UNIT-III

Unit – III

Investment Decision: Concept of Time Value of money – Techniques of Time Value of Money – Nature and Significance of Investment Decision – Estimation of Cash flows – Capital Budgeting Process – Techniques of Investment Appraisal – Pay back period, Accounting Rate of Return, Time Value of Money – DCF Techniques- Net Present Value, Profitability Index and Internal Rate of Return.

Concept of Time Value of money�

• The value of money received today is more than its value received at a later time

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• A rupee today has more value than a rupee power after a year . Therefore , rational investors would prefer current receipts to future receipts
• For example :
• If someone receives ₹ 25 lakh today , will its value be same after two years
• Answer in no . Because ₹ 25 lakh received today has higher purchasing power than 25 lakh received after two years

Techniques of time value of money or methods of time value of money

• Techniques of time value of money divided into two types
• Compound techniques
• Discounting technique

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• Compounding techniques: the future value of all cash flows of the at the end of the time horizon at a particular compound interest rate are found under this techniques

Future value : compound value

• The amount of money which an investor expects to receive after a certain period of time which contain both principal and return on investment in the form of compound interest is called future value or compound value
• For example :future value of ₹1000 at the end of three years @8% p.a is as follows
• Amount at the end of the year 1 = 1000(1+0.08) = 1080
• Amount at the end of the year 2 = 1080(1+0.08) = 1166.4
• Amount at the end of the year 3 = 1166.4 (1+0.08) = 1259.712

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• Alternatively 1000(1+0.08)^3 = 1000*1.259712 = 1259.712
• So ₹ 1259.712 is the F.V at the end of 3 years
• A1:Future value of single flow /lump-sum
• Calculation of future value of a single flow or one time lump-sum investment is as follows :
• FV_n = PV (1+K)ⁿ
• Where FV_n ⁼ future value of the initial flow in n years
• PV = Present amount of investment
• K= annual rate of compound interest (no .of compounding p.a = 1)
• n = life of investment

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• Mr .A has ₹ 10,000 to be invested . How much does it grow in four years ,if the fixed deposit scheme of a commercial bank offers the following interest rates
• Period of deposits rate per annum
• 46 days to 179 days 7.5 %
• 180 days to 364 days 8%
• 365 days to and above 8.5%

• FV_n = PV (1+K)ⁿ
• = 10,000 ( 1+0.085)⁴
• ⁼ 13858

• Compounding is done in semi-annually (half-yearly )
• FV_n = PV (1+K/2)²*ⁿ
• Compounding is done in quarterly
• FV_n = PV (1+K/4)⁴*ⁿ
• Compounding is done in monthly
• FV_n = PV (1+K/12)¹²*ⁿ

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• What will be te compound or future value of ₹ 1,30,000 after 4 years if 8% p.a interest is compounded at i) half –yearly ii) quarterly

• If interest is compounded half yearly
• FV_n = PV (1+K/2)²*ⁿ
• = 130000(1+0.08/2)^2*4

= 130000(1+0.04)⁸

= 130000 x 1.36857

= 177914

• If interest is compounded quarterly
• FV_n = PV (1+K/4)⁴*ⁿ
• = 130000(1+0.08/4)^4*4

= 130000(1+0.02)¹⁶

= 130000 x 1.37278

= 178461

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Effective rate vs nominal rate of interest

• An interest rate takes two forms: nominal interest rate and effective interest rate. The nominal interest rate does not take into account the compounding period. The effective interest rate does take the compounding period into account and thus is a more accurate measure of interest charges.
• A statement that the "interest rate is 10%" means that interest is 10% per year, compounded annually. In this case, the nominal annual interest rate is 10%, and the effective annual interest rate is also 10%. However, if compounding is more frequent than once per year, then the effective interest rate will be greater than 10%. The more often compounding occurs, the higher the effective interest rate.

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• The relationship between nominal annual and effective annual interest rates is:
• r = [ 1 + (K / m) ] ^m - 1
• where “r" is the effective annual interest rate, “K" is the nominal annual interest rate, and "m" is the number of compounding periods per year.

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• Example: A credit card company charges 21% interest per year, compounded monthly. What effective annual interest rate does the company charge?

