Class Handout On CID

CAPITAL INVESTMENT DECISIONS (or Capital Budgeting): Involves companys long term investment decision. It includes evaluation of firms expenditure decisions that involve current outlays but are likely to produce benefits or returns over a long period of time. Features/Characteristics of CID (Importance): # Long term investment decision (Future profitability of firm). # Returns or benefits are expected over number of years # Investment involves huge amount of cash outflow (Determines the destiny of the firm) # Investment decision is generally irreversible (Once made can not be changed) # Relatively high degree of risk # Relatively long time period between the initial outlay and the anticipated return After Tax Cash Flows Cash flows should always be after tax Conventional Cash Flow - It consists of an initial cash outlay followed by a series of cash inflows. Non-conventional Cash Flow - It consists initial cash outlay followed by alternative inflows and outflows and an inflow followed by outflows etc. Techniques of Capital Budgeting DCF Techniques: a) NPV (Net Present Value) = PV of Cash Inflow PV of Cash Outflow Accept-Reject Criterion: If NPV is positive, accept the project. If negative reject the project.

b) IRR (Internal Rate of Return) = Rate of discount that makes NPV of a project zero.
PV of CO = CI1/(1+IRR) + CI2/(1+IRR)2 + CI3/(1+IRR)3 + CI4/(1+IRR)4 + . Accept-Reject Criterion: If IRR > Discount Rate/Cost of Capital/Required Rate of Return (RRR), Accept the project, otherwise, reject the project.

c) PI (Profitability Index) or Benefit-Cost Ratio = PV of CI/ PV of CO

Accept-Reject Criterion: If PI > 1, accept the project. Otherwise, reject the project. Capital Rationing: It refers to a situation in which the firm has more acceptable investment projects requiring a greater amount of finance that is available with the firm. The acceptable projects are ranked usually on the basis of PI and selections are made on the basis ranking order. d) Discounted PB Period: Number of years it takes for Cash Inflows to pay the original Cost of an Investment i.e. Cash Outflow. Here, cash flows are discounted to consider the time value of money. Non-discounted C.F. Techniques: e) Payback Period (PB): Number of years it takes for Cash Inflows to pay the original Cost of an Investment i.e. Cash Outflow. Time value of money is NOT considered. Accept-Reject Criterion: If calculated PB is less than the pre-determined PB, accept the project. Otherwise, reject the project. b) Accounting Rate of Return or Average R R (ARR): Avg. annual profit after tax/ Avg. Investment Accept-Reject Criterion: If calculated ARR > Pre-determined ARR, accept the project. Otherwise, reject the project.

The Sprint Inc. is trying to estimate the net cash outlay required to replace an old machine with a new one. The new machines purchase price is $270,000. An additional $5,000 will be required for transportation and another $5,000 will be required to install the machine. As the new machine has greater capacity to produce, there will be an additional investment of $20,000 in raw material inventory in the initial year. The new machine will be depreciated on straight-line basis over 10 years of useful life. The old machine was purchased two years ago at a cost of $70,000 has a remaining useful life of five years. It is also subject to straight-line depreciation. The company is entitled to investment tax allowance of 25%. The corporate tax rate is 55% and the capital gain tax rate is 30%. Find the net cash outlay considering separately each of the following scenarios: i) If the old machine is sold for $40,000 ii) If the old machine is sold for $50,000. iii) If the old machine is sold for $60,000. iv) If the old machine is sold for $90,000.