BBA 2203: FINANCIAL MANAGEMENT Lecture Notes

Topic 3. INVESTMENT DECISION

Introduction
This topic introduces you to the essentials of investment appraisal and will cover the meaning of
investment appraisal, capital budgeting, the importance of capital budgeting decision, investment
appraisal and capital budgeting, cash flows versus profits, the types of cash flows, capital
budgeting decisions, investment appraisal techniques, allowing for inflation and taxation in
discounted cash flows, and capital rationing.

Investment Appraisal
Investment appraisal is the evaluation of proposed investment projects involving capital
expenditure. Capital expenditure is spending on non-current assets, such as buildings and
equipment, or investing in a new business. The purpose of investment appraisal is to make a
decision about whether the capital expenditure is worthwhile and whether the investment project
should be undertaken.

Capital Budgeting
The decision to invest in long term assets by the firm is called the investment or capital
budgeting decision. The primary task in this decision is to evaluate proposals for investment in
long term assets to ensure capacity to produce, and select those investment proposals that
maximise the value of the firm, that is, capital expenditure by a company should provide a long-
term financial return, and the spending should be consistent with the company’s long-term
corporate and financial objectives. Capital expenditure should therefore be made with the
intention of implementing chosen business strategies that have been agreed by the board of
directors.

The Importance of Capital Budgeting Decision

It is important that the capital budgeting decision is handled with utmost care in the firm
because:
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 1) It determines which permanent assets the firm will hold (asset mix).
2) Initial outlays in investment in long-term assets are usually very substantial normally
running into hundreds of millions of shillings. If the financial manager has to commit
such huge amounts of resources into assets, then the decision must be taken very
carefully. A wrong decision can easily lead to the demise of the firm.
3) Capital budgeting decisions are normally very difficult to reverse or usually reversed at a
very high cost.
4) Constant and up to date capital budgeting decisions enable the firm to acquire the
relevant assets necessary for producing competitively.

Investment Appraisal and Capital Budgeting

Investment appraisal takes place within the framework of capital budgeting and strategic
planning. The capital budgeting decision involves five major stages:
1) Generating capital investment proposals in line with the company’s strategic objectives.
The process should be as broad and democratic as possible since no substantial resources
of the firm are committed at this stage.
2) Forecasting relevant cash flows relating to the project. The purpose is to separate the
feasible from a set of all possible investment proposals. This is a highly technical activity
and should be handled by technical experts.
3) Evaluating the projects. This involves using various techniques of analysis to determine
the viability of projects while taking into consideration the five M’s: manpower or man,
money, materials, machinery and market.
4) Implementing projects which satisfy the company’s criteria for deciding whether the
project will earn a satisfactory return on investment.
5) Monitoring the performance of investment projects and follow-up to ensure that the
assets acquired are used as planned and adjustments made where necessary. All this is
inclined towards ensuring that the projects perform in line with expectations.

Cash Flows versus Profits

It’s imperative to understand that in capital budgeting decisions, cash flows as opposed to
accounting profits is the concept used. There are two compelling reasons as to why investment
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opportunities are evaluated in terms of cash flows rather than accounting profits (earnings),
namely:
1) Cash flows are theoretically a better measure of the net economic benefits or costs
associated with a prospective project. This value is the value of economic out flow (cost)
and inflow, which the firm will experience if the project is taken up.
2) Use of cash flows minimises accounting ambiguities. There are many ways to value
inventories, allocate costs and choose a depreciation schedule to calculate earnings, all of
which are permissible under the Generally Accepted Accounting Principles (GAAPs).
Thus, different earnings numbers could be developed for the same project depending on
the accounting method followed, but only one set of cash flow is associated with the
project.

The Types of Cash Flows Used in Capital Budgeting

Cash flows fall into two categories, namely: cash outflows and cash inflows.

Cash Outflows
These consist of expenditure (initial outlay) that needs to be made before the assets become
operational. The initial outlay components include the following:
1) The invoice value of the assets to be acquired.
2) All the other incidental costs incurred in making the assets operational e.g. installation
costs, and freight charges, among others.
3) Opportunity costs - reflects implicit cost that aren’t directly paid for in cash. For example
when the investor is given free accommodation for the project, the rent that would
otherwise have been paid is an opportunity cost and should be considered when
determining the outlay of the investment.
4) Investment allowances, which actually reduce the initial outlay.
5) Increases or decreases in the existing working capital. For example, if it is an expansion
project there will be an increased need for cash, inventories and higher levels of accounts
receivable.

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 6) Sunk costs should be ignored. These are costs incurred in the assessment of the feasibility
of the project and have no direct relationship with the value of the investment. A typical
example is the feasibility study costs.

Example 1: Cash Out flows

Riham Cola Ltd is proposing to modernise its soda bottling plant located in Namanve, Kampala.
The additional equipment will cost Shs 400 million while freight and carriage charges from
Mombasa will be Shs 8 million. Clearing charges are estimated at Shs 2 million.

The company currently spends Shs 3 million on salary of a specialist technician who maintains
the equipment. This is expected to increase to Shs 4.5 million as an additional engineer will be
engaged. The new equipment will be housed in an extension building provided by Uganda
Manufacturers Authority at no cost in appreciation of the company’s effort to improve the
welfare of the area. It would otherwise have cost Shs 5 million to set up the facility.

Required: Compute the value of initial outlay of the proposed venture.

