It is the minimum rate of return that the project must earn to keep
the value of the company intact. The minimum rate of return is equal to cost of
capital.
It is the opportunity cost of an investment; that is, the rate of return that a company
would otherwise be able to earn at the same risk level as the investment that has
been selected.

The cost of capital in always expressed in terms of percentage. Proper allowance is
made for tax purposes. This is done to get a correct picture of the cost of capital. In
order to calculate the overall cost of capital, a finance manager has to take the
following steps:-
1. Determine the type of funds to be raised and their share in the capital
structure.
2. Determine cost of each type of funds.
3. Calculate combined cost of capital of the company by giving weights to each
type of funds in terms of proportion of funds raised to total funds.
The most widely used concept is weighted average cost of capital. A company's
weighted average cost of capital (WACC) is comprised of the following costs:
1. Cost of debt
2. Cost of preferred stock
3. Cost of retained earnings
4. Cost of external equity

Chapter 2: CAPITAL BUDGETING
Definition of Capital Budgeting
Capital Budget is also known as "Investment Decision Making or Capital
Expenditure Decisions" or "Planning Capital Expenditure" etc. Normally such
decisions where investment of money and expected benefits arising there from are
spread over more than one year, it includes both raising of long-term funds as well
as their utilization.
Charles T. Horngnen has defined capital budgeting as "Capital Budgeting is long-
term planning for making and financing proposed capital outlays."
From the above definition, it may be concluded that capital budgeting relates to the
evaluation of several alternative capital projects for the purpose of assessing those
which have the highest rate of return on investment.
Meaning
The term Capital Budgeting refers to the long-term planning for proposed capital
outlays or expenditure for the purpose of maximizing return on investments. The
capital expenditure may be:
(1) Cost of mechanization, automation and replacement.

(2) Cost of acquisition of fixed assets. e.g., land, building and machinery etc.
(3) Investment on research and development.
(4) Cost of development and expansion of existing and new projects.
Capital budgeting (or investment appraisal) is the planning process used to
determine whether an organization's long term investments such as new machinery,
replacement machinery, new plants, new products, and research development
projects are worth the funding of cash through the firm's capitalization structure
(debt, equity or retained earnings). It is the process of allocating resources for
major capital, or investment, expenditures. One of the primary goals of capital
budgeting investments is to increase the value of the firm to the shareholders.
Capital budgeting involves allocating the firm's capital resources between
competing project and investments.
Objectives of Capital Budgeting
The following are the important objectives of capital budgeting:
(1) To ensure the selection of the possible profitable capital projects.
(2) To ensure the effective control of capital expenditure in order to achieve by
forecasting the long-term financial requirements.
(3) To make estimation of capital expenditure during the budget period and to see
that the benefits and costs may be measured in terms of cash flow.
(4) Determining the required quantum takes place as per authorization and
sanctions.

(5) To facilitate co-ordination of inter-departmental project funds among the
competing capital projects.
(6) To ensure maximization of profit by allocating the available investible.
Principles or Factors of Capital Budgeting Decisions
(1) A careful estimate of the amount to be invested.
(2) Creative search for profitable opportunities.
(3) A careful estimates of revenues to be earned and costs to be incurred in future
in respect of the project under consideration.
(4) A listing and consideration of non-monetary factors influencing the decisions.
(5) Evaluation of various proposals in order of priority having regard to the amount
available for investment.
(6) Proposals should be controlled in order to avoid costly delays and cost over-
runs.
(7) Evaluation of actual results achieved against those budget.
(8) Care should be taken to think all the implication of long range capital
investment and working capital requirements.
(9) It should recognize the fact that bigger benefits are preferable to smaller ones
and early benefits are preferable to latter benefits. Capital budgeting is vital in
marketing decisions. Decisions on investment, which take time to mature, have to
be based on the returns which that investment will make. Unless the project is for

social reasons only, if the investment is unprofitable in the long run, it is unwise to
invest in it now.
Often, it would be good to know what the present value of the future investment is,
or how long it will take to mature (give returns). It could be much more profitable
putting the planned investment money in the bank and earning interest, or investing
in an alternative project.
Typical investment decisions include the decision to build another grain silo,
cotton gin or cold store or invest in a new distribution depot. At a lower level,
marketers may wish to evaluate whether to spend more on advertising or increase
the sales force, although it is difficult to measure the sales to advertising ratio.
Chapter objectives
This chapter is intended to provide:
 An understanding of the importance of capital budgeting in marketing decision
making
 An explanation of the different types of investment project
 An introduction to the economic evaluation of investment proposals
 The importance of the concept and calculation of net present value and internal
rate of return in decision making
 The advantages and disadvantages of the payback method as a technique for
initial screening of two or more competing projects.
Structure of the chapter

