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CH - 1.Nature and Introduction of Investment Decision.

An efficient allocation of capital is the most important finance function

in the modern items. It involves decisions to commit the firm’s funds to

the long term assets. Capital budgeting or investment decisions are of

considerable importance to the firm since they tend to determine its

value by influencing its growth, profitability and risk.

The investment decisions of a firm are generally known as the capital

budgeting, or capital expenditure decisions. A capital budgeting decision

may be define as the firm’s decisions to invest its current funds most

efficiently in the long term assets in anticipation of an expected flow of

benefits over a series of years.

The long term assets are those that affect the firm’s operations beyond

the one year period. The firm’s investment decisions would generally

include expansion, acquisition, modernization and replacement of the

long term asset. Sale of division or business is also as an investment

decision. Decisions like the change in the methods of sales distribution,

or an advertisement campaign or a research and development

programmed have long term implications for the firm’s expenditures and

benefits, and therefore, they should also be evaluated as investment

decisions.

It is important to note that investment in the long term assets invariably

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requires large funds to be tied up in the current assets such as inventories

and receivables. As such, investment in fixed and current assets is one

single activity.

The following are the features of investment decisions,

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.

CH - 2. Capital Budgeting Process.

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Capital budgeting is the process that companies use for decision making

on capital project. The capital project lasts for longer time, usually more

than one year. As the project is usually large and has important impact

on the long term success of the business, it is crucial for the business to

make the right decision.

Capital Budgeting Process

The specific capital budgeting procedures that the manager uses depend

on the manger's level in the organization and the complexities of the

organization and the size of the projects. The typical steps in the capital

budgeting process are as follows:

Brainstorming. Investment ideas can come from anywhere, from

the top or the bottom of the organization, from any department or

functional area, or from outside the company. Generating good

investment ideas to consider is the most important step in the process

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Project analysis. This step involves gathering the information to

forecast cash flows for each project and then evaluating the project's

profitability.

Capital budget planning. The company must organize the

profitable proposals into a coordinated whole that fits within the

company's overall strategies, and it also must consider the projects'

timing. Some projects that look good when considered in isolation

may be undesirable strategically. Because of financial and real

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resource issues, the scheduling and prioritizing of projects is

important.

Performance monitoring. In a post-audit, actual results are

compared to planned or predicted results, and any differences must

be explained. For example, how do the revenues, expenses, and cash

flows realized from an investment compare to the predictions? Post-

auditing capital projects is important for several reasons. First, it

helps monitor the forecasts and analysis that underlie the capital

budgeting process. Systematic errors, such as overly optimistic

forecasts, become apparent. Second, it helps improve business

operations. If sales or costs are out of line, it will focus attention on

bringing performance closer to expectations if at all possible. Finally,

monitoring and post-auditing recent capital investments will produce

concrete ideas for future investments. Managers can decide to invest

more heavily in profitable areas and scale down or cancel

investments in areas that are disappointing.

Complexity of Capital budgeting Process

The budgeting process needs the involvement of different departments

in the business. Planning for capital investments can be very complex,

often involving many persons inside and outside of the company.

Information about marketing, science, engineering, regulation, taxation,

finance, production, and behavioral issues must be systematically

gathered and evaluated.

The authority to make capital decisions depends on the size and

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complexity of the project. Lower-level managers may have discretion to

make decisions that involve less than a given amount of money, or that

do not exceed a given capital budget. Larger and more complex

decisions are reserved for top management, and some are so significant

that the company's board of directors ultimately has the decision-making

authority. Like everything else, capital budgeting is a cost-benefit

exercise. At the margin, the benefits from the improved decision making

should exceed the costs of the capital budgeting effort.

CH - 3. Capital Investment Decisions.

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The capital investment decisions can also be termed as capital

budgeting in finance. The purpose of the capital investment decisions

includes allocation of the firm' s capital funds most effectively in order

to ensure the best return possible.

Evaluating the projects and allocating capital depending on the

requirements of the projects are the most important aspects of capital

investment decisions.

There may be various criteria for selecting the right and appropriate

decision for capital investment. For example, a firm may emphasize on

the projects that promise for the immediate return while some other

firms may insist on the projects that ensure long term growth. The major

goal of capital investment decision is to increase the value of firm by

undertaking right project at right time.

