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Chapter: Business Science : Financial Management : Investment Decision

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 Pay-back 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

1.1 Need Of Capital Budgeting

1.2 Principles

2 Need and importance/Nature

3 Identifying Relevant Cash Flows

4 Evaluation Techniques

4.1 Pay-back 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


Ø   Cost of addition, expansion and improvement or alteration in fixed assets


Ø   Cost of replacement of permanent assets


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.


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.





v   Decisions are based on cash flow not accounting income


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


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.


v   Financing cost should be ignored


v   Cash flow should be considered


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) Long-term effect on profitability


-         Capital expenditure decision are long-term 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

 -- >



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




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 Non-Discounted method


2.1Net Present Value method


2.2Internal Rate of Return method


2.3 Rate of return method or accounting method


Time-adjusted method or discounted methods


(i) Net Present Value method


(ii) Internal Rate of Return method


(iii)Profitability Index method


4.1 Pay-back 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)



v   It is a simple method to calculate and understand


v   It is a method in terms of years for easier appraisal



v   It is a method rigid


v   It has completely discarded the principle of time value of money


v   It has not given any due weight age to cash inflows after the payback period


v   It has sidelined the profitability of the project.


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:



v   It is simple method to compute the rate of return


v   Average return is calculated from the total earnings of the enterprise through out the life of the firm


v   The entire rate of return is being computed on the basis of the available accounting data




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


v   The time value of money is not considered


v   It does not consider the life period of the project


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


v        Compute the present value of total cash inflows


v        Calculate Net Present Value by subtracting the present value of cash inflow by present value of cash outflow.


v        NPV = is positive or zero the project is accepted



v        NPV= is negative then reject the proposal


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


v        Determine the rate of discount at which the value of cash inflow is equal to the present value of cash outflows


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.


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


v   Nominal values are the actual amount of money making up cash flows



v   real values reflect the purchasing power of the cash flows


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.


v   Market interest rates are nominal values that already contain a premium for anticipated inflation.


v   Income tax obligations are based on nominal values.


v   Therefore, it is usually easier to use nominal values.


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,.


v   To achieve the objective of wealth maximization, a firm must earn a rate of return more than its cost of capital.


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, If , 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 If , 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


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 = Cost of equity  capital


D = Dividend per equity  share


Np = Net proceeds  of an equity  share



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