Methods of investment

evaluation
What is capital budgeting?
Capital budgeting is a process used by
companies for evaluating and ranking
potential expenditures or investments
that are significant in amount. The
large amounts spent for these types of
projects are known as capital
expenditures.
Capital budgeting usually involves the
calculation of each project's future
accounting profit by period, the cash
flow by period, the present value of the
cash flows after considering the time
value of money, the number of years it
takes for a project's cash flow to pay
back the initial cash investment, an
assessment of risk, and other factors.
Generally : firms are classify
investment projects into the following
categories.
Replacement : replace equipment
which are worn out.
Cost reduction,
Output expansion of traditional
products and markets.
Expansion into new products and/or
markets.
Government regulation
The evaluation of the worth of long
tern investment necessitates a certain
nor not standard againist which the
benefits are to be judged.There are five
reasons which owners and managers of
a firm thinks important.
1)

2)

3)

4)

5)

Since capital budgeting is

long term investment they
take form of sinking cost.
Therefore cannot be
reversed without significant
loss of capital
The investments are of
large sum so it has an
impact on profitability is
quite significant.
Extends beyond the current
accounting peiod and
cannot be immediately and
easily ascertained.
Needs vital reputation of
management. Once the
capital expenditure is
undertaken the capital base
on which the profit has to
be earned also expands.
Has to be on sound
judgement, scientific
analysis and product
forecasting to help reduce
uncertainties and thereby
improving profitability.

Capital investment analysis is in

comparing the benefits that accrue over
a period of time with the amount
invested.
There are several methods available for
making such comparisons.
The common five methods are:
1)
2)
3)
4)
5)

The payback period

method.
The average return on
investment
The net present value
method.
The internal rate of return
method.
Profitability index criterion.

Payback Period
The length of time required to recover
the cost of an investment.

Internal rate of return method

a. It is the actual rate of return on the
investment.
b. It ignores cash flows after the
payback period.
c. It is the rate of return which would
create a new present value of zero.
d. It incorporates the time value of
money.
The internal rate of return (IRR) is a
way of putting a number to how
profitable a potential business
enterprise is. It is used to try to
compare investment opportunities with
very different projected cash flows, to
come down to a particular number
(IRR) that represents the overall value
of each investment considering not
simply the amount of money it
generates, but the length of the

All other things being equal, the better

investment is the one with the shorter
payback period.
There are two main problems with the
payback period method:
1. It ignores any benefits that occur
after the payback period and, therefore,
does not measure profitability.
2. It ignores the time value of money.
Because of these reasons, other
methods of capital budgeting like net
present value, internal rate of return or
discounted cash flow are generally
preferred.
Accounting Rate of Return - ARR
Mean?
ARR provides a quick estimate of a
project's worth over its useful life.
ARR is derived by finding profits
before taxes and interest.
ARR is an accounting method used for
purposes of comparison. The major
drawbacks of ARR are that it uses
profit rather than cashflows, and it
does not account for the time value of
money.

investment. Money earned late in the

investment is worth less (in this
calculation) than money earned early
on, because the money earned early on
can be reinvested during the course of
the business enterprise.

Profitability Index

Profitability index (PI) is the ratio of

investment to payoff a suggested
project. It is a useful capital budgeting
technique for grading projects because
it measures the value created per unit
of investment made by the investor.

This technique is also known as Profit

Investment Ratio (PIR), Benefit-Cost
Ratio and Value Investment Ratio
(VIR).

The ratio is calculated as follows:

Net Present value

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.

Profitability Index = Present Value

of Future Cash Flows / Initial
Investment

If project has positive NPV, then the

PV of future cash flows must be higher
than the initial investment. Thus the

Cost concepts: involving managerial

decision in selection between
alternative courses of action. Helps in
specifying various alternatives in terms
of their quantitate values.

Profitability Index for a project with

positive NPV is greater than 1 and less
than 1 for a project with negative NPV.

This technique may be useful when

available capital is limited and we can
allocate funds to projects with the
highest PIs.

Decision Rule:

Rules for the selection or rejection of a

proposed project: Project should be

Future and past cost: Futurity is an

important aspect decision in all
business. It estimates the time adjusted
in the present and the past. It is
reasonably expected to be incurred in
some future period/s. Their actual
incurrence is a forecast and their
management is an estimate.
Incremental and Sunk cost: defined as
the change in overall cost that result
from a particular decision made. It may
include in both fixed and variable cost.
It can be avoided by not bringing any
change in the activity. It is also called
avoidable cost and escapable cost.
Difference in total cost resulting from a
contemplated cost so called differential
cost.

accepted if Profitability Index > 1and

project

should

be

rejected if

Profitability Index < 1

WHAT IS COST ANALYSIS?
A cost analysis (also called cost-benefit
analysis, or CBA) is a detailed outline
of the potential risks and gains of a
projected venture. Many factors are
involved, including some abstract
considerations, making the creation of
CBA. It is useful for making many
types of business and personal
decisions, especially ones with a
potential for profit.
THREE TYPES OF COST
ANALYSIS IN EVALUATION:
1.

