techniques of investment analysis

8/13/2019 Techniques of Investment Analysis

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Pranjal Verma

Techniques of Investment analysis


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INVESTMENT DECISION

Investment decision relates to the determinationof total amount of assets to be held in the firm

,the composition of these assets and the

business risk complexions of the firm as

perceived by its investors.

It is the most important financial decision that the

firm makes in pursuit of making shareholders

wealth.


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Classifications

Longterm investment decision i.e. Capitalbudgeting.

Short-term investment decision i.e. Working

Capital Management.


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Evaluation of long-term investment

decisions

Investment analysis to be consistent with thefirms goal involves the following three basic

steps:

1. Estimation or determination of cash flows.

2. Determining the rate of discount or cost of

capital.

3. Applying the technique of capital budgeting to

determine the viability of the investment proposal


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1. Estimation of relevant cash

flows.

There are two alternative criteria available forascertaining future economic benefits of an

investment proposal-

1. Accounting profit

2. Cash flow.


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Accounting profit vs Cash flow

profit

The term accounting profitrefers to the figure ofprofitas determined by the Income statement or

Profit and Loss Account, while cash flow

refers to cash revenues minus cash expenses.

The difference between these two criteria arisesprimarily because of certain non-cash

expenses, such as depreciation, being

charged to profit and loss account .Thus, the

accounting profits have to be adjusted for suchnon-cash charges to determine the actual cash

inflows. In fact, cash flows are considered to be

better measure of economic viabilityas

compared to accounting profits.


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2. Determining the rate of discount

or cost of capital.

It is the evaluation of investment decisions on netpresent value basis i.e. determine the rate of

discount .

Cost of capital is the minimum rate of return

expected by its investors.


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3. Applying the technique of capital budgeting to determine

the viability of the investment

proposal.

Capital Budgeting is the process of makinginvestment decisions in capital expenditures

A capital expenditure may be defined as an

expenditure the benefit of which are expected to

be received over period of time exceeding one

year.


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CAPITAL BUDGETING

PROCESS

Identificationof investment

proposals.

Screening theproposals

Evaluation ofvarious

proposals.

Fixingpriorities.

Final approvaland

preparation ofcapital

expenditurebudget.

Implementingproposal.

Performancereview.


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Objective of Capital Budgeting

maximize the profitability of a firm or the return oninvestment


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EVALUATION OF INVESTMENT

PROPOSALS (INVESTMENT APPRAISAL

TECHNIQUES)

INVESTMENTAPPRAISALTECHNIQUES

Traditionalmethods

Pay back periodmethod or pay out

or pay offmethod.(PBP)

Accounting Rate ofReturn method or

Average Rate ofReturn. (ARR)

Time adjustedmethod or

discounted method

Net Present Value

method.(NPV)

Profitability Index

method (PI)

Internal Rate of

Return method(IRR)

Net Terminal

Value method(NTV)


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Pay back period method or pay

out or pay off method.(PBP)

The basic element of this method is to calculatethe recovery time, by year wise accumulation of

cash inflows (inclusive of depreciation) until the

cash inflows equal the amount of the original

investment. The time taken to recover suchoriginal investment is the payback period for the

project.

The shorter the payback period, the more

desirable a project


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Calculation of PBP When annual cash inflow are equal: Pay back period =

Original cost of the project (cash outlay)Annual netcash inflow (net earnings)

When annual cash inflows are unequal It is ascertained by cumulating cash inflows till the

time when the cumulative cash inflows become equalto initial investment.

Pay back period =Y+B/C

Y=No of years immediately preceding the year of finalrecovery.

B=Balance amount still to be recovered.

C=Cash inflow during the year of final recovery.


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Merits of Pay back period :

No assumptions about future interest rates.

In case of uncertainty in future, this method is

most appropriate.

A company is compelled to invest in projects with

shortest payback period, if capital is a constraint.

It is an indication for the prospective investors

specifying the payback period of their

investments. Ranking projects as per their payback period

may be useful to firms undergoing liquidity

constraints


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Demerits of Pay back period:

Cash generation beyond payback period isignored.

The timing of returns and the cost of capital is not

considered.

The traditional payback method does not

consider the salvage value of an investment.

