INTERNATIONAL JOURNAL OF MANAGEMENT RESEARCH AND REVIEW A FUNDAMENTAL STUDY ON LONG- TERM INVESTMENT DECISION P. Selvam* 1, N. Punitavati 2 1 Assistant Professor, Department of Management studies, Alpha College of Engineering, Chennai, Tamil Nadu 2 Assistant Professor, Department of Management studies, Alpha College of Engineering, Chennai, Tamil Nadu ABSTRACT A Fundamental study on Capital Budgeting has been viewed with the intention of providing fundamental knowledge to investors whose inclination is making a profit by investing in long term securities. In the world of investment, as capital budgeting is of paramount importance, this study will help them in knowing the difficulties associated with capital budgeting decision. This paper proposes to address the key features of various investment decisions. The methodology of this study is to help the organization to take investment decision in order to invest its current funds prudently & efficiently in the long term assets with the anticipation of expected flow of benefits over a series of year. The capital expenditure decision has its effects over a long time span and inevitably affects the company s future cost structure. Capital expenditure management includes addition, disposition, modification and replacement of fixed assets. A systematic blending of current and fixed assets into a profitable combination is challenging task for the financial management. Keywords: Long Term Investment, Wealth Maximization and Risk Minimization. INTRODUCTION Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting. A logical prerequisite to the analysis of investment opportunities is the creation of investment *Corresponding Author www.ijmrr.com 13
opportunities. Unlike the field of investments, where the analyst more or less takes the investment opportunity set as a given, the field of capital budgeting relies on the work of people in the areas of industrial engineering, research and development, and management information systems (among others) for the creation of investment opportunities. As such, it is important to suggest that students keep in mind the importance of creativity in this area, as well as the importance of analytical techniques. Investment in long term assets is most important since they are irreversible without loss and they determine the value of firm through growth, profitability and risk. Investment in long-term assets is known as capital budgeting. Capital Budgeting decision pertains to fixed assets which are in operation, and yield return over a period of time usually exceeding one year. Capital Budgeting is a process of evaluating and selecting long term investments that are consistent with the goal of shareholders wealth maximization Definition of 'Capital Budgeting' The process in which a business determines whether projects such as building a new plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. OBJECTIVE OF THE STUDY: To understand ABC of capital budgeting. To select best investment alternatives. To elucidate various techniques of capital budgeting. To illustrate investors wealth and profit maximization. To provide suggestions and recommendations for aggressive investors SCOPE OF THE STUDY: As a matter of prudence, the investors have to take an effective investment decision. For this the investors have to be aware of risk associated with various portfolios. The scope of the study is to make the investor s to have good acquaintance with financial management. METHODS IN CAPITAL BUDGETING: 1). Payback Period Method: (Uniform Cash Inflow) Copyright 2012 Published by IJMRR. All rights reserved 14
The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. This period is sometimes referred to as" the time that it takes for an investment to pay for itself." Payback period = Investment required / Net annual cash inflow Advantages of PBP It is very simple and easy to understand The cost involvement in calculating PBP is much less compare to modern methods It helps to take investment decision Payback Period Method: (Uniform Cash Inflow) For Example, An investment of Rs.50,000 in a machine is expected to produce CFAT of Rs.10,000 for five years. Hence, Payback period is Payback period = 50,000 / 10,000 = 5Years (The money invested on a machine can be recovered in 5 years) Payback Period Method: (Un uniform Cash Inflow) An investment of Rs.40,000 in a machine is expected to produce following CFAT S.No 01 02 03 04 05 Year 2001 2002 2003 2004 2005 CFAT 15000 17000 8000 3000 5000 Hence, Payback period can be calculated in the following way S.No 01 02 03 04 05 Year 2001 2002 2003 2004 2005 CFAT 15000 17000 8000 3000 5000 15000 32000 40000 43000 48000 Invested money can be recovered in three years 2). Net present Value Method: Copyright 2012 Published by IJMRR. All rights reserved 15
NPV is the difference between the present value of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return. Symbolically, Advantages and Disadvantages of NPV Advantages Easy to understand Adjusts for uncertainty of later cash flow Biased toward liquidity Disadvantages Ignores time value of money Biased against long-term projects Ignores cash flow beyond payback period Acceptance or Reject of the project based on NPV This can be illustrated in the following example A project requires an initial investment of Rs 20,000 which involves in a net cash inflow of Rs 7500 each year for 5 years. Cost of funds 10%. Year Net Cash Inflow Discount Factor 6 % Present Value in Rs. 1 5 7500 3.791 28,432.5 (-) Present value of cash out flow Net Present Value 20,000 8,432.5 Copyright 2012 Published by IJMRR. All rights reserved 16
