CHAPTER- FIVE

CAPITAL BUDGETING
DECISION
 Introduction

 One of the important functions of financial

management is investment decisions.

 The success of a business unit depends upon the

investment of resource in such a way that brings in
benefits or best possible returns from any investment.
 Cont’d……
 If the financial resources were in plenty, it would be
possible to accept several investment proposals which
satisfy the norms of approval. .

 However , we are sure that resources are limited; a

choice has to be made among the various investment
proposals by evaluating their comparative merit.
 Cont’d……..
 This would help us to select the relatively superior
proposals keeping in view the limited available
resources.
 For this purpose, we have to develop some evaluating
techniques for the appraisal of investment proposals.
5.1.1 Definition and Importance of capital budgeting

Capital Budgeting: is the process of planning expenditures on

assets whose cash flows is expected to extend beyond one year.

Three steps are involved in the evaluation of an

investment:
 Estimation of cash flows,

 Estimation of the required rate of return (the

opportunity cost of capital),
 Application of a decision making rule.
 Cont’d…..
Annual Cash Flows: The calculation of annual cash
flows in investment appraisal plays a key role.

 The computation of cash flows is a simple

task. The following areas are to be considered.

 Sales revenue: This is going to be the function of
sales any wrong calculation in this regard will bear
impact on the investment opportunity.
 Cont’d…..

 In simple terms, Annual cash flow is equivalent to

Net profit after tax plus depreciation. Procedurally,
 ACF = Sales – (Operating expenses + Non-
operating expense + Tax) + Depreciation
 5.2. Investment analytical tools.

There are two important methods of evaluating the investment

proposals

Traditional/Non-discounting method
 Payback period
 Accounting rate of return

Discounted cash flow method

 Net present value

 Profitability Index method / Benefit cost Ratio

 Internal Rate of Return

 5.2.1. Traditional /Non discounting method

a. Payback period
This method is one of the widely used methods for

evaluating the investment/project proposals.

 It is the amount of time needed to recover the initial

investment.
 This method does not take into account after payback

cash inflows that are received by the investors.

 Cont’d….
 There are two methods in use to calculate the payback period

1) Where annual cash flows vary from year to year

2) where the annual cash flows are uniform

Decision rule
Project which has shorter payback period is better.

 1. Unequal cash flows

P = E + B/C
 Cont’d……
 Where, P= Payback period.

E= Number of years immediately preceding the year of final

recovery.

B= The balance amount still to be recovered.

C= Cash flow during the year of final recovery.

 Example
Project A Project B
Year Cash Cumulative Year Cash flows Cumulative
flows Br. cash flows Br cash flows

0 -700 -700 0 -700 -700

1 100 -600 1 400 -300

2 200 -400 2 300 0

3 300 -100 3 200 200

4 400 300 4 100 300

5 500 800 5 0 -
 Cont’d…..
Project A Project B
P = E + CB P=E+ B
C
3+ 100/400 2 +0
= 3.25 year 2 Years
2. Uniform cash flows:
Where the annual cash flows are uniform
PB Original investment
Annual cash flows

Example: A project requires an investment of Br. 100, 000; it

will generate annual cash flow of Br. 25,000 per year.
Calculate the payback period.

PB Original investment = 100,0000

 Annual cash flows 25,000

= 4 years
 b. Accounting rate of return
 This method is based on the financial accounting practices of the

company working out the annual profits.

 Here, instead of taking the annual cash flows, we take the annual

profits into account.

 The net annual profits are calculated after deducting depreciation

and taxes.

 The average of annual profits thus derived is worked out on

the basis of the period.

ARR A v e r a g e a n n u a l p r o fits a fte r ta x e s
 100
A v e r a g e in v e s tm e n t o v e r th e life o f p r o je c t
Average investment = Net working capital + Salvage value + ½ (Initial
cost of plant + installation charges – salvage value)
Net working capital = current assets – current liabilities

Average annual profits after tax =

Total of annual profits
Number of years

Decision rule
If ARR > RRR = Accept the project

If ARR < RRR = Reject the project

 Example
 Initial investments of plant $10, 000

 Installation costs $1, 000

 Salvage value $1, 000

 Working capital $1, 000

 Life of plant 5 years
 Annual profit per year $2, 500

The required rate of return for investor is 25 %

Based on the above information calculate ARR?