Capital budgeting is very obviously a vital activity in business. Vast sums of
money can be easily wasted if the investment turns out to be wrong or uneconomic.
The subject matter is difficult to grasp by nature of the topic covered and also
because of the mathematical content involved. However, it seeks to build on the
concept of the future value of money which may be spent now. It does this by
examining the techniques of net present value, internal rate of return and annuities.
The timing of cash flows are important in new investment decisions and so the
chapter looks at this "payback" concept. One problem which plagues developing
countries is "inflation rates" which can, in some cases, exceed 100% per annum.
The chapter ends by showing how marketers can take this in to account.
Capital budgeting versus current expenditures
A capital investment project can be distinguished from current expenditures by two
features:
a) such projects are relatively large
b) a significant period of time (more than one year) elapses between the investment
outlay and the receipt of the benefits.
As a result, most medium-sized and large organisations have developed special
procedures and methods for dealing with these decisions. A systematic approach to
capital budgeting implies:
a) the formulation of long-term goals
b) the creative search for and identification of new investment opportunities

c) classification of projects and recognition of economically and/or statistically
dependent proposals
d) the estimation and forecasting of current and future cash flows
e) a suitable administrative framework capable of transferring the required
information to the decision level
f) the controlling of expenditures and careful monitoring of crucial aspects of
project execution
g) a set of decision rules which can differentiate acceptable from unacceptable
alternatives is required.
The last point (g) is crucial and this is the subject of later sections of the chapter.
The classification of investment projects
a) By project size
Small projects may be approved by departmental managers. More careful analysis
and Board of Directors' approval is needed for large projects of, say, half a million
dollars or more.
b) By type of benefit to the firm
· an increase in cash flow
· a decrease in risk
· an indirect benefit (showers for workers, etc)
c) By degree of dependence

 Mutually exclusive projects (can execute project A or B, but not both)
 Complementary projects: taking project A increases the cash flow of project
B.
 Substitute projects: taking project A decreases the cash flow of project B.
d) By degree of statistical dependence
· Positive dependence
· Negative dependence
· Statistical independence.
e) By type of cash flow
· Conventional cash flow: only one change in the cash flow sign
e.g. -/++++ or +/----, etc
· Non-conventional cash flows: more than one change in the cash flow sign,
e.g. +/-/+++ or -/+/-/++++, etc.
The economic evaluation of investment proposals
The analysis stipulates a decision rule for:
I) accepting or
II) rejecting investment projects

Chapter 3- CASH FLOW, INFLOW, OUTFLOW
Cash Flow – Basic Principles
Each capital expenditure project has two aspects: cash is expected to be paid out
(cash outflow); and in return cash is expected to come in or saved (cash inflow or
savings). Therefore a decision on capital expenditure is generally taken on the
basis of comparative study of cash inflows and cash outflows.
1. Incremental Principle: The cash flows of a project must be measured in
incremental terms. To ascertain a project’s incremental (additional) cash
flows, one has to look at what happens to the cash flows of the firm ‘with the
project and without the project’, and not before the project and after the
project as is sometimes done. The difference between the two reflects the
incremental cash flows attributable to the project.
Project cash flows for year t = cash flow for the firm with project for year t –
cash flow for the firm without the project for year t.
2. Long term funds principle: A project may be evaluated from various points
of view: total funds point of view, long-term funds point of view, and equity
point of view. The measurement of cash flows as well as the determination