Net Present Value of above said project is 8,432.5 Since NPV is greater than 0(NPV>0), this project can be accepted 3). Profitability Index Method It is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment proposal. This approach measures the present value of returns per rupee invested. PI is also known as Discounted Benefit Cost Ratio. Advantages of Profitability Index: It considers all cash flows to determine PI It helps to rank projects according to their PI It gives due consideration to time value of money It is consistent with the objective of maximization of shareholders wealth Symbolically, PI = Present Value of Cash Inflows / Present Value of Cash Outflows This can be illustrated in the following example A project requires cash outlay of Rs. 1,00,000 and it generates cash inflow of Rs.40,000, 30,000, 60,000, 25,000 and 50,000. Assume a 10% rate of discount. Year CFAT DF 10% Present Value 1990 40,000 0.909 36,360 1991 30,000 0.826 24,780 1992 60,000 0.751 45,060 1993 25,000 0.683 17,075 1994 50,000 0.621 31,050 PV of Cash Inflows 1,54,325 Profitability Index = 1,54,325/1,00,000 = 1.5432 Since PI is greater than 0(NPV>0), this project can be accepted Copyright 2012 Published by IJMRR. All rights reserved 17
4). Internal rate of Return Method: (IRR) It is a rate of return used to identify the profitability status of an Investment. This enables the investor to identify the potential of the instrument such that the investment yields a better return. It is an effective tool as it is not affected by interest rate, inflation rate etc It is a process where over the Initial Investment and below the Initial Investment has to be identified. The cost of capital is compared to the internal rate of return promised by a project. Any project whose internal rate of return is less than the cost of capital is rejected. Symbolically, PVLDF - COF IRR = LDF % + Change in DF PVLDF - PVHDF LDF = Low Discount Factor COF Cash Outflow PVLDF = PV Of cash inflow at low discounting factor PVHDF = PV Of cash inflow at high discounting factor Advantages of Profitability IRR: It takes into account time value of money It considers cash flow throughout project life It consistent with the objective of shareholder wealth maximization It does not use the concept of required rate of return, it itself provides rate of return which is indicative of profitability This can be illustrated in the following example A project needs an investment of Rs. 1,38,500. The cost of capital is 12%. The net cash flows are as follows: Year 1990 1991 1992 1993 1994 CFAT 30,000 40,000 60,000 30,000 20,000 Solution Copyright 2012 Published by IJMRR. All rights reserved 18
Year CFAT Discount Factor Present Value 10% 8% 10% 8% 1990 30,000 0.909 0.926 27,270 27,780 1991 40,000 0.826 0.857 33,040 34,280 1992 60,000 0.751 0.794 45,060 47,640 1993 30,000 0.683 0.735 20,490 22,050 1994 20,000 0.621 0.681 12,420 13,620 PV of Cash Inflows 1,38,280 1,45,370 Cash outflow Rs.1,38,500 lies between 10% and 8%. Hence there is a need to use the formula. Calculation of IRR: 1,45,370-1,38,500 IRR = 8% + 2 1,45,370-1,38,280 6870 IRR = 8% 2 = 8 + 1.938 = 9.94% 7090 Project cannot be selected as the IRR of the project (9.94%) is less than the cost of capital (12%). 5). Accounting Rate of Return Method: (ARR) It is a tool which is used in computing the return generated from the net income of the investment. It is also known as average rate of return. Advantages of Profitability ARR It provides a quick estimate of a project's worth over its useful life. It enables comparison of Investments. Copyright 2012 Published by IJMRR. All rights reserved 19
Decision Rule: Accept: Cal ARR > Predetermined ARR Reject: Cal ARR < Predetermined ARR Symbolically, ARR= Average Profit/ Average Investment. Average Investment= Book value at the beginning + Book value at the end / 2 This can be illustrated in the following example (Initial Investment = 60000). Opening Value = 300000. Closing Value = 380000. Profit for the year (Average) = 50000 Management expects a rate of return of 10% Solution: Average Investment= Book value at the beginning + Book value at the end / 2 = 300000+380000/2 = 680000/2 = 340000. ARR= Average Profit/ Average Investment. = 50000/340000 = 0.14 = 14.70% The project is accepted since the ARR is higher than the management expectation. RECOMMENDATION AND SUGGESTION: Investors have to be aware of recovering period of original cash out flow before an investment. Copyright 2012 Published by IJMRR. All rights reserved 20
1. It recommends the investors to apply first method when annual cash flows stream of each year is equal. 2. It recommends the investors to apply second method of NPV when annual cash flows after taxes are unequal. 3. It recommends the investors to not proceed with the investment when NPV is adverse. 4. It recommends the investors to not proceed with investment when ARR is lower than the expectation. 5. When particular investment takes ample time to recover its original investment, it recommends investors to give up particular project. 6. Investors have to choose the project in which PBP is low. 7. When it comes to mutually exclusive project, the investors are recommended to be more prudent to choose the project which is financially viable. 8. It recommends the investors to choose the projects which are financially viable. 9. Investors are recommend to go for diversification in order to reduce financial risk. REFERENCES Khan, M.Y & Jain, P K. (2010). Financial Management. TATA McGraw Hill Education Pvt. Ltd., New Delhi. Pandey, I.M. (2009). Financial Management. Vikas Publishing House Pvt. Ltd. Sudarsana, R.G. (2010). Financial Management. Himalaya Publishing House Pvt. Ltd., Mumbai. Copyright 2012 Published by IJMRR. All rights reserved 21
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