Chapter: 3Investment Decisions

Introduction
One of the most important finance functions is to intelligently allocate capital to long
term assets. This activity is also known as capital budgeting. It is important to allocate
capital in those long term assets so as to get maximum yield in future. Following are
the two aspects of investment decision

Evaluation of new investment in terms of profitability

Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of expected
return. Along with uncertainty comes the risk factor which has to be taken into
consideration. This risk factor plays a very significant role in calculating the expected
return of the prospective investment. Therefore while considering investment proposal
it is important to take into consideration both expected return and the risk involved.
Investment decision not only involves allocating capital to long term assets but also
involves decisions of using funds which are obtained by selling those assets which
become less profitable and less productive. It wise decisions to decompose
depreciated assets which are not adding value and utilize those funds in securing
other beneficial assets. Therefore, evaluation of investment projects under uncertainty
and risk become important.
Capital Budgeting
Capital budgeting is a process of making investment decisions in capital
expenditure.
Investment means
commitment of funds and a capital expenditure is an
expenditure incurred for acquiring or improving the fixed assets, the benefits of which
are expected to be received over a number of years in future. A capital expenditure is
incurred when a business spends money either to buy fixed assets or to add to the
value of an existing fixed asset with a useful life extending beyond the taxable year.
Capital Budgeting Definition
Capital budgeting has been formally defined as follows.
Capital budgeting is long-term planning for making and financing proposed capital
outlay. - Charles T. Horngreen
The capital budgeting generally refers to acquiring inputs with long-term returns. Richards & Greenlaw
Capital budgeting involves the planning of expenditure for assets, the returns from
which will be realized in future time periods. - Milton H. Spencer
Feature of capital budgeting decision
1. Funds are invested in current period in order to obtain future benefits.
2. Future benefits are obtained over a series of year and only in one year
3. Capital budgeting decisions involves huge funds

4. Associated with risk and uncertainty

5. Irreversible in nature
Capital Budget Decision
Capital budgeting refers to the total process of generating, evaluating, selecting and
following up on capital expenditure alternatives. The firm allocates or budgets
financial resources to new investment proposals. Basically the firm may be confronted
with three types of capital budgeting decisions
1. Accept / Reject decision - This is the fundamental decision in capital budgeting.
If the project is accepted, the firm invests in it. If the proposal is rejected the firm does
not invest. In general all those proposals which yield a rate of return greater than a
certain required rate of return or cost of capital are accepted and the rest are
rejected. By applying this criteria, all independent projects are accepted. Independent
projects are projects that do not compete with one another in such a way that
acceptance of one precludes the possibility of acceptance of another. Under the
acceptance decision, all the independent projects that satisfy the minimum
investment criteria are implemented.
2. Mutually exclusive project decision - Mutually exclusive projects are projects
which compete with other projects in such a way that the acceptance of one will
exclude the acceptance of other projects. The alternatives are mutually exclusive and
only one may be chosen. It may be noted that the mutually exclusive project decisions
are not independent of accept / reject decision. Mutually exclusive investment
decisions acquire significance when more than one proposal is acceptable under the
accept / reject decision. Then some techniques have to be used to determine the best
one. The acceptance of 'best' alternative automatically eliminates the other
alternatives.
3. Capital rationing decision - firm may have several profitable investment
proposals but only limited funds to invest. In such a case, these various investments
compete for limited funds and, thus, the firm has to ration them. The firm effects the
combination of proposals that will yield the greatest profitability by ranking them in
descending order of their profitability.
Capital Budgeting Process & Steps
The important steps involved in the capital budgeting process are (1) Project
generation, (2) Project evaluation, (3) project selection and (4) project execution.
1. Project Generation
Investment proposals of various types may originate at different levels within a firm.
Investment proposals may be either proposals to add new product to the product line
or proposals to expand capacity in existing product lines. Secondly, proposals
designed to reduce costs in the output of existing products without changing the scale
of operations. The investment proposals of any type can originate at any level. In a
dynamic and progressive firm there is a continuous flow of profitable investment
proposals.
2. Project evaluation

Project evaluation involves two steps: i) estimation of benefits and costs and ii)
selection of an appropriate criterion to judge the desirability of the projects. The
evaluation of projects should be done by an impartial group. The criterion selected
must be consistent with the firms objective of maximizing its market value.
3. Project Selection
There is no uniform selection procedure for investment proposals. Since capital
budgeting decisions are of crucial importance, the final approval of the projects should
rest on top management.
4. Project Execution
After the final selection of investment proposals, funds are earmarked for capital
expenditures. Funds for the purpose of project execution should be spent in
accordance with appropriations made in the capital budget.
Methods/Techniques of investment evaluation or capital budgeting appraisal
methods
There are several methods of evaluating and ranking the capital investment
proposals. The basic approach is to compare the investment of the project with the
returns derived thereof. The following are main methods generally adopted in
investment evaluation.
1. Payback Period Method
Payback Period refers to the period in which the project will generate the necessary
cash to recover the initial investment. It is one of the simplest investment appraisal
techniques. This method answers the question - how many years will it take for cash
benefits to pay the original cost of an investment normally disregarding salvage value.
Cash benefits here represent cash flow before depreciation and after tax (CFDAT)
technique to pay back the original outlay required in an investment proposal.
The formula to calculate payback period of a project depends on whether the cash
flow per period from the project is even or uneven. In case they are even, the formula
to calculate payback period is:
Payback Period =

Initial Investment
Annual cash flow

When cash inflows are uneven, we need to calculate the cumulative net cash flow for
each period and then use the following formula for payback period:
Payback Period = Year before recovery
+