Solution
Particulars Shs Shs
Invoice value of the equipment 400,000,000
Add: Carriage and freight charges 8,000,000
Clearing Charges 2,000,000
Increase in working capital Shs (4.5 – 3) m 1,500,000
Building from UMA 5,000,000 16,500,000
Initial Outlay 416,500,000

Cash Inflows
These refer to the returns expected from the investment. Cash inflows are generated from
operations and terminal value.
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Cash Inflows from Operations
These are either increases in revenue or decreases in costs as a result of undertaking the
investment. These cash inflows should also take into account non-cash expenses like
depreciation. Depreciation refers to the gradual loss in value of an asset. Whereas depreciation is
deducted from net revenues in order to determine the net earnings, it doesn’t involve an actual
movement of cash like other expenses. On this basis it is regarded as a boost to inflow, and
therefore it should be added back to the cash inflow after tax.

Example 2: Cash Inflows from Operations

An asset has an initial cost of Shs 4.5 million, a salvage value of 2.5 million, and a useful life of
4 years. The firm that owns this asset expects cash inflows from this asset to remain constant at
Shs 10 million in those 4 years and the tax rate is 30%.

Required are:
a) The depreciation computation using straight line method.
b) The depreciation computation using reducing balance method and in particular the double
declining balance method.
c) The earnings after tax using the straight-line method of depreciation.
d) The earnings after tax using the double declining balance method of depreciation.

Solutions
a) Depreciation computations using the straight-line method
Depreciation = Cost – salvage value
Useful life

= 4,500,000 – 2,500,000
4
= Shs 500,000 per annum

b) Depreciation computations using the double declining balance method

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 Depreciation rate = 2 x depreciation rate on straight line method

Depreciation rate = 2 x Depreciation charge x 100%

Net book value

Depreciation rate = 2 x 500,000 x 100%

2,000,000

= 2 x 25%

= 50%

c) The earnings after tax after applying the straight line method of depreciation.
Year 1 Year 2 Years 3 Year 4
Particulars Shs’000 Shs’000 Shs’000 Shs’000
Revenues 10,000 10,000 10,000 10,000
Depreciation (500) (500) (500) (500)
Earnings before tax 9,500 9,500 9,500 9,500
Tax @ 30% (2,850) (2,850) (2,850) (2,850)
Earnings after tax 6,650 6,650 6,650 6,650
Depreciation 500 500 500 500
7,150 7,150 7,150 7,150
Net salvage proceeds (W-1) - - - 1,750
CFAT 7,150 7,150 7,150 8,900
Workings
W-1: Net salvage value = (1- t) x salvage value; Where t = tax rate
= (1- 0.3) x 2,500,000
= Shs 1,750,000
d) The earnings after tax after applying the DDBM.
Year 1 Year 2 Year 3 Year 4
Particulars Shs’000 Shs’000 Shs’000 Shs’000
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 Revenue 10,000 10,000 10,000 10,000
Depreciation (W-1) (2,250) (1,125) (562.5) (281.5)
Earnings before tax 7,750 8,875 9,437.5 9,718.5
Tax @ 30% (2,325) (2,663) (2,831.3) (2,915.6)
Earnings after tax 5,425 6,212 6,606.2 6,802.9
Depreciation 2,250 1,125 562.5 281.5
7,675 7,337 7,168.7 7,084.4
Net salvage value - - - 1,750
7,675 7,337 7,168.7 8,834.4

Workings
W-1: Depreciation Computations
Year 1: 50% x 4,500,000 = Shs 2, 250,000
Year 2: 50% x [4,500,000 - 2,250,000] = Shs 1,125,000
Year 3: 50% x [4,500, 000 – (2,250,000 +1,125,000)] = Shs 562, 500
Year 4: 50% x [4,500, 000 - [2,250, 000 + 1,125,000 + 562,500)] = Shs 281,500

The Terminal Cash Flows

These are cash flows that accrue in the final year of the useful life of the asset. The terminal cash
flows differ from the intermediate ones with respect of the expected net realisable value from
disposal of the assets in its final year of use.

The net salvage value would be Sv (1-t); where Sv is the realisable value on selling scrap of the
asset and t is the tax rate to which incomes of the business are subjected.

The Capital Budgeting Decisions

There are three basic types of capital budgeting decisions, namely: The accept-reject decision,
the mutually exclusive choice decision, and the capital rationing decision.

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The Accept –Reject Decision
The accept-reject decision is the fundamental decision of whether to invest in a proposed project,
that is, every asset a firm acquires must successfully pass the accept-reject decision. The decision
here involves accepting a proposed project if it satisfies the investor interests or otherwise.

The Mutually Exclusive Choice Decisions

Mutually exclusive choice decisions involve selecting only one project and excluding all the
others. This is achieved by ranking projects, and thereafter choosing the acceptable proposal that
is ranked best.

The Capital Rationing Decisions

Capital rationing refers to a situation where the firm has many acceptable investment projects,
but insufficient funds to undertake all of them at once. This amounts to having a budget
constraint in one or more time periods during which the firm is choosing investments. The
emphasis here is on the selection of a group of assets and is usually more difficult to resolve than
choosing a single alternative.