 Solution
Average profit = 2, 500 x 5 = 12,500/5 = 2, 500

Average investment = NWC + Sal.V. + ½ (Cost + Inst. Charges –

Salv. Val)

= 1, 000 + 1, 000 + ½ (10, 000 + 1, 000 – 1, 000)

= 2, 000 + ½ (10, 000)
= 2, 000 + 5, 000
= 7, 000

ARR = 2,500/ 7000 x 100

= 35.71% ≈ 36 %
Decision :Accept the project
 Non discounted evaluation criteria is not
consistent with the concept of wealth
maximization
 5.2.2 Discounted cash flow method

These Investment Evaluation Methods is consistent

with the concept of wealth maximization:
 Include all cash flows that occur during the life of
the project,
 Consider the time value of money (discounted
methods):
 It considers all cash flows
 Cont’d…..
 The decision rule should consider the riskiness of
cash flows.
 The decision rule should always rank projects so
that those projects that add the most to the value of
the firm are ranked highest.
 Should help to choose among mutually exclusive
projects which maximizes the shareholders wealth.
 a) Net Present Value
The Net Present Value measures the value added by
investing in the project by explicitly recognizes the
time value of money.
NPV is the present value of an investment project’s net
cash flows minus the project’s initial cash outflow.
 Cont’d…….
 It correctly postulates that cash flows arising at
different time periods differ in value and are
comparable only when their equivalents Present
values are founded out.
 It is most consistent with the goal of owner’s wealth
maximization.
 Steps involved in the calculation of net present value:

I. Cash flows of the investment projects should be

forecasted based on realistic assumptions,

II. Appropriate discount rate should be identified to

discount the forecasted cash flows,
III. Present Value of cash flows should be calculated using
the opportunity cost of capital as the discount rate,
 Cont’d……..
Net Present Value should be found out by:
NPV = Present value of future cash flows-Initial out lay

NPV =  FCF - Initial outlay

(1+k)n
 Decision rule
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a return
Positive . . . greater than the required rate of
return.

Zero . . . Acceptable, since it promises a return

equal to the required rate of return.

Not acceptable, since it promises a

Negative . . . return less than the required rate of
return.
 Example
Assume Yirgalem PLC is considering to invest in a
cement project. It has on hand Br. 180,000. It is
expected that the project may work for seven years and
likely to generate the following annual cash flows and
the cost of capital is 8%. Calculate the Net present value
of the project.
Example
Year ACF
1 30,000
2 50,000
3 60,000
4 65,000
5 40,000
6 30,000
7 16,000
Solution
Comparing more projects by using NPV
 When to Reject Projects?

Rule: “Do not accept any project unless it generates a positive net
present value when discounted by the opportunity cost of funds”

Examples:

 Project A: Present Value Costs $1 million, NPV + $70,000

 Project B: Present Value Costs $5 million, NPV - $50,000

 Project C: Present Value Costs $2 million, NPV + $100,000

 Project D: Present Value Costs $3 million, NPV - $25,000

Result:

 Only projects A and C are acceptable.

b. When You Have a Budget Constraint?
Rule: “Within the limit of a fixed budget, choose that subset of the available
projects which maximizes the net present value
Example: If budget constraint is $4 million and 4 projects with positive NPV:

 Project E: Costs $1 million, NPV + $60,000

 Project F: Costs $3 million, NPV + $400,000

 Project G: Costs $2 million, NPV + $150,000

 Project H: Costs $2 million, NPV + $225,000

 Result:

 Combinations FG and FH are impossible, as they cost too much. EG and EH are

within the budget, but are dominated by the combination EF, which has a total NPV

of $460,000. GH is also possible, but its NPV of $375,000 is not as high as EF.
 When You Need to Compare Mutually Exclusive Projects?
 Rule: “In a situation where there is no budget constraint but a project
must be chosen from mutually exclusive alternatives, we should always
choose the alternative that generates the largest net present value”
Example:
Assume that we must make a choice between the following three
mutually exclusive projects:
 Project I: PV costs $1 million, NPV $300,000
 Project J: PV costs $4 million, NPV $700,000
 Projects K: PV costs $1.5 million, NPV $600,000
Result:
 Projects J should be chosen because it has the largest NPV.
 b. Internal rate of return (IRR)
 Internal rate of return (IRR) is the rate of interest which equates
the present value of future earnings with the present value of
investment or, equivalently, the rate that forces the NPV to
equal zero.

