You have learned in unit 2, that one of the important functions of financial management is investment decisions. The success of a business unit depends upon the investment of resource in such a way that bring in benefits or best possible returns from any investment. The investment in general means an expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying a net cash inflows or its equivalent in some future time period or periods.
The investment in any project will bring in desired profits or benefits in future. If the financial resources were in abundance, it would be possible to accept several investment proposals which satisfy the norms of approval or acceptability. Since, we are sure that resources are limited, a choice has to be made among the various investment proposals by evaluating their comparative merit. This would help us to select the relatively superior proposals keeping in view the limited available resources. For this purpose, we have to develop some evaluating techniques for the appraisal of investment proposals.
7.2 Importance of investment decisions
The terms in financial management like investment decisions, investment projects, and investment proposals are generally associated with application of long-term resources. What is long-term? There is no hard and fast rule to define it, but by common practice and accordance with the financing policies, practices and regulations of the financial institutions and banks a period of ten years and above may be treated as long period. The decisions related to long-term investment is also known as capital budgeting techniques. It is important because of the following reasons:
The investment decisions are the vehicles of a company to reach the desired destiny of the company. An appropriate decision would yield spectacular results whereas a wrong decision may upset the whole financial plan and endanger the very survival of the firm. Even firm may be forced into bankruptcy.
Capital budgeting techniques involve huge amounts of funds and imply permanent commitment. Once you invest in the form of fixed assets it is not easy to reverse the decision unless you incur heavy loss.
A capital expenditure decision has its effect over a long period of time span and inevitably affects the company’s future cost.
Investment decision are among the firm’s most difficult decisions. They are the predictors of future events which are difficult to predict. It is a complex problem investment. The cash flow uncertainty is caused by economic, political, social and technological forces.
7.3 Types of investment proposals
The long-term funds are required for the following purposes:
Expansion: A company adds capacity to its existing product lines to expand existing operations. For example, a manufacturing unit producing one hundred thousand units per year. If it intends to double the output by two hundred thousands, this will obviously increase the need for funds for acquiring fixed and current assets.
Diversification: Some times the management of a company may decide to add new product line to the existing product lines. Philips, a famous company for radio and electric bulbs etc. diversified into production of other electrical appliances and television sets.
Replacements: Machines used in production may either wear out or may be rendered obsolete on account of new technology. The productive capacity of the enterprise and its competitive ability may be adversely affected. Extra funds are required for modernization or renovation of the entire plant. The investment obviously is going to be long terms.
Research and Development: There has been an increased realization that the efficiency of production and the total operations can be improved by application of new and more sophisticated techniques of production and management. To acquire the technology huge funds are needed.
The useful way of classifying investments is as under
Accept - Reject Decisions
Mutually Exclusive Decisions
Under this, if a project is accepted, the firm is going to invest, otherwise it is not going to invest its funds. In general, the project proposals that yield a rate of return greater than the certain required rate of return or cost of capital are accepted and others are rejected. By applying this criteria more than one independent projects are accepted subject to availability of funds. Various appraisal techniques are used to evaluate each project.
Mutually Exclusive Decisions
These are the projects which compete with each other in such a way that the acceptance of one will exclude the acceptance of the other one. The alternatives are mutually exclusive one may be chosen.
We are aware that the financial resources are limited. But, a large number of investment proposals compete for those limited funds. The firm, therefore ration them. The firm allocates funds to projects in a manner that it maximizes long-run returns. Thus, capital rationing refers to the situation in which the firm has more acceptable investments, requiring a greater amount of finance than is available with the firm. It is concerned with the selection of a group of investment proposals out of making investment proposals acceptable under the accept-reject decision. The projects are ranked as per their merits of acceptance basing on certain predetermined criteria.
7.4 Data required for investment decisions
Initial Investment: The total amount of cash required to buy various assets like land, buildings, plant, machinery, equipment, etc and there installation expenses have to be estimated. In addition to fixed cost, the cost of maintaining stocks, contingency reserves to cover the cost of supporting the additional receivables. Benefit of credit from suppliers will have the effect of reducing the quantum of additional working capital required.
Subsequent Investment: The cost of maintenance, replacement and updating are to be treated as outflows during the period in which they are expected to be incurred.
Economic Life of the project:
The economic life of a project is to be distinguished from the life of an individual assets. The building may have life of fifty years, plant may have ten years, and some equipments may have five years only. The economic life of the project is determined by the duration of the “earnings flow” generated by the project.
The economic life may end:
The cost of replacement becomes uneconomical in relation to the likely benefits.
When the viability is adversely affected due to obsolescence.
When maintenance costs exceed the disposable value, and
When the development of new technology necessitates new investment
Some times the plant assets may have value for the enterprise at the end of the life of the project or there may be some anticipated sales value of the plant. Such amount is to be treated as an inflow at the end of the life of the project.
