Guidelines for using Investment Techniques

Techniques provide tools for analysis, which help in decision-making. However, they do not give decision, which is the prerogative of human judgment. Thus, it must be noted that if a particular criterion argues for the selection of a particular project, the investor must go for it if and if it is satisfied on other grounds, which are not incorporated in that particular technique. All that the various investment techniques do is that each one of them reduces all the quantifiable costs and benefits into one number and by examining that number in relation to the decision rule the investor is able to conclude on the viability of the project. In the absence of these techniques, the analyst would have difficulties on compressing the huge data into a meaningful parameter to arrive at a decision.

It is essential that the parameters of the investment measures are unambiguously defined lest they misguide the investor. In this connection, five parameters merit attention: capital cost (C), project life, salvage value, the discount or hurdle rate, and net cash inflows (R’s).

There are large projects which take years to commission. The capital cost of such projects is accordingly spread over years. While estimating the capital cost of such projects, due consideration to time value of money must be given. In general, analysts compute the cost as on the year the project is ready for commercial production. Further, for projects which are located in the backward districts, there is a provision for capital subsidy from the center which stands 15% of the total capital cost subject to a maximum of Rs. 15 lakhs. The capital cost of the project must be adjusted against this subsidy. Thus, if the capital cost of a project is, say, Rs. 200 crores, it is divided as Rs. 50 crores in the first year, Rs 100 crores in the second year and Rs. 50 crores in the third year, the project will be completed, the cost of capital is 15%, and the capital subsidy of Rs. 15 lakhs becomes available in the third year, then the capital cost of the project as on project’s completion stands at Rs.

50(1+ 0.15)2 + 100 (1 + 0.15) + 50 –15 = 210.125

Sometimes the financial institutions have commitment charges on the commitments they make to advance loans at a pre-specified future date. If so, that should also be included in the capital cost of the project.

There are four relevant lives in investment projects: asset life, activity life, economic life and planning horizon. The asset life is concerned with the life of assets that are inevitable for running the project. A project usually has several assets, and if so, there are several assets’ lives. The least of these becomes the binding constraint for the project. The activity life is concerned with the number of years the activity (product) of a project would be in demand in the market. Thus, if one of thinking of a radio manufacturing plant and the plant has assets which could be operative even for 20 years but the radios would be in demand, say, for only 10 more years, then the activity life is 10 years and that would put a constraint on the continuation of the project. The economic life of a project is defined as the number of years until which the project would be worth operating on economic consideration. The last, planning horizon is the period within which the investor would care to reap the benefit. The least of all lives is the project life.

The salvage value of a project, also called the scrap value, is the price all the assets, including the goodwill if any, of the project commands in the year the project is wound up. This need not equal to the written down value (WDV), also called the book value, of the project, for there could be capital gain or loss. It is obvious that salvage value accrues on the expiry of the project life.

The discount rate and the hurdle rate, in the absence of changing prices, uncertainty and capital constraint, is the weighted average cost of capital, weights being the percentage of capital raised through a particular source. To illustrate this, let the capital cost (C) of Rs. 100 lakhs consists of Rs 40 lakhs of equity and Rs. 60 lakhs of debt and let the cost of equity (dividend + capital gain) be 20% and that of debt 15%. Incidentally note that, as per the corporate taxation rule, interest cost on borrowing is a deductible expense while dividend on equity is not a permissible deduction. Thus, to compute the effective cost of capital, we need the corporate tax rate as well. Suppose that the tax rate is 60%. The cost of capital (i) the would be

i = 40/100 (20) + 60/100 (15) (1 – 0.60)

= 11.6%

Thus, the discount rate to be used in the NPV formula would be 11.6%. The hurdle rate for IRR method as well as the cost of capital for NTV method would also be 11.6%. This rate would need to be adjusted upward for inflation, uncertainty and capital constraint, if any.

The net cash inflows of a project accrue all through the project life and yet the concept is used erroneously by some analysts. This is partly because it is a difficult concept and partly because it is rarely defined unambiguously. Its definition depends on whether the project is evaluated on the basis of the total capital cost of the project or on the basis of the equity capital only.