CAIIB ABFM Module B Unit 3 : Capital Investment Decisions

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Oct 6

CAIIB Paper 3 ABFM Module B Unit 3 : Capital Investment Decisions (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for CAIIB Exam 2023. Following the format of the current exam, CAIIB 2023 will have now four papers. The CAIIB Paper 3 (ADVANCED CONCEPTS OF FINANCIAL MANAGEMENT) includes an important topic called "Capital Investment Decisions". Every candidate who are appearing for the CAIIB Certification Examination 2023 must understand each unit included in the syllabus.

In this article, we are going to cover all the necessary details of CAIIB Paper 3 (ABFM) Module B (THE MANAGEMENT PROCESS) Unit 3 : Capital Investment Decisions, Aspirants must go through this article to better understand the topic, Capital Investment Decisions and practice using our Online Mock Test Series to strengthen their knowledge of Capital Investment Decisions. Unit 3 : Capital Investment Decisions

Objective Of Capital Investment Decisions

The goal of management is to increase the wealth of the shareholders as much as possible.
In order to achieve this goal, the Finance Manager is responsible for analysing potential investment possibilities and identifying those that can boost the value of the company.
Consider the following scenario: three companies, Company A, Company B, and Company C, all have the same assets and opportunities for investment.
However, the management of Company A does not take advantage of its investment opportunities and instead distributes all of its earnings to its shareholders;
the management of Company B only makes the investments necessary to replace deteriorating plant and equipment and distributes any

leftover earnings to its shareholders; and

the management of Company C invests in all of those possibilities that generate a return that is higher than what the shareholders could have received if they had invested the funds themselves.
This allows them to earn a higher return.
The objective of the capital investment decision is to first assess the requirement and then think about the sources, the cost, the form and the time

Estimation Of Project Cash Flows

Cash requirement of any project can be safely analyzed in terms of long term, short term, owned, borrowed, fixed cost, working capital, inflows and outflows.
All this can be appropriately included in a projected cash flow statement.

The process requires the following;

Identify the elements of cash flow: A business typically will have three elements of cash flows:
initial,
operating and
Initial Investment: Capital expenditure and the contribution for net working capital to start the project.
The Operating one will comprise of the outflow and resulting inflow of the operations of the business.
The Terminal is the one what remains that is net inflow after paying off all the realizations of the assets on liquidation of the business when the economic life comes to an end.
All the flows are post tax for the reasons that that element does not belong to the business or the owners.

How to estimate and basis of each such element:

There are four principles to be kept in mind.

1^st: Separation Principle which means we have to separate the investment side from finance side which simply means separating assets for servicing cost of it. Cost flows in to investment side and the interest, if any, flows in to financing side.
Then there is Incremental which means estimate separately the cost which will be incurred even if the project is not run from the cost which we incur while running it. We can also say it is fixed versus variable cost.
While considering the cash flows, considering the Post -tax Cash Flow Always, is advisable since the tax payments cannot be ignored. This is the Third Principle.
If you ignore, you will have to Discount Pretax Flows with a discount rate which may or may not be reliable. The last principle is consistency principle.

Collate all the components of cash flow:

All the components of the cash flow namely fixed capital, working capital, own capital (Equity), long term borrowing, outflow for operations such as purchases, production expenses, operating and administration expenses, selling expenses, interest cost, and inflow on account of
Sales and services are collated and net flow or the cash balance is found out to complete the cash flow statements.
This is prepared for the period of the entire project period or for reasonably long enough period to reach a break even or achieve other objectives such as debt free status of closure or hive off etc.

Cash Forecasts

Cash forecasts shall also include the inflow on account of sales and services.
Forecasting sales will be an elaborate exercise and will take into account various factors such as estimated demand, production capacity planned, procurement or availability of raw materials, fixing price of the product, keeping in mind the competition and need to penetrate the market in the face of current market conditions and market leaders, availability or required engagement of working capital funds, discounts, incentives to marketing team, cost of sales campaigns, exhibitions, touring, advertisements etc.

Statement showing the calculation of Cash Inflow After Tax

ILLUSTRATION

XYZ Ltd is evaluating the purchase of a new machinery with a depreciable base of Rs. 1,00,000; expected economic life of 4 years and change in earnings before taxes and depreciation of Rs. 45,000 in 2021, Rs. 30,000 in year 2022, Rs. 25,000 in year 2023 and Rs. 35,000 in year 2024. Assume straight-line depreciation and a 20% tax rate. You are required to compute relevant cash flows.