Cost allocation, Cost

allocation is the process of identifying,
aggregating, and assigning costs
to cost objects. A cost object is any
activity or item for which you want to
separately measure costs.
Cost-effectiveness analysis, (CEA)
is a form of economic analysis that
compares the relative costs and
outcomes (effects) of two or more
courses of action. Cost-effectiveness
analysis is distinct from cost-benefit
analysis, which assigns a monetary
value to the measure of effect.
Cost-benefit analysis A process by
which business decisions are analysed.
The benefits of a given situation or
business-related action are summed
and then the costs associated with
taking that action are subtracted.

Sunk cost is which is not affected by

any altered change or activity and will
remain same whatever the level of
activity.it is the amortisation of the past
expenses.
Out of pocket and Book cost : those
that involve immediate payment to
outsiders as opposed to book cost that
do not require current cash
expenditure.
Book cost can be converted into out of
pocket cost by selling assets and
leasing them back from the buyer. The
difference is that whether the company
owns it or not.
Replacement and historical cost.:
Historical cost is the cost of the plant,
equipment and materials at the price
paid originally for them.
Replacement cost means the price that
would have to be paid currently for
acquiring the same plant.
National income analysis
The national income analyses are an
accounting framework used in
measuring current economic activity.
The national income analyses are
based on the idea that the amount of
economic activity that occur during a
period of time can be measured in
terms of:
1.The amount of output produced,
excluding output used up in
intermediate stages of production
(product approach).

2. The income received by the

producer of output (income approach);
3.The amount of spending by the
ultimate purchase of output
(expenditure approach);

National Aggregates: Concepts like

GDP, GNP and national income are
significant from the view of the macro
economy of the country. They provide
valuable information about the
information of the economys health.
GNP is the sum of all final goods and
services produced by the factors of
production land, labor, capital, and
entrepreneurship of a country during
a certain period of time
If all such goods are valued as a price
paid to all the factors of production, it
is known as GNP at Factor cost.
Factors of production earn income in
the form of wages, salaries, rent,
interest and profits etc. GNP is a flow
concept.
GDP, on the other hand, is the total
market value of all final goods and
services produced during a given
period within the boundaries of the
country, whether by domestic or
foreign-supplied resources.
Gross Domestic Product (GDP)a) at
market price (MP) b) at factor cost
(FC) 2. Gross National Product (GNP)
a) at market price (MP) b) at factor
cost (FC) 3. Net Domestic Product
(NDP) a) at market price (MP) b) at
factor cost (FC) 4. Net National
Product (NNP) a) at market price (MP)
b) at factor cost (FC)
Relationship between Gross & Net;
MP & FC; and National & Domestic
Concepts Gross = Net + Depreciation
Market Prices = Factor Cost + [Indirect
Taxes Subsidies] National =
Domestic + Net Factor Income from
Abroad
Gross Domestic Product (GDP) at
Market Price Less: Indirect taxes Add:
Subsidies Gross Domestic Product
(GDP) at Factor Cost Add: Net factor
income from abroad Gross National
Product (GNP) at Factor Cost
Depreciation Net National Product
(NNP) at Factor Cost (= National
Income) Less: (Corporate income tax +
Social security contributions) Add:
Transfer payments Personal Income
Less: Personal taxes Disposable
Income
Gross Domestic Product (GDP) at
Market Price Less: Indirect taxes Add:
Subsidies Gross Domestic Product

(GDP) at Factor Cost Add: Net factor

income from abroad Gross National
Product (GNP) at Factor Cost
Depreciation Net National Product

(NNP) at Factor Cost (= National

Income) Less: (Corporate income tax +
Social security contributions) Add:
Transfer payments Personal Income

Less: Personal taxes Disposable

Income

2.

a trade practice which is expressly authorised by any law in force.

