Financial Decisions

Financial Decisions relate to three major decisions which the finance manager has to
take:

 Investment Decisions
 Finance Decisions
 Dividend Decisions
LONG-TERM INVESTMENT DECISIONS
 CONTENTS
Introduction
Definition
Objectives
Need & Importance
Factors Affecting Capital Budgeting
Methods & Techniques
* Pay-back Period Method
* Average Rate of Return
* Net Present Value
* Profitability Index
* Internal Rate of Return
 INTRODUCTION

Long-Term Investment Decisions – involves long-term commitment of funds

Also called Capital Budgeting (CB)

Process of making investment decisions about capital expenditure i.e.

expenditure incurred for acquiring or improving fixed assets, the benefits of
which are expected to be received over period of time exceeding one year

Involves planning and control of capital expenditure

 INTRODUCTION

Finance manager concerned with the investment decision requires

comparison of cost against benefits over a long period.

Capital Budgeting is a combination of two words

Capital” refers to be the total investment of a company or firm in fund

deposits and tangible and intangible assets.

“Budgeting” refers to the art of building budgets and are a blue print of
a plan and action expressed in quantities and manners.
 EXAMPLES

Examples where Capital Budgeting is required

Purchase of fixed assets such as land, building, plant, goodwill, etc.

Expenditure relating to addition/expansion of the fixed assets.

Replacement of fixed assets.

Research and development project.

DEFINITION OF CAPITAL BUDGETING (CB)

 “CB is the long-term planning for making and financing proposed capital
outlays.” (Charles T Horngreen)

“CB consists of planning and development of available capital for the

purpose of maximizing the long term profitability of the concern.”
(Lynch)
 Objectives of Capital Budgeting

 Finds out the profitable capital expenditure.

 Helps to know whether the replacement of any existing fixed assets gives more return
than earlier.

 Assists in deciding whether a specified project is to be selected or not.

 Suggests the quantum of finance required for the capital expenditure.

 Assess various sources of finance for capital expenditure.

 Evaluates the merits of each proposal to decide which project is best.

 NEED & IMPORTANCE OF CAPITAL BUDGETING

 Capital Budgeting  Capital Expenditures  The capital

Commitment of Funds

Irreversible Nature
decisions involve large involves funds for expenditure decision
Large Investment

investment of funds. long term or is of irreversible

permanent basis. nature.

Long Term
 These funds are
limited and the  This increases the  Once the decision is
demand of funds is financial risk involved taken, it becomes
more. in the investment difficult to reverse
 Hence it becomes decision without incurring
critical for a firm to  Thus, calls for careful heavy losses
plan and control its planning of Capital
capital expenditure. Budgeting.
 NEED & IMPORTANCE OF CAPITAL BUDGETING

 Capital budgeting

National Importance
Long Term Effect on

decisions have a long  Investment decision though

term effect on the
Profitability

taken by individual concern

profitability of a concern. is of national importance
 Present earnings and because it determines
future growth and employment, economic
profitability of the firm activities and growth.
depends upon the
investment decision
taken today.
FACTORS AFFECTING CAPITAL BUDGETING DECISIONS

Availability of Funds
 Funds are limited and different projects require different levels of investment.
 So only those projects must be undertaken which give relatively better returns.

Minimum Rate of Return on Investment

 Every management expects a minimum rate of return or cut-off rate on capital

investment (i.e the point below which a project would not be accepted.)
 The endeavor is to identify such projects and invest accordingly.
FACTORS AFFECTING CAPITAL BUDGETING DECISIONS

Future Earnings
 The future earnings may be uniform or fluctuating.
 Depending on the requirement of the company a project can be selected or
rejected.

Quantum of Profit Expected

 It is necessary to assess the quantum of profit expected on implementation of
selected project.
 Here, the term profit refers to realized amount of projects as per the
accounting records.
FACTORS AFFECTING CAPITAL BUDGETING DECISIONS

Cash Inflows
 The cash inflows could be uniform or fluctuating. Depending on the
requirement of the company the project may be selected.
 Here, the term cash inflows refers to profit after tax but before
depreciation.