SOLUTION:

Depreciation = 1,00,000 divided by 4 = Rs. 25,000 per year

Evaluation Techniques

Payback period, discounted payback period

Payback period is the period at the end of which the initial investment is entirely returned to the investor.
Return of investment = Net cash flow for each of the years of operation.
When the cumulative cash flow is equal to the investment, the investment is considered to be returned and no further.
It is to be remembered that both the positive or negative cash flows are to be added till the total net cash flow equals the amount of the initial investment.

When Cash Inflow is Same

Example: A firm requires an initial cash outflow of Rs. 24000 & cash inflows for 5 years are rs. 6000 every year. Calculate payback period.

When Cash Inflow is not same

Example: A firm requires an initial cash outflow of Rs. 20000 & cash inflows for 5 years are rs. 5000, 7000, 6000, 6000, 8000. Calculate payback period.

The following points are worth noting:

This method simply identifies the period in which the initial investment in the project is fully recovered.
It does not take time value of money into account unless it is discounted payback period method.
This is suitable for small businesses where it is not worth spending more time and money to make more detailed or scientific analysis.
The shorter the period for recovery of initial investment, lesser is the risk and better or quicker is the probability to earn profits.
Payback Period method ignores the cash flow beyond the payback period and hence ignores profit aspect.
While payback period method is used across the line, the other more sophisticated methods are used in larger sized budgeting exercise.

ILLUSTRATION

Suppose a project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after depreciation @ 10% (straight line method) but before tax at 50%. The first step would be to calculate the cash inflow from this project. The cash inflow is calculated as follows:

While calculating cash inflow, depreciation is added back to profit after tax since it does not result in cash outflow. The cash generated from a project therefore is equal to profit after tax plus depreciation. The payback period of the project shall be:

Payback period = Rs. 20,00,000 Rs. 3,50,000/Year = 5.71 Years

ILLUSTRATION

Rs. 30,000 cash outlay for a project with annual cash inflows of Rs. 6,000 would have a payback period of 5 years (Rs. 30,000/ Rs. 6,000). The problem with the Payback Period is that it ignores the time value of money. In order to correct this, we can use discounted cash flows in calculating the payback period. Referring back to our example, if we discount the cash inflows at 15% required rate of return, we have:

The cumulative total of discounted cash flows after ten years is Rs. 30,114. Therefore, our discounted payback is approximately 10 years as opposed to 5 years under simple payback. It should be noted that as the required rate of return increases, the distortion between simple payback and discounted payback grows.

Accounting Rate of Return (ARR)

The foregoing method of appraisal does not help you to know the rate of return because we stop once the investment is recovered.
The methods to determine the rate of return are many but the most common, easy, simple and practical is the accounting rate of return.

This method involves estimating the revenue and expenses for say over three years and to find out the average rate of return which can be considered as the rate for appraising the investment.

ACCOUNTING RATE OF RETURN = Average annual net Income/ Investment

ILLUSTRATION

Suppose A Ltd. is going to invest in a project a sum of Rs. 3,00,000 having a life span of 3 years. Salvage value of machine is Rs. 90,000. The profit before depreciation for each year is Rs. 1,50,000. The Profit after Tax and value of Investment in the Beginning and at the End of each year shall be as follows:

Net Present Value (NPV)

The meaning of NPV: A bird in hand is better than two in the bush!
A rupee now is more valuable than the same rupee a year later.
This is what the present value means.
Net present value used in terms of cash flow means the present value of all future cash flows.
Cash flows mean net flow = The inflow - outflows
Net flow after setting off the negative flows.
If the NPV = 0, then the project will neither add value nor are you likely to lose.
Positive NPV means project can be given go ahead the negative is red signal.

Strengths and limitations of NPV method:

The main strength of the NPV is that it takes into account the time element and brings the rate of return nearer to the reality.

It helps you quickly evaluate the surplus you will end up with at the end of the project period and whether it matches your expectations all things considered.
The biggest limitation is that it is all estimate and surreal.
The discounting factor applied is very subjective.
Moreover, this method does not provide the overall result of profit or loss over the period of the project.
Equivalent Annual Costs (EAC): This cost of the asset is other than that for acquisition. In other words, it is an annual cost of owning, operating and maintaining an asset over its life time.
Net present value = Present value of net cash inflow - Total net initial investment

The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.