Pricing methods in practice

There are different types of pricing in
the market.
1] Cost based pricing. It has 3 types of
pricing. Full Cost or break even
pricing. Cost plus pricing and marginal
pricing. In the first it includes the total
cost. In the second one some mark-up
is add to the average cost. Cost
oriented pricing is quiet popular.
Limitations are difficulties in getting
accurate estimates of cost.
2] Simple cost plus pricing: it includes
the real cost + arbitrary percentage to
cover over heads which leads to profit.
The apparent contradiction is that
traditional pricing methods often fail.
1] The price of the competing products.
2] The need of maximum loading of
production facilities throughout the
year. 3] The restraining factors.

3] Profit planning: the method of

contribution determining the variable
costs and the fixed costs to dictate the
market force and still enjoy an extra
contribution.
4] Main Application: restraining
factors changing according to the
companys activity and circumstances.
5] Penetration Pricing: when entering
to new market firms deliberately set a
relatively low price in hope of
penetration into the market to establish
the market share and gradually move to
a profitable price.
6] Price Skimming: is a product
pricing strategy by which a firm
charges the highest initial price that
customers will pay. As the demand of
the first customers is satisfied, the firm
lowers the price to attract another,
more price-sensitive segment. 1] loss

leader pricing, 2] transfer pricing, 3]

Ramsey pricing
7] Peak load Pricing: used to reduce
cost and increase profit if the same
facilites are used to provide products or
service at different periods. 1] product
bundling, 2] prestige/ psychological
pricing- perception by charging a
higher price on product sold 3] value
pricing- selling quality products at
lower prices than previously given.
8] Governments control on pricing:
the government controls the pricing
from time to time for certain
commodities which are mostly
necessities
9] Promotional pricing or Discounting:
Exchanges, freebies, interest free
financing to make a decimal growth in
market share.

The MRTP Commission has the following powers:

1.

Power of Civil Court under the Code of Civil Procedure, with respect to:
i.

Summoning and enforcing the attendance of any witness and examining him on oath;

ii.

Discovery and production of any document or other material object producible as evidence;

iii.

Reception of evidence on affidavits;

iv.

Requisition of any public record from any court or office.

v.

Issuing any commission for examination of witness; and

vi.

Appearance of parties and consequence of non-appearance.

PRELIMINARY INVESTIGATION
Before making an inquiry, the Commission may order the Director General to make a preliminary investigation into the complaint, so as to
satisfy itself that the complaint is genuine and deserves to be inquired into.
Remedies under The Act
The remedies available under this act areTEMPORARY INJUNCTION
Where, during any inquiry, the commission may grant a temporary injunction restraining such undertaking or person form carrying on such
practice until the conclusion of inquiry or until further orders.
COMPENSATION
Where any monopolistic, restrictive or unfair trade practice has caused damage to any Government, or trader or consumer, an application
may be made to the Commission asking for compensation, and the Commission may award appropriate compensation.
Where any such loss or damage is caused to a number of persons having the same interest, compensation can be claimed with the
permission of the commission, by any of them on behalf of all of them.
3.

Producers may have patents over designs,

or copyright over ideas, characters, images,

sounds or names, giving them exclusive rights to
sell a good or service

Monopoly
A pure monopoly is a single supplier in a market.
For the purposes of regulation, monopoly
power exists when a single firm controls 25% or
more of a particular market.

4.

A monopoly could be created following the

merger of two or more firms. Given that this will

reduce competition, such mergers are subject to
close regulation and may be prevented if the two
firms gain a combined market share of 25% or
more.
characteristics

Formation of monopolies
1.

Monopolies can maintain super-

Monopolies can form for a variety of reasons,

normal profits in the long run. As with all firms,

including the following:

profits are maximised when MC = MR. In general,

the level of profit depends upon the degree

1.

If a firm has exclusive ownership of a

scarce resource

of competition in the market, which for a pure

monopoly is zero. At profit maximisation, MC =
MR, and output is Q and price P. Given that price

2.

Governments may grant a firm monopoly

(AR) is

status, such as with the Post Office

2.

above ATC at Q, supernormal profits are

possible (area PABC).

2.

With no close substitutes, the monopolist

can derive super-normal profits, area PABC.

3.

A monopolist with no substitutes would be

able to derive the greatest monopoly power.

Monopoly power comes from a firm's ability to set prices. This

competition. In addition to the assumptions stated above, the

ability is dictated by the shape of the demand curve facing that

Cournot duopoly model relies on the following:

firm. If the firm faces a downward sloping demand curve, it is

no longer a price taker but rather a price setter. In our perfect

1.

Each firm chooses a quantity to produce.

competition model, we assume there exist multiple participants,

2.

All firms make this choice simultaneously.

and because there are so many participants, the slice of the

3.