Legal Compulsions
 The management should consider the legal provisions while selecting a
project.
FACTORS AFFECTING CAPITAL BUDGETING DECISIONS

Ranking of the Capital Investment Proposal

 Ranking is necessary if there are many profitable projects in hands of management
and funds are limited.
 If there is only one profitable project that uses all the funds, then there is no need
of ranking of capital investment proposal.

Degree of Risk and Uncertainty

 Every proposal involves certain risk and uncertainty due to economic conditions,
competition, demand and supply conditions, consumer preferences etc, which
affects the profitability of the project.
 Hence, it is needs to be taken into consideration for selection.
FACTORS AFFECTING CAPITAL BUDGETING DECISIONS

Research and Development Projects

 Research and Development projects are crucial for technology based
industries.
 More than for immediate profitability, they are essential for the survival of the
business and for long run benefits.

Competitors Activities
 Every company should watch the activities of the competitors and take a
decision accordingly.
 METHODS or TECHNIQUES

Firm may have a number of proposals

But its not possible to invest funds in all of them

Selection of best proposal is required which gives highest benefits

 Is a trade-off between risk and return (profitability)

For evaluation of proposals, there are various methods or techniques

 Capital Budgeting Techniques

Non-Discounted or
Discounted
Traditional
Techniques
Techniques

Payback Period Accounting Rate Profitability Index

Net Present Value
of Return
Internal Rate of
Return
 PAY-BACK PERIOD METHOD

Pay-Back Period – period in which total investment in assets pays back itself

Also called Pay-Out or Pay-Off Period

Measures period of time for the original cost of a project to be recovered from
the additional earnings of the project itself (cash inflows)

Cash Inflows: Net Profit after tax before depreciation

Rule: Shorter the Pay-back Period, better it is.

PAY-BACK PERIOD METHOD FORMULA

If the project generates constant annual cash inflows, the payback period can be computed
by dividing cash outlay by the annual cash inflow.

 Acceptance rule
⇒ Accept if PB > standard payback
⇒ Reject if PB < standard payback
(In case of evaluation of a single project, it is adopted if it pays back itself within a period
specified by the management and if the project does not pay back itself within the period
specified by the management than it is rejected.)
 PAY-BACK PERIOD METHOD EXAMPLE

Example 1: Equal Annual Cash Flow

A project costs Rs. 1,00,000 and yields an annual cash inflow of

Rs. 20,000 for 8 years.

Pay-Back Period = Initial Outlay of the Project

Annual Cash Inflow

= 1,00,000 = 5 years
20,000
 Practice

A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000
after depreciation @ 12½% but before tax at 50%. Calculate the pay-back
period.

(Hint: Cash Inflows is taken as Net Profit after tax before depreciation)
* Tax is paid on profit and Depreciation is calculated on project cost

Formula: Pay-Back Period = Initial Outlay of the Project

Annual Cash Inflow
Solution
 PAY-BACK PERIOD METHOD EXAMPLE
Example 2: Unequal Annual Cash Flow
 A project requires cash outlay of Rs. 10,000 and generates cash inflows of Rs. 2,000,
Rs. 4,000, Rs. 3,000 and Rs. 2,000 in 1st, 2nd, 3rd and 4th year respectively.
 Cash Inflow for all 4 years: 2000+4000+3000+2000 = Rs. 11,000
 Cash Inflow for first 3 years: 2000+4000+3000 = Rs. 9,000
 Pay-Back Period : between 3rd and 4th year
 Pay-Back Period = 3 years + 10000-9000 x 12 months
11000-9000
= 3 years + 1000 x 12 months
2000
= 3 years 6 months
 Practice

Certain projects require an initial cash outflow of Rs. 25,000. The cash
inflows for 6 years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000
and Rs. 3,000 respectively. Calculate Pay Back period.
Solution
 PAY-BACK PERIOD METHOD

POINTS TO NOTE:
The payback period can be ascertained in the following manner: Calculate
annual net earning (profit) before depreciation and after taxes; these are called
the annual cash flows.