of the discount rate for evaluating the cash flows depends on the point of
view adopted. It is generally recommended that a project may be evaluated
from the point of view of long-term funds (which are provided by equity
stockholders, preference stockholders, debenture holders, and term lending
institutions) because the focus of such evaluation is normally on the
profitability of long term funds.
3. Exclusion of financial cost of principle: When cash flows relating to long
term funds are being defined, financing costs of long term funds (interest on
long term debt and equity dividend) should be excluded from the analysis.
The weighted average cost of capital used for evaluating the cash flows
takes into account the cost of long-term funds. Put differently, the interest
and dividend payments are reflected in the weighted average cost of capital.
Hence, if interest on long term debt and dividend on equity capital are
deducted in defining the cash flows, the cost of long term funds will be
counted twice. The exclusion of financing costs principle means that:
1. The interest on long term debt (or interest) is ignored while comparing
profits and taxes. Since interest is usually deducted in the process of
arriving at profit after tax, an amount equal to interest (1- tax rate) should
be added back to the figure of profit after tax.
2. The expected dividends are deemed irrelevant in cash flow analysis, as
they come only from profits after taxes.
4 Post tax principle: Tax payments must be deducted in computing the cash
flows. That is, cash flows must be defined in post tax terms.
Cash Inflow

1. Operating Inflows: The estimate of the future benefits accruing from the
investment proposal is the starting point of capital expenditure decisions. A
new investment proposal is the starting point of capital expenditure
decisions. A new investment may increase cash either by actual receipt of
cash or by reducing expenditure. Such benefits should be calculated on cash
basis and hence it is also called cash inflow. Hence, the accounting profit has
to be adjusted for estimating the future cash inflows. Further, such cash
inflows should be estimated on an after tax basis.
Thus, cash inflows after tax should be calculated as under:
1. Calculate Accounting profit i.e., total revenues minus total expenses
including depreciation.
2. Deduct the amount of tax applicable to the above amount of accounting
profit.
3. Add the amount of depreciation.
These inflows, during the operational life of investment, are known as
operating cash inflows.
2. Salvage Value: Cash inflows in the last year of the investment project may
also arise from salvage value. Salvage value is the estimated value of the
asset (investment) at the completion of its economic life. This should be
treated as cash inflows in that year of the completion of economic life.
3. Working Capital: Again, an investment proposal may require increased
working capital in the beginning which is a cash outflow for initial
investment. Such increased working capital will be released or recovered at
the end of project’s useful life and hence in that year, it should be treated as
cash inflow.

4. Terminal Inflows: Inflows from salvage and recovery of working capital in
the last year are known as terminal cash inflows.
Illustration 1:
X ltd is considering purchase of a machine whose cost is Rs.12000. Assuming the
annual cash savings from using this machine is Rs.5600 before depreciation
(Rs.2400) and tax rate is 50%, calculate cash inflow.
Solution:
Computation of cash inflow
Particulars Amount
Income (annual cash savings)
Less: Depreciation
Net Profit after deprecation
Less: Tax
Net Profit after tax (Savings after tax)
Add: Depreciation
Cash inflow
5600
(2400)
3200
(1600)
1600
2400
4000

Cash Outflow
Cash outflow at zero time period refers to the sum of all cash outflows and inflows
occurring at the time the expenditure is made to determine the initial investment
requirement of the proposed capital expenditure. This time is generally called zero
time period. The following factors are taken into account, while determining the
initial investment or cash outflow:
1. Cash cost of new project: This is the total cash payments made to suppliers
of, say, machineries.
2. Installation charges: This is the cash paid for installation of above machines.
3. Working Capital:
1. First Year: If the proposed investment project creates the need for
additional working capital, additional funds will have to be arranged and
will be tied up for the whole period of investment project’s life. Thus,
this additional working capital or increased working capital should be
added to cost of new project.
2. Subsequent Year: It should be noted that the increased working capital
required in the subsequent years should be treated as cash outflow of that
year and should be adjusted against cash inflow of that very year. It
should not be added to initial investment.