The model is restricted to a one-stage game. Firms

demand curve each firm sees is but a flat line. These firms are
price takers.

There is a medium between monopoly and perfect competition

in which only a few firms exist in a market. None of these firms
faces the entire demand curve in the way a monopolist would,
but each does have some power to set prices. A small collection
of firms who dominate a market is called an oligopoly. A
duopoly is a special case of an oligopoly, in which only two
firms exist.

choose their quantities only once.

4.

The cost structures of the firms are public

information.

In the Cournot model, the strategic variable is the output

quantity. Each firm decides how much of a good to produce.
Both firms know the market demand curve, and each firm
knows the cost structures of the other firm. The essence of the
model is this: each firm takes the other firm's choice of output
level as fixed and then sets its own production quantities.

Duopolies
The best way to explain the Cournot model is by walking
We will begin our discussion with an investigation of duopolies.
For the following duopoly examples, we will assume the

The two firms produce homogeneous and

indistinguishable goods.

2.

curve, the key to understanding the Cournot model (and

elementary game theory as well).

following:

1.

through examples. Before we begin, we will define the reaction

There are no other firms in the market who produce

the same or substitute goods.

A reaction curve for Firm 1 is a function Q 1 *() that takes as

input the quantity produced by Firm 2 and returns the optimal
output for Firm 1 given Firm 2's production decisions. In other
words, Q 1 *(Q 2) is Firm 1's best response to Firm 2's choice
of Q 2 . Likewise, Q 2 *(Q1) is Firm 2's best response to Firm 1's

3.

No other firms can or will enter the market.

4.

Collusive behavior is prohibited. Firms cannot act

together to form a cartel.

5.

There exists one market for the produced goods.

Cournot Duopoly

In 1838, Augustin Cournot introduced a simple model of

duopolies that remains the standard model for oligopolistic

choice of Q 1 .

Let's assume the two firms face a single market demand curve as
follows:

Q = 100 - P
where P is the single market price and Q is the total quantity of
output in the market. For simplicity's sake, let's assume that both
firms face cost structures as follows:

MC_1 = 10

Q1* = 45 - Q2*/2 = 45 - (44 - Q1*/2)/2

MC_2 = 12

= 45 - 22 + Q1*/4
= 23 + Q1*/4

Given this market demand curve and cost structure, we want to

=> Q1* = 92/3

find the reaction curve for Firm 1. In the Cournot model, we

assume Q 2 is fixed and proceed. Firm 1's reaction curve will

By the same logic, we find:

satisfy its profit maximizing condition, MR = MC . In order to

find Firm 1's marginal revenue, we first determine its total

Q2* = 86/3

revenue, which can be described as follows

Again, we leave the actual computation of Q 2 * as an exercise
Total Revenue = P * Q1 = (100 - Q) * Q1

for the reader. Note that Q 1 * and Q 2 * differ due to the

= (100 - (Q1 + Q2)) * Q1

difference in marginal costs. In a perfectly competitive market,

= 100Q1 - Q1 ^ 2 - Q2 * Q1

only firms with the lowest marginal cost would survive. In this
case, however, Firm 2 still produces a significant quantity of

The marginal revenue is simply the first derivative of the total

goods, even though its marginal cost is 20% higher than Firm

revenue with respect to Q 1 (recall that we assume Q 2 is fixed).

1's.

The marginal revenue for Firm 1 is thus:

An equilibrium cannot occur at a point not in the intersection of
MR1 = 100 - 2 * Q1 - Q2\

the two reaction curves. If such an equilibrium existed, at least

one firm would not be on its reaction curve and would therefore

Imposing the profit maximizing condition of MR = MC , we

not be playing its optimal strategy. It has incentive to move

conclude that Firm 1's reaction curve is:

elsewhere, thus invalidating the equilibrium.

100 - 2 * Q1* - Q2 = 10 => Q1* = 45 - Q2/2

The Cournot equilibrium is a best response made in reaction to a

best response and, by definition, is therefore a Nash equilibrium.

That is, for every choice of Q 2 , Q 1 * is Firm 1's optimal choice

of output. We can perform analogous analysis for Firm 2 (which
differs only in that its marginal costs are 12 rather than 10) to
determine its reaction curve, but we leave the process as a
simple exercise for the reader. We find Firm 2's reaction curve to
be:

Q2* = 44 - Q1/2

Unfortunately, the Cournot model does not describe the

dynamics behind reaching equilibrium from a non-equilibrium
state. If the two firms began out of equilibrium, at least one
would have an incentive to move, thus violating our assumption
that the quantities chosen are fixed. Rest assured that for the
examples we have seen, the firms would tend towards
equilibrium. However, we would require more advanced
mathematics to adequately model this movement.