Percentage Return on the capital invested is not

measured. Projects with long payback periods are

characteristically those involved in long-term

planning, which are ignored in this approach.


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Accounting Rate of Return method

or Average Rate of Return (ARR)

This method measures the increase in profitexpected to result from investment.

It is based on accounting profits and not cash

flows.

ARR=(Average income or return Average

investment)*100

Average investment =(Original investment +

Salvage value)/2


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Merits of ARR

This method considers all the years in the life ofthe project.

It is based upon profits and not concerned with

cash flows.

Quick decision can be taken when a number of

capital investment proposals are being

considered.


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Demerits of ARR

Time Value of Money is not considered.

It is biased against short-term projects.

The ARR is not an indicator of acceptance or

rejection, unless the rates are compared with the

arbitrary management target.

It fails to measure the rate of return on a project

even if there are uniform cash flows.


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Net Present Value

method.(NPV)

NPV= Present Value of Cash Inflows

PresentValue of Cash Outflows

The discounting is done by the entitys weighted

average cost of capital.

The discounting factors is given by : n (1+ i)

Where

i = rate of interest per annum

n = no. of years over which discounting is made.


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Time Value of Money The discount rate is a number used to convert the

values of the expected future cash flows into theirpresent values. This is necessary because ofwhat is known as the "time value of money.

The interest rate used in discounted cash flowanalysis to determine the present value of futurecash flows. The discount rate takes into accountthe time value of money (the idea that moneyavailable now is worth more than the sameamount of money available in the future becauseit could be earning interest) and the risk oruncertainty of the anticipated future cash flows(which might be less than expected).


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Merits of Net Present Value

method

It recognizes the Time Value of Money.

It considers total benefits during the entire life of

the Project.

This is applicable in case of mutually exclusive

Projects.

Since it is based on the assumptions of cash

flows, it helps in determining Shareholders

Wealth.


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Demerits of Net Present Value

method

This is not an absolute measure.

Desired rate of return may vary from time to time

due to changes in cost of capital.

This Method is not effective when there is

disparity in economic life of the projects.

More emphasis on net present values. Initial

investment is not given due importance.


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NPV


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Profitability Index method (PI)

Profitability Index = P.V. of cash outflow P.V. ofcash inflow

If P.I > 1, project is accepted

P.I < 1, project is rejected

The Profitability Index (PI) signifies present value

of inflow per rupee of outflow. It helps to compare

projects involving different amounts of initial

investments.


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Internal Rate of Return method

(IRR)

Internal Rate of Return is a percentage discountrate applied in capital investment decisions which

brings the cost of a project and its expected

future cash flows into equality, i.e., NPV is zero.

The decision rule for the internal rate of return isto invest in a project if its rate of return is greater

than its cost of capital.


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IRR

IRR = Cost of Capital means the investment isexpected not to change shareholder wealth.

IRR > Cost of Capital means the investment is

expected to increase shareholders wealth- Accept

IRR < Cost of Capital means the investment is

expected to decrease shareholders wealth-

Decline


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Merits of Internal Rate of Return

method :

The Time Value of Money is considered.

All cash flows in the project are considered.


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Demerits of IRR

Possibility of multiple IRR, interpretation may bedifficult.

If two projects with different inflow/outflow

patterns are compared, IRR will lead to peculiar

situations.

If mutually exclusive projects with different

investments, a project with higher investment but

lower IRR contributes more in terms of absolute

NPV and increases the shareholders wealth.


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IRR vs NPV

The conflict between NPV & IRR for theevaluation of mutually exclusive projects is due tothe reinvestment assumption:

- NPV assumes cash flows reinvested at the cost

of capital. -IRR assumes cash flows reinvested at the

internal rate of return.

The reinvestment assumption may cause different

decisions due to : - Timing difference of cash flows.

- Difference in scale of operations.

-Project life disparity.


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IRR

N T i l V l h d


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Net Terminal Value method

(NTV)

Assumption : Each cash flow is reinvested in another project at

a predetermined rate of interest.

Each cash inflow is reinvested elsewhere

immediately after the completion of the project.

Decision-making:

If the P.V. of Sum Total of the Compound

reinvested cash flows is greater than the P.V. ofthe outflows of the project under consideration,

the project will be accepted otherwise not.


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Warren Buffet

techniques of investment analysis

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