The capital investment decisions are mainly governed by the process

of ranking and identifying the capital investments of the firm. The firm

needs to decide which of the given investments will ensure the most

value to the business.

The decisions of capital investment often suffer from a number of

constraints. The amount of capital that a firm collects is limited and it

brings down the constraint on the choice of the firm over various project

investments. As the debt of the firm is increased, the debt-equity ratio of

the firm also gets increased and hence it becomes difficult for the

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business to raise more debts.

The decision of project ranking plays significant role in the decisions of

capital investment. Depending on the various projects the firm is having

at a certain period of time, the firms prioritize the projects. The ranking

of projects depends on how much a project will return and which project

will be able to add maximum value to the business.

There are various measures that give the estimation of the return of the

firm over various investment projects. In order to determine the value of

a particular project, three most famous methods are - IRR methods, net

present value and payback method. These methods are applied while

taking decisions on capital investment.

CH - 4. Corporate Finance - Cash Flow and NPV

Applications.

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Accounting Profits

Accounting profits are cash flows that include non-cash

inflows/outflows such as depreciation.

Cash Flows

Cash flows are a firm's actual cash inflows/outflows and are important

in capital budgeting.

Example: Net Cash Flows

Assume Newco has $10,000 in annual depreciation and $20,000 in

accounting net income. Because the $10,000 in annual depreciation is

not an actual cash outflow, the $20,000 in accounting net income is not

the true cash flow to the firm.

If, while all else is constant, annual depreciation were to decline by

$5,000 to $5,000, accounting net income would increase to $25,000, but

actual cash flow would remain unchanged. However, calculations of net

cash flow exclude the effects of depreciation.

Formula :-

For purposes of capital budgeting,

Net Cash Flow = Net Income + Depreciation

Answer: Therefore, net cash flow would be equal to $30,000 ($20,000

net income +$10,000 depreciation) before the changes in depreciation

and $30,000 ($25,000 net income + $5,000 depreciation) after the

changes in depreciation.

Incremental Cash Flow and Capital Budgeting

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Once a company makes a decision to accept a project, an incremental

cash flow is then the cash flow that is added to the firm's existing cash

flow as a result of accepting a new project.

However, in determining incremental cash flows from a new project,

problems arise, such as:

1. Sunk Costs

These are the initial outlays required to analyze a project that cannot be

recovered even if a project is accepted. As such, these costs will not

affect the future cash flows of the project and should not be considered

when making capital-budgeting decisions.

Suppose Newco is considering whether to make an addition to its

current plant to increase production. To determine if the new addition is

worthwhile, Newco hired a consulting firm for $50,000 to analyze the

addition and the effect it will have on production. The $50,000 is

considered a sunk cost. If the project is rejected, the $50,000 will still be

paid, and if the project is accepted, the $50,000 will not affect the future

cash flows of the addition.

2. Opportunity Cost

This is the cost of not going forward with a project or the cash outflows

that will not be earned as a result of utilizing an asset for another

alternative. For example, the opportunity cost of Newco's new addition

considered above is the cost of the land on which Newco is considering

putting the new plant addition. As such, it should be included in the

analysis of the project.

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3. Externality

Additionally, in the consideration of incremental cash flows of a new

project, there may be effects on the existing operations of the company

to consider, known as "externalities". For example, the addition to

Newco's plant is for the purpose of producing a new product. It must be

considered if the new product may actually take away or add to sales of

the existing product.

4. Cannibalization

This is the type of externality where the new project takes sales away

from the existing product.

Changes in Net Working Capital

A change in net working capital is essentially the changes in current

assets minus changes in current liabilities. Within the capital-budgeting

process, a project typically adds to current assets given additional

inventories or potential increases in accounts receivables from new

sales. The increases to current assets, however, are offset by current

liabilities needed to finance the new project.

Overall, there may be change to net working capital from the new

project.

If the change in net working capital is positive, the change to

current assets outweighs the change in the current liabilities.

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If, however, the change in net working capital is negative, the

change to current liabilities outweighs the change in current assets.

CH - 5. Basic principle of measuring project cash flows.

Estimating cash flows – the investment outlays and the cash inflows

after the project is commissioned – is the most important, but also the

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most difficult step in capital budgeting. Estimating cash flows process

involves many people and numerous variables.