• k = 0.21 per year
• m = 12 months per year
• r = [ 1 + (.21 / 12) ] ¹² - 1
• = [1 + 0.0175 ] ¹² - 1
• = (1.0175)¹² - 1 = 1.2314 - 1
• = 0.2314 = 23.14%

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• Calculate the effective rate of interest if the nominal rate of interest is 8% and interest is compounded
• Half –yearly
• Quarterly

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• k = 0.08 per year
• m = half-yearly = 6/12 = 2
• r = [ 1 + (.008 / 2) ]² - 1
• = [1 + 0.04 ] ² - 1
• = 1.0816 - 1
• = 0.0816 = 8.16%

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• k = 0.08 per year
• m = quarterly = 3/12 = 4
• r = [ 1 + (.008 / 4) ]⁴ - 1
• = [1 + 0.02 ] ⁴ - 1
• = 1.0824 - 1
• = 0.0824 = 8.24%

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Capital Budgeting

Financial decision making is viewed as an integral part of the overall management of a business concern. The financial manager has to make the financial decision within the framework of overall corporate objectives and policies. The decisions in financial management has been divided in to three categories. They are

1. Investment Decisions

2. Financing Decision

3. Dividend Decision.

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The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets that can be acquired with these funds are broadly divided into

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Long term assets

Short term assets

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The decision regarding short term assets is designated as Working Capital management and the decsions related to long term assets known as Capital Budgeting.

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Capital budgeting is the long -term investment decision. It is probably the most crucial financial decision of a firm. It relates to the selection of an assetst or investment proposal or course of action that benefits are likely to be available in future over the lifetime of the project. Capital budgeting is the process of making investment decision in long-term assets or courses of action. Capital expenditure incurred today is expected to bring its benefits over a period of time. These expenditures are related to the acquisition & improvement of fixes assets.

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“Capital Budgeting is the long term planning for making and financing proposed capital outlay”

----Charles T. Horngren

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Capital budgeting decision may be defined as “ the firm’s decision to invest its current funds most efficiently in the long term assets, in anticipation of an expected flow of benefits over a series of years.

• The exchange of current funds for future benefits
• The funds are invested in longterm assets
• The future benefits will occur to the firm over a series of years

Capital budgeting or investment decision includes addition, disposition, modification and replacement of fixed assets. The capital bedgeting dicision include the following proposals:

• Expansion
• Diversification
• Replacement
• Research and Development
• Miscellaneous Proposals

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Types of capital budgeting:

Independent projects:

Independent projects are the projects which do not compete with one another. Based on the profitability of the projects and the availability of funds, a company undertakes any number of projects. In such a case, projects will be taken up to a level where marginal cost of funds equal to marginal rate of return of the project.

Mutually exclusive projects:

Incase of mutually exclusive projects, acceptance of one project causes the rejectrion of another project. For example if there are two proejcts X and Y, either X or Y or Y should be accepted by the company

Contingent projects:

Acceptance of one project proposal depends on acceptance of one or more projects. A proposal for acquiring new machinery is dependent upon expansion of plant or replacement of old machinery or replacement of labour force.

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Capital Budgeting Process:

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Project Generation:

In the project generation, the company has to identify the proposal to be undertaken depending upon its future plans of activity. After identification of the proposals they can be grouped according to the following categories:

Replacement of equipment: In this case the existing outdated equipment and machinery may be replaced by purchasing new and modern equipment.

Expansion: The Company can go for increasing additional capacity in the existing product line by purchasing additional equipment.

Diversification: The Company can diversify its product line by way of producing various products and entering into different markets. For this purpose, It has to acquire the fixed assets to enable producing new products.

Research and Development: Where the company can go for installation of research and development suing by incurring heavy expenditure with a view to innovate new methods of production new products etc.,

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Project evaluation: In involves two steps.

 Estimation of benefits and costs: These must be measured in terms of cash flows. Benefits to be received are measured in terms of cash flows. and costs to be incurred are measured in terms of cash flows.

• Selection of an appropriate criterion to judge the desirability of the project.

Project selection:

There is no standard administrative procedure for approving the investment decisions. The screening and selection procedure would differ from firm to firm. Due to lot of importance of capital budgeting decision, the final approval of the project may generally rest on the top management of the company. However the proposals are scrutinized at multiple levels. Some times top management may delegate authority to approve certain types of investment proposals. The top management may do so by limiting the amount of cash out lay. Prescribing the selection criteria and holding the lower management levels accountable for the results.

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Project Execution:

In the project execution the top management or the project execution committee is responsible for effective utilization of funds allocated for the projects. It must see that the funds are spent in accordance with the appropriation made in the capital budgeting plan. The funds for the purpose of the project execution must be spent only after obtaining the approval of the finance controller. Further to have an effective cont. It is necessary to prepare monthly budget reports to show clearly the total amount appropriated, amount spent and to amount unspent.

