Investment evaluation a important part of capital budgeting decision .
Three steps are involved in the evaluation of an investment.
1)Estimation of cash flow.
2)Estimation of the required rate of return.
3)Application of decision rate for making the choice.
Investment decision rule
1)It should consider all cash flow to determine the true profitable of the project.
2)It should provide for an objective and unambiguous way of separating good projects from bad projects.
3)It should help ranking of project according to their true profitability.
4)It should help to choose among mutually exclusive projects that project which maximises the shareholders’ wealth.
Evaluation criteria of investment
Evaluation criteria has two important method NPV and IRR
NPV (Net present value method)-Net present value method of evaluation the investment proposal.It is a DCF technique that explicitly recognize the time value of money.it correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents present value and are found out .
Following steps are involved in the calculation of NPV.
1)Cash flow of the investment project should be forecasted based on realistic assumption.
2)Appropriate discount rate should be identified discount the forecasted cash flow.The appropriate discount rate is the project’s opportunity cost of capital which is equal to the required rate of return.
3)Present value of cash flow should be calculated using opportunity cost capital as the discount rate.
3)Net present value should be found out by subtracting present value of cash out flow from from present value of cash inflow.The project should be accepted if NPV is positive.
Acceptance rule of NPV
1)Accept the project when NPV is positive NPV>0
2)Reject the project when NPV is negative NPV<0
3)May accept the project when NPV is zero NPV=0
Evaluation of the NPV
NPV provides the most acceptable investment rate for the following reason.
1)Time value-It recognise the time value of money a rupee recevied today is worth more than rupee recevied tommorrow.
2)Measure of true profitability-It uses all cash flow occurring over the entire life of the project in calculating its worth.Hence,it is a measure of the projects true profitability.
3)Value-additivity-The discounting process facilitates measuring cash flow in terms of present value that is,in terms of equivalent current rupees.The NPV of project can be added NPV(A+B)=NPV(A)+NPV(B)
This is called the value additivity principle.
4)Share holder value-The NPV method are always consistent with the objective of the share holder value maximisation.This is greatest virtue of method.
Formula of NPV
Cash flow−initial investment
IRR(Internal rate of return)-The internal rate of return method is another discounted cash flow technique which takes account of the magnitude and timing of cash flow other term to describe the IRR yield on an investment.Rate of return over cast.
The IRR is the rate that equates the investment outlay with the project value of cash inflow recieved after one period Acceptance rule of IRR
1)Accept the project when r>k
2)Reject the project when r<k
3)May accept the projct r=k
Evaluation of IRR method
IRR method has following points
1)Time value -The IRR method recognises the time value of money
2)Profitability measures-It consider all cash flow occurring over the entire life of the project to calculate its rate of return.
3)Acceptance rule-Its generally gives the same acceptanc rule as the NPV method.
4)share holder value-IT is consistent with the shareholders’ wealth maximisation objective whenever a project IRR is greater then opportunity cost of capital.The share holder wealth will be enhanced.