Session 02. Investment Decisions

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1 Session 02 Investment Decisions Programme : Executive Diploma in Accounting, Business & Strategy (EDABS 2017) Course : Corporate Financial Management (EDABS 202) Lecturer : Mr. Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA Contact : asanka.ranasinghe11@yahoo.com

2 Learning Outcomes Calculate net present value and internal rate of return; Show an appreciation of the relationship between net present value and internal rate of return; Describe and explain at least three potential problems that can arise with internal rate of return in specific circumstances; Demonstrate awareness of the propensity for management to favour a percentage measure of investment performance and be able to use the modified internal rate of return. 2

3 Introduction Decision on whether it is better to build a new factory or extend the old; Whether it is wiser to use an empty piece of land for a multi-storey car park or to invest a larger sum and build a shopping centre; Whether shareholders would be better off if the firm returned their money in the form of dividends because shareholders can obtain a better return elsewhere, Whether the firm should pursue its expansion plan and invest in that new chain of hotels, or that large car showroom, or the new football stand. 3

4 Types of Investment Decisions One classification is as follows: Expansion of existing business Expansion of new business Replacement and modernization Yet another useful way to classify investments is as follows: Mutually exclusive investments Independent investments Contingent investments 4

5 5

6 Features of Investment Decisions The exchange of current funds for future benefits. The funds are invested in long-term assets. The future benefits will occur to the firm over a series of years. Investment decisions affect the firm s value. Importance of Investment Decisions Influence the firm s growth in the long run. Affect the risk of the firm. Involve commitment of large amount of funds. Are irreversible, or reversible at substantial loss. Are among the most difficult decisions to make. 6

7 Investment Evaluation Criteria Three steps are involved in the evaluation of an investment: Estimation of cash flows Estimation of the required rate of return (the opportunity cost of capital) Application of a decision rule for making the choice 7

8 Evaluation Criteria 1. Discounted Cash Flow (DCF) Criteria Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) 2. Non-discounted Cash Flow Criteria Payback Period (PB) Discounted Payback Period (DPB) Accounting Rate of Return (ARR) 8

9 Net Present Value (NPV) The Net Present Value (NPV) of an investment is the present value of the expected cash flows, less the cost of the investment. Cash flows of the investment project should be forecasted based on realistic assumptions. Appropriate discount rate should be identified to discount the forecasted cash flows. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. The project should be accepted if NPV is positive (i.e., NPV > 0) 9

10 Net Present Value (NPV) NPV is most acceptable investment rule for the following reasons: Time value Measure of true profitability Value-additivity Shareholder value Limitations: Involved cash flow estimation Discount rate difficult to determine 10

11 Internal Rate of Return (IRR) The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implies that the rate of return is the discount rate which makes NPV = 0. The project should be accepted if IRR is more than cost of capital (i.e., IRR > k) 11

12 Internal Rate of Return (IRR) Strengths: Accounts for TVM Considers all cash flows Less subjectivity Limitations: Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs 12

13 Ranking Mutually Exclusive Projects Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded. Two independent projects may also be mutually exclusive if a financial constraint is imposed. The NPV and IRR rules give conflicting ranking to the projects under the following conditions: The cash flow pattern of the projects may differ. That is, the cash flows of one project may increase over time, while those of others may decrease or vice-versa. The cash outlays of the projects may differ. The projects may have different expected lives. 13

14 Modified IRR (MIRR) It does not require the assumption that the project cash flows are reinvested at the IRR; rather, it factors in a discrete reinvestment rate into the model. What is MIRR for these cash flows? Cost of Capital = 10% Investment : 1,000 Yr 1 : 500 Yr 2 : 400 Yr 3 : 300 Yr 4 :

15 Profitability Index (PI) Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. Accept the project when PI is greater than one. PI > 1 Reject the project when PI is less than one. PI < 1 May accept the project when PI is equal to one. PI = 1 15

16 Profitability Index (PI) The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. Assume a 10 per cent rate of discount. The PV of cash inflows at 10 per cent discount rate is: 16

17 Evaluation of PI It recognises the time value of money. It is consistent with the shareholder value maximisation principle. A project with PI greater than one will have positive NPV and if accepted, it will increase shareholders wealth. In the PI method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a project s profitability. Like NPV method, PI criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems. 17

18 Payback Period The payback period for a capital investment is the length of time before the cumulated stream of forecasted cash flows equals the initial investment. The decision rule is that if a project s payback period is less than or equal to a predetermined threshold figure it is acceptable. Drawbacks No allowance for the time value of money Receipts beyond the payback period are ignored Arbitrary selection of the cut-off point The project would be accepted if its payback period is less than the maximum or standard payback period set by management 18

19 Discounted Payback Period The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis. The discounted payback period still fails to consider the cash flows occurring after the payback period. 19

20 Accounting Rate of Return (ARR) Some merits Simplicity Accounting data Accounting profitability Serious shortcomings Cash flows ignored Time value ignored Arbitrary cut-off Accept all those projects whose ARR is higher than the minimum rate established by the management 20

21 Summary Technique Acceptance Criteria Comments NPV NPV > 0 Most widely used, maximize shareholder wealth IRR IRR > Cost of capital Use MIRR for projects with non conventional cash flows Payback Less than set standard Ignores time value Discounted Payback ARR Less than set standard Higher than set standard Considers time value Simple but ignores cash flows and time value 21

22 Asanka Ranasinghe BBA (Finance), ACMA, CGMA 22

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