Annual Cash Flows:
The calculation of annual cash flows in investment appraisal plays a key role. The computation of cash flows is a simple task. The following areas are to be considered.
Sales revenue: This is going to be the function of sales any wrong calculation in this regard will bear impact on the investment opportunity. Care has to be taken to forecast accurately and the additional revenue generated by the investment should be taken into account. The investment must also result into the reduction of operating cost either by modernization or replacement models where the savings benefit or cash flows will increase. In simple terms annual cash flow is equivalent to net profit after tax plus deprecation. Procedurally,
ACF = Sales – (Operating expenses + Non-operating expense + Tax) + Depreciation
Ex: The following is the information related to ABC Ltd. The company has been asked to compute the annual cash flows.
Machine A Machine B
Cost of machine 15, 000 24, 000
Estimated life in years 5 years 6 years
Estimated income 1, 000 1, 500
Estimated material cost 800 900
Estimated supervision cost 1, 200 1, 600
Estimated maintenance cost 500 1, 000
Estimated savings in wages 9, 000 12, 000
Depreciation may be charged on straight line method
The tax rate may be assumed 50% and
Calculate Annual cash flows.
Machine A Machine B
Income: 1, 000 1, 500
Savings in wages 9, 000 12, 000
Total income / sales 10, 000 13, 000
Cost: material costs 800 900
Maintenance 500 1, 000
Supervision 1, 200 1, 600
2, 500 3, 500
Profit before Depreciation & Tax 7, 500 10, 000
Depreciation 3, 000 4, 000
Profit Before tax 4, 500 6, 000
Tax @ 50% 2, 250 3, 000
Profit after tax (Net profit) 2, 250 3, 000
Add back depreciation 3, 000 4, 000
Annual cash flows 5, 250 7, 000
7.5 Project appraisal methods
There are two important methods of evaluating the investment proposals
Pay back period
Accounting rate of return
Discounted cash flow method
Net present value
Profitability Index method / Benefit cost Ratio
Internal Rate of Return
Pay Back Period:
This is one of the widely used methods for evaluating the investment proposals. Under this method the focus is on the recovery of original investment at the earliest possible. It determines the number of years to recoup the original cash out flow, disregarding the salvage value and interest. This method do not take into account the cash inflows that are received after the pay back period. There are two methods in use to calculate the pay back period
1) Where annual cash flows are not consistent vary form year to year 2) Where the annual cash flow are uniform
1. Unequal cash flows
P = E + (B/C)
where, P stands for pay back period.
E stands for number of years immediately preceding the year of final recovery.
B stands for the balance amount still to be recovered.
C stand for cash flow during the year of final recovery.
Ex: The following is the information related to a company
Project A Project B
Year Cash flow $ Year Cash flow $
0 -700 0 -700
1 100 1 400
2 200 2 300
3 300 3 200
4 400 4 100
5 500 5 0
Calculate pay back period
Project A Cumulative Project B Cumulative
Year Cash flow cash flow Year Cash flow Cash flow
0 -700 -700 0 -700 -700
1 100 -600 1 400 -300
2 200 -400 2 300 0
3 300 -100 3 200 200
4 400 300 4 100 300
5 500 800 5 0 -
P = E + (B/C)
= 3 + (100/400)
= 3.25 year
P = E + (B/C)
= 2 + 0
= 2 years
Uniform cash flows:
Where the annual cash flows are uniform
PB = Original Investment / Annual Cash Flows
Shorter is the payback period better is the product
EX: A project requires an investment of $ 100, 000, it will generate annual cash flow of $25,000 per year. Calculate the pay back period.
PB =Original Investment / Annual Cash Flows
= 100,000 / 25, 000
= 4 years
Accounting Rate of Return
This method is based on the financial accounting practices of the company working out the annual profits. Here, instead of taking the annual cash flows, we take the annual profits into account. The net annual profits are calculated after deducting depreciation and taxes. The average of annual profits thus derived is worked out on the basis of the period
ARR = (Average annual profit after tax / Average investment over the life of project) x 100
Average investment = Net working capital + Salvage value +
(Initial cost of plant – salvage value)
Net working capital = current assets – current liabilities
Average profits = Total of annual profits / No of years
Ex: Initial investments of plant $ 10, 000
Installation costs $ 1, 000
Salvage value $ 1, 000
Working capital $ 1, 000
Life of plant 5 years
Annual profit per year $ 2, 500
Average profit = 2, 500 x 5 = = 2, 500
Average investment = Wc + Sal.V. + 1/2(Cost + Inst. Charges – Salv. Val)
= 2, 000 + 1, 000 + 1/2(10, 000 + 1, 000 – 1, 000)
= 3, 000 + 1/2(10, 000)
= 3, 000 + 5, 000
= 8, 000
ARR = 2500/8000x 100
The ARR is compared to the predetermined rate. The project will be accepted if the actual ARR is higher than the desired ARR. Otherwise it will be rejected.