Amount required to recover original

investment
Actual cashflow received during the year

Accept / Reject criterion

The payback period can be used as a decision criterion to accept or reject an
investment proposal. One application of this technique is to compare the actual

payback period with a predetermined payback i.e., the payback set up by the
management. If the actual payback period is less than the predetermined payback,
the project will be accepted. If not, it will be rejected. Alternatively the payback can be
used as a rationing method. When mutually exclusive projects are under one
consideration, they may be ranked according to the length of payback period. Thus
the project having the shortest payback may be assigned rank one followed in the
order so that the project with longest payback might be ranked last. The term
mutually exclusive refers to the proposals out of which only one can be accepted.
Obviously project with shorter payback period will be selected.
Steps in calculation: Refer class notes
Advantages of the payback period method
1. It is easy to understand, compute and communicate to others.
2. Gives importance to the speedy recovery of investment in capital assets
3. This method focuses on the liquidity.
Disadvantages of the payback period method
1. Does not consider the time value of money concept: does not discount cash
inflows
2. Does not consider cash inflows after the original investment is recovered
3. Does not measure the profitability of a project
4. Does not effectively evaluate projects with small cash inflows in the beginning
and large cash inflows later on
5. It does not take into account salvage value of asset.
2. Post Pay-back Profitability Method
One of the major limitations of pay-back period method is that it does not consider the
cash flows earned after pay-back period and if the real profitability of the project
cannot be assessed. To improve over this method, it can be made by considering the
receivable after the pay-back period. These returns are called post pay-back profits.
Steps in calculation: Refer class notes
3. Accounting Rate of Return or Average Rate of Return or Rate of return
method
Average rate of return means the average rate of return or profit taken for considering
the project evaluation. This method is one of the traditional methods for evaluating
the project proposals. Under this method average profit after tax and depreciation is
calculated and then it is divided by total investment.
Average rate of return=

Average annual profit after tax and depreciation

Average

Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.

x 100

3. It is not based on the time value of money.

4. It considers the total benefits associated with the project.
Demerits
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some difficulties
in the calculation of the project.
Accept/Reject criteria
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.
Steps in calculation: Refer class notes
4. Net Present Value
Net present value method is one of the modern methods for evaluating the project
proposals. In this method cash inflows are considered with the time value of the
money. Net present value describes as the summation of the present value of cash
inflow and present value of cash outflow. Net present value is the difference between
the total present value of future cash inflows and the total present value of future
cash outflows.
Features and Merits
1.
2.
3.
4.

It
It
It
It

recognizes the time value of money.

considers the total benefits arising out of the proposal.
is the best method for the selection of mutually exclusive projects.
helps to achieve the maximization of shareholders wealth.

Demerits
1. It is difficult to understand and calculate.
2. It needs the discount factors for calculation of present values.
3. It is not suitable for the projects having different effective lives.
Accept/Reject criteria
With NPV the acceptance rule is NPV > 0 Accept, = 0 Indifferent, < 0 Reject
Time value of money
The idea that money available at the present time is worth more than the same
amount in the future due to its potential earning capacity.
Present value = 1/ (1+r)n
METHODS OF CAPITAL BUDGETING OF EVALUATION (summary)
By matching the available resources and projects it can be invested. The funds
available are always living funds. There are many considerations taken for investment

decision process such as environment and economic conditions. The methods of

evaluations are classified as follows:
(A) Traditional methods (or Non-discount methods)
1. Pay-back Period Methods
2. Post Pay-back Methods
3. Accounts Rate of Return
(B) Modern methods (or Discount methods)
1. Net Present Value Method
2. Internal Rate of Return Method
3. Profitability Index Method
Need and Importance of Capital Budgeting
1. Huge investments:
Capital budgeting requires huge investments of funds, but the available funds are
limited, therefore the firm before investing projects, plan are control its capital
expenditure.
2. Long-term:
Capital expenditure is long-term in nature or permanent in nature. Therefore financial
risks involved in the investment decision are more. If higher risks are involved, it
needs careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed
back. Once the decision is taken for purchasing a permanent asset, it is very difficult
to dispose off those assets without involving huge losses.
4. Long-term effect:
Capital budgeting not only reduces the cost but also increases the revenue in longterm and will bring significant changes in the profit of the company by avoiding over
or more investment or under investment. Over investments leads to be unable to
utilize assets or over utilization of fixed assets.
Therefore before making the investment, it is required carefully planning and analysis
of the project thoroughly.
Limitations of capital budgeting
1.

2.

3.

Uncertainty
The estimate of profitability of investment proposals is not accurate because they
relate to future uncertainties.
Complex in nature
It is very complicated process because it is difficult to

To estimate the cost of capital

To estimate the rate of return

To estimate the period for which investment is to be made

Problem of time value of money
The cost incurred and benefits received occur at different time periods. Here arises
the problem of time value of money. So the cost and benefits cannot be logically
comparable.

4. Subject to various considerations

There are immeasurable considerations such as employee welfare, reputation of

the firm etc.
5. Irreversible
Capital budgeting is an irreversible decision. Once taken is taken, it cannot revert.
If it is reverted, there occurs a huge loss.
Previous examination questions from this chapter
1.
2.
3.
4.
5.
6.
7.
8.
9.

Mention the silent features of NPV method

What is capital Budgeting? How it is significant to a firm
Explain the merits and demerits of NPV method
What is Net Present Value Method?
Mention the steps involved in Capital budgeting process
What is capital budgeting?
Explain in brief limitations of capital budgeting
What is capital expenditure budget?
Explain different phases of capital budgeting and also bring out the reasons for
capital budgeting decisions
10. Explain difficulties in capital budgeting process
11. What is the accept and reject criteria in PBP?
12. State techniques of capital budgeting
13. What is accept and reject criteria in NPV?