FINANCIAL MANAGEMENT

PAPER- C- 410
SEM IV- BBA
UNIT 6 – INVESTMENT DECISION

Prof. (Dr.) Jui Banerjee

Department of BBA
St. Xavier’s College, Ranchi

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 Meaning of Investment Decisions
• In the terminology of financial management, the
investment decision means capital budgeting.
• Investment decisions are concerned with the question
whether adding to capital assets today will increase the
revenues of tomorrow to cover costs. Thus investment
decisions are commitment of money resources at
different time in expectation of economic returns in
future dates.
• Choice is required to be made amongst available
alternative revenues for investments. As such investment
decisions are concerned with the choice of acquiring real
assets over the time period in a productive process.

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Meaning of Investment Decisions …contd

Investment decision can be long-term, also known as capital budgeting

where the funds are committed into long-term basis. Short-term
investment decision also known as working capital decision and it is
concerned with the levels of cash, inventories and debtors.

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 Objective of Investment Decision
Analysis of Capital Expenditure

Selection of Best Option

Co-ordination of Expenditure

Control over Capital Expenditure

To Save from Losses

Analysis of Decision

Evaluation of Fixed Asset

Forecasting Expenditure

Analysis of Expenditure & Risks

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 Nature of Investment Decisions
• Demand of Capital – It refers to assessing financial
requirements for the various capital projects.

• Supply of Capital – It refers to making an assessment

as to how much money can be secured from different
sources for the various capital projects. The means
available for such a purpose are:
i. Internal Sources
ii. External Sources

• Rationing of Capital – It refers to the allocation of all

available cash reserves/ resources for different
competitive projects.

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 Types of Investment Decisions

Replacement
Expansion Projects Extension Projects
Projects

Products or
Research and
Process House Keeping
Development
Improvement Projects
Projects
Projects

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Investment Evaluation Criteria

Average Rate
Payback
of Return
period
(ARR)
Method
Method

Net Present Internal Rate

Value (NPV) of Return
Method (IRR) Method

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 1. Pay Back Period
• This is the simplest and commonly prevalent method of
assessment of capital expenditure. The period in which the
capital invested in any project can be fully recovered is
assessed and this period is termed as pay- back period.
• The payback period refers to the amount of time it takes to
recover the cost of an investment. Simply put, the payback
period is the length of time an investment reaches a break-
even point.
• The desirability of an investment is directly related to its
payback period. Shorter paybacks mean more attractive
investments.
• If the inflow of Cash remains uniform during all the years, then
by dividing the total investment by the average annual return,
the total time period for the recovery of the project cost can
be found out.

Pay- back period = Initial Investment / Uniform annual net return ( before
depreciation & interest but after taxes).
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 Pay Back Period
• When the annual inflow of cash is variable during the different
years, then in such a situation, a total return of some years
enables to formulate an idea of total recovery period of
investment made.
• The period by which the total collection of cash inflow
becomes equal to the investments made, is termed as the
repayment period.

• To make decisions regarding acceptance or rejection of a

project, the following rules are applied:-

Accept the Project – Pay- back Period < Predetermined cut- off
time period
Reject the Project - Pay- back Period > Predetermined cut- off
time period
Project may be accepted - Pay- back Period = Predetermined
cut- off time period
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 Example 1 & 2
• 1. The management of a manufacturing Company proposes to
invest Rs.50,000 in a project which will give earnings for six years as
follows:
Year Rs.
1 15,000
2 10,000
3 10,000
4 9,000
5 9,000
6 6,000
Find out pay- back period.

• 2. A project costs Rs.1,00,000 and yields annually a profit of Rs.16,000

after depreciation @12% p.a but before tax of 50%. Calculate the
Pay- back period.

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 Advantages & Disadvantages of ARR
Advantages:
• Extremely simple and easy to understand method
• It is more suitable for those organizations which have shortage
of funds and who manage projects with the help of loans.
• The fear of obsolescence of assets is always greater in those
institutions which are making rapid technical progress. Hence,
they select only those projects where the pay- back period is
the lowest.

Disadvantages:
• More importance is given to the liquidity of investment rather
than on investment itself.
• Does not take into account the total earnings made through
the project during its whole life span.
• Cost of Capital is ignored and as a result the investment are
made not on the basis of sound reasoning and decisions.
• The time factor for income generation is ignored.

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 2. Average Rate of Return Method
• This method is known by several names such as
‘Accounting Method’, Return on Investment Method’,
‘Average Rate of Return method, etc.
• In this method rate of return is calculated on the
investment made in the project. Time factor is not taken
into account in this method. For selecting a project, rate
of return on several projects is ascertained and the
project which is expected to yield maximum rate of
return is selected.
• If decision is to be made for only one project, then the
rate of return from the project should be either equal to
or greater than the rate of return fixed by the
management for the project to get finally selected.
• Long term projects are generally evaluated by this
method.

