LAW PPT

1. INTRODUCTION
• In the terminology of financial management, the
investment decision means capital budgeting.
• The word ‘Capital’ is exclusively understood to refer to
real assets viz. building, plant and machinery, raw
material etc whereas investment refers to any such real
assets.
•Thus investment decisions are commitment of money
resources at different time in expectation of economic
returns in future dates.

2. NEED FOR INVESTMENT DECISONS
• Expansion of the productive process to meet the existing excessive
demand in local market to exploit the international markets and to
avail the benefits of economies of scale.
• Replacement of an existing asset, plant, machinery or building may
become necessary for reaping advantages of technological
innovations, minimising cost of products and increasing the efficiency
of labour.
• Buy or hire on rent or lease a particular asset is another important
consideration which establishes the need for making investment
decisions.

3. FACTORS
• Estimate of capital outlays and the future earnings of the proposed
project focusing on the task of value engineering and market forecasting,
• Availability of capital and consideration of cost-focusing attention as
financial analysis, and
• A correct set of standards by which to select projects for execution to
maximise return-focusing attention on logic and arithmetic.

4. Techniques for Capital Budgeting
The techniques for evaluating capital budgeting revolve around the
following factors:
i. Economic life of the project
ii. Investment made
iii. Rate of return
iv. Cash flow
v. Time period
vi. Time value of money
vii. Cost of capital

5. Categorisation of Techniques
Techniques can be categorised on the basis of discounted and non
discounted methods.
Non-discounted or traditional methods are:
i. Payback period
ii. Accounting rate of return
Discounted cash flow methods are:
i. Net present value (NPV)
ii. Interest rate of return (IRR)

6. Payback Period Method
• This method refers to the
period which a particular
project will take to generate
the cash in order to recover
the initial investment.
• This method only emphasizes
on cash inflows and not on
time value of money.
• With this method the earning
capacity of a project can be
determined.
• Payback
period=investment/annual
cash inflow
Project
Act A
Project
Bject B
Cost 1,00,000 1,00,000
Expected
future
cash flow
Year 1 50,000 1,00,000
Year 2 50,000 5,000
Year 3 1,10,000 5,000
Year 4 None None
TOTAL 2,10,000 1,10,000
Payback 2 years 1 year
Payback period of project B is shorter
than A, but project A provides higher
returns. Hence, project A is superior to
B.

7. Net Present Value(NPV)
• In this technique the cash inflow
that is expected at different periods
of time is discounted at a particular
rate.
• The present values of cash inflows
are compared to the original
investment.
• If the difference between the
present value and original
investment is positive then the
project is accepted otherwise it is
rejected.
• This method considers the time
value of money and aims at
maximising profits for the owners.
• NPV=present value of benefits-
present value of costs

8. Internal rate of return(IRR)
• This is defined as the rate at which
the net present value of the
investment is zero.
• The discounted cash inflow is equal
to the discounted cash outflow.
• This method tries to arrive to a rate
of interest at which funds invested
in the project could be repaid out of
the cash inflows.
• This method considers time value of
money
• If IRR>WACC , project is
profitable
• If IRR>firm’s cost of capital,
project can be accepted
• If IRR<firm’s cost of capital,
project has to be rejected

9. Accounting Rate of Return
The accounting rate of return (ARR) is the percentage rate of return
expected on an investment or asset as compared to the initial investment
cost. ARR divides the average revenue from an asset by the company's
initial investment to derive the ratio or return that can be expected over
the lifetime of the asset or related project. ARR does not consider the
time value of money or cash flows, which can be an integral part of
maintaining a business.

10. Interpretation
The accounting rate of return is a capital budgeting metric useful for a
quick calculation of an investment's profitability. ARR is used mainly as
a general comparison between multiple projects to determine the
expected rate of return from each project.
ARR can be used when deciding on an investment or an acquisition. It
factors in any possible annual expenses or depreciation expense that's
associated with the project. Depreciation is an accounting process
whereby the cost of a fixed asset is spread out, or expensed, annually
during the useful life of the asset.
ARR= Average Annual profit/ Initial Investment

11. Steps for Calculation
1. Calculate the annual net profit from the investment, which could
include revenue minus any annual costs or expenses of implementing the
project or investment.
2. If the investment is a fixed asset such as property, plant, or equipment,
subtract any depreciation expense from the annual revenue to achieve the
annual net profit.
3. Divide the annual net profit by the initial cost of the asset, or
investment. The result of the calculation will yield a decimal. Multiply
the result by 100 to show the percentage return as a whole number.

12. Examples:
1. A project is being considered that has an initial investment of 2,50,000
and it's forecasted to generate revenue for the next five years. Below are
the details:
initial investment: 2,50,000
expected revenue per year: 70,000
time frame: 5 years
ARR calculation: 70,000 (annual revenue) / 2,50,000 (initial cost)
ARR = .28 or 28% (.28 * 100)

13. 2. XYZ Company is looking to invest in some new machinery to replace its
current malfunctioning one. The new machine, which costs 4,20,000, would
increase annual revenue by 2,00,000 and annual expenses by 50,000. The
machine is estimated to have a useful life of 12 years and zero salvage value.
Calculate the depreciation expense per year: 4,20,000 / 12 = 35,000
Calculate the average annual profit: 2,00,000 – (50,000 + 35,000) = 1,15,000
Use the formula: ARR = 1,15,000 / 4,20,000 = 27.4%
Therefore, this means that for every rupee invested, the investment will return a
profit of about 27 paise.

14. Limitations
Although ARR is an effective tool to grasp a general idea of whether to proceed with
a project in terms of its profitability, there are several limitations to this approach:
1. It ignores the time value of money. It assumes accounting income in future years
has the same value as accounting income in the current year. A better metric that
considers the present value of all future cash flows is NPV and Internal Rate of
Return (IRR).
2. It does not consider the increased risk of long-term projects and the increased
variability associated with prolonged projects.
3. It is only a financial guidance for projects. Sometimes projects are proposed and
implemented to enhance other important variables such as safety, environmental
concerns, or governmental regulations.
4. It is not an ideal comparative metric between projects because different projects
have different variables such as time and other non-financial factors to consider.

15. ARR v RRR
As stated, the ARR is the annual percentage return from an investment
based on its initial outlay of cash. However, the required rate of
return (RRR), also known as the hurdle rate, is the minimum return an
investor will accept for an investment or project, that compensates them
for a given level of risk.