1. Chapter Introduction
2. Pay Back Period
3. Accounting Rate of Return
4. Net Present Value
5. Internal Rate of Return
6. Profitability Index
7. Major Investment Decisions
1. Chapter Introduction:
A very important aspect of financial management is proper decision-making in respect of investment of funds. Successful operation of any business depends upon the investment of resources in such a way as to bring in benefits or best possible returns from any investment.
An appraisal of any investment proposal is necessary to ensure that the investment resources will bring in desired benefits in future. Since resources are limited, a choice has to be made among the various investment proposals by evaluating their comparative merit. It is apparent that some techniques should be followed for making appraisal of investment proposals. This chapter focuses on various appraisal methods.
Q. Write short notes on the following:
- Pay Back Period (Dec. 97, Dec. 98, June 03)
- Accounting Rate of Return (June 03)
- Net Present Value
- Internal Rate of Return (June 98, Dec. 98, June 99)
- Profitability Index
2. Pay Back Period: In simple terms it means the total period within which the total amount invested will be recovered throughout net cash flow (after tax). Suppose a sum of Rs. 5 lakh has to be invested in a project whose expected net cash flows are as follows:
|
|
Incremental cash Flow (Rs. 000) |
||
|
Year |
Annual |
Annual |
Cumulative |
|
0 |
(---) 500 |
(---) |
500 |
|
1 |
185 |
(---) |
315 |
|
2 |
125 |
(---) |
190 |
|
3 |
140 |
(---) |
50 |
|
4 |
170 |
(---) |
120 |
|
5 |
180 |
|
300 |
P = E + B/C
Where P: payback period
E: no. of years immediately preceding the year of final recovery
B: balance amount still to be recovered
C: cash flow during the year of final recovery
Weaknesses
The greatest weakness of this method is that it ignores the timing and amount of all cash inflows. It does not any cognizance of the cash flows after the payback period. Thus, this method is not appropriate either for absolute or comparative appraisal. The payback method concentrates only on liquidity aspect and ignores the overall profitability of a project
3. Accounting Rate of Return:
This method of working out the rate of return on investment is based on the financial accounting practices of the company for working out the annual profits. The net annual profits are derived after deducting depreciation and taxes. The average of annual profits thus derived is worked out on the basis of the period of the life of the project. Example:
|
Years |
Cash Flow (after tax) |
Depreciation |
Interest |
|
1 |
13,000 |
6,000 |
400 |
|
2 |
11,000 |
6,000 |
400 |
|
3 |
9,000 |
6,000 |
400 |
|
4 |
6,400 |
6,000 |
400 |
|
5 |
6,400 |
6,000 |
400 |
|
Total |
45,800 |
30,000 |
2,000 |
|
(45,800 - 30,000 - 2,000) x 1/5 |
|
|
|
|
= |
9.2 |
|
Rs. 30,000 |
|
|
|
(45,800 - 30,000 - 2,000) x 1/5 |
|
|
|
|
= |
18.4 |
|
Rs. 15,000 |
|
|
Weakness
This method like the Payback method ignores the time value of cash flows since it does not give any recognition to the timing of the generation of income. Thus ARR method suffers from a serious drawback by neglecting the quality or pattern of benefits and by ignoring the time value of money. It also does not take into account the scrap value of asset (or project) at the end of its useful life. Finally, the calculation of profit is subject to varying practices. All these factors make ARR a less reliable method.