 It is also known as yield on investment, marginal efficiency of capital,

marginal productivity of capital, time adjusted rate of return and so on.

Decision Rule:
 If IRR > Required rate of return, accept

 If IRR < Required rate of return, reject

 Cont’d…..
 Therefore, IRR depends entirely on the initial
outlay and the cash proceeds of the project which
is being evaluated for acceptance or rejection.

 The computation of IRR is difficult one; you have

to start equating the two values i.e., present value
of future earnings and present value of investment.
 It is possible through trial and error method.
 Cont’d…..
 IRR can be calculated by trial and error procedure.

Where; IRR = Internal Rate of Return

OI = Original investment
LR = Lower Rate
LRPV = lower rate present value
HRPV = higher rate present values
RD = The difference between higher and lower rates of
discount.
 Example
 Yegermal Plc. has Br.100, 000 on hand. This amount
is invested in a project, where the annual benefits
after taxes are as below. Assume the required rate of
return/cost of capital is 10%
 The company would like to know the rate of return
earned by the company at the end of the life of the
project.
Example
 Table 5.1 Yigermal plc five year cash flow
Year ACFS
1 Br. 40, 000
2 35, 000
3 30, 000
4 25, 000
5 20, 000

Solution IRR
Benefit cost ratio (BCR)/ Profitability Index (PI)

 As its name indicates, the benefit-cost ratio (R), or what is

sometimes referred to as the profitability index,
 It is the ratio of the PV of the net cash inflows (or
economic benefits) to the PV of the net cash outflows (or
economic costs):
 Profitability Index cont’d…..
 PI is the ratio of the present value of the future free
cash flows to the initial outlay. It yields the same
accept/reject decision as NPV.
 PI = PV FCF/ Initial outlay

Decision Rule:

PI > 1 = accept

PI < 1 = reject

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Example
A firm with a 10% required rate of return is considering
investing in a new machine with an expected life of six
years. The initial cash outlay is $50,000.

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 PI Example
FCF PVF @ 10% PV

Initial Outlay -$50,000 1.000 -$50,000

Year 1 15,000 0.909 13,636

Year 2 8,000 0.826 6,612
Year 3 10,000 0.751 7,513
Year 4 12,000 0.683 8,196
Year 5 14,000 0.621 8,693
Year 6 16,000 0.564 9,032

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 Cont’d……..

 PI = (13,636 + 6,612+7,513 + 8,196 +

8,693+ 9,032) / 50,000
=Br 53,682/50,000
= 1.0736
 Project PI > 1, accept.
 NPV and PI
 Usually, PI is consistent with NPV

 When the present value of a project’s free cash

inflows are greater than the initial cash outlay, the
project NPV will be positive. PI will also be greater
than 1.
 NPV and PI will always yield the same decision.

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 Which technique is superior?
 The NPV and IRR methods make the same
accept/reject decisions for independent projects, but if
projects are mutually exclusive, ranking conflicts can
arise. Here, the NPV method should be used.
 Among all investment decision techniques NPV is
superior because NPV method fulfills all the criteria of
wealth maximization.

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 Capital budgeting under uncertainty
 While appraising of an investment project, importance is
given to the reliability of data assessed and of the project
design
 (marketing concept, sales program, project inputs,
technology, engineering design, management, personnel
and organization) as well as implementation of the
project.
 Cont’d…….
 To minimizing uncertainty, the financial analyst should
check whether the feasibility study covers all aspects
relevant to the investment and financing decisions.
 Cont’d……
The most common reasons for uncertainty, however, are:

 Inflation, changes in technology, false estimates of

rated capacity and length of construction and
running periods.

 Other reasons include changes in political, social,

and commercial and business environment, as well
as changes in technology, productivity and prices.
Coping mechanisms
Insurance: risk transfer
Insurance strategy can be successful only when the risks
are spread over a number of carefully selected
investments.
 Risk minimization

 “Do not keep all your eggs in one basket” Italy proverb

OH MY GOD!
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