The Capital Budgeting (Investment Appraisal) Techniques

These are broken down into two types, namely:
1) The traditional or basic investment appraisal techniques. These techniques are also
referred to as the non-discounted cash flow (NDCF) techniques. They do not take into
account the time value of money.
2) The modern or more sophisticated methods of investment appraisal. These techniques are
also called the discounted cash flow (DCF) techniques. The discounted cash flow
techniques take into consideration the project's entire life and the time factor by
discounting the future inflows and outflows to their present value.

The Non-discounted Cash flow (NDCF) Techniques

The two basic appraisal techniques are: Return on capital employed (ROCE) and payback (PB)
method.
Return on Capital Employed (ROCE) Method
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This is known as the accounting rate of return (ARR). The formula for ROCE is as follows:
ROCE = Average annual profits before interest and tax x 100%
Initial capital cost
The initial capital cost could comprise any or all of the following: cost of new assets bought, net
book value of the existing assets to be used in the project, investment in working capital,
capitalised research and development expenditure.

Alternatively:
ROCE = Average annual profits before interest and tax x 100%
Average capital investment

The average capital investment can be computed as follows:

The average capital investment = Initial investment + scrap value
2
The Decision Rule
If the expected ROCE for the investment is greater than the target or the hurdle rate as decided
by management then the project should be accepted.

Example 3: ROCE
A project requires an initial investment of Shs 800 million and then earns net cash inflows as
follows:
Year 1 2 3 4 5 6 7
Cash inflows (Shs millions) 100 200 400 400 300 200 150

In addition, at the end of the seven-year project the assets initially purchased will be sold for
Shs 100 million.

Required is to determine the projects ROCE using:

a) Initial capital cost, and (b) Average capital investment.

Solutions
ROCE uses profits rather than cash flows. The necessary computations are as follows:
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 Average annual inflows = 1,750,000,000/7 = 250,000,000.
Average annual depreciation = (800,000,000 - 100,000,000)/7 = 100,000,000. A net
shilling 700 million is being written off as depreciation over 7 years.
Average annual profit = 250,000,000 – 100,000,000 = 150,000,000.
The average capital invested is (800,000,000 + 100,000,000)/2 = 450,000,000.
a) Initial capital cost
ROCE = Average annual profit x 100% = 150,000,000 x 100% = 18.75%
Initial capital cost 800,000,000

a) Average capital investment

ROCE = Average annual profit x 100% = 150,000,000 x 100% = 33.33%
Average capital investment 450,000,000

Advantages and Disadvantages of ROCE

1) Simplicity – being based on widely reported measures of return (profits) and asset
(statement of financial position), it is easily understood and calculated.
2) Links with other accounting measures – annual ROCE, calculated to assess a business
(and therefore the investment decisions made by a business), is a widely used measure.
It is expressed in percentage terms which managers and accountants are familiar.

Disadvantages of ROCE
1) It fails to take account of either the project life or the timing of the cash flows within that
life. This therefore ignores the time value of money.
2) It might ignore working capital requirements.
3) It will vary with specific accounting policies, and the extent to which project costs are
capitalised. Profit measurement is thus subjective and ROCE figures for identical
projects would vary from business to business.

Payback Method

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Payback is the time a project will take to pay back the money spent on it. It is based on the
expected cash flows from the project, not accounting profits. The payback method of appraisal is
used in one of the following two ways:
1) A business may establish a rule for capital spending that no project should be taken
unless it is expected to pay within a given length of time.
2) When two alternative capital projects are being compared, and the decision is to
undertake one or the other but not both. Preference must be given to the project that is
expected to pay back sooner.
Payback is commonly used as an initial screening method and projects that meet the payback
requirement are then analysed using another investment appraisal method.

Calculating payback: Constant annual cash flows

If the expected cash flows from a project are an equal annual amount, the payback period is
simply calculated as:
Payback period = Initial Investment
Annual Cash Inflow

Example 4: Payback Method

A project will involve spending Shs 20 million now. Annual cash flows from the project are Shs
4 million. What is the expected payback period?

Solution
Payback = Shs 20,000,000/ Shs 4,000,000 = 5 years

Calculating Payback: Uneven annual cash flows

Annual cash flows from a project are unlikely to be a constant amount, but are likely to vary
from year to year. If cash flows are uneven, payback is calculated by finding out when the
cumulative cash inflows from the project will pay back the money spent. Cumulative cash flows
must be worked out by adding each year’s cash flows, on a cumulative basis to net cash flow to
date for the project.
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Example 5: Payback Method
A project is expected to have the following cash flows:
Year Cash flow (Shs’000)
0 (20,000)
1 10,000
2 (5,000)
3 4,000
4 6,000
5 3,000
6 2,000
What is the expected payback period of the project?

Solution
Year Cash flow Cumulative cash flow
Shs’000 Shs’000
0 (20,000) (20,000)
1 10,000 (10,000)
2 (5,000) (15,000)
3 4,000 (11,000)
4 6,000 (5000)
5 3,000 (2,000)
6 2,000 0

The payback is 6 years.

The merits of payback technique
1) Simplicity – as a concept, it is easily understood and easily calculated.
2) It is useful in certain situations:
Rapidly changing technology – If a new plant is likely to be scrapped in a short
period because of obsolescence, a quick payback is essential.

