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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.

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