A project which involves cash outflows followed by cash inflows

comprises of three basic components. They are,

Initial investment: Initial investment is the after-tax cash outlay

on capital expenditure and net working capital when the project is set

up.

Operating cash inflows: The operating cash inflows are the after-

tax cash inflows resulting from the operations of the project during

its economic life.

Terminal cash inflow: The terminal cash inflow is the after-tax

cash flow resulting from the liquidation of the project at the end of

its economic life.

For developing the stream of financial costs and benefits, the following

principles must be kept in mind:

1. Principle of Incremental Cash Flows

The cash flows of a project must be measured in incremental terms. To

ascertain a project’s incremental cash flows, one has to look at what

happens to the cash flows of the firm with the project and without the

project. The difference between the two reflects the incremental cash

flows attributable to the project.

That is;

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Project Cash Flow for year t = Cash flow for the firm with the project

for year t – Cash flow for the firm without the project for year t

In estimating the incremental cash flows of a project, the following

guidelines must be borne in mind:

Consider all incidental effects

Ignore sunk costs

Include opportunity costs

Question the allocation of overhead costs

2. Principle of Long Term Funds

A project may be evaluated from various points of view: total funds

point of view, long term funds point of view, and equity point of view.

The measurement of cash flows as well as the determination of the

discount rate for evaluating the cash flows depends on the point of view

adopted. It is generally recommended that a project may be evaluated

from the point of view of long-term funds (which are provided by equity

stockholders, preference stock-holders, debenture holders, and term-

lending institutions) because the principal focus of such evaluation is

normally on the profitability of long-term funds. This argument, though

plausible, cannot be regarded as unassailable. Nonetheless, we

subscribed to the position that it is quite reasonable to view a project

from the long-term funds point of view. Hence for determining the costs

and benefits of an investment project we will raise the questions. What

is the sacrifice made by the suppliers of long term funds? What benefits

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accrue to the suppliers of long-term funds? The sacrifice made by the

suppliers of long-term funds is equal to the outlays on fixed assets and

net working capital (it may be recalled that net working capital, which

represents the difference between current assets and current liabilities, is

supported by long-term funds). The benefits accruing to the suppliers of

long-term funds consist of operational cash inflows after taxes and

salvage value of fixed assets and net working capital.

3. Principle of Financing Costs Exclusion

When cash flows relating to long-term are being defined, financing costs

of long-term funds [interest on long-term debt and equity dividend]

should be excluded from the analysis. Why? The weighted average cost

of capital used for evaluating the cash flows takes into account the cost

of long-term funds. Put differently the interest and dividend payments

are reflected in the weighted average cost of capital. Hence, if interest

on long term debt and dividend on equity capital are deducted in

defining the cash flows, the cost of long-term funds will be counted

twice – an error that should be carefully guarded against.

Operationally, the exclusion of financing costs principle means that

The interest on long-term debt [referred to hereafter as just

interest for the sake of simplicity] is ignored while computing profits

and taxes thereon and

The expected dividends are deemed irrelevant in cash flow

analysis.

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While dividends pose no difficulty as they come only from profit after

taxes, interest needs to be handled properly. Since interest is usually

deducted in the process of arriving at profit after tax, an amount equal to

interest [1 -tax rate] should be added back to the figure of profit after

tax. Thus, whether the tax rate is applied directly to the profit before

interest and tax figure or whether the tax adjusted interest, which is

simply interest [1-tax rate], is added to profit after tax, we get the same

result.

4. Principle of Post-tax

Tax payments like other payments must be properly deducted in

deriving the cash flows. Put differently cash flows must be defined in

post-tax terms [It may be noted that the cost of capital employed for

evaluating the cash flow stream is also measured in post-tax terms].

Capital budgeting is the process most companies use to authorize capital

spending on long‐term projects and on other projects requiring

significant investments of capital. Because capital is usually limited in

its availability, capital projects are individually evaluated using both

quantitative analysis and qualitative information. Most capital budgeting

analysis uses cash inflows and cash outflows rather than net income

calculated using the accrual basis. Some companies simplify the cash

flow calculation to net income plus depreciation and amortization.