The solution to the Cournot model lies at the intersection of the

two reaction curves. We solve now for Q 1 * . Note that we
substitute Q 2 * for Q 2 because we are looking for a point which
lies on Firm 2's reaction curve as well.

Stackelberg duopoly

The Stackelberg duopoly model of duopolies is very similar to

the Cournot model. Like the Cournot model, the firms choose
the quantities they produce. In the Stackelberg model, however,
the firms do not move simultaneously. One firm holds the

Qualitative forecasting involves combining the available

privilege to choose production quantities before the other. The

assumptions underlying the Stackelberg model are as follows:

data with a heavy dose of expert opinion about the firm and
industry, assigning subjective weights to these pieces of

1.

Each firm chooses a quantity to produce.

2.

A firm chooses before the other in an observable

evidence. Qualitative forecasting is complex and not easily

replicated. It is difficult to teach qualitative forecasting

manner.
3.

techniques because the subjective or judgment component of the

forecast depends upon the experience and knowledge of the

The model is restricted to a one-stage game. Firms

choose their quantities only once.

forecaster
Seasonal (or Cyclical) Variation. Time-series data may
frequently exhibit regular, seasonal, or cyclical variation over
time, and the failure to take such regular variation into account

Bertrand Duopoly

when estimating a forecasting equation would bias the forecast.

When data exhibit cyclical variation, such as seasonal patterns,

The Bertrand duopoly Model, developed in the late nineteenth

dummy variables can be added to the time-series model to

century by French economist Joseph Bertrand, changes the

account for the seasonality.

choice of strategic variables. In the Bertrand model, rather than

choosing how much to produce, each firm chooses the price at

A dummy variable is a variable that takes only values of 0

and 1.

which to sell its goods.

Correcting for seasonal variation by using dummy

variables: If there are N seasonal time periods to be
accounted for, N-1 dummy variables can be added to the

1.

Rather than choosing quantities, the firms choose the

demand equation. Each dummy variable accounts for one

price at which they sell the good.

2.

All firms make this choice simultaneously.

3.

Firms have identical cost structures.

4.

The model is restricted to a one-stage game. Firms

of the seasonal time periods. The dummy variable takes a

value of 1 for those observations that occur during the
season assigned to that dummy variable and a value of 0
otherwise.

choose their prices only once.

The Bertrand Model differs from the Cournot model only in the

Dummy variables are used:

(equal to 1 in the ith

season and 0 otherwise),

This type of dummy variable allows the intercept of the

strategic variable, the two models yield surprisingly different

results. Whereas the Cournot model yields equilibriums that fall
somewhere in between the monopolistic outcome and the free

demand equation to take on different values for each season

the demand curve can shift up and down from season to season.
8.4 Econometric Models
. Econometric models use an explicit structural model to

market outcome, simply reduces to the competitive equilibrium,

where profits are zero. Rather than go through a series of
convoluted equations to derive this result, to show there could
be no other outcome. It is the no profit equilibrium.

explain the underlying economic relations. If we wish to employ

an econometric model to forecast future sales, we must develop
a model that incorporates the variables that actually determine
the level of sales (e.g., income, the price of related goods, and so

Demand Forecasting

it can be used to forecast demand conditions in future time

periods.

Qualitative Forecasting Techniques

on). This approach differs from the qualitative approach, in

which a loose relation was posited between sales and some
leading indicators, and the time-series approach, in which sales
are assumed to behave in some regular fashion over time.
l

Advantages of using econometric models

This approach requires analysts to define explicit

causal relations. This specification of an explicit

(false) correlation between normally unrelated

consistent and reliable.

supply.
l

Forecasting future industry demand and supply for price-

changes in the exogenous explanatory variables.

Therefore, the analyst can examine the behavior of

Forecasting future industry demand and supply for pricetaking firms

Estimate the firms demand function (was

introduced in chap.7);

Econometric forecasting can be utilized to forecast either

demand for a price-setting firm.

supply

Calculate the intersection of future demand and

setting firms

future industry price and quantity for price-taking firms or future

and

Locate industry demand and supply in the forecast

sensitivity of the variable to be forecasted to

these variables more closely.

industry demand

period;

variables and may make the model more logically

This approach allows analysts to consider the

the

equations (was introduced in chap.7);

model helps eliminate problems such as spurious

Estimate

Forecast the future values of the demand-shifting

variables

Calculate the location of future demand