Chapter V:Investment Decision Making /Capital Budgeting

• Capital budgeting is the process of planning for purchases of long-term assets.

In other words, Capital Budgeting is a process of undertaking Project
Decision/Capital Investment Decision/Long-term Investment Decision or
Capital Expenditure Decision.
• Objectives of Capital Budgeting
• The following are the .important objectives of capital budgeting:
(1) To ensure the selection of the possible profitable capital projects.
(2) To ensure the effective control of capital expenditure in order to achieve by
forecasting the long-term financial requirements.
(3) To make estimation of capital expenditure during the budget period and to see
that the benefits and costs may be measured in terms of cash flow.
(4) Determining the required quantum takes place as per authorization and
sanctions.
(5) To facilitate co-ordination of inter-departmental project funds among the
competing capital projects.
(6) To ensure maximization of profit by allocating the available investible.
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 Principles or Factors of Capital Budgeting Decisions

• A decision regarding investment or a capital budgeting decision involves the

following principles or factors:
(1) A careful estimate of the amount to be invested.
(2) Creative search for profitable opportunities.
(3) A careful estimates of revenues to be earned and costs to be incurred in future
in respect of the project under consideration.
(4) A listing and consideration of non-monetary factors influencing the decisions.
(5) Evaluation of various proposals in order of priority having regard to the
amount available for investment.
(6) Proposals should be controlled in order to avoid costly delays and cost over-
runs.
(7) Evaluation of actual results achieved against those budget.
(8) Care should be taken to think all the implication of long range capital
investment and working capital requirements.
(9) It should recognize the fact that bigger benefits are preferable to smaller ones
and early benefits are preferable to latter benefits.
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 Capital Budgeting Process
• The following procedure may be considered in the process of capital
budgeting decisions:
(1) Identification of profitable investment proposals.
(2) Screening and selection of right proposals.
(3) Evaluation of measures of investment worth on the basis of profitability and
uncertainty or risk.
(4) Establishing priorities, i.e., uneconomical or unprofitable proposals may be
rejected.
(5) Final approval and preparation of capital expenditure budget.
(6) Implementing proposal, i.e., project execution.
(7) Review the performance of projects.

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 Steps in the Capital Budgeting Process

• The capital budgeting process is so critical to the survival of a firm that it is

worth discussing the full scope of the capital budgeting process, rather than
simply how the evaluation tools are computed. We can identify five steps that
a firm should follow.
1. Identification of opportunities: Initially, the firm must have some method in
place by which new opportunities are identified and brought to the attention
of management.
2. Evaluation of opportunities: Once the firm identifies an opportunity, it must
be evaluated. This requires that all of the costs and benefits be tabulated.
These data are then subjected to analysis.
3. Selection: Often firms have more good projects than they can accept in any
given year. This may be because of limited funds or because of human or
physical constraints facing the firm. In this chapter we look at how a firm
might rank projects to facilitate selecting among them.

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 Cont …
4. Implementation: Once a project has been selected, it must be implemented.
The machines will be purchased, people hired, or investments made.
Management must be vigilant at this stage to ensure that the costs reflect what
was initially proposed and evaluated.
5. Post audit: Once the project has been completed, management must compare
the costs and revenues with the original projections. This is a critical step that
is often overlooked.
Taken together, these steps can dramatically improve a firm’s ability to select
wealth increasing projects, bring them to fruition, and learn from each
experience.

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 Types of Capital Budgeting Proposals

• A firm may have several investment proposals for its consideration. It may
adopt after considering the merits and demerits of each one of them. For
this purpose capital expenditure proposals may be classified into :
(1) Independent Proposals/project
(2) Dependent Proposals or Contingent Proposals /project
(3) Mutually Exclusive Proposals project

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 Cont …
(1) Independent Proposals: These proposals are said be to economically
independent which are accepted or rejected on the basis of minimum return on
investment required. Independent proposals do not depend upon each other.
(2) Dependent Proposals or Contingent Proposals: In this case, when the acceptance
of one proposal is contingent upon the acceptance of other proposals. it is called
as "Dependent or Contingent Proposals." For example, construction of new
building on account of installation of new plant and machinery.
(3) Mutually Exclusive Proposals: Mutually Exclusive Proposals refer to the
acceptance of one proposal results in the automatic rejection of the other
proposal. Then the two investments are mutually exclusive. In other words, one
can be rejected and the other can be accepted. It is easier for a firm to take
capital budgeting decisions on such projects.
•

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 Characteristics of Capital Budgeting Decision

• Following are important characteristics of Capital Budgeting Decision:

1. Substantial investment: As compared to working capital decision, Capital
Budgeting Decision requires substantial investment.
2.Long-term effect: Capital budgeting decision provides long-term effect i.e. up
to the life of the project.
3.Irreversibility: Capital Budgeting Decision once taken cannot be reversed
otherwise it will involve substantial cost.

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 Difficulties associated with Capital Budgeting Decision

• Following are difficulties associated with capital budgeting decision:

1. Uncertainty regarding expected benefits: In capital budgeting decision,
investment is made today whereas benefits are received in future and since future
is always uncertain, expected benefits therefore remain in uncertainty.
2. Measurement problem: Because of uncertainties associated with future due to
change in external factors like technological, political, social and economical
etc., it becomes difficult to measure cost and benefits associated with capital
budgeting decision.
3. Problems in equating Cost