Session6 Investment Decisions

Project Appraisal and Management Financial Analysis Investment Decisions

Mona Iyer CEPT University Ahmedabad

Session Outline • Investment Decisions • Discounted Cash Flow Method – NPV – IRR – PI

Investment Decisions When do u need to take investment decisions? – Starting a new project – Expanding the existing project – Replacement and modernization

Investment Decisions What are the features of Investment Decisions? – Current funds are allocated for future benefits – Funds invested in long term assets – Future benefits will occur over a long period

Why Important to take appropriate investment decision? – Involve commitment of large amount of funds – Almost Irreversible decisions – Long term Implications

Investment Decisions Steps Involved in Investment Evaluation – Estimating Cash Flows – Estimating required rate of return – Application of Decision Rule for selecting most appropriate investment

Investment Evaluation Criteria/ Capital Budgeting Techniques/Investment decision Rules • Discounted Cash Flow (DCF) Criteria – Net Present Value – Internal Rate of Return – Profitability Index

• Non-Discounted Cash Flow Criteria – Pay Back Period – Accounting Rate of Return

Time Value of Money Suppose you have Rs. 100 today and you invest in some scheme with rate of return 10% per annum. Then to know cash in hand after One year your have to compound it by compounding factor…. (C1)= 100* (1+0.1)=110 Now, assume a reverse scenario…that u know that u will have Rs. 110 cash after one year and you want to know the present value of the same, then u will have to discount it by discount factor (inverse of compounding factor) Present value= 110* 1/(1+0.1)= 100 You may call C1 as Future Value (Cash Flow at year 1) Important terms Rate of Return/ Discount Rate /Opportunity cost of capital Discount Factor Present Value (Time Value of Money)

Net Present Value (NPV) Suppose you have to make an investment of Rs. 100 today in a project…it will give you a cash flow if Rs. 150 after 1 year.

What is the present value of your cash flow if discount rate is 10% PV= C1* (1/1+r)=150*(1/1+0.1) =136 Net Present Value = Present Value –Initial /required investment =136-100=36 Thus your investment is worth more than it costs i.e it makes net contribution to value NPV formula : NPV=C1/(1+r)^1 + C2/(1+r)^2…… - Initial investment OR NPV=C0+ C1/(1+r)^1 + C2/(1+r)^2……Where C0 is initial outflow of money/investment and hence necessarily negative. NPV= Discounted or present value of future cash flow - Initial investment

Net Present Value (NPV) Rule NPV>0 Accept NPV=0 May Accept NPV<0 Reject Accept project with higher NPV Features of NPV 1. Value additivity principle applies i.E For Project A and Project B NPV(A+B)= NPV A + NPV B 2. Is dependent on Rate of return/discount rate 3. Is dependent on the duration of project

NPV Simulations For different discount Rates For different durations

Some Important Concepts Rate of Return/Discount Rate Opportunity Cost of Capital • The cost of pursuing one course of action measured in terms of forgone return offered by the most attractive alternative investment.

Internal Rate of Return

Internal Rate of Return (IRR) The rate of Return which makes the Discounted Value of Cash Flow (Present value) equal to Initial Investment i.e. PV= C0 i.e. C0=C1/(1+r) i.e. C1/(1+r)-C0=0 i.e. NPV = 0 Thus equation for IRR is same as NPV. Only difference is that NPV is calculated for a given/known/assumed rate of return whereas in IRR method rate of return ‘k’ has to be determined for which NPV is 0

IRR Rule k >r (cost of capital)Accept k=r May Accept k < r (cost of capital) Reject Features of IRR 1. Value additivity principle does not apply i.E For Project A and Project B IRR (A+B) ≠ IRR A + IRR B 2. Depends on duration of project and sequence of cash flow 3. While comparing two investments, Higher IRR does not indicate necessarily better investment

Profitability Index Ratio of Benefits to Costs i.e. BC=PI=PV of cash flows/Initial Investment Also some sources say PI=NPV/Initial Investment i.e. (PV-Investment)/Investment i.e. (PV/Investment)- (Investment/Investment) i.e. PI = PV/ Investment-1 PI= B/C -1 i.E B/C = PI+1 Select projects with highest PI till u run out of capital PI based on B/C i.e present value PI based on NPV BC>1 Accept PI>0 BC=1 May Accept PI=0 BC<1 Reject PI<0

Features of PI 1. Works well for capital rationing in one period •

Select project with higher PI till u exhaust capital

2. Breaks down when capital rationing in more than one period

• Non-Discounted Cash Flow Method – Pay back – ARR

Non-Discounted Cash Flows Payback Period •

Most popular traditional method of evaluating investment proposals…simple to understand …easy to calculate

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Incase of equal annual cash flows (C) payback = C0/C

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Incase of unequal cash flows the payback can be found out by adding the cash inflows till total equals initial investment

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Acceptance Rule : Pay back cutoff generally fixed by the project proponents/owners…is subjective

Non-Discounted Cash Flows Payback Period Pay back rule Tends to give misleading answers because….. • The payback rule ignores all the cash flows after cutoff period regardless of the size of cash flow in the subsequent year/s – The cutoff should be fixed keeping in mind life of alternative projects so that it does not end up accepting many poor short lived projects and reject good long term projects.

• The payback rule gives equal weightage to all the cash flows before the cutoff period – This is taken care of in discounted payback period but still the cashflows after the cutoff period are ignored

• Generally No rational basis for fixing the cut off period

Non-Discounted Cash Flows Accounting/Book Rate of Return/ Return on Investment (ROI) • Uses Income and Investment details as available from Accounting statements (P&L account) not Cash Flows • ARR or ROI= Average Income/ Average Investments • ARR = [sum (PADT 1 to n)/n]/ Avg Dep Investments

Non-Discounted Cash Flows Accounting/Book Rate of Return/ Return on Investment (ROI) • Acceptance Rule: Accept if ARR is higher than minimum rate established by management. • ARR can be misleading because – It uses accounting profits and not cash flows – No time value of money

Used widely for performance evaluation but not investment criteria