Illustration

Compute the net present value for a project with a net initial investment of Rs. 1,00,000. The net cash flow for year one is Rs. 55,000; for year two is Rs. 80,000 and for year three is Rs. 15,000. Further, the company's cost of capital is 10%. [PVIF @ 10% for three years are 0.909, 0.826 and 0.751]

Recommendation: Since the net present value of the project is positive, the company should accept the project

Internal Rate of return (IRR)

An Internal Rate of Return means an annual rate of growth in investment a business is going to generate.
The concept of calculating NPV and IRR is the same.
However, while calculating IRR, the NPV is set to zero;

The formula and calculation used to determine this figure are as follows:

However, the formula is such that the resultant IRR will not be generated easily and therefore permutations and combinations through excel sheet on trial and error basis will give you the result which finally can be tested by simple calculations.
If this rate of return is higher than basic or required RR(RRR), then only the investment is worth.
RRR is equivalent to the cost of funds.

Limitations of the IRR method:

If the factors comprising the IRR calculations are difficult to predict, it may be misleading. In case cash flows intermittently turn positive as well as negative, there can be multiple rates. If the estimates in IRR and NPV differ drastically from actual results, the analysts will have to choose to combine IRR analysis with scenario analysis.

Scenarios can show different possible NPVs based on varying assumptions.
If studied in conjunction with weighted average cost of capital (WACC) and or Required Rate of Return (RRR), the results can be more authentic.
Multiple IRRs: This situation arises when the project has non-conventional or casual or interruptive cash flows.

Definition and explanation of MIRR:

A Modified IRR is the one calculated to correct aberrations arising out of disruptive or alternatively positive and negative cash flows as also to correct the unrealistic assumption of investing intermittent cash inflows at project IRR.
Under this approach, any negative cash flow in any period, during the life of the project, is treated as the cost of the project and added to the initial cost of the project by discounting at the cost of the capital.
This is called the Present Value of Costs (PVC).
Also, the project inflows are compounded at the cost of capital to arrive at the total compounded terminal value (TV) of the inflows.
Then an appropriate rate of discount for this compounded terminal value is found out so that this discounted terminal value is equal to the total present value of the cost of the project (PVC). This discount rate is called MIRR.

ILLUSTRATION

The calculation of MIRR can be illustrated through the following example. Square Limited is evaluating a project which has the following initial investment and cash inflows:

Profitability Index

This is an index that either explains or represents the relationship between the cost and the benefit of a project proposal.
It is also called value investment ratio or profit investment ratio.
PI is calculated by dividing the present value of future expected cash flows by the initial investment amount in the project.
Higher the Index better is profitability of the project. Anything below 1 indicates that the project is unprofitable.

Mathematically: The Profitability Index (PI) is calculated as below:)

Profitability Index (PI) = Sum of discounted cash inflows/ Initial cash outlay or Total discounted cash outflow (as the case may be

Illustration

Suppose we have three projects involving discounted cash outflow of Rs. 5,50,000, Rs. 75,000 and Rs. 1,00,20,000 respectively. Suppose further that the sum of discounted cash inflows for these projects are Rs. 6,50,000, Rs. 95,000 and Rs. 1,00,30,000 respectively. Calculate the respective Profitability Index (PI) for the three projects.

SOLUTION:

The respective Profitability Index for the three projects would be as follows:

Profitability Index (PI) = Sum of discounted cash inflows/ Initial cash outlay or Total discounted cash outflow (as the case may be

PI = Rs. 6,50,000 / Rs. 5,50,000 = 1.18

PI = Rs. 95,000 /Rs. 75,000 = 1.27

PI = Rs. 1,00,30,000 /Rs. 1,00,20,000 = 1.001

It can be seen that in absolute terms, project 3 gives the highest cash inflows yet its Profitability Index is low.
This is because the outflow is also very high. The Profitability Index factor helps us in ranking various projects.

Social Cost Benefit Analysis

Central and State Governments and local bodies or designated corporations take up many projects of infrastructure developments, airports, ports, bridges, dams etc.
To support decision making process, SCBA is carried out. On one hand we have total cost of the project and on the other hand the social cost as well as benefits.
One has to attach or allot value to each such impact or benefit. Adverse impact will have negative value and the benefits will have positive value.
Adverse impact is the social cost. Loss of mangroves, generation of pollution, impact on plants, extinction of some birds and rare species, water level going down, health hazards are some of the social cost and environment impact.
Benefits are ease of travel, fuel savings, time savings, employment generation, uplifting of living standards and bringing order in traffic management and safety, among others.
If net result of positive and negative values is positive and equal or more than the cost of the project, the project is considered as beneficial.

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CAIIB ABFM Module B Unit 3 CAPITAL INVESTMENT DECISIONS ( Ambitious_Baba )