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UNIT 4 Investment Decision Theory Questions

The document discusses various investment decision methods including payback period, net present value (NPV), accounting rate of return, internal rate of return, and profitability index. It provides definitions of each method and outlines their advantages and disadvantages.

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28 views5 pages

UNIT 4 Investment Decision Theory Questions

The document discusses various investment decision methods including payback period, net present value (NPV), accounting rate of return, internal rate of return, and profitability index. It provides definitions of each method and outlines their advantages and disadvantages.

Uploaded by

Divyasree Ds
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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UNIT 4 : INVESTMENT DECISION

Investment Decision

Investment decision is concerned with the allocation of funds to investment


proposals. In other words, it is concerned with the decision relating to investment
of funds in both capital and current assets. Investment decision involves decision-
making in respect of the following:

(a) Where to invest funds.

b) What should be the amounts that should be invested on different investment


proposals.

C) Re - allocation of resources

What Is the Payback 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 breakeven point.

Advantages of Payback Method

The main advantages of payback period are as follows:

 A longer payback period indicates capital is tied up.


 Focus on early payback can enhance liquidity
 Investment risk can be assessed through payback method
 Shorter term forecasts
 This is more reliable technique
 The calculation process is quicker than and simple than any other appraisal
techniques
 This is a very easily understood concept
Disadvantages of Payback Period Method:

There are numbers of serious drawbacks to the payback Period Method:

 It ignores the timing of cash inflows within the payback period


 It ignores the cash flow produced after the end of the payback period and
therefore the total return of the project.
 It ignores the time value of money
 It influence for excessive investment in short term projects.

NPV

NPV is one of the discounted cash flow techniques used in capital budgeting to
determine the viability of a project or an investment. NPV is the difference
between the present value of cash inflows and the present value of cash outflows
over a period of time. The cash flows are discounted to the present value using the
required rate of return. A positive NPV denotes a good return and a negative NPV
denotes a poor return.

Advantages

 It takes into account Time Value of Money


 Helps in Decision Making

Disadvantages

 No Set guidelines to Determine the Required Rate of Return


 Cannot be used to Compare Projects of Different Sizes
 Hidden Costs

ACCOUNTING RATE OF RETURN

ARR Stands for Accounting Rate of Return (ARR) or Average Rate of


Return (ARR). It is also referred to as the simple rate of return. Accounting Rate is
the most important capital budgeting technique that does not involve discounting
cash flows.
Advantages of Accounting Return

 Very simple to understand and easy to calculate


 Consider the profits of the project earned over the life of the project
 Allows projecting to compare which require different amounts of initial
capital investment.

Limitations of Accounting Rate of return

 It is based on accounting profits and not on cash flows


 It ignores the time value of money. Profits earned in different years are
considered at “par”.
 It doesn’t consider that earned profits can be reinvested
 It only considers the rate of return of the project but ignores the length of
project lives

Internal Rate of Return

The internal rate of return (IRR) is used to measure and compare the profitability
of various business projects and investments. The IRR is a common measurement
used by business leaders to decide which projects will yield the greatest results in
the form of return on investments

Advantages of IRR

i)Time Value of Money: The IRR Method gives due consideration to the Time
Value of Money which makes it highly reliable. The time value of money
considers the money on the basis of the time which makes it dependable. This
feature is not available in many of the other projects which is a drawback.

(ii) Simplicity: The best thing about IRR is that it is easy to interpret. It is easy to
use and the results of IRR can be easily studied and taken into consideration unlike
other results in other methods. These results are highly reliable. Due to its easy
accessibility the managers use this method unless any other peculiar situation
arises in which other methods are suitable to be applied.
(iii) Hurdle Rate: Hurdle Rate is the Required Rate of Return. It is a difficult task
to ascertain a hurdle rate that is reliable enough to draw the results. But the IRR
method does not consider the Required Rate of Return while examining the results
which gives this method a cover of any risk of wrong interpretations.

(iv) Required Rate of Return is a Rough Estimate: The required rate of return is
a rough estimate and is not completely used by the IRR method. Once IRR is
found then it can be compared with the Required Rate of Return. The managers
can safely take the decision without any risk because the IRR is no where linked
with the required rate of return.

Disadvantages of IRR

1. Ignores Economies of Scale: The IRR method ignores the economies of


scale completely. It ranks the projects on the basis of the returns they will
produce. For example there are two projects: Project with investment of
$5000 and earning 20% return and another is investing $ 1000 and earning
50% return. The project with $5000 will be given preference over $1000 just
because it is earning a good amount i.e. $1000 as compared to $500. But
IRR will Plan with $1000 before $5000 just because of the Rate of Return.

2. Mutually Exclusive Projects: Mutually Exclusive Projects means that if


one project is accepted the other cannot be accepted. Thus it is a difficult
task to ascertain which project gives a better return not just on the
percentage basis but also the quantitative basis.

3. A mix of positive and negative future cash flows: The IRR is based on the
project’s cash flows in future discounted at a rate to bring them to present value.
The cash flows could be positive as well as negative. Thus IRR is based on a
multiple IRR basis which renders it unreliable for results and interpretation.
Profitability Index

The profitability index is the present value of the projects future cash flows divided
by the projects initial cash outflow.

The formula for PI is given by-

PV of cash inflows

Initial cash outlay

The decision rule for profitability index is that it should be greater than one. If the
index is greater than one then the project should be accepted else it should be
rejected.

Profitability index is more or less the same as NPV. It's just a different way of
presentation. While calculation NPV we subtract the initial cash outlay, while in
this case we divide the initial cash outlay by the PV of all cash inflows.

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