1. Duration 1 hour 30 mins Investment Analysis

2. Topics to be covered Review of last session Investment background Capital budgeting Methods

3. Meaning of Investment Decision Decision of allocation of capital or commitment of funds to long term assets that would yield benefit in the future. Key things to remember Allocation Benefits in future

4. Investment Decision The evaluation of the prospective profitability of new investments How much Return the new investment would generate? The measurement of cut-off rate against that the prospective return new investment could be compared What rate should be used to discount project's cash flow?

5. Investment Setting Risk & Safety Principal Current Income Vs Capital Appreciation Liquidity Considerations Short Term Vs Long Term Investments Tax Factors Retirement & Estate Planning

6. Securities Market Primary market: where new securities are sold For Example – Initial public offer Secondary market: where existing securities are traded For Example- Existing share of any listed company say reliance.

7. Techniques of Selling Securities Direct sale Sale through intermediaries Managers to the Issue Underwriting securities

8. Stock Market Association Organization or body of individuals As per Security Exchange Commission (SEC) Whether incorporated or not, established for the purpose of assisting, regulating and controlling business in buying, selling and dealing in securities.

9. Function of the Stock Market Facilities the exchange Price discovery Safeguarding the investors Capital formation Facilities Hedging and Speculation

10. Foreign Exchange Market The market in which foreign currency trading takes place. For example Buying dollars ($) by giving rupees. The major players are, Corporate Houses (Example: Infosys, TCS) Commercial Banks (SBI,ICICI) Exchange Brokers Central Banks (RBI)

11. Capital budgeting Capital budgeting is the process of making decision regarding capital expenditure in projects or assets Capital Expenditure For acquiring capital assets which are used in the business and not for resale and such assets would give benefits for long period Example: Land, Plant & Equipments

12. Importance of capital Budgeting Heavy Investment Permanent commitment of funds Long term Impact on profitability Irreversible in nature

13. Methods of Capital Budgeting Traditional methods Pay back period method or pay out or pay off method Discounted pay back period method Rate of return method or accounting method Time adjusted method or discounting method Net present value method Internal rate of return method Profitability index method

14. Payback Method Payback period is the length of time required to recover initial cash outlay. For Example Here the payback period is 4 years because sum of cash flows during first four years equals to initial investment Cash flows Initial outlayYear 1Year 2Year 3Year 4Year 5 -6,00,0002,00,0001,50,000 1,00,0001,50,000

15. Payback method Decision criteria under payback method is Accept the projects with shorter payback period. Advantage: 1.Easy to calculate Disadvantage: 1.Ignores the time value of money 2. Ignores the cash flows beyond payback period

16. Discounted Payback All cash flows are calculated taking into consideration appropriate discount rate Advantages: It takes into consideration time value of money

17. Accounting or Average Rate of Return Method ARR = Average annual profit / original investment * 100 For example Average annual profit = (1,50,000 / 6,00,000) * 100 Here the ARR is 25% Decision criteria: Accept the projects which gives you the ARR higher then the return required by company Cash flows Initial outlayYear 1Year 2Year 3Year 4Year 5 -6,00,0002,00,0001,50,000 1,00,0001,50,000

18. Accounting or Average Rate of Return Method Advantages: Simple to calculate No estimation Required Disadvantages: It is based on accounting profit not cash flow It does not take into account time value of money

19. Net present value [NPV] method Decide appropriate discounting rate Present value of estimated cash inflows and outflows should also be computed Equation for calculating NPV is as follows NPV = P.V cash inflows – P.V cash out flows Criteria for Selection Accept when NPV > zero Reject when NPV < zero

20. Net present value [NPV] method For example Find the NPV if Required rate of return is 10% NPV is Rs. 10124.74 Cash flows Initial outlayYear 1Year 2Year 3Year 4Year 5 -1,00,00020,00025,00030,00035,00040,000

21. Net present value [NPV] method Advantage: Takes into account time value of money Additive property: NPV (A+B) = NPV of project A + NPV of project B Limitations: It’s in Absolute terms not relative terms Biased to long term projects in case projects are mutually exclusive.

22. Profitability index [PI] or excess present value index method P.I = Present value future cash inflow / Present value of future cash outflow For Example: At 10% discount rate, Profitability index for the project is 1,10,000 / 1,00,000 = 1.1 Criteria for decision Accept the project in P.I >1 Reject the project if P.I <1 Cash flows Initial outlayYear 1Year 2Year 3Year 4 -1,00,00022,00024,20039,93058,564

23. Profitability index [PI] or excess present value index method Advantages: Takes in to account Time value of money Takes into account Scale on investment Used when capital is scare

24. Internal Rate of Return Rate which makes present value of all future cash flows equals to values of initial outlay or which makes NPV=0 IRR=Cash Inflows/ Cash outflows=1 Methods of finding IRR Trial and Error Excel Example IRR = 12% Cash flows Initial outlayYear 1Year 2Year 3Year 4 -1,00,00025,00030,00040,000

25. Internal Rate of Return Decision criteria Accept the project If IRR is greater than required return. Advantages It takes into consideration Time value of money It gives the same result as given by NPV

26. Internal Rate of Return Disadvantages: Projects with negative cash flows For example Cash flows Year 0 Year 1 Year 2 -16,000 10,000 -10,000 Mutually exclusive projects ProjectInitial investmentCashflowIRRNPV A-10,00020,000100%7,857.14 B-50,00075,00050%16,964.29

27. Which one to choose? Survey evidence on percentage of CFOs using particular technique for evaluating investment projects Source: J. R. Graham and C. R. Harvey, “ The Theory and Practice of Finance: Evidence from the Field, Journal of Financial Economics 61 (2001)

28. In class exercise Suppose you buy a land at Rs 10 lac and you construct a building which costs Rs 5. you can rent it to a hotel with annual rent of Rs 4 lac per year for 5 years. If the Rate of interest is 10% Will you invest in the project ? In case the rate of interest increases to 12% would it impact your decision?

29. In class Exercise ProjectInitial Investment Cash Flows 1st Year2nd Year3rd Year4th year5th year A-100,000200003000040000 50000 B-7500015000 C-150,000500006000040000 50000 D-200,000800007000040000 30000

30. Decision Based on each criteria which project would you select Payback ARR NPV IRR P.I.

31. Thank You