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 Average Rate of Return Method
• Accounting Rate of Return on Initial Investment

• Rate of Return on Average Investment

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 Example 3 & 4
3. A Project costs Rs.50,000 and has a scrap value of Rs.10,000. Its
stream of income before depreciation and taxes during the first
five years is Rs.10,000, Rs.12,000, Rs.14,000, Rs.16,000 and
Rs.20,000. Assume a 50% tax rate and depreciation on straight-
line basis. Calculate the accounting rate for the project.
4.

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Example 5

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 Advantages & Disadvantages of ARR
Advantages:
• It is a simple method. Thus it is used on large scale basis.
• Investment for the total economic life of the project is
taken into consideration.
• Helpful in the evaluation of long term projects.
• By adopting this method, a businessman can invest his
resources in the best and most profitable way.

Disadvantages:
• Variations in currency value is not taken into
consideration.
• It is not possible to fix appropriate rate of return on
investment.
• The concept of investment and return on investment is
not very cear.

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3. Net Present Value (NPV) Method
• This method is specifically used when the management
has already fixed the minimum rate of return on
investment.

• In this method, cash inflow through investment is

compared with the expected rate of return and the
present asset value is ascertained. This present value is
compared with the cost of Investment.

• If on comparison, the present value of inflows received

through investment is equal or greater than the amount
of investment, then the project is accepted for
implementation, otherwise rejected.

• The project would be accepted if the NPV is positive

and rejected if the NPV is negative.

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 Net Present Value (NPV) Method
The process of calculating NPV is as follows:

STEP I : The annual net cash flow expected from a project is

calculated by estimating all cash receipts and deducting
from them all expenditure arising out of the project.

STEP II : The net cash flow is then discounted to give its

present value. The rate used to discount the cash flow is
the required rate of return i.e., minimum rate of return
expected to be earned from the investment projects.

STEP III : The NPV of an investment proposal is then

computed. It is equal to the sum of the present value of its
annual net cash flows after tax less the investments initial
outlay.
NPV = PV - I
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Example 6

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Example 7

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 Advantages & Disadvantages of NPV
Advantages:
• It considers the cash flow stream in its entirety.
• It takes into account the time value of money.
• The NPV represents the contribution to the wealth of
shareholders.
• It indicates the financial objective of maximization of the
wealth of shareholders.

Disadvantages:
• This method requires detailed long- term forecasts of the
incremental benefits and costs.
• It is difficult to decide the appropriate rate of discount
for finding the present values of cash flows coming in
over the project life.
• The relative desirability of an investment proposal may
change with a change in the discount rate.
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4. Internal Rate of Return (IRR) Method
 With the help of Net Present Value Method the expected rate
of return is known in advance and so the present value of
earnings in future can be easily found out. In case it is
assumed that the expected rate of return is not known in
advance, then in such a situation the present value of the
expected amount in future will have to be equivalent to the
amount of initial investment. For this, the rate which is used is
termed as The Internal Rate of Return.

 IRR is known by various names such as:

• Discounted Cash Flow Rate
• Time Adjusted Rate
• Yield Rate
• Marginal Productivity of Capital
• Project Return Rate
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 Internal Rate of Return (IRR) Method
• To calculate Internal Rate of Return, the following formula is
used:

• The decision rule is as follows:

Accept – If IRR > Cost of Capital
Reject - If IRR < Cost of Capital
May Accept – If IRR = Cost of Capital

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 Calculation of the correct IRR
Sometimes, it becomes extremely difficult to calculate the
present value of the investment by assuming various
internal rate of returns. Under such a situation, on the basis
of two approximate internal rate of returns, correct internal
rate of return can be calculated. For this the following
formula is useful.

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 Example 8 & 9
Ex 8:

Ex 9:

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Solution 9:

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 Advantages & Disadvantages of IRR
Advantages:
• Time value of money is taken into consideration for
whole of its economic life
• It is not necessary to fix cost of capital
• It is easy to determine the rankings of the various
projects.

Disadvantages:
• It is difficult to correctly evaluate the cash inflows during
the economic life of the project.
• It is difficult to forecast the total cost of the project.

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 Factors Influencing Investment Decisions
Urgency of the Project

Degree of Certainty

Intangible Factors

Legal Factors

Availability of Funds

Fully Utilization of Funds

Future Earning Capacity

Obsolescence

Research and Development Projects

Cost of Consideration

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