Discounted cash flow techniques:
This concept is based on the time value of money. The flow of income is spread over a few years. The real value of Birr in your hand today is better than value of birr you earn after a year. The future income, therefore, has to be discounted in order to be associated with the current out flow of funds in the investment. Two methods of appraisal of investment project are based on this concept. These are net present value and internal rate of return method.
Net Present Value
Net present value may be defined as the total of present value of the cash proceeds in each year minus the total of present values of cash outflows in the beginning
where; NPV = Net present value
CFt = Cash inflows at different periods
Wn = Working capital adjustments
Co = Cash outflow in the beginning
K = Cost of capital
Sn = Salvage value at the end
The decision rule here is to accept a project if the NPV is positive and reject if it is negative
NPV > Zero accept
NPV = Zero accept
NPV < Zero reject
EX: ABC PLC is considering to invest in a cement project. It has on hand $180, 000. It is expected that the project may work for seven years and likely to generate the following annual cash flows. Calculate the Net present value.
The cost of capital is 8%
Solution: Year ACF PV factor Present value
1 30, 000 .926 27, 780
2 50, 000 .857 42, 850
3 60, 000 .794 47, 640
4 65, 000 .735 47, 775
5 40, 000 .681 27, 240
6 30, 000 .630 18, 900
7 16, 000 .583 9, 328
- Original investment 180, 000
Net present value 41, 513
I. The above problem the NPV is greater than zero hence, it may be accepted. You have already learned in financial accounting to calculate the time value of money and the usage of present value tables. Hence, you may directly use the present value factors from tables.
Present value of birr 1 = 1/(1+r)n = 1/ (1+.10)1
The present value of 1 Birr @ 10 cost after one year .909
two year .826
Profitability Index Method / Benefit Cost Ratio B/C Ratio
Profitability index method is the relationship between the present values 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
PI > 1 Accept
PI = 1 indifference
PI < 1 reject
Higher the profitability index more is the project preferred.
From the above example we can calculate the profitability index as below
Present value of cash out flows $ 180, 000
Present value of cash inflows $ 221, 513
: - PI = 221,512 / 180,000
Internal Rate of Return (IRR)
The internal rate of return is also known as yield on investment, marginal efficiency of capital, marginal productivity of capital, rate of return time adjusted rate of return and so on. Internal rate of return is nothing but the rate of interest which equates the present value of future earnings with the present value of present investment. Therefore, IR depends entirely on the initial outlay and the cash proceeds of the project which is being evaluated for acceptance or rejection. The computation of IRR is difficult one; you have to start equating the two values i.e., present value of future earnings and present value of investment. It is possible through trial and error method.
IRR can be calculated basing on the pay back period where annual cash flows are uniform, in case the annual cash inflows are different for the periods, the fake pay back period is calculate then adopt trial and error procedure.
IRR = r- ((PB-DFr) / (DFrL-DFrH))
where; PB = Pay back period
DFr = Discount Factor for interest
DFrL = Discount Factor for lower interest rate
DFrH = Discount Factor for higher interest rate
r = Either of the two interest rates used
IRR = LRD + (NPVL/PV) x R
where; IRR = Internal Rate of Return
LRD = Lower Rate of Discount
NPVL = Net present value at lower rate of discount
(i.e., difference between present values of cash)
PV = The difference in present values at lower and higher discount values at lower.
R = The difference between two rates of discount.
Ex: Nissan Plc. has $100, 000 on hand. This amount is invested in a project, where the annual benefits after taxes are as below. It would like to know the rate of return earned by the company at the end of the life of the project.
$ 40, 000
At Discount Factor 20% At Discount Factor 10%
Year ACFS PV Factor PV in $ PV Factor PV in $
1 40, 000 .833 33, 300 .909 36, 400
2 35, 000 .694 24, 300 .826 28, 900
3 30, 000 .579 17, 400 .751 22, 500
4 25, 000 .482 12, 100 .683 17, 100
5 20, 000 .402 8, 000 .621 12, 400
95, 100 117, 300
IRR = LRD + (NPVL/PV) x R
= 10 + (17,300/22,200) X 10
The management will achieve wealth maximization by using the long-term investment effectively. Decision effecting investments in long-term capital projects or assets have a major impact on the future well-being of the organization. Apart from being uncertain such decisions typically, involve large commitments of funds. The capital analysis will enable the management to rank and choose intelligently among the proposals competing for essentially scarce long-term funds.
The commonly used appraisal methods are payback, accounting rate of return which are known as traditional methods. The major drawback of these methods is time value of money is not considered. To overcome those defects modern methods namely net present value, profitability index and internal rate of return have become popular and most commonly acceptable.