Others look more specifically at estimated cash inflows from customers,

reduced costs, proceeds from the sale of assets and salvage value, and

cash outflows for the capital investment, operating costs, interest, and

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future repairs or overhauls of equipment.

The Cottage Gang is considering the purchase of $150,000 of equipment

for its boat rentals. The equipment is expected to last seven years and

have a $5,000 salvage value at the end of its life. The annual cash

inflows are expected to be $250,000 and the annual cash outflows are

estimated to be $200,000.

CH - 6. Profitability Technique For Measurement Of Cash

Flow.

Payback technique

The payback measures the length of time it takes a company to recover

in cash its initial investment. This concept can also be explained as the

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length of time it takes the project to generate cash equal to the

investment and pay the company back. It is calculated by dividing the

capital investment by the net annual cash flow. If the net annual cash

flow is not expected to be the same, the average of the net annual cash

flows may be used.

Cash Pay-back Period = Capital Investment

Average Annual net cash flow

For the Cottage Gang, the cash payback period is three years. It was

calculated by dividing the $150,000 capital investment by the $50,000

net annual cash flow ($250,000 inflows ‐ $200,000 outflows)

$ 1,50,000

$ 50,000

= 3.0 Years.

The shorter the payback period, the sooner the company recovers its

cash investment. Whether a cash payback period is good or poor

depends on the company's criteria for evaluating projects. Some

companies have specific guidelines for number of years, such as two

years, while others simply require the payback period to be less than the

asset's useful life.

When net annual cash flows are different, the cumulative net annual

cash flows are used to determine the payback period. If the Turtles Co.

has a project with a cost of $150,000, and net annual cash inflows for

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the first seven years of the project are: $30,000 in year one, $50,000 in

year two, $55,000 in year three, $60,000 in year four, $60,000 in year

five, $60,000 in year six, and $40,000 in year seven, then its cash

payback period would be 3.25 years. See the example that follows.

The cash payback period is easy to calculate but is actually not the only

criteria for choosing capital projects. This method ignores differences in

the timing of cash flows during the project and differences in the length

of the project. The cash flows of two projects may be the same in total

but the timing of the cash flows could be very different. For example,

assume project LJM had cash flows of $3,000, $4,000, $7,000, $1,500,

and $1,500 and project MEM had cash flows of $6,000, $5,000, $3,000,

$2,000, and $1,000. Both projects cost $14,000 and have a payback of

3.0 years, but the cash flows are very different. Similarly, two projects

may have the same payback period while one project lasts five years

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beyond the payback period and the second one lasts only one year.

Net present value

Considering the time value of money is important when evaluating

projects with different costs, different cash flows, and different service

lives. Discounted cash flow techniques, such as the net present value

method, consider the timing and amount of cash flows. To use the net

present value method, you will need to know the cash inflows, the cash

outflows, and the company's required rate of return on its investments.

The required rate of return becomes the discount rate used in the net

present value calculation. For the following examples, it is assumed that

cash flows are received at the end of the period.

Using data for the Cottage Gang and assuming a required rate of return

of 12%, the net present value is $80,452. It is calculated by discounting

the annual net cash flows and salvage value using the 12% discount

factors. The Cottage Gang has equal net cash flows of $50,000

($250,000 cash receipt minus $200,000 operating costs) so the present

value of the net cash flows is computed by using the present value of an

annuity of 1 for seven periods. Using a 12% discount rate, the factor is

4.5638 and the present value of the net cash flows is $228,190. The

salvage value is received only once, at the end of the seven years (the

asset's life), so its present value of $2,262 is computed using the Present

Value of 1 table factor for seven periods and 12% discount rate factor

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of .4523 times the $5,000 salvage value. The investment of $150,000

does not need to be discounted because it is already in today's dollars (a

factor value of 1.0000). To calculate the net present value (NPV), the

investment is subtracted from the present value of the total cash inflows

of $230,452. See the examples that follow. Because the net present value

(NPV) is positive, the required rate of return has been met.

DEFINITION of 'Discounted Cash Flow - DCF'

A valuation method used to estimate the attractiveness of an investment

opportunity. Discounted cash flow (DCF) analysis uses future free cash

flow projections and discounts them (most often using the weighted

average cost of capital) to arrive at a present value, which is used to

evaluate the potential for investment. If the value arrived at through

DCF analysis is higher than the current cost of the investment, the

opportunity may be a good one.