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 Improving investment conditions – When investment conditions are expected to
improve in the near future, attention is directed to those projects which will release
funds soonest, to take advantage of the improving climate.
3) Payback favours projects with a quick return – It is often argued that these are to be
preferred for three reasons:
Rapid project payback leads to rapid company growth, but in fact such a policy will
lead to many profitable investment opportunities being overlooked because their
payback period does not happen to be particularly swift.
Rapid payback minimises risk (the logic being that the shorter the payback period, the
less there’s that can go wrong).
Rapid payback maximises liquidity – but liquidity problems are best dealt with
separately, through cash forecasting.
4) Unlike the other traditional methods, it uses cash flows, rather than profits, and so is less
likely to produce an unduly optimistic figure distorted by assorted accounting
conventions which might permit certain costs to be carried forward and not affect profit
initially.

Demerits
1) Project returns after payback period may be ignored – cash flows arising after the
payback period are totally ignored.
2) It ignores the basic idea behind the investors’ decision to commit resources. Acceptance
criterion on an investment with a payback period of 1 year is better than one with 2 years.
3) Timing ignored – cash flows are effectively categorized as pre-payback or post-payback,
but no more accurate measure is made. In particular, the time value of money is ignored
(except in the case of discounted payback).
4) The payback period criterion that firm’s stipulate for assessing projects has little
theoretical basis. How do firms justify setting, say, a two-year payback requirement?

The Discounted Cash Flow (DCF) Techniques

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The DCF methods take into account both the magnitude and timing of expected cash flows in
each period of a project's life. The two methods are the net present value method and the
internal rate of return method.

The Net Present Value (NPV) Method

The NPV of a project is the sum of the discounted cash flows less the initial investment. The
NPV value is a fundamental investment appraisal technique.

Example 6: NPV Calculations

Project A requires an immediate investment of Shs 150 million and will generate net cash
inflows of Shs 60 million for the next three (3) years. The project’s discount rate is 7%. If the
NPV method is used to appraise the project, should project A be undertaken?

Solution
Year Cash flow Discount factor Present value
Shs’000 7% Shs’000
0 (150,000) 1.000 (150,000)
1 60,000 0.935 56,100
2 60,000 0.873 52,380
3 60,000 0.816 48,960
7,440
The NPV of this project is Shs 7,440,000. As the NPV is positive, project A should be
undertaken as it will increase shareholders’ wealth.

Advantages and disadvantages of NPV

When appraising projects or investments, NPV considered to be superior in theory to most other
methods. This is because it:
1) Considers the time value of money – discounting cash flows to PV takes account of the
impact of interest, inflation and risk overtime. These significant issues are ignored by the
basic methods of payback and accounting rate of return.

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 2) Is an absolute method – the NPV of an investment represents the actual surplus raised by
the project. This allows the business to plan more effectively.
3) Is based on cash flows not profits – the subjectivity of profits makes them less reliable
than cash flows and therefore less appropriate for decision-making. Neither ARR nor
payback provides an absolute method.
4) Considers the whole life of the project – methods such as payback only considers the
earlier cash flows associated with the project. NPV takes account of all relevant flows
associated with the project.
5) Should lead to maximisation of shareholder wealth. If the cost of capital reflects the
investor’s (shareholders) required return, then the NPV reflects the theoretical increase in
their wealth. For a company, this is considered to be the primary objective of the
business.

However, there are some potential drawbacks:

1) It is difficult to explain to managers. To understand the meaning of the NPV calculated
requires an understanding of discounting. The method is not as intuitive as techniques
such as payback.
2) It requires knowledge of cost of capital. The calculation of the cost of capital is, in
practice, more complex than identifying interest rates. It involves gathering data and
making a number of calculations based on that data and some estimates. The process may
be deemed too protracted for the appraisal to be carried out.
3) It is relatively complex. For reasons explained above, NPV may be rejected in favour of
simpler techniques.

The Internal Rate of Return (IRR)

The IRR represents the discount rate at which the NPV of an investment is zero. As such it
represents a break even cost of capital.

Decision rule:
Projects should be accepted if their IRR is greater than the cost of capital.

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Calculating the IRR using Linear Interpolation - The steps in linear interpolation are:
1) Calculate two (2) NPVs for the project at two (2) different costs of capital.
2) Use the formula to find the IRR:
IRR = L% + NL x (H-L) %
NL - NH
Where: L = Lower rate of interest; H = Higher rate of interest; NL= NPV at the lower rate
of interest; and, NH = NPV at the higher rate of interest

Example 7: IRR
An investment opportunity is available which requires a single cash outlay of Shs 850 million.
Cash inflows of Shs 388 million will then arise at 12 months intervals for three years
commencing in one year’s time. Loan finance is available at 8% p.a.

Required: Compute the IRR of the project.

Solution
We shall use discount rates of 8% and 20%.
Year Cash flow PV factor PV PV factor PV
Shs’000 at 8% Shs’000 at 20% Shs’000
0 (850,000) 1.000 (850,000) 1.000 (850,000)
1-3 388,000 2.577* 999,876 2.106* 817,128
Net present value 149,876 (32,872)
*These are the cumulative factors for three (3) years at 8% and 20% respectively.

