CHAPTER 4

BUSINESS FINANCE
INVESTMENT DECISION

Lecturer: Hibak A. Nouh

 What is an investment
 In an economic sense, an investment is the purchase of goods that are not
consumed today but are used in the future to create wealth.
In finance, an investment is an monetary asset purchased with the idea that
the asset will provide income in all the future or will later be sold at higher
price for a profit
Nature of investment Decision
The investment decision of a firm are generally known as the capital
budgeting, or capital expenditure. A capital budgeting is the
planning process used to determine whether an organization’s long
term investments such as new machinery, replacement machinery,
new plants, new products, and research development projects are
worth the funding of cash through the firm’s capitalization structure.
 FEATURES OF CAPITAL BUDGETING
 Involve massive investment
 The exchange of current funds for future benefits
 The funds are invested in long-term assets
 The future benefits will occur to the firm over a series of years.
 Involves uncertainty and risk for the firm.
IMPORTANCE OF INVESTMENT
Growth
The effect of investment decisions extends in to future and have to
be endured for a longer period than the consequences of the current
operating expenditure. A firm’s decision to invest in long-term
assets has a decisive influence decision to invest in long-term
assets has a decisive influence on the rate and direction.
 Risk
Along-term commitment of funds may also change the risk
complexity of the firm. If the adoption of an investment increases
average gain but causes frequent fluctuation in its earning the firm
will become more risky. Thus, Investment decisions shape the basic
character of firm
Funding
Investment decision generally involve large amount of funds, which
make it imperative for the firm to plan its investment programmers
very carefully and make an advance arrangement for procuring
finances internally or externally.
Irreversibility
Most investment decisions are irreversible. It is difficult to find a
market for such capital items once they have been acquired. The
firm will incur heavy losses if such assets are scrapped .
Complexity
Investment decision are among the firm’s most difficult decision.
They are an assessment of future events, which are difficult to
predict. It is really a complex problem to correct. It estimate the
future cash flows of an investments economic, political, social
and technological forces causes the uncertainty in cash flow
estimation.
Investment Decision Rule
• Maximize the shareholders wealth.
• Consider all cash flows to determine the true profitability of the
projects.
• Help ranking of projects according to their true profitability.
• Recognize the facts that bigger cash flows are preferable to smaller
ones and early cash flows are preferable to later ones.
• Help to choose among mutually exclusive projects that projects
with maximizes the shareholder’s wealth.
 Types Of Investment Decision
On the basis of expansion
1. Expansion of existing business
2. Expansion of new business
3. Replacement and modernization
On the basic of Dependency
4. Mutually exclusive investments
5. Independent investments
6. Contingent investments
 Types Of Investment Decision

Non-discounted cash
Discounted methods flow methods/ modern
method
Net resent value method
(NPV)  Payback period (PB)
Profitability index method  Accounting rate of return
(PI) method (ARR)
Internal Rate of Return (IRR)  Discounted payback period
(DPR)
 Discounted Methods 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
values of future cash inflows and the total present value of future cash
outflows.
NPV = Total Present value of cash inflows – Net Investment
Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive
projects.
4. It 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.
Decision criteria
Accept the project with a positive NPV
For Mutually exclusive projects accept the project with the highest
positive NPV
Example 1
• If offered an investment that costs $5,000 today and promises to pay you
$7,000 two years from today and if your opportunity cost for projects of similar
risk is 10%, would you make this investment? You
• Need to compare your $5,000 investment with the $7,000 cash flow you expect
in two years. Because you feel that a discount rate of 10% reflects the degree of
uncertainty associated with the $7,000 expected in two years, today it is worth:
Present value of $7000 to be received in two years
$7,000
(1+0.10)2 =$5,785.12
• By investing $5,000 today, you are getting in return a promise of a cash flow in
the future that is worth $5,785.12 today. You increase your wealth by $785.12
when you make this investment.
 PROFITABILITY INDEX METHOD
• The profitability index (PI) is the ratio of the present value of
change in operating cash inflows to the present value of investment
cash outflows:
PI = Present value of change in operating in cash inflow
Present value of investment cash outflow
• Instead of the difference between the two present values, as in
equation PI is the ratio of the two present values. Hence, PI is a
variation of NPV. By construction, if the NPV is zero, PI is one.
Decision Criteria
Accept project with the highest PI
Example 2
The initial cash outlay over the project is 100,000 and
it can generate cash flow of # 40,000 , $30,000,
$50,000 and 20,000 in year. Assume 10% rate of
discount . What is the profitability index?
 INTERNAL RATE OF RETURN METHOD
• This method is popularly known as time adjusted rate of return
method/discounted rate of return method also. The internal rate of
return is defined as the interest rate that equates the present value
of expected future receipts to the cost of the investment outlay.
This internal rate of return is found by trial and error.
• We are looking for a rate that when multiplied with the cash flows
will gives in the present value of cash flows.
IRR= Lr+(Hr-Lr) (NPVlr- 0)
NPVlr- NPVhr
Merits
1. It considers the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.
4. It gives the approximate/nearest rate of return.
Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking
decisions.
3. It is assume that all intermediate cash flows are reinvested at
the internal rate of return.
Decision Criteria
 Accept project with the highest IRR
Steps in calculating IRR
1.Compute the NPV of the project using any rate.
2. Find out positive net present value Step
3. Find out negative net present value Step
4. Find out formula net present value
Example 3
A project cost $ -16,000 and is required to generate cashflows of
$8000, $7000, and $6000. Calculate the internal rate of return?
Assume the hurdle rate is 16% should the project be accepted or
rejected.
 Non-discounted cash flow methods
Pay-back Period Method
• The ‘pay back’ sometimes called as pay out or pay off period
method represents the period in which the total investment in
permanent assets pays back itself. This method is based on the
principle that every capital expenditure pays itself back within a
certain period out of the additional earnings generated from the
capital assets.
• Under this method, various investments are ranked according to the
length of their payback period in such a manner that the investment
within a shorter payback period is preferred to the one which has
longer pay back period. (It is one of the non- discounted cash flow
methods of capital budgeting).
Pay-back Period= Initial investment
Annual cash inflow
MERITS
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over the
accounting rate return.
3. Pay-back method reduces the possibility of loss on account of
obsolescence.
Decision Criteria
Accept project with the shortest Pay-back Period
Example 4
Star enterprises wants to buy one of two machines both costing
$1000,000. The machines will generate cashflows as follows.
Machine X= $310,000, $360,000 ,$340,000, 210,000
Machine Y= $ 350,000, $ 220,000, 430,000 and $110,000
 Accounting Rate of Return
• This is the ratio of average profit to average investment.
• It uses accounting profit while all the other methods use cashflows.
• The cash flows are adjustment for depreciation and tax to get the
accounting profit.
ARR= Average profit
Average Investment
Average profit= Thyr1 +Thyr2+ Thyr3…..+Thyr4
N
Average Investment= 1/2 (Cost+ Salvage /Scrap value)
 Method of Adjusting Cash Flows
Cash flows before depreciation and tax xxx
Less depreciation (xxx)
Cash flows/ profit before Tax (PBT ) xxx
Less Tax (xxx)
profit before Tax xxx
Add back depreciation xxx
Adjusted cash flow xxx
Decision Criteria
Accept project with the highest ARR