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Unit 3 of 4 · BBA Sem 4

Unit 3: Investment decision-making

Financial Management notes · PTU syllabus (BBA 403-18)

3 min read4 topics8 exam questions
On this page
  1. Unit summary
  2. Nature and importance of investment decisions
  3. Non-discounted cash flow techniques
  4. Discounted cash flow techniques
  5. Comparing techniques
  6. Key terms
  7. Quick revision
  8. Important questions

Unit summary

Investment (capital budgeting) decisions commit large sums for many years and are hard to reverse. This unit covers the nature and importance of investment decisions and the evaluation techniques: payback, post-payback, ARR, NPV, IRR and the profitability index.

After this unit you can

  • Explain the nature and importance of capital budgeting
  • Calculate payback period, post-payback profitability and ARR
  • Calculate NPV, IRR and the profitability index
  • Compare discounted and non-discounted techniques

PTU syllabus topics

  • Meaning
  • importance and nature of investment decisions
  • investment evaluation criteria
  • non-discounted cash flow methods (payback, post-payback, ARR)
  • discounted cash flow techniques — NPV
  • IRR
  • profitability index
Key formulasCapital budgeting techniques

  • Payback period

    Initial investment / annual cash inflow

  • ARR

    Average profit / average investment × 100

  • NPV

    PV of inflows − initial outlay

    Accept if NPV > 0

  • Profitability index

    PV of inflows / initial outlay

    Accept if PI > 1

  • IRR

    Rate at which NPV = 0

    Accept if IRR > cost of capital

1

Topic 1

Nature and importance of investment decisions

Capital budgeting is the process of evaluating and selecting long-term investments — new machinery, plants, expansion or new products. Importance: large funds involved, long-term effects, irreversibility, risk, and impact on the firm's growth and value.

ProcessCapital budgeting process
  1. 1

    Identify investment proposals

  2. 2

    Estimate cash flows

  3. 3

    Evaluate using techniques

  4. 4

    Select projects

  5. 5

    Implement

  6. 6

    Review (post-audit)

2

Topic 2

Non-discounted cash flow techniques

  • Payback period: time taken to recover the initial investment from cash inflows. Shorter is better. It ignores cash flows after payback and the time value of money.
  • Post-payback profitability: cash inflows earned after the payback period — corrects one weakness of payback.
  • Accounting rate of return (ARR): average annual profit after tax / average investment × 100, where average investment = (initial cost + scrap) / 2.

Example

Cost ₹1,00,000; inflows ₹30,000 a year for 5 years. Payback = 1,00,000 / 30,000 = 3.33 years.

3

Topic 3

Discounted cash flow techniques

Key formulasDCF techniques

  • Net present value

    NPV = PV of inflows − PV of outflows

    Accept if NPV > 0

  • Internal rate of return

    The rate at which NPV = 0

    Accept if IRR > cost of capital

  • Profitability index

    PI = PV of inflows / initial outlay

    Accept if PI > 1

Example

Same project at 10%: PV of ₹30,000 for 5 years = 30,000 × 3.791 = ₹1,13,730. NPV = ₹13,730 > 0, PI = 1.137 — accept. IRR is about 15.2%.

IRR is found by trial and error (interpolation between two rates giving positive and negative NPVs).

4

Topic 4

Comparing techniques

ComparisonNPV vs IRR
NPV
IRR

Measure

Absolute rupees of value created

Percentage return

Reinvestment assumption

At the cost of capital

At the IRR itself

Multiple rates

Never

Possible with unusual cash flows

Conflicting rankings

Preferred, as it maximises wealth

Can mislead for mutually exclusive projects

Key terms

Capital budgeting
Evaluating long-term investment projects
Payback period
Time to recover the initial investment
NPV
Present value of inflows minus outflows
IRR
Discount rate making NPV zero
Profitability index
Ratio of PV of inflows to initial outlay

Quick revision

  • Payback and ARR ignore time value.
  • NPV > 0, IRR > cost of capital, PI > 1 → accept.
  • NPV is preferred when NPV and IRR conflict.

Important exam questions

Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).

Short-answer questions

  1. Q1.Define capital budgeting.
  2. Q2.What is the payback period? State one limitation.
  3. Q3.Define NPV.
  4. Q4.What is IRR?
  5. Q5.When is a project accepted under the profitability index?

Long-answer questions

  1. Q1.Explain the nature, importance and process of capital budgeting.
  2. Q2.Calculate payback, ARR, NPV, IRR and PI for a given project.
  3. Q3.Compare NPV and IRR methods.

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