INVESTMENT DECISION
1 Capital Budgeting
1.1 Need Of Capital Budgeting
1.2 Principles
2 Need and importance/Nature
3 Identifying Relevant Cash Flows
4 Evaluation Techniques
4.1 Payback period method
4.2 Average Rate of Return method (ARR)
4.3 Net present value method(NPV)
4.4 Internal Rate of Return Method (IRR)
4.5 Profitability index method or Benefit cost
ratio (P.I)
5 Project Selection Under Capital Rationing
5.1 Capital Rationing
6 Inflation and capital budgeting
7 Concept And Measurement Of Cost Of Capital
7.1 Computation of cost of capital
7.2 Computation of specific source of finance
7.3 Measurement of cost of capital(specific cost
and overall cost)
1 Capital Budgeting
It is the process of making investment decision in
capital expenditures. Capital expenditure defined as an expenditure the benefits
of which are expected to be received more than one year. It is incurred in one
point of time and the benefits are received in different point of time in
future.
^{Ø }Cost of acquisition of permanent asset as land and building, plant and machinery, goodwill^{}
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^{Ø }Cost of addition, expansion and improvement or alteration in fixed assets^{}
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^{Ø }Cost of replacement of permanent assets^{}
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^{Ø }Research and development project cost etc.^{}
1.1 Why the
capital budgeting is
considered as most important
decision ove r the others?
^{Ø }The capital budgeting is the decision of long term investments, which mainly focuses the acquisition or improvement on fixed assets.^{}
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^{Ø }The capital budgeting decision is a decision of capital expenditure or long term investment or long term commitment of funds on the fixed assets.^{}
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1.2Principles
^{v }Decisions are based on cash flow not accounting income^{}
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^{v }The capital budgeting decisions are based on the cash flow forecasts instead of relying on the accounting income.these are the incremental cash flows that is additional cash^{}
^{ }
flows
that will occur if the project undertaken compare to if the project is not
undertaken
^{v }Timing of cash flows^{}
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^{v }To estimate the timing of cash flows as accurately as possible. it is used the concept of time value of money, the time at which the cash flows occur significantly impacts at the present value of the project.^{}
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^{v }Financing cost should be ignored^{}
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^{v }Cash flow should be considered^{}
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^{v }Opportunity cost are also considered^{}
2 Need and importance/Nature
(1) Large investment
 Involve
large investment of funds
 Fund
available is limited and the demand for funds exceeds the existing resources
 Important
for firm to plan and control capital expenditure
(2) Long term commitment of funds

Involves not only large amount of fund but also
long term on permanent basis.

It increases financial risk involved in investment
decision.

Greater the risk greater the need for planning
capital expenditure.
(3) Irreversible Nature
 Capital
expenditure decision are irreversible

Once decision for acquiring permanent asset is
taken, it become very difficult to dispose of these assets without heavy
losses.
(4) Longterm effect on
profitability

Capital expenditure decision are longterm and have
effect on profitability of a concern

Not only present earning but also the future growth
and profitability of the firm depends on investment decision taken today

Capital budgeting is needed to avoid over
investment or under investment in fixed assets.
(5) Difficulties of investment
decision

Long term investment decision are difficult to take
because (i) decision extends to a series of year beyond the current accounting
period