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Project Review:

After the execution, a continous monitoring of the project is imperative so that expected and actual operating results compared. This helps in taking corrective action against the responsible people

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IMPORTANCE OF CAPITAL BUDGETING

INVOLVEMENT OF HEAVY FUND

Capital budgeting decisions require large capital outlays. It is therefore absolutely necessary that the firm should carefully plan they are put to most profitable use.

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LONG TERM IMPLICATION

The effect of capital budgeting decision will be felt by the firm over a long period and therefore they have decisive influence on the rate and direction of the growth of the firm.

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IRREVERSIBLE DECISION

In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market for the capital assets. The only alternative will be to scrap the capital assets so purchased or sell them at a substantial loss in the event of the decision being proved wrong.

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MOST DIFFICULT TO MAKE

The capital budgeting decision require an assessment of future events which are uncertain . It is really difficult task to estimate the probable future events, the probable benefits and cost accurately in quantitative terms because of economic ,political, social , and technological factors.

Computation of Cashflows:

Capital Budgeting Methods

Payback period

It can be defiend as ‘the number of years required to recover the original capital invested in a porject’

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To calculate the Pay Back Period two approaches are there.

• When cash flows are equal

Pay Back Period =

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• When cash flows are not equal

Pay Back Period =

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Advantages

.Easy to calculate

• Knowledge
• Easily availability of information
• It dose not involve any cost for computation of the payback period.
• It is one of the widely used methods in small scale industry sector.
• It can be computed on the basis of accounting information available from the books.

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Demerits:

Failure in taking cash flows after payback peiod:

This methods is not taking into account the cashflows received by the company after the pay back period

Not consider the time value of money

It does not take into account the time value of money

Non consideration of interest factor

It does not take into account the interest factor involved in the capital outlay

Failure in taking magnitude and timing of cash inflows

It fails to considered the pattern of cash inflows i.e the magnitude and timing of cash inflows

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1 a project requires an initial investment of Rs. 1,00,000 with an useful life of 5 years. The projected cash inflows after tax(CFAT) are as follows

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Calculate Pay Back Period

A machine costs Rs. 4,00,000 and is expected to generate the following cash infloes during its life time. Compute the pay back period

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Merits:

It is very simple to understand and calculate.

It can be readily computed with the help of the available accounting data.

It uses the entire stream of earning to calculate the ARR.

Demerits:

It is not based on cash flows generated by a project.

This method does not consider the objective of wealth maximization

IT ignores the length of the projects useful life.

It does not take into account the fact that the profits can be re-invested.

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Determine the Average Rate of Return from the following data of two machines A and B

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Discounted Cash Flow Techniques:

The discounted cash flow methods provide a more objective basis for evaluating and selecting an investment project. These methods consider the magnitude and timing of cash flows in each period of a project's life. Discounted cash flow methods enable us to isolate the differences in the timing of cash flows of the project by discounting them to know the present value. The present value can be analyzed to determine the desirability of the project. These techniques adjust the cash flows over the life of a project for the time value of money.

Net Present Value methods (NPV)

Internal Rate of Return (IRR)

Profitability Index(PI)

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“It is a present value of future returns, discounted at the required rate of return minus the present value of the cost of the investment.” ----Ezra Solomon

NPV is the difference between the present value of cash inflows of a project and the initial cost of the project.

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The formula for NPV is

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Merits:

It recognizes the time value of money.

It is based on the entire cash flows generated during the useful life of the asset.

It is consistent with the objective of maximization of wealth of the owners.

The ranking of projects is independent of the discount rate used for determining the present value.

Demerits:

It is different to understand and use.

The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of capital. If self is difficult to understood and determine.

It does not give solutions when the comparable projects are involved in different amounts of investment.

It does not give correct answer to a question whether alternative projects or limited funds are available with unequal lines.

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A project requires an investment of Rs.1, 44,000 and is expected to generate cash inflows of Rs.54, 000, Rs.63, 000, Rs.72, 000, Rs.63, 000 and Rs.54, 000 per annum for the next 5 years. Compute (i) Pay-back period (ii) IRR with the help of 31% and 32% D.f

Years 1 2 3 4 5

P.V.Factor@31% 0.763 0.583 0.445 0.340 0.259

P.V.Factor@32% 0.758 0.574 0.435 0.329 0.250

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Merits:

It requires less computational work then IRR method

It helps to accept / reject investment proposal on the basis of value of the index.

It is useful to rank the proposals on the basis of the highest/lowest value of the index.

It takes into consideration the entire stream of cash flows generated during the useful life of the asset.

Demerits:

It is very difficult to understand the analytical part of the decision on the basis of probability index.

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