IRR = 8% + 149,876,000 x (20% - 8%)

182,748,000
IRR = 17.8% or approximately 18%
The project should be accepted because the IRR is greater than cost of borrowing which is 8%.
Advantages of IRR
1) IRR considers the time value of money. The current value earned from an investment
project is therefore more accurately measured.
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 2) IRR is a percentage and therefore easily understood. Although managers may not
completely understand the detail of the IRR, the concept of a return earned is familiar and
the IRR can be simply compared with the required rate of return of the organisation.
3) IRR uses cash flows not profits. These are less subjective.
4) IRR considers the whole life of the project rather than ignoring later flows (which would
occur with payback for example).
However, there are a number of difficulties with the IRR approach:
1) It is not a measure of absolute profitability. A project of Shs 10 million invested now and
paying back Shs 10.1 million in one year’s time has an IRR of 10%. If a company’s
required return is 6%, then the project is viable according to the IRR rule but most
businesses would consider the absolute return too small to be worth the investment.
2) Interpolation only provides an estimate (and an accurate estimate requires the use of a
spreadsheet programme).
3) Non-conventional cash flows may give rise to no IRR or multiple IRRs. For example, a
project with an outflow at T 0 and T2 but income at T1 could depending on the size of the
cash flows have a number of different profiles of a graph (see below). Even where the
project doesn’t have one IRR, it can be seen from the graph that the decision rule would
lead to the wrong result as the project doesn’t earn a positive NPV at any cost of capital.

NPV Two IRRs

One IRR Discount rate

No IRR
The Impact of Inflation on Interest Rates
Inflation is a general increase in prices leading to a general decline in the real value of money. In
times of inflation, the fund providers will require a return made up of two elements:
Real return for the use of their funds (i.e. the return they would want if there was no
inflation in the economy).
Additional return to compensate for inflation.
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The overall required return is called the money (or market, or nominal) rate of return. The real
and money (or market, or nominal) returns are linked by the formula: (1 + m) = (1 + r) (1 + i);
Where: m = money rate, r = real rate and i = inflation

The Impact of Inflation on Cash Flows

Where cash flows have not been increased for expected inflation they are known as current cash
flows, or real cash flows and where cash flows have been increased to take account of expected
inflation they are known as money cash flows or nominal cash flows.

The impact of inflation can be dealt with in two different ways - both methods give the same
NPV.
METHODS OF DEALING WITH INFLATION

REAL METHOD MONEY/ NOMINAL

METHOD

Inflate each cash flow by

DO NOT inflate the cash
the inflation rate i.e.
flows - leave them in
convert it to a money
real terms.
flow.

Discount using the real Discount using the money

rate rate

Types of Inflation Rates

TYPES OF INFLATION

Specific Inflation Rate General Rate of Inflation

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 Each cash flow is affected by a Impacts the investors’ overall
specific rate required rate of return

In situations where you are given a number of specific inflation rates, the real method seen
before cannot be used. The following gives a useful summary of how to approach the question.

When to use the money or real method

Is there one rate of inflation (and no tax) in the question?

No Yes

Money/nominal method If the cash flows are in:

e.g. wages 3%, materials 4% Real terms Money terms
and general inflation 5%.
Inflate cash flows to money terms
Real method Money method
(N.B. Use this for
annuities and perpetuities)

Explanation - Specific and General Inflation Rates

If there is one rate of inflation in the question both the real and money method will give the same
answer. However, it is easier to adjust one discount rate, rather than all the cash flows over a
number of years. This is particularly true where the cash flows are annuities. The real method is
the only possible method where they are perpetuities.

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Although it is theoretically possible to use the real method in questions incorporating tax, it is
extremely complex. It is therefore much safer (and easier) to use the money/ nominal method in
all questions where tax is taken into account.

To use the real method when cash flows inflate at different rates (specific rates) is extremely
complex and would involve a lot of calculations. It is therefore advisable to always use the
money method in these situations. This involves:
Inflating the cash flows at their specific inflation rates.
Discounting using the money rate.

Very often the money rate will not be given in the question but will need to be calculated. This
should be done using the real rate and the general inflation rate.

Example 8: General and Specific Inflation Rates

A company is considering a cost saving project. This involves purchasing a machine costing Shs
7,000,000 which will result in annual savings (in real terms) on wage costs of Shs 1,000,000 and
on material costs of Shs 400,000.

The following forecasts are made of the rates of inflation each year for the next five years:
Wage costs 10%
Material costs 5%
General prices 6%

The cost of capital of the company, in real terms, is 8.5%.

Required: Evaluate the project assuming that the machine has a life of five years and no scrap
value.

Solution
Since the question contains both specific and general inflation rates, the money method
should be used.
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Step 1: The money rate needs to be calculated using the information provided on the real rate
of return and the general rate of inflation.
(1 + m) = (1+ r) (1+ i)
(1 + m) = (1.085) (1.06)
m = 15%

Step 2: Inflate the cash flows using the specific inflation rates and discount using the money rate
calculated in Step 1.
T0 T1 T2 T3 T4 T5
Shs’000 Shs’000 Shs’000 Shs’000 Shs’000 Shs’000
Investment (7,000)
Wages savings
(Inflating @ 10%) 1,100 1,210 1,331 1,464 1,610
Materials savings
(Inflating @ 5%) 420 441 463 486 510
Net cash flow (7,000) 1,520 1,651 1,794 1,950 2,120
PV factor @
15% 1.000 0.870 0.756 0.658 0.572 0.497
PV of cash flow (7,000) 1,322 1,248 1,180 1,115 1,054

Therefore, the NPV = Shs (1,081,000) which suggests the project isn’t worthwhile.