(ii) uncertainties of future

(iii) higher degree of risk
(6) National importance

Investment decision taken by individual concern is
of national importance because it determines employment, economic activities
and economic growth.
3 Identifying Relevant Cash Flows
&Capital budgeting Process
Capital
budgeting is a difficult process to the investme nt of available funds. The
benefit will attained only in the near future but, the future is uncerta in.
However, the following steps followed for capital budgeting, then the process
may be easier are
Identification
of Various Investments
 >
Screening
or Matching the Available Resources
 >
Evaluation of Proposals
 >
Fixing Property
 >
Final Approval
 >
Implementation
1.Identification of various
investments proposals : The capital budgeting may have various investment
proposals. The proposal for the investment opportunities may be defined from
the top manage me nt or may be even from the lower rank. The heads of various
department analyse the various investment decisions, and will select proposals
sub mitted to the planning committee of competent authority.
2. Screening or matching the
proposals : The planning committee will analyse the various
proposals and screenings. The selected proposals are considered with the
available resources of the concern. Here resources referred as the financial
part of the proposal. This reduces the gap between the resources and the
investment cost.
3.Evaluation: After screening, the proposals are evaluated with the help of
various methods, such as pay back
period proposal, net discovered present value method, accounting rate of return
and risk analysis.
4. Fixing property: After
the evolution, the planning committee will predict which proposals will give
more profit or economic consideration. If the projects or proposals are not
suitable for the concern‘s financial condition, the projects are rejected
without considering other nature of the proposals.
5.Final approval: The planning committee approves the final proposals, with the help of the following:
(a)
Profitability,
(b) Economic
(c)Financial
6. Implementing: The competent authority spends
the money and implements the proposals. While implementing the proposals,
assign responsibilities to the proposals, assign responsibilities for
completing it, within the time allotted and reduce the cost for this purpose.
The network techniques used such as PERT and CPM. It helps the management for
monitoring and containing the implementation of the proposals.
7. Performance review of feedback: The final
stage of capital budgeting is actual results compared with the standard
results. The adverse or unfavourable results identified and removing the
various difficulties of the project. This is helpful for the future of the
proposals.
4 Evaluation Of Investment Proposals
Traditional methods or NonDiscounted method
2.1Net
Present Value method
2.2Internal
Rate of Return method
2.3 Rate
of return method or accounting method
Timeadjusted method or discounted methods
(i) Net
Present Value method
(ii) Internal
Rate of Return method
(iii)Profitability
Index method
4.1 Payback period method
This method
represent the period in which total investment in permanent asset pays back
itself. It measure the period of time for the original cost of a project to be
recovered from the additional earning of a project itself.
Investment
are ranked according to the length of the payback period, investment with
shorter payback period is preferred.
How the payback period is calculated?
The
payback period is ascertained in the following manner
·
Calculate annual net earnings(profit) before
depreciation and after taxes, these are called annual cash inflow
·
Divide the initial outlay(cost) of the project by
the annual cash inflow, where the project generates constant annual cash inflow
Payback
period = cash outlay of the project or original cost of the asset
Annual cash
inflows
·
Where the annual cash inflows (profit before
depreciation and after taxes) are unequal the
payback
period is found by adding up the cash inflows until the total is equal to the
initial cash outlay of the project.
Selection criterion
Improvement of Traditional
Appraoch To Payback Period:
Payback Reciprocal Method
Discounted payback period : 
(time value of money in consider)
Merits
^{v }It is a simple method to calculate and understand^{}
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^{v }It is a method in terms of years for easier appraisal^{}
Demerits
^{v }It is a method rigid^{}
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^{v }It has completely discarded the principle of time value of money^{}
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^{v }It has not given any due weight age to cash inflows after the payback period^{}
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^{v }It has sidelined the profitability of the project.^{}
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4.2Average Rate of Return method (ARR)
This method takes in to account the earnings
expected from the investment over their whole life. It is known as accounting
rate of return.
The project which gives the higher rate of return
is selected when compared to one with lower rate of return.
Selection criterion of the
projects:
Merits
^{v }It is simple method to compute the rate of return^{}
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^{v }Average return is calculated from the total earnings of the enterprise through out the life of the firm^{}
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^{v }The entire rate of return is being computed on the basis of the available accounting data^{}
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Demerits
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^{v }Under this method, the rate of return is calculated on the basis of profits extracted from the books but not on the basis of cash inflows^{}
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^{v }The time value of money is not considered^{}
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^{v }It does not consider the life period of the project^{}
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^{v }The accounting profits are different from one concept to another which leads to greater confusion in determining the accounting rate of return of the projects^{}
4.3 Net present value method(NPV)
It is a modern method of evaluating investment
proposals. It takes into consideration time value of money and calculates the
return on investment by introducing the factor of time element.
^{v }First determine the rate of interest that should be selected as the minimum required rate of return^{}
^{v }Compute the present value of total investment outlay^{}
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^{v }Compute the present value of total cash inflows^{}
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^{v }Calculate Net Present Value by subtracting the present value of cash inflow by present value of cash outflow.^{}
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^{v }NPV = is positive or zero the project is accepted^{}
^{v }NPV= is negative then reject the proposal^{}
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^{v }In order for ranking the project the first preference is given to project having maximum positive net present value^{}
NPV= Present value of cash inflow – present value
of cash outflow/Initial investment Selection criterion of Net present value
method
4.4 Internal Rate of Return Method (IRR)
Under the
internal rate of return method, the cash flows of a project are discounted at a
suitable rate by hit and trial method, which equates the net present value so
calculated to the amount of investment.
^{v }Determine the future net cash flows during the entire economic life of the project. The cash inflows are estimated for future profits before depreciation but after taxes^{}
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^{v }Determine the rate of discount at which the value of cash inflow is equal to the present value of cash outflows^{}
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^{v }Accept the proposal if the internal rate of return is higher than or equal to the cost of capital or cut off rate.^{}
^{v }In case of alternative proposals select the proposal with the highest rate of return.^{}
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4.5 Profitability index method or Benefit cost
Ratio (P.I)
It is
also called Benefit cost ratio is the relationship between present value of
cash inflow and present value of cash outflow
The
proposal is accepted if the profitability index is more than one and is
rejected the profitability index is less than one
The
various projects are ranked; the project with higher profitability index is
ranked higher than other.
Profitability Index Method (or) Benefit cost Ratio:

5 Project Selection Under Capital Rationing
5.1 Capital Rationing
Capital rationing refers to a situation where the
firm is constrained for external, or self imposed, reasons to obtain necessary
funds to invest in all investment projects with positive net present value
(NPV). Under capital rationing, the management has not simply to determine the
profitable investment opportunities, but it has also to decide to obtain that combination
of the profitable projects which yields highest net present value (NPV) within
the available funds.
Why capital rationing?
Capital rationing may rise due to external factors
or internal constraints imposed by the management. Thus there are two types of
capital rationing.
^{v }External capital rationing^{}
^{ }
^{v }Internal capital rationing^{}
External capital rationing
External capital rationing mainly occurs on account
of the imperfections in capital markets. Imperfections may be caused by
deficiencies in market information, or by rigidities of attitude that hamper
the free flow of capital. The net present value (NPV) rule will not work if
shareholders do not have access to the capital markets. Imperfections in
capital markets alone do not invalidate use of the net present value (NPV)
rule. In reality, we will have very few situations where capital markets do not
exist for shareholders.
Internal capital rationing
Internal capital rationing is caused by self
imposed restrictions by the management. Various types of constraints may be
imposed. For example, it may be decide not to obtain additional funds by
incurring debt. This may be a part of the firm‘s conservative financial policy.
6 Inflation and capital budgeting
^{v }Inflation is the increase in the general level of prices for all goods and services in an economy^{}
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^{v }Nominal values are the actual amount of money making up cash flows^{}
^{v }real values reflect the purchasing power of the cash flows^{}
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^{v }real values are found by adjusting the nominal values for the rate of inflation^{}
Inflation
effects two aspects of capital budgeting
o projected cash flows
o discount rate
if
projected cash flows are in nominal terms (with inflation considered) the
discount rate used should be a nominal rate
Is it
better to use real or nominal values?
^{v }Using nominal values is more common.^{}
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^{v }Market interest rates are nominal values that already contain a premium for anticipated inflation.^{}
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^{v }Income tax obligations are based on nominal values.^{}
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^{v }Therefore, it is usually easier to use nominal values.^{}
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^{v }However, if a nominal discount rate is used, projected cash flows should reflect anticipated inflation.^{}
Risk And
Capital Budgeting
Risk
pertains to the possibility that the projected cash flows will be less than
estimated adjusting the discount rate
Discount
rate components include:
– time preference
– inflation expectations
– risk premium
Risk
premium is the cost of risk bearing
•
increasing the discount rate adds a cost for taking
risk by requiring a higher rate of return for risk bearing.
Certainty
equivalent approach
•
adjusts the cash flows to a level with a higher
―certainty‖ that they will be received.
• conceptually
similar to a risk premium.
.
7 Concept And Measurement Of Cost Of Capital
The cost
of capital of a firm is the minimum rate of return expected by its investors.
It is the weighted average cost of various sources of finance used by the firm.
The capital used may be debt, preference shares, retained earnings and equity
shares.
^{v }The decision to invest in particular project depends on cost of capital or cut off rate of the firm,.^{}
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^{v }To achieve the objective of wealth maximization, a firm must earn a rate of return more than its cost of capital.^{}
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^{v }Higher the risk involved in the firm, higher is the cost of capital.^{}
Factors Affecting The Cost Of Capital Of A Firm
1) Risk Free Interest Rate:
The risk
free interest rate, I_{f} , is the interest rate on the risk free and
default free securities. Theoretically speaking, the risk free interest rate
depends upon the supply and demand consideration in financial market for long
term funds. The market sources of demand and supply determines the I_{f}
, which is consisting of two components:
a) Real interest Rate:
The real
interest rate is the interest rate payable to the lender for supplying the
funds or in other words, for surrendering the funds for a particular period.
b)
Purchasing
power risk premium:
Investors,
in general, like to maintain their purchasing power and therefore, like to be
compensated for the loss in purchasing power over the period of lending or
supply of funds. So, over and above the real interest rate, the purchasing