Calculated as:

Also known as the Discounted Cash Flows Model.

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'Discounted Cash Flow - DCF'

There are many variations when it comes to what you can use for your

cash flows and discount rate in a DCF analysis. Despite the complexity

of the calculations involved, the purpose of DCF analysis is just to

estimate the money you'd receive from an investment and to adjust for

the time value of money.

Discounted cash flow models are powerful, but they do have

shortcomings. DCF is merely a mechanical valuation tool, which makes

it subject to the axiom "garbage in, garbage out". Small changes in

inputs can result in large changes in the value of a company. Instead of

trying to project the cash flows to infinity, terminal value techniques are

often used. A simple annuity is used to estimate the terminal value past

10 years, for example. This is done because it is harder to come to a

realistic estimate of the cash flows as time goes on.

[1]. Net Present Value.

Net present value method (also known as discounted cash flow

method) is a popular capital budgeting technique that takes into account

the time value of money. It uses net present value of the investment

project as the base to accept or reject a proposed investment in projects

like purchase of new equipment, purchase of inventory, expansion or

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addition of existing plant assets and the installation of new plants etc.

First, I would explain what is net present value and then how it is used

to analyze investment projects.

Net present value (NPV): Net present value is the difference between

the present value of cash inflows and the present value of cash outflows

that occur as a result of undertaking an investment project. It may be

positive, zero or negative. These three possibilities of net present value

are briefly explained below:

Positive NPV: If present value of cash inflows is greater than the

present value of the cash outflows, the net present value is said to be

positive and the investment proposal is considered to be acceptable.

Zero NPV: If present value of cash inflow is equal to present value of

cash outflow, the net present value is said to be zero and the investment

proposal is considered to be acceptable.

Negative NPV: If present value of cash inflow is less than present value

of cash outflow, the net present value is said to be negative and the

investment proposal is rejected.

Example 1 – cash inflow project:

The management of Fine Electronics Company is considering to

purchase an equipment to be attached with the main manufacturing

machine. The equipment will cost $6,000 and will increase annual cash

inflow by $2,200. The useful life of the equipment is 6 years. After 6

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years it will have no salvage value. The management wants a 20% return

on all investments.

Required:

Compute net present value (NPV) of this investment project.

Should the equipment be purchased according to NPV analysis?

Solution:

(1)Computation of net present value:

*Value from present value of an annuity of $1 in arrears table.

(2) Purchase decision:

Yes, the equipment should be purchased because the net present value is

positive ($1,317). Having a positive net present value means the project

promises a rate of return that is higher than the minimum rate of return

required by management (20% in the above example).

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In the above example, the minimum required rate of return is 20%. It

means if the equipment is not purchased and the money is invested

elsewhere, the company would be able to earn 20% return on its

investment. The minimum required rate of return (20% in our example)

is used to discount the cash inflow to its present value and is, therefore,

also known as discount rate.

Investments in assets are usually made with the intention to generate

revenue or reduce costs in future. The reduction in cost is considered

equivalent to increase in revenues and should, therefore, be treated as

cash inflow in capital budgeting computations.

The net present value method is used not only to evaluate investment

projects that generate cash inflow but also to evaluate investment

projects that reduce costs. The following example illustrates how this

capital budgeting method is used to analyze a cost reduction project:

Example 2 – cost reduction project:

Smart Manufacturing Company is planning to reduce its labor costs by

automating a critical task that is currently performed manually. The

automation requires the installation of a new machine. The cost to

purchase and install a new machine is $15,000. The installation of

machine can reduce annual labor cost by $4,200. The life of the machine

is 15 years. The salvage value of the machine after fifteen years will be

zero. The required rate of return of Smart Manufacturing Company is

25%.

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Should Smart Manufacturing Company purchase the machine?

Solution:

According to net present value method, Smart Manufacturing Company

should purchase the machine because the present value of the cost

savings is greater than the present value of the initial cost to purchase

and install the machine. The computations are given below:

*Value from present value of an annuity of $1 in arrears table.

Net present value method – uneven cash flow:

Notice that the projects in the above examples generate equal cash

inflow in all the periods (the cost saving in example 2 has been treated

as cash inflow). Such a flow of cash is known as even cash flow. But

sometimes projects do not generate equal cash inflows in all the periods.