The Impact of Taxation on Cash Flows

Since most companies pay tax, the impact of corporation tax must be considered in any
investment appraisal. Corporation tax charged on a company’s profits is a relevant cash flow for
NPV purposes. It is assumed, unless otherwise stated in the question, that:
Operating cash inflows will be taxed at the corporation tax rate.
Operating cash outflows will be tax deducted and attract tax relief at the corporation tax
rate.

Investment Decision P a g e 21 | 33
 Tax paid on operating flows is due one year after the related operating cash flow is
earned.
Investment spending attracts capital allowances [or writing down allowances (WDAs)]
which get tax relief - a tax deductible alternative to depreciation. The effect of this is to
reduce the amount of tax that organisations are required to pay.

In dealing with these tax effects it is always assumed that:

Where a tax loss arises from the project, there are sufficient taxable profits elsewhere in
the organisation to allow the loss to reduce any relevant (subsequent) tax payment (and it
may therefore be treated as a cash inflow) and that the company has sufficient taxable
profits to obtain full benefit from capital allowances.

In practice, the effects of taxation are complex and are influenced by a number of factors
including the following the taxable profits and tax rate, the company’s accounting period and tax
payment dates, capital allowances, and losses available for set-off.

But many of these issues are ignored or simplified for the purposes of NPV investment appraisal.

Capital Allowances/WDAs
For tax purposes, a business may not deduct the cost of an asset from its profits as depreciation
(in the way it does for financial accounting purposes). Instead the cost must be deducted from
taxable profits in the form of ‘capital allowance or WDAs. The basic rules are as follows:
WDA are calculated on a reducing balance basis (usually at a rate of 25%).
The total WDAs given over the life of an asset equate to its fall in value over the period
(i.e. the cost less any scrap proceeds).
WDAs are claimed as early as possible.
WDAs are given for every year of ownership except the year of disposal.
In the year of sale or scrap a balancing allowance (BA) or balancing charge arises (BC).

Example 9: Balancing Allowance or Charge

Investment Decision P a g e 22 | 33
An asset was purchased for Shs 100 million. At the time of its disposal the cumulative capital
allowances claimed over the life of the asset were Shs 68,000,000.

Calculate the balancing allowance or balancing charge if the asset is disposed of for Shs
20,000,000.

Solution
a) Particulars Shs’000
Original cost of asset 100,000
Cumulative capital allowances claimed (68,000)
Written down value of the asset 32,000
Disposal value of the asset (20,000)
BA (a deduction against profits) 12,000

For tax purposes care must be taken to identify the exact time of asset purchase. Assets are
assumed to be bought at T0. This could be the very end of an accounting period (e.g. 31.12.2010)
or the start of another (e.g. 1.1.2011).

Asset Bought at the Start of an Accounting Period

31.12.00 = 1.1.01 31.12.01 = 1.1.02 31.12.02 = 1.1.03 31.12.03 = 1.1.04
T0 T1 T2 T3

First year of ownership Year of disposal

Asset 1st WDA 2nd WDA claimed Asset sale

purchased claimed (against profits (against profits No WDA
1.1.01 earned in period earned in period given but
1.1.01-31.12.01 1.1.02-31.12.02) BA/BC
1st tax paid (on profits set against profits
earned in the period earned in the
1.1.01-31.12.01) and period
Investment Decision P a g e 23 | 33
 therefore benefit of 1.1.03-31.12.03
1st WDA gained
Asset Bought at the End of an Accounting Period
31.12.00 = 1.1.01 31.12.01 = 1.1.02 31.12.02 = 1.1.03 31.12.03 = 1.1.04
T0 T1 T2 T3

First year Year of disposal

of ownership

Asset 2nd WDA 3rd WDA claimed Asset sale

purchased claimed (against profits (against profits No WDA
31.12.00 earned in period earned in period given but
1.1.01-31.12.01) 1.1.02-31.12.02) BA/BC
1st WDA 1st tax paid (set against
claimed (on profits earned in profits earned
(against profits earned the period ended in the period
in the period ended 31.12.00) and 1.1.03-31.12.03)
31.12.00) therefore benefit of 1st WDA gained
Example 10: NPV Including Tax
An asset is bought on the first day of the year for Shs 10,000,000 and will be used on a project
for four years after which it will be disposed of on the final day of year 4. Tax is payable at 30%
one year in arrears and capital allowances are available at 25% reducing balance.

Required:
Calculate the WDA and hence the tax savings for each year if the proceeds on disposal of the
asset are Shs 2,500,000.

Solution
Time Shs Tax saving @ 30% Timing of tax relief
T0 Initial investment 10,000,000
T1 WDA @ 25% (2,500,000) 750,000 T2
Investment Decision P a g e 24 | 33
 Written down value 7,500,000
T2 WDA @ 25% (1,875,000) 562,500 T3
Written down value 5,625,000
T3 WDA @ 25% (1,406,250) 421,875 T4
Written down value 4,218,750
T4 Sale proceeds (2,500,000)
T4 BA 1,718,750 515,625 T5

Incorporating Working Capital

Investment in a new project often requires an additional investment in working capital, i.e. the
difference between short-term assets and liabilities. The treatment of working capital is as
follows:
Initial investment is a cost at the start of the project.
If the investment in working capital is increased during the project, the increase is a
relevant cash outflow.
At the end of the project all the working capital is ‘released’ and treated as a cash inflow.

To calculate the working capital, cash flows you should:

1) Calculate the absolute amounts of working capital needed in each period.
2) Work out the incremental cash flows required each year.