power risk premium is added to find out the risk free interest rate. Higher the
expected rate of inflation, greater would be the purchasing power risk premium
and consequently higher would be the risk free interest rate.
2) Business Risk:
Another
factor affecting the cost of capital is the risk associated with the firm‘s
promise to pay interest and dividends to its investors. The business risk is
related to the response of the firm‘s Earnings Before Interest and Taxes, EBIT,
to change in sa les revenue. Every project has its effect on the business risk
of the firm. If a firm accepts a proposal which is more risky than average
present risk, the investors will probably raise the cost of funds so as to be
compensated for the increased risk. This premium is added for the business risk
compensation is also known as Business Risk Premium.
3) Financial Risk:
The
financial risk is a type of risk which can affect the cost of capital of the
firm. The particular composition and mixing of different sources of finance,
known as the financial plan or the capital structure, can affect the return
available to the investors. The financial risk is affected by the capital
structure or the financial plan of the firm. Higher the proportion of fixed
cost securities in the overall capital structure, greater would be the
financial risk.
4) Other Consideration:
The
investors may also like to add a premium with reference to other factors. One
such factor may be the liquidity or marketability of the investment. Higher the
liquidity available with an investment, lower would be the premium demanded by
the investor. If the investment is not easily marketable, then the investors
may add a premium for this also and consequently demand a higher rate of
return.
7.1 Computation Of Cost Of Capital
A.
Computation of cost of specific source of finance
B.
Computation of cost of weighted average cost of
capital
7.2Computation of specific source of finance
(i)
Cost of
debt
It is the
rate of interest payable on debt.
Debenture before tax
^{Ø }Issued at par^{}
^{ }
^{Ø }Issued at premium or discount^{}
Debenture after tax
(ii) Cost of
redeemable debt
The debt
is to be redeemed after a certain period during the life time of the firm. Such
debt issued is known as redeemable debt.
^{Ø }Before tax cost of redeemable debt^{}
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^{Ø }After tax cost of redeemable debt^{}
(iii) Cost of preference capital
A fixed
rate of dividend is payable on preference shares. Dividend is payable at the
discretion of the board of directors and there is no legal binding to pay
dividend. In case dividend are not paid, it will affect the fund raising
capacity of the firm. Hence dividends are paid regularly except when there is
no profit
^{Ø }Issued at par^{}
^{ }
^{Ø }Issued at premium or discount^{}
Cost of redeemable preference
shares
Redeemable
preference shares are issued which can be redeemed or cancelled on maturity
date.
(iv) Cost of equity share capital
The cost
of equity is the maximum rate of return that the company must earn on equity
financed position of its investments in order to leave or unchanged the market
price of its stock.It may or may not be paid. Shareholders invest money in
equity shares on the expectation of getting dividend and the company must earn
this minimum rate so that the market price of the shares remains unchanged.
(a)
Dividend
yield method or dividend / price ratio method
(b)
Dividend
yield plus growth in dividend method
(c)
Earnings
yield method
(v) Cost of
retained earnings
The
retained earnings do not involve any cost because a firm is not required to pay
dividend on retained earnings. But shareholder expects return o n retained
earnings.
Computation Of Cost Of Capital
Co
mputation of cost of capital consists of
two important parts:
1.
Measureme nt of specific costs
2.
Measureme nt of overall cost of
capital
7.3Measurement of Cost of Capital
It
refers to the cost of each specific
sources of finance like:
•
Cost of equity
•
Cost of debt
• Cost of
prefere nce share
• Cost of
retained earnings
Cost of
Equity
Cost of
equity capital is the rate at which investors discount the expected dividends
of the firm to deter mine its share value.
Conceptually the cost of equity capital (Ke) defined
as the ―Minimum rate of
retur n
that a firm must earn on the equity financed portion of an investme nt project in
order to leave unc hanged the market price of the shares‖.
Cost of
equity can be calculated from the following approach:
•
Dividend price (D/P) approach
•
Dividend price plus growth (D/P + g) approach
• Earning
price (E/P) approach
•
Realized yield approach.
Dividend Price Approach
The cost of equity capital will be
that rate of expected
dividend which will ma
inta in the present market price
of equity shares.
Dividend price approach can be measured with the
help of the following formula:
Ke=D/Np
Where,
Ke = Cost of equity
capital
D =
Dividend per equity share
Np = Net proceeds of
an equity share
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