Where the annual cash inflows are equal: Divide the initial outlay (cost) of the
project by annual cash inflows.

Where the annual cash inflows are unequal: the pay back period can be found
by adding up the cash inflows until the total is equal to the initial cash outlay of
project or original cost of the asset.
ADVANTAGES OF PAY BACK PERIOD METHOD

 Simple to understand and easy to calculate.

Saves cost; requires less time and labor compared to other methods of
capital budgeting.

 Particularly suited to a firm, which has shortage of cash or whose

liquidity position is not particularly good.

 Pay-back method reduces the possibility of loss on account of

obsolescence.
 DISADVANTAGES OF PAY BACK PERIOD

Doesn't take into consideration the cost of capital.

Cash inflows earned after pay back period are ignored. Hence, true profitability
of project can’t be correctly assessed.

Ignores the time value of money and does not consider the magnitude and
timing of cash inflows.

Treating each asset individually in isolation with other assets is not feasible in real
practice.

Short-time period is considered and not the full life of the asset.
 Accounting Rate of Return (ARR)

Accounting Rate of Return is an accounting concept (where net profit after tax
and depreciation) is used

Also known as Return on Investment (ROI)

Rule: Higher the Rate of Return, better it is

Average Rate of Return – measures relationship between average annual profits

to total investments

 Average Rate of Return = Average Annual Profit x 100

Net Investment in the Project
 ACCOUNTING RATE OF RETURN METHOD

 The accounting rate of return, thus, is an average rate.

Acceptance rule
⇒ Accept if ARR > minimum rate
⇒ Reject if ARR < minimum rate
(If the actual accounting rate of return is more than the predetermined required rate of
return, the project would be accepted. If not it would be rejected.)
ACCOUNTING RATE OF RETURN EXAMPLE

Example 3:

A project requires an investment of Rs. 5,00,000 and has a scrap value of

Rs. 20,000 after 5 years. It is expected to yield profits after depreciation
and taxes during 5 years amounting to Rs. 40,000, Rs. 60,000, Rs. 70,000,
Rs. 50,000 and Rs. 20,000. Calculate average rate of return on the
investment.
ACCOUNTING RATE OF RETURN EXAMPLE
Solution:
Total Profit = 40,000+60,000+70,000+50,000+20,000
= Rs. 2,40,000

Average Profit = 2,40,000/5 = Rs. 48,000

Net Investment in the Project = 5,00,000 -20,000 (i.e scrap value)

= Rs. 4,80,000

Average Rate of Return = 48000 x 100 = 10%

480000

If this rate is more than firm specified (cut-off) rate, then it is selected
 Practice

The net investment in a project is Rs 25,000 and its expected life

is 5 years.
The profit in year 1 = Rs 10,000, in year 2 = Rs 10,692, in year 3 =
Rs 12,769, in year 4 = Rs 13,462, in year 5 = Rs 20,385. Compute
ARR.
 Solution

ARR = 13461 X 100 = 53.84 %

25000

Note: Average income =Rs 67308

5
(Accept if ARR > minimum rate
Reject if ARR < minimum rate)
ADVANTAGES OF AVERAGE RATE OF RETURN

Easy to calculate and simple to understand.

It is based on the accounting information rather than cash inflow.

It considers the total benefits associated with the project.

DISADVANTAGES OF AVERAGE RATE OF RETURN

It ignores the time value of money.

It ignores the reinvestment potential of a project.