Example 11: Working Capital

A company expects sales for a new project to be Shs 225,000,000 in the first year growing at 5%
pa. The project is expected to last for 4 years. Working capital equaling to 10% of annual sales is
required and needs to be in place at the start of each year.

Required: Calculate the working capital flows for incorporation into the NPV calculation.
Solution
Step 1: Calculate the absolute amounts of working capital needed over the project
T0 T1 T2 T3 T4
Investment Decision P a g e 25 | 33
 Shs’000 Shs’000 Shs’000 Shs’000 Shs’000
Sales 225,000 236,250 248,063 260,466
WC (10% sales) 22,500 23,625 24,806 26,047

Step 2: Work out the incremental investment required each year (remember that the full
investment is released at the end of the project):
T0 T1 T2 T3 T4
Shs’000 Shs’000 Shs’000 Shs’000 Shs’000
Working 22,500 - 23,625 - 24,806 - 26,047 - 26,047 -
0 22,500 23,625 24,806 0
Working capital (22,500) (1,125) (1,181) (1,241) 26,047

Example 11: NPV with Tax and Inflation

Uganda Clays Ltd is considering a potential project with the following forecasts:
Now T1 T2 T3
Initial investment (Shs million) (100)
Disposal proceeds (Shs million) 20
Demand (Thousands of units) 5 10 6
The initial investment will be made on the first day of the new accounting period. The selling
price per unit is expected to be Shs 1,000 and the variable cost Shs 300 per unit. Both of these
figures are given in today’s terms.

Tax is paid at 30%, one year after the accounting period concerned and WDA’s are available at
25% reducing balance. The company has a real required rate of return of 6.8%.

General inflation is predicted to be 3% pa but the selling price is expected to inflate at 4% and
variable costs by 5% pa.

Required: Determine the NPV of the project.

Solution
Investment Decision P a g e 26 | 33
Particulars T0 T1 T2 T3 T4
Shs Shs Shs Shs Shs
Sales (W-1) 5,200,000 10,816,000 6,749,184
Variable costs (W-1) (1,575,000) (3,307,500) (2,083,725)
Net trading inflows 3,625,000 7,508,500 4,665,459
Tax payable (30%) (1,087,500) (2,252,550) (1,399,638)
Initial investment 100,000,000
Sales proceeds 20,000,000
Tax relief on WDAs
(W-2) 7,500,000 5,625,000 10,875,000
Net cash flows (100,000,000) 3,625,000 13,921,000 28,037,909 9,475,362
DF @ 10% (W-3) 1.000 0.909 0.826 0.751 0.683
PV (100,000,000) 3,295,125 11,498,746 21,056,470 6,471,672
NPV = 57,677,987
W-1: Revenue and Costs
Revenue and costs need to be expressed in money terms.
E.g. revenue at T2 = Shs [10,000 x 1,000 x (1.04)2] = Shs 10,816,000
Cost at T2 = Shs [10,000 x 300 x (1.05)2] = Shs 3,307,500

W-2: WDAs
Time Shs Tax saving @ 30% Timing of tax relief
T0 Initial investment 100,000,000
T1 WDA @ 25% (25,000,000) 7,500,000 T2
Written down value 75,000,000
T2 WDA @ 25% (18,750,000) 5,625,000 T3
Written down value 56,250,000
Sales proceeds (20,000,000)
T3 BA 36,250,000 10,875,000 T4
W-3: Discount rate
(1+ m) = (1+ r) x (1+ i) = 1.068 x 1.03 = 1.10, giving a money rate (m) = 10%.
Investment Decision P a g e 27 | 33
Capital Rationing
Capital rationing is a situation whereby a budget ceiling exists and the firm may not invest in all
acceptable investment projects. This means that the investment must be undertaken in phases (a
project is divided into stages of investment). Where capital rationing is involved, the discounted
cash flow technique becomes inappropriate and the analyst has to use the cost benefit index.

The Causes of Capital Rationing

There are two causes of capital rationing, namely:
The hard (external) capital rationing - Although, theoretically, finance is always
available at a price, in practice most lending institutions decide that there is a point
beyond which they will not lend, at any price. This may provide an absolute limit to the
funds available. This may be due to:
 Industry wide factors limiting funds.
 Company specific factors such as: lack of or poor track records, lack of asset security,
poor management team.
The soft (internal) capital rationing - Particularly following a period of economic
depression, many firms may be more concerned with survival than growth. In order to
minimise risk, they adopt conservative growth and financing policies. Also, they would
want to maintain stable dividends rather than use cash for expansion.

Whether the restriction is caused by internal or external causes doesn’t affect the analysis.
Capital rationing might therefore exist for reasons other than inability to obtain additional
capital:
A company might be aware that when proposals are made for new capital investments,
the managers who put forward the proposals are often over-optimistic in their
expectations and with their forecasts. Imposing capital spending limits can be a way of
weeding out weak or marginal investments, by making them compete for funds with
stronger and profitable projects. This can be a crude but effective way of reducing the
risk of making poor investments.

Investment Decision P a g e 28 | 33
 A company might be able to raise new finance externally, but decides on a strategy of
organic growth. An advantage of organic growth is that the benefits of growth should all
be enjoyed by the existing shareholders. However, a strategy of organic growth inevitably
places restrictions on the amount of investment capital available.
A company might be able to raise additional capital by borrowing externally. However,
higher borrowing has implications for financial risk, through higher financial gearing. A
company might therefore impose limits on its external borrowing by setting a limit to its
gearing level.