When projects generate different cash inflows in different periods, the

flow of cash is known as uneven cash flow. To analyze such projects

the present value of the inflow of cash is computed for each period

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separately. It has been illustrated in the following example:

Example 3:

A project requires an initial investment of $225,000 and is expected to

generate the following net cash inflows:

Year 1 2 3 4

Cash inflow $95,000 $80,000 $60,000 $55,000

Compute net present value of the project if the minimum desired rate of

return is 12%.

Solution:

The cash inflow generated by the project is uneven. Therefore, the

present value would be computed for each year separately:

Year

Present

value of $1

at 12%

Net cash

flowPresent value of cash flow

1 0.893* $ 95,000 $ 84,835

2 0.797 80,000 63,760

3 0.712 60,000 42,720

4 0.636 55,000 34,980

——–

Total $ 226,295

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Initial investment required 225,000

——–

Net present value $ 1,295

——–

*Value from present value of $1 table.

The project seems attractive because its net present value is positive.

Choosing among several alternative investment proposals:

Sometime a company may have limited funds but several alternative

proposals. In such circumstances, if each alternative requires the same

amount of investment, the one with the highest net present value is

preferred. But if each proposal requires a different amount of

investment, then proposals are ranked using an index called present

value index (or profitability index). The proposal with the highest

present value index is considered the best. Present value index is

computed using the following formula:

Formula of present value or profitability index:

Example 4:

Choose the most desirable investment proposal from the following

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alternatives using profitability index method:

Proposal X Proposal Y Proposal Z

Present value of net cash

flow$212,000 $171,800 $185,200

Amount required to invest 200,000 160,000 180,000

———– ———– ———–

Net present value 12,000 11,800 5,200

———– ———– ———–

Solution:

Because each investment proposal requires a different amount of

investment, the most desirable investment can be found using present

value index. Present value index of all three proposals is computed

below:

Present Value Index

Proposal X 1.06 (212,000/200,000)

Proposal Y 1.07 (171,800/160,000)

Proposal Z 1.03 (185,200/180,000)

Proposal X has the highest net present value but is not the most

desirable investment. The present value indexes show proposal Y as the

most desirable investment because it promises to generate 1.07 present

value for each dollar invested, which is the highest among three

alternatives.

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Assumptions:

The net present value method is based on two assumptions. These are:

The cash generated by a project is immediately reinvested to

generate a return at a rate that is equal to the discount rate used in

present value analysis.

The inflow and outflow of cash other than initial investment

occur at the end of each period.

Advantages and Disadvantages:

The basic advantage of net present value method is that it considers the

time value of money. The disadvantage is that it is more complex than

other methods that do not consider present value of cash flows.

Furthermore, it assumes immediate reinvestment of the cash generated

by investment projects. This assumption may not always be reasonable

due to changing economic conditions.

[2]. DEFINITION of 'Profitability Index'

An index that attempts to identify the relationship between the costs and

benefits of a proposed project through the use of a ratio calculated as:

'Profitability Index'

A ratio of 1.0 is logically the lowest acceptable measure on the index.

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Any value lower than 1.0 would indicate that the project's PV is less

than the initial investment. As values on the profitability index increase,

so does the financial attractiveness of the proposed project.

[3]. Definition of "Internal Rate Of Return - IRR"

The discount rate often used in capital budgeting that makes the net

present value of all cash flows from a particular project equal to zero.

Generally speaking, the higher a project's internal rate of return, the

more desirable it is to undertake the project. As such, IRR can be used to

rank several prospective projects a firm is considering. Assuming all

other factors are equal among the various projects, the project with the

highest IRR would probably be considered the best and undertaken first.

IRR is sometimes referred to as "economic rate of return (ERR)."

You can think of IRR as the rate of growth a project is expected to

generate. While the actual rate of return that a given project ends up

generating will often differ from its estimated IRR rate, a project with a

substantially higher IRR value than other available options would still

provide a much better chance of strong growth.

[4]. Discounted Payback Period .

One of the major disadvantages of simple payback period is that it

ignores the time value of money. To counter this limitation, an

alternative procedure called discounted payback period may be

followed, which accounts for time value of money by discounting the

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cash inflows of the project.