4. Net Present Value:
Calculation of the net present value of future income is related to the understanding of the compounded rate of interest or the general formula of compounding. Suppose a sum of Rs. 100 (P) is invested for a period of one year at a rate of interest (r) of 10% per annum. The investment at the end of one year will be equal to
= 110
It can also be stated that Rs. 110 in one year's time is worth only Rs. 100 today. Applying the compounding formula over a number of years to work out the present value (PV) of a future flow of income will be reconstructed as
Where P is the amount to be received in future (number of years = n). Example: Suppose we want to know cash flow of Rs. 500 to be received at the end of five years discounted at 10% rate of interest. The PV will be:
The following table shows the discount factor for 10% over a period of 5 years in respect of the present value of one rupee.
|
Years |
Amount Rs. |
Present value factor |
Present value Rs. |
|
1 |
1,000 |
.909 |
909 |
|
2 |
1,000 |
.826 |
826 |
|
3 |
1,000 |
.751 |
751 |
|
4 |
1,000 |
.683 |
683 |
|
5 |
1,000 |
.621 |
621 |
|
|
|
|
3790 |
Internal Rate of Return: The Internal Rate of return is a method under the discounted cash flow technique which is used for appraising the investment proposals. Under this method, we derive the discounting rate at which the aggregate of the PVs of all future cash inflows equals the present cash outflows for the proposal.
Weakness
Compared to pay back period or ARR methods, the NPV method is difficult to calculate. What discount rate is to be used in calculating net present values may be difficult to decide. The selection of discount rate has a significant effect on the desirability of the project. With a change in rate, a desirable project may become undesirable and vice versa. Moreover, NPV is an absolute measure. For projects involving different outlays the NPV method may not give dependable results. It may also not give satisfactory results where the projects under competition have different lives.
5. Internal Rate of Return:
The internal rate of return is another method under the Discounted cash Flow technique that is used for appraising the investment proposals. Under this method, we derive the discounting rate at which the aggregate of the PVs of all future cash inflows equals the present cash outflows for the proposal.
Mathematically
|
|
|
NPVL |
|
|
|
IRR = |
LRD + |
|
x |
R |
|
|
|
PV |
|
|
IRR is the internal rate of return
LRD is the Lower rate of discount
NPVL is the net present valus at lower rate of dicount
PV is the difference in present values at lower and higher discount rates
R is the difference between two rates of discount
Advantages & Limitations
IRR, like NPV, takes into consideration time value of money and also the total cash inflows & outflows over the entire life of the project. For managers it is easier to understand as the calculation is always a % and not an absolute value. Another advantage is that it does not require discounting rate. The method itself provides a rate of return.
However, IRR require tedious calculations. Under IRR method, it is assumed that cash flows are reinvested at the same rate of IRR. This also implies that if IRR of two projects is 16% and 20%, the cash flows arising from these two projects will also be reinvested at their respective rates, i.e., 16% & 20%
6. Profitability Index:
It is also known as benefit-cost ratio. The profitability index is the relationship between the present value of net cash inflows and the present value of cash outflows. It can be worked out either in unitary or in percentage terms. The formula is:
Profitability Index = Present value of cash inflows/present value of cash outflows
7. Major Investment Decisions:
Q. What are the factors influencing major investment decisions of a large corporation? (June 02)
The following are some important factors that are generally considered while making a major investment decision:
- Amount of Investment: If a firm has abundant funds then it can accept all capital investment proposals which give a rate of return higher than the minimum acceptable or cut-off rate. But most firms have limited funds.
- Minimum Rate of Return: The minimum rate of return is decided on the basis of the cost of capital. For example, if the cost of capital is 15%, the management will not be interested in a proposal that will return less than 15%.
- Cut-of-point: The cut-off-point is a point below which the management does not accept a project.
- Ranking of Investment Proposals: When there are multiple acceptable projects, the management will rank the projects in order of their profitability & select the most profitable project.
- Risk Factor: Different investment proposals have different degrees of risk. A project may provide high degree of return but it may also have a high degree of risk.
- Return Expected from Investment: Capital investment decisions are made in anticipation of increased return in future. It is therefore very necessary to estimate the future return of benefits accruing from the investment proposals. There are two criteria available for quantifying benefits from capital investment decisions. They are: (a) accounting profit, (b) cash flows. The term accounting profit is identical with income concept used in accounting. While in estimating cash flows, depreciation charges and other amortization charges of fixed assets are not subtracted from gross revenue, because no cash expenditure is involved.