capital budgeting: invesment appraisal
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CAPITAL BUDGETING:CAPITAL BUDGETING:
INVESMENTINVESMENT
APPRAISALAPPRAISAL
ARR, PAYBACK, NPV,
IRR
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NATURE OF INVESTMENT
DECISIONSOut lay precedes economic benefits hence concept
of Time Value of money
Large size of outlay/resources
Difficult to bail out of investment
HOW TO EVALUATE INVESTMENTOPPERTUNITIES?
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ACCOUNTING RATE OF RETURN
(ARR)
It is defined as % of the average investment
translated as accounting profit over the
life of project
ARR = Average Annual Profit
_______________________________ x 100%
Average investment to earn that profit
Average Investment = Cost of machine + Disposal Value
2
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MERITS
1. Widely in Practice
2. It is a measure ofprofit hence liked by
many as evaluation
criteria of
investment
3. % results are easy to
comprehend by
managers
DEMERITS
1. Accounting profit is
of less value ascompared to
accounting profits
2. Can not be useful for
evaluating options
3. It ignores time value
of money
4. It is useful for shortterm reporting
instead of whole
project
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PAYBACK PERIOD (PP)
It is length of time during which initial
investment/out flow is recovered from
cash inflows of the project.
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NET PRESENT VALUE (NPV)
It is the present value of future cash flows of the
project worked out after considering all costs
and benefits of investment.
It is assumed that present value of future cash
flows should be >investment being made.
Following ingredients of Time Factor are
incorporated
Interest Loss, Risk and Inflation
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Logical investor desires that proposed
investment should yield a return that is
greater than Risk free rate of return after
giving allowances for risk and inflation
Discount
RateInterest foregoneInflation
Risk Premium
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PV of cash flows of year n
= Actual cash flow of year n
( 1+ r )n
As the time in which cash flow is to be
received increases its present value of it
would diminish proportionately.
Using discount tables
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MERITS
1. Time value of themoney
2. All cash flows arerecorded
3. Maximization ofshareholders wealth isascertained
4. Additivity is possible
5. Useful both forevaluating mutuallyexclusive projects or
otherwise.6. It takes in to account
investment size
DEMERITS
1. Managers are not
familiar with thishence do not like it
2. It is not a measure of
profitability
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INTERNAL RATE OF RETURN (IRR)
It is the discount rate that when applied to
future cash flows of the project, will
produce an NPV of Zero.
Simply when present value of future cash
flows is equal to the cash outflow
Trial and the error is the approach that mustusually be adapted
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Formula
= A +
(NPVA
)x B A
NPVBWhere A and B are the two discount rates.
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MERITS
1. Provides the
minimum
requirement
2. Can choose from
options. One withhighest IRR
DEMERITS
1. It does not address scaleof investment hencemay lead to a wrongdecision
2. It is represented in %hence easily
understandable3. Additivity is not
possible.
4. It is useful whenprojects are not mutually
exclusive. Projects withyield than opportunitycost are accepted.