Formulas and Calculation Procedure

In discounted payback period we have to calculate the present value of

each cash inflow taking the start of the first period as zero point. For this

purpose the management has to set a suitable discount rate. The

discounted cash inflow for each period is to be calculated using the

formula:

Discounted Cash Inflow = Actual Cash Inflow

(1 + i)n

Where,

i is the discount rate;

n is the period to which the cash inflow relates.

Usually the above formula is split into two components which are actual

cash inflow and present value factor ( i.e. 1 / ( 1 + i )^n ). Thus

discounted cash flow is the product of actual cash flow and present

value factor.The rest of the procedure is similar to the calculation of

simple payback period except that we have to use the discounted cash

flows as calculated above instead of actual cash flows. The cumulative

cash flow will be replaced by cumulative discounted cash flow.

Discounted Payback Period = A + B

C

Where,

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A = Last period with a negative discounted cumulative cash flow;

B = Absolute value of discounted cumulative cash flow at the end of

the period A;

C = Discounted cash flow during the period after A.

Note: In the calculation of simple payback period, we could use an

alternative formula for situations where all the cash inflows were even.

That formula won't be applicable here since it is extremely unlikely that

discounted cash inflows will be even.

The calculation method is illustrated in the example below.

Decision Rule:- If the discounted payback period is less that the target

period, accept the project. Otherwise reject.

Example:- An initial investment of $2,324,000 is expected to generate

$600,000 per year for 6 years. Calculate the discounted payback period

of the investment if the discount rate is 11%.

Solution :- Step 1: Prepare a table to calculate discounted cash flow of

each period by multiplying the actual cash flows by present value factor.

Create a cumulative discounted cash flow column.

Year

no.

Cash Flow

CF

Present

Value

Factor

PV$1=1/(1

+i)n

Discounted Cash

Flow

CF×PV$1

Cumulative

Discounted

Cash Flow

0 $ −2,324,000 1.0000 $ −2,324,000 $ −2,324,000

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1 600,000 0.9009 540,541 − 1,783,459

2 600,000 0.8116 486,973 − 1,296,486

3 600,000 0.7312 438,715 − 857,771

4 600,000 0.6587 395,239 − 462,533

5 600,000 0.5935 356,071 − 106,462

6 600,000 0.5346 320,785 214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32

years

Advantages and Disadvantages

Advantage: Discounted payback period is more reliable than simple

payback period since it accounts for time value of money. It is

interesting to note that if a project has negative net present value it won't

pay back the initial investment.

Disadvantage: It ignores the cash inflows from project after the

payback period.

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CH - 7.Capital Rationing.

Capital rationing is a strategy used by organizations attempting to limit

the costs of their own investments. Typically, a company engaging in

capital rationing has made unsuccessful investments of capital in the

recent past and would like to raise the return on those investments prior

to engaging in new business.

Why Ration Capital : The main goal of capital rationing is to protect a

company from over-investing its assets. If this were to occur, the

company might continue to see low return on investment and even face

a compromised financial position. Further, this can cause a company's

stock to drop.

How to Ration Capital

The main device for capital rationing is increasing the cost of capital.

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"Cost of capital" is a term used to describe the cost of debt and equity,

and it can be raised or lowered based on the company's willingness to

borrow money or issue stocks. A company can increase the cost of

capital by borrowing less, thus making it more challenging to invest.

The company would engage in new products only if the anticipated

return is higher than the new cost of capital. For example, raising the

cost of capital from 10 percent to 5 percent would demand the company

see a 5 percent higher return on any future investment than on those in

the past.

What are the benefits of capital rationing?

The main benefit of capital rationing is budgeting a company's

corporate resources. When a company issues stock or borrows money, it

can use these resources for new investments. However, if the company

does not see a good return on investments, it is wasting these resources.

By capital rationing, which is the process of increasing the cost of

capital, the company can make sure it takes on fewer projects. Further, it

can take on only projects for which the anticipated return on investment

is high. This will prevent the company from over-extending its finances,

which would cause a decrease in stock price and stability.

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CH - 8. Bibliography.

Refers from the books of “Advanced Financial Management”.

www.slideshare.com

Refers from “Investopedia Notes”.

Refers from the Notes of “Financial Management of M.B.A”.