22-08-2012, 03:52 PM
Investment Decisions
Investment.ppt (Size: 1.12 MB / Downloads: 30)
CAPITAL BUDGETING
It refers to the process of acquisition and investment of capital
It refers to long term planning of the proposed outlays & their financing
IRR(Internal Rate of Return)
The internal rate of return method is another discounted cash flow technique which takes into account the magnitude and timing of cash flows.
IRR is the rate at which the sum of discounted cash inflow=discounted cash outflow
EVALUATION OF PI METHOD:
Like the NPV and IRR rules, PI is a conceptually sound method of appraising investment projects. It is a variation of the NPV method, and requires the same computations as the NPV method.
• Time value it recognizes the time value of money.
• Value maximization it is consistent with the share holder value maximization principle. A project with PI greater than one will have positive NPV and if accepted, it will increase share-holders wealth.
• Relative profitability in the PI method, since the present value of cash inflows is divided by the PV of the cash outflow, it is a relative measure of a project’s profitability.
PAYBACK PERIOD
Payback period is a the length of time required to recover the initial cash outlay on the project.
When the annual cash inflow is a constant sum, the payback period is simply the initial outlay divided by the annual cash inflow.
According to payback criterion , the shorter the payback period, the more desirable the project. Firms using this criterion generally specify the maximum acceptable payback period.
Advantages
It is simple, both in concept and application. It does not use involved concepts and tedious calculations and has a few hidden assumptions.
It is rough and ready method for dealing with risk.
Since it is emphasizes cash inflows, it may be a sensible criterion when the firm is pressed with problems of liquidity.
Limitations
It fails to consider the time value of money.
It ignores cash flows beyond the payback period. This leads to discrimination against project which generate substantial cash inflows in later years.
It is a measure of project’s capital recovery, not profitability.
Though it measures a project’s liquidity. It does not indicate the liquidity position of the firm as a whole, which is more important.
Discounted payback period
In case of discounted payback period the present value of cash inflow is used to determine the payback period, shorter the payback period better is the proposal.
The discounted payback method simply measures how long (in years and/or months) it takes, using discounted cash flows, to recover the initial investment.
The maximum acceptable discounted payback period is determined by management.
Cash flow estimation for new product
A new product may be slight modification of the firms existing product. Or it may be an altogether different, innovative product.
The cash flow estimation for new product will be depend on forecast of sales and operating expenses. Sales forecasts require information on the quantity of sales and the price of the product.
The selling price and sales quantity depend on the nature of competition.