Different methods are used for accounting profit. So, it leads to some
difficulties in the calculation of the project.
 NET PRESENT VALUE METHOD

Net Present Value Method:- It is the best method for evaluation of

investment proposal. This method takes into account time value of
money.
i.e rupee earned today is worth more than rupee earned tomorrow

NPV= PV of inflows- PV of outflows

Evaluation of Net Present Value Method:- Project

with the higher NPV should be selected.
Decision Criteria

Where

CF - cash flow,
t - is the time period and
r -is the rate of return
Present Value Table
 NET PRESENT VALUE EXAMPLE
Example 4:
Project X Project Y
Initial Investment Rs. 20,000 Rs. 30,000
Estimated Life 5 years 5 years
Scrap Value Rs. 1,000 Rs. 2,000

The discount rate is 10%. The cash inflows (profits before

depreciation and after tax) is given in below (Rs.):
Year 1 Year 2 Year 3 Year 4 Year 5
Project X 5,000 10,000 10,000 3,000 2,000
Project y 20,000 10,000 5,000 3,000 2,000
PV of Rs. 1 0.909 0.826 0.751 0.683 0.621
 NET PRESENT VALUE EXAMPLE

Solution:
Year Cash Inflows Cash Inflows PV of Re.1 PV of CI PV of CI
(X) (Y) @ 10% (X) (Y)
1 5000 20000 0.909 4545 18180
2 10000 10000 0.826 8260 8260
3 10000 5000 0.751 7510 3755
4 3000 3000 0.683 2049 2049
5 2000 2000 0.621 1242 1242
5 (Scrap 1000 2000 0.621 621 1242
Value)
PV of Total Cash Inflows 24227 34728
 NET PRESENT VALUE EXAMPLE

NPV= PV of inflows- PV of outflows

NPV of Project X = 24227 (i.e PV of CI) – 20000 (i.e initial investment) = Rs. 4227

NPV of Project Y = 34728 (i.e PV of CI)– 30000 (i.e initial investment) = Rs. 4728

NPV of Y is more than NPV of X

Project Y selected
 Practice

A company is considering an investment proposal to install new milling controls at

a cost of Rs 50,000. The facility has a life expectancy of 5 years and no salvage
value. The estimated cash flows (CF) from the investment proposal are as follows:

Year CF PV of Re 1 (10%)
1 Rs 10,000 .909
2 10,450 .826
3 11,800 .751
4 12,250 .683
5 16,750 .621

Find Net Present Value at 10 per cent discount rate.

Solution
 NET PRESENT VALUE

Advantages Disadvantages
Accounts for time value of money Project size is not measured
 Considers all cash flows  Difficulty in calculating discount rate
 Considers objective of maximum  Over sensitivity to change in rates
profitability Not suitable for comparing two projects
have unequal life
 INTERNAL RATE OF RETURN

Considers Time-Value of Money

Also called as Time-adjusted Rate of Return or Discounted Rate of Return

or Yield Method

Rate of Return is determined by Hit and Trial method

IRR – Rate of discount at which PV of Cash Inflows is equal to PV of Cash

Outflows
 INTERNAL RATE OF RETURN

Steps:

Start with any assumed discount rate – calculate PV of cash inflows

Calculate NPV

If NPV is positive – apply higher discount rate and vice-versa

Now if NPV is negative, IRR must be between these two rates

 INTERNAL RATE OF RETURN

Initial cost of the project Rs. 21,000

Year Cash Inflows PV at 10% PV at 12%

1 4,000 0.909 0.893

2 6,000 0.826 0.797

3 8,000 0.751 0.712

4 10,000 0.683 0.636

 Solution:
Year Cash Inflows PV at 10% PV of Cash PV at 12% PV of Cash
Flows Flows

1 4,000 0.909 3,636 0.893 3,572

2 6,000 0.826 4,956 0.797 4,782

3 8,000 0.751 6,008 0.712 5,696

4 10,000 0.683 6,830 0.636 6,360

Sum 21,430 20,410

The present value of cash inflows at 10 % rate of discount is Rs 21,430 and at 12 % rate of discount is
Rs 20,410. But the initial cost of investment, which is Rs 21,000, falls in between these two discount
rates. At 10 % the NPV is +430 but at 12 % the NPV is -590, we say that Internal Rate of Return (IRR)
= 10 % + 430 X (12% - 10 %)
430 +590
= 10 % + 430 X 2 = 10.843%
1020
 Practice