3. Last Year: In the last year, working capital will be released/recovered and
is added to the terminal cash inflow.
4. Proceeds from sale of old assets: Where the investment proposal involves
the replacement of old asset by new asset and for that purposeold asset is
disposed off, proceeds of old asset should be deducted from the cost of
new project. In other words, cash realized on account of the sale of old
asset is a cash inflow and should be adjusted against cash outflow at the
zero period. The profits on such sale proceeds may give rise to taxes. It
should be noted that the sale proceeds minus taxes should be deducted
from the cost of new project.
Calculation of cash outflow
Step Particulars Amount
1
2
3
4
5
Cost of the new project
Add: Installation charges
Increased working capital at zero time
Total(A)
Less: working capital at zero time
Sale proceeds of assets
Total(B)
Net Cash outflow (A-B)
Xxx
Xxx
Xxx
Xxx
Xxx
Xxx
Xxx
xxx

Illustration 2:
X ltd. is planning to replace an old machine with a new one. The cost of the new
machine is Rs.540000. installation charges will be Rs.20000. it is expected that
additional working capital requirement will be Rs.40000. the old machine was
bought two years ago at a cost of Rs.140000. and it has its economic life of 7
years. It was depreciated on straight line basis. A buyer is willing to purchase this
machine for Rs.180000 and will also bear removal expenses. The income tax on
profit from sale on machine is Rs.34000. Estimate the net investment (cash outflow
at zero time period)
Solution:
Particulars Amount Amount
Cost of new machine
Add: Installation charges
Additional working capital
Total (A)
Less: Sale proceeds of old machine 180000
540000
20000
40000
600000

Less: Tax on profit from sale
Net Sales Proceeds
Net Investment/Initial Cash Outflow
34000
146000
454000
Chapter 4- TECHINQUES OF EVALUATION
1. NET PRESENT VALUE (NPV)
In finance, the net present value (NPV) or net present worth (NPW) is defined
as the sum of the present values (PVs) of incoming and outgoing cash flows over a
period of time. Incoming and outgoing cash flows can also be described as benefit
and cost cash flows, respectively.
Time value of money dictates that time has an impact on the value of cash flows.
Cash flows of nominal equal value over a time series result in different effective
value cash flows that makes future cash flows less valuable over time. If for
example there exists a time series of identical cash flows, the cash flow in the
present is the most valuable, with each future cash flow becoming less valuable
than the previous cash flow. Thus, a cash flow today is more valuable than an
identical cash flow in the future. This decrease occurs because the discount factor
represents the expected rate of return of each cash flow in a different investment

with identical risk. With each additional period, the present value of a subsequent
future cash flow decreases.
The NPV method is used for evaluating the desirability of investments or projects.
where:
Ct = the net cashreceipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on investment
n = the project/investment's duration in years.
The discount factor r can be calculated using:
Steps in present value method :
1.
Draw the table showing relevant Outflows associated with
the outflows.

2.
Calculate cash inflows associated with the projects.
3.
Calculate the Present value Figures by multiplying Discount Factor
by the Cash flows.
4.
Make a total of the present values
obtained
5.
Calculate Present Value of cash
inflows.
6.
Calculate the Net Present Value .
N.P.V = P.V. of all Cash inflows – P.V. of all cash outflows .
7.
Decision rule:
If NPV is positive (+): accept the project
If NPV is negative (-): reject the project

Calculationof P.V of Cashoutflow:
Year P.V Factor Rs PV
1 .Costof new machinery
2. Fright carriage & installation
expenses.
3. Workers training expenses
4. Less subsidy from Govt.
5. Working capital at the initial
stage
6. Additional working capital
introduced.
7. Retrenchment compensation.
8. Less Saving tax on
retrenchment compensation
0
0
0
Year of
receipt
0
Year of
induction
0
1
1
1
P.V Factor
1
P.V Factor of
respective year
1
xx
xx
xx
(xx)
xx
xx
xx
xx
xx
xx
(xx)
xx
xx
xx

1 P.V Factor of
year 1 Total P.V
(xx) (xx)
Calculationof P.V. of Cash inflow
Year
(1)
Cash Inflow
(2)
P.V.
Factor (3)
P.V.
(4)
(2X 3)
1
2
3
4
5
XX
XX
XX
XX
XX
XX
XX
XX
XX
XX
XX
XX
XX
XX
XX
XX
 Interpretation of Net PresentValue:
It indicates immediate increase in firm’s wealth on acceptance of project. It
indicates that the firm could raise at the cost of capital.
ADVANTAGES:

1. It considers the cash inflows over the life of the project.
2. This is the best method for decision making for mutually exclusive projects.
3. It leads to maximization of share holders wealth.
4. It considers the total benefits arising out of proposals over its life.
5. It is useful for selection of mutually exclusive projects.
DISADVANTAGES:
1. It is more difficult to calculate than Pay back or ARR method.
2. The accuracy of this method depends on the authenticity of the discounting rate
for calculating the present values. There is lot of difference of opinion regarding
the method of calculating it.
3. This method may not give satisfactory results where two projects having
different effective lives are being compared.
2. PAYBACK PERIOD METHOD
Payback period in capital budgeting refers to the period of time required to recoup
the funds expended in an investment, or to reach the break-even point. For
example, a $1000 investment which returned $500 per year would have a two-year
payback period. The time value of money is not taken into account. Payback period
intuitively measures how long something takes to "pay for itself." All else being
equal, shorter payback periods are preferable to longer payback periods.

It is the time by which the initial investment will be paid by the project. It is the
time required for the project to break-even. The cash inflows here mean the annual
profits after tax but before depreciation. Depreciation is first reduced from the
profits given since it is a valid allowable expenditure. This will give us the profit
before tax from which the tax liability for the year is deducted to get the profits
Post tax. However, depreciation does not involve any outflow of cash since it is not
to be paid and is only an accounting charge.
Therefore, in order to find the actual effective cash inflow it is then added back to
the profits post-tax before comparing the same with the initial outflow to take the
capital budgeting decision.
Formula:
Payback period is usually expressed in years. Start by calculating Net Cash Flow
for each year:
Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1.
Then
Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 +
Net Cash Flow Year 3, etc.)
Accumulate by year until Cumulative Cash Flow is a positive number: that year is
the payback year.
To calculate a more exact payback period: Payback Period = Amount to be
Invested/Estimated Annual Net Cash Flow
It can also be calculated using the formula:

Payback Period = (p - n)÷p + ny
= 1 + ny - n÷p (unit:years)
Where
ny= The number of years after the initial investment at which the last negative
value of cumulative cash flow occurs.
n= The value of cumulative cash flow at which the last negative value of
cumulative cash flow occurs.
p= The value of cash flow at which the first positive value of cumulative cash flow
occurs.
This formula can only be used to calculate the soonest payback period; that is, the
first period after which the investment has paid for itself. If the cumulative cash
flow drops to a negative value some time after it has reached a positive value,
thereby changing the payback period, this formula can't be applied. This formula
ignores values that arise after the payback period has been reached.
There are two ways of calculating Pay-Back (PB) Periods.
a. When the Cash Inflows are uniform every year:
Here the initial cost of investment is divided by the constant annual cash inflow as
defined above to get the Pay-Back Period.
Pay-Back Period = Initial Investment / Normal Cash Inflow

a. When the projected cash inflows are not equal every year:
In such a situation, Pay-Back is calculated by a process of cumulating cash inflows
till they equate the original investment outlay.
Pay-Back Period = Year before full recovery + (Unrecovered amount of
investment + Cash flow during the year)
The project or expenditure with a lower Pay-Back Period is normally preferred.
An alternative way of expressing the Pay-Back Period is the Pay-Back Period
reciprocal which is expressed as:
1 * 100
Pay-Back Period
Higher the reciprocal, more profitable will be the project.
Disadvantages of the payback method:
 It ignores the timing of cash flows within the payback period, the cash flows
after the end of payback period and therefore the total project return.
 It ignores the time value of money. This means that it does not take into
account the fact that $1 today is worth more than $1 in one year's time. An
investor who has $1 today can consume it immediately or alternatively can
invest it at the prevailing interest rate, say 30%, to get a return of $1.30 in a
year's time.
 It is unable to distinguish between projects with the same payback period.
 It may lead to excessive investment in short-term projects.
Advantages of the payback method:

a. It favours projects with shorter pay-back periods since risks normally stand
to be greater in long-term projects as a future is uncertain.
b. The method is very useful in situations of Liquidity Crunch and high cost of
capital as faster recovery of initial investment is necessary.
c. It is most suitable when the future is uncertain.
d. It indicates to the prospective investors when their funds are likely to be
repaid. It does not involve assumptions about the future interest rates.
Decision making
The project with shorter Pay-Back Period should be accepted
i. Accept : Cal PBP < Standard PBP
ii. Reject : Cal PBP > Standard PBP
iii. Considered: Cal PBP = Standard PBP.
3. ACCOUNTING RATE OF RETURN
Accounting rate of return, also known as the Average rate of return, or ARR is
a financial ratio used in capital budgeting. The ratio does not take into account the
concept of time value of money. ARR calculates the return, generated from net
income of the proposed capital investment. The ARR is a percentage return. Say, if
ARR = 7%, then it means that the project is expected to earn seven cents out of
each dollar invested (yearly). If the ARR is equal to or greater than the required
rate of return, the project is acceptable. If it is less than the desired rate, it should
be rejected. When comparing investments, the higher the ARR, the more attractive

the investment. Over one-half of large firms calculate ARR when appraising
projects.
Basic formulas
where
=Profit/investment equals to ARR.
ARR = Incremental Revenue - Incremental Expenses (Including
Depreciation)/Initial Investment
Average Profit = Profit After Tax/Life of Project
4. DISCOUNTED PAYBACK PERIOD METHOD:
Under this method cash flows involved in a project are discounted back to present
value terms. Then the cash flows are compared with the original investment to find
out the payback period. This method allows for timing of the cash flows but it does
not take into account the cash flows after the Payback Period.
Steps:
a) Calculate cash inflows after tax.
b) Calculate cash outflows.
c) Calculate P.V. of all cash Inflows.

d) Calculate P.V. of all cash Outflow.
e) Calculate cumulative cash flow after tax.
f) Find out Discounted Payback Period.
g) Accept the project if Discounted payback period <_ Maximum Acceptable
payback period. Reject if Discounted payback period > Maximum
Acceptable payback period.
5. INTERNAL RATE OF RETURN [IRR] METHOD:
This is the second time-adjusted rate of return method for appraising capital
expenditure decisions. It is the discount rate at which the aggregate present value
of inflows equal the aggregate present value of outflows i.e. the rate at which NPV
= 0. In the Net Present Value Method, the discount rate is normally equal to the
cost of capital which is external to the project under consideration.
But in this method, the discount rate depends on the initial outlay and cash inflows
of the project under consideration. It is therefore, called the Internal Rate of
Return. The IRR, once calculated is then compared to the required rate of return
known as cut- off rate. The project is accepted if the IRR exceeds the cut- off rate.
Otherwise, it is rejected.
Steps:
i. Select a discount Rate and calculate NPV of the Project using the Discount
Rate.
ii. If the NPV is less than zero, try a lower Discount Rate. If the NPV is greater
than zero, try a higher Discount Rate.

iii. Fix up the two discount rates so as to have one negative NPV and one
positive NPV.
iv. Apply the formulas of interpolation.
v. Accept the Project if the IRR exceeds the required rate of return.
IRR = Lower DiscountRate + [(NPV at lowerrate / NPV at lower rate – NPV
at higher rate) * (Higher rate – Lower rate)]
ADVANTAGES:
 It also considers the time value of money.
 It considers the cash flows over the entire life of a project.
 It does not use the cost of capital to determine the present value. It itself
provides a rate of return indicative of the profitability of the proposal.
 It would also lead to a rate in share prices and to maximization of
shareholder’s wealth in the same way as Net Present Value Method.
DISADVANTAGES:
 The procedure for its calculation is complicated and at times tedious.
 Sometimes it leads to multiple rates which further complicate its calculation.
 In case of more than one project, the project with the maximization IRR may
be selected which may not turn out to be one which is the most profitable in
the long run.
 Projects selected on the basis of higher IRR may not be profitable.

 Unless the life of the project can be accurately estimated, assessment of cash
flows cannot be done.
Chapter 5- PROBLEMS WITH SOLUTIONS
Q. Avanti products ltd wants to introduce a new productwill estimated sales life of
5 years. The manufacturing equipment will costRs 250000 with scrap value of
Rs15000 at the end of 5 years. The working capital requirements is Rs20000 which
will be realised after 5 years.
The annual cash inflow and PV factor @10% are :
Year P.V.Factor Rs
1
2
3
4
5
0.909
0.826
0.751
0.683
0.621
125000
150000
187500
180000
112500
The depreciation to be charged under Straight Line Method.
Tax applicable @ 40%.

Evaluate the proposalunder various alternatives.
Solution :
Pay back period
Year Profit
before
depreciation
and tax
Depreciation Tax @
40%
Profit
before
depreciation
but after tax
Cumulative
cash flow
1
2
3
4
5
125000
150000
187500
180000
112500
47000
47000
47000
47000
47000
78000
103000
140500
133000
65500
31200
41200
56200
53200
26200
46800
61800
84300
79800
39300
Net present value
Year Profit before
depreciation
but after tax
Discount factors
@10%
Present value
1 93800 0.909 85264

2
3
4
5
Add : scrap
Working capital
Present value of cash
inflows
Less : present value
of cash outflows
(250000 + 20000)
Net present value
108800
131300
126800
86300
15000
20000
0.825
0.751
0.683
0.621
0.621
0.621
89760
98606
86058
53592
413280
9315
12420
435015
270000
165015
Net present value index = Total Present Value of Cash Inflows
Total Present Value of Cash Outflows
= 435015
270000
= 1.61

Payback period
C ltd considering investing in a project. The expected original investment in the
project will be Rs 200000; the life of project will be 5 years with no salvage value.
The expected net cash inflow after depreciation but before tax during the life of the
project will be as following.
Year 1 2 3 4 5
Rs 85000 100000 80000 80000 40000
The project will be depreciated at the rate of 20% on original cost. The company is
subjected to 30% tax rate. Calculate cash inflow.
Solution
Calculation of Net Cash Inflow
Year PBT Tax @30% PAT Depreciation Net cash
inflow
1
2
85500
100000
25500
30000
59500
70000
40000
40000
99500
110000

3
4
5
Total
Average
80000
80000
40000
24000
24000
12000
56000
56000
28000
269500
53900
40000
40000
40000
96000
96000
68000
469500
93900
Net present value
1. When cashinflows are equal :
Initial investment Rs 200000 . Net cash inflow Rs60000 per year. Life 6 years.
Costof capital 8%. No scrap value . PVAF at 8% for 6 years is 4.63. calculate
NPV.
2. When cashinflows are uneven
Initial investment Rs 60000. Life 5 years. Costof Capital 10 % .
Year Rs P.V. factor at 10% P.V
1
2
3
4
5
14000
16000
18000
20000
25000
0.909
0.826
0.751
0.683
0.621
12726
13216
13518
14660
15525
69645
Solution

1. When cashinflows are equal :
PV of cash inflow ( 60000 * 4.63 ) = 277380
Less: Cash Inflow = 200000
NPV = 77380
The proposal should be accepted.
2. When cashinflows are uneven
NPV = PV of cash inflow – PV of cash outflows
= 69645 – 60000
= 9645
Discounted payback period
DCF ltd is implementing a project with an initial capital outlay of Rs 8000. Its
cash inflows are as under .
Year Cash Inflow
1
2
3
4
6000
2000
1000
5000
The expected rate of return is 12 % p.a.
Calculate the discounted payback period of the project.

Solution
Calculation of Present Values of Cash Flows.
Year Cash Inflow Discount Factor
12%
Present Value
1
2
3
4
6000
2000
1000
5000
0.893
0.797
0.712
0.636
5358
1594
712
3180
10844
Discounted payback period:
Discounted Cash Inflow for the 3 years is Rs 7664 , for Rs 336 ( 800 – 7664 )
1.27 months will be required . Total discounted pay back period will be 3 years
and 1.27 months

CONCLUSION
 They influence the industry growth in long run.
 They affect the risk of the firm
 They involve commitment of large amount of funds
 They are irreversible, or reversible at substantial loss
 They are among the most difficult decisions to make
 Most investment decisions are irreversible. It is difficult to find a market for
such capital items once they have been acquired. The firm will incur heavy
losses.
 Investment decisions shape the basic character of a firm.

BIBLIOGRAPHY
 M.COM PART II SEMESTER IV TEXTBOOK BY
ANIPURE
 www.wikipedia.com
 www.google.com

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