Types of Capital Rationing

Two types of capital rationing may be distinguished:
1) Single period - Shortage of funds now, but funds are expected to be freely available in all
later periods.
2) Multi- period - Where the period of funds shortage is expected to extend over a number
of years or even indefinitely.

Project Divisibility
Projects may be divided into two categories, divisible and non-divisible projects. With divisible
Projects either the whole project or any fraction of the project, may be undertaken. If a fraction
only is undertaken, then both initial investment and cash inflows are reduced pro rata. Quoted
shares represent a divisible investment - varying numbers of shares may be purchased with
resultant pro-rating of investment returns. Indivisible projects must be undertaken in its entirety,
or not at all. Decisions about introducing new product ranges are indivisible - either new
products are introduced or they’ are not.

In reality, almost all projects are indivisible. However, the assumption of divisibility enables the
easier use of mathematical tools.

Single-Period Capital Rationing, Divisible Projects

Investment Decision P a g e 29 | 33
Maximising NPV is achieved in these circumstances by ranking projects according to their
profitability index (cost-benefit ratio), then allocating funds accordingly until they are exhausted.
The profitability index of a project is the NPV per shilling invested.

Example 12: Single-Period Capital Rationing, Divisible Projects

Okello Investments Ltd with a cost of capital of 10% has Shs 40 million available for investment
in year 0. Four (4) divisible projects are available.
Project Outlay Receipts (cash flows)
Year 0 Year I Year 2 Year 3 Year 4
Shs’000 Shs’000 Shs’000 Shs’000 Shs’000
1 100,000 40,000 100,000 80,000 60,000
2 30,000 40,000 40,000 40,000 40,000
3 20,000 40,000 30,000 40,000 50,000
4 40,000 20,000 30,000 30,000 30,000
You are required to calculate the optimal investment policy.

Solution

Project 1
Year Cash flow (Shs’000) DF at 10% PV (Shs’000)
0 (100,000) 1.000 (100,000)
1 40,000 0.909 36,360
2 100,000 0.826 82,600
3 80,000 0.751 60,080
4 60,000 0.683 40,980
NPV= 120,020

Project 2
Year Cash flow (Shs’000) DF at 10% PV (Shs’000)
0 (30,000) 1.000 (30,000)
1 40,000 0.909 36,360
Investment Decision P a g e 30 | 33
 2 40,000 0.826 35,040
3 40,000 0.751 30,040
4 40,000 0.683 27,320
NPV= 98,760
Project 3
Year Cash flow (Shs’000) DF at 10% PV (Shs’000)
0 (20,000) 1.000 (20,000)
1 40,000 0.909 36,360
2 30,000 0.826 24,780
3 40,000 0.751 30,040
4 50,000 0.683 34,150
NPV= 105,330

Project 4
Year Cash flow (Shs’000) DF at 10% PV (Shs’000)
0 (40,000) 1.0000 (40,000)
1 20,000 0.909 18,180
2 30,000 0.826 24,780
3 30,000 0.751 22,530
4 30,000 0.683 20,490
NPV= 45,980

Project NPV at 10% Profitability indices (NPV/Cost) Ranking

Shs’000
1 120,020 1.200 3
2 98,760 3.292 2
3 105,330 5.267 1
4 45,980 1.150 4
Investment Decision P a g e 31 | 33
 370,090

Summary of optimal plan for X Ltd

Project Fraction of the project accepted Outlay at time 0 NPV
Shs’000 Shs’000
3 1.00 20,000 105,330
2 2/3 20,000 65,840*
Capital used and available 40,000
NPV obtained 171,170
*Two-thirds of Shs 98,760,000.

Single-Period Capital Rationing, Indivisible Projects

In these circumstances the objectives can only be achieved by selecting from amongst the
available projects on a trial and error basis. Because of the problem of indivisibility this may
leave some funds unutilised.

Example 13: Single-Period Capital Rationing, Indivisible Projects

XY Ltd has Shs 50 m available to invest. Its cost of capital is 10%. The following indivisible
projects are available (Note: For single period capital rationing between indivisible projects, use
trial and error).
Project Initial outlay Return p.a perpetuity
Shs’000 Shs’000
1 20,000 1,500
2 10,000 1,500
3 15,000 3,000
4 30,000 5,400
5 25,000 4,800

Solution
The first stage to calculate the NPV of the projects
Project Initial outlay PV of cash flows PV
Investment Decision P a g e 32 | 33
 Shs’000 Shs’000 Shs’000
1 20,000 15,000 (5,000)
2 10,000 15,000 5,000
3 15,000 30,000 15,000
4 30,000 54,000 24,000
5 25,000 48,000 23,000
Note: PV of perpetuity = Annual receipt
Discount rate as a proportion

Employing the combination method to get the optimal mix

Project Combinations Combined outlay Combined NPV
Shs’000 Shs’000
123 45,000 15,000
14 50,000 19,000
235 50,000 43,000
34 45,000 39,000
The optimal selection of projects is as follows
Projects Initial Outlay NPV
Shs’000 Shs’000
2 10,000 5,000
3 15,000 15,000
5 25,000 23,000
50,000 43,000
Unused funds NIL
Funds available 50,000

Investment Decision P a g e 33 | 33