A company is considering an investment proposal to install new milling controls at a

cost of Rs 50,000. The facility has a life expectancy of 5 years and no salvage value.
The estimated cash flows from the investment proposal are as follows:
Year CF PV (6 %) PV (7 %)
1 Rs 10,000 .943 .935
2 10,450 .890 .873
3 11,800 .840 .816
4 12,250 .792 .763
5 16,750 .747 .713

Calculate Internal Rate of Return

Solution
Advantages Disadvantages

Accounts for time value of Difficulty in project

rankings
money

It uses cash flows rather

Multiple IRR problem
than accounting profits

It may yield contradicting

Considers all cash flows
answers with NPV in
mutually exclusive projects
 PROFITABILITY INDEX (PI)

Considers Time-Value of Money

Also called as Benefit-Cost Ratio or Desirability Factor

Determines relationship between PV of Cash Inflows and PV of Cash Outflows

Profitability Index (PI) = PV of Cash Inflows

PV of Cash Outflows

Rule: Proposal Accepted if Profitability Index is more than One (1) or Higher PI,
better it is
 PROFITABILITY INDEX (PI)
Example

Project X Project Y
Initial Investment Rs. 20,000 Rs. 30,000
Estimated Life 5 years 5 years
Scrap Value Rs. 1,000 Rs. 2,000

The discount rate is 10%. The cash inflows (profits before

depreciation and after tax) is given in below (Rs.):
Year 1 Year 2 Year 3 Year 4 Year 5
Project X 5,000 10,000 10,000 3,000 2,000
Project y 20,000 10,000 5,000 3,000 2,000
PV of Rs. 1 0.909 0.826 0.751 0.683 0.621
 NET PRESENT VALUE EXAMPLE

Solution:
Year Cash Inflows Cash Inflows PV of Re.1 PV of CI PV of CI
(X) (Y) @ 10% (X) (Y)
1 5000 20000 0.909 4545 18180
2 10000 10000 0.826 8260 8260
3 10000 5000 0.751 7510 3755
4 3000 3000 0.683 2049 2049
5 2000 2000 0.621 1242 1242
5 (Scrap 1000 2000 0.621 621 1242
Value)
PV of Total Cash Inflows 24227 34728
 PROFITABILITY INDEX (PI)

Example (same as NPV example):

Profitability Index (PI) = PV of Cash Inflows

PV of Cash Outflows

PI of Project X = 24227/20000 = 1.21

PI of Project Y = 34728 /30000 = 1.16

PI of X is more than PI of Y

Project X selected
 Practice

A company is considering an investment proposal to install new milling controls at

a cost of Rs 50,000. The facility has a life expectancy of 5 years and no salvage
value. The estimated cash flows (CF) from the investment proposal are as follows:
Year CF
1 Rs 10,000
2 10,450
3 11,800
4 12,250
5 16,750

Find the profitability Index at 10 % discount rate

Solution
 Solution

PI = Present Value of cash inflows = Rs 45,352 = .907

Present Value of cash outflows 50,000
 Focus on Ethics

Nonfinancial Considerations in Project Selection

For most companies ethical considerations are primarily concerned with
the reduction of potential risks associated with a project.
Consider likely decisions impact on stakeholders- Employees,
shareholders, customers, and society.
 For more detail click on :

https://nptel.ac.in/courses/110/107/110107144/

Then select Unit 4

Or connect with your course instructor

 References

“Financial Management”, Pandey I.M., 10th Edition, Pubs: Vikas Publishing

House Pvt. Ltd., Noida

“Financial Management,” Text and Problems, Khan MY and Jain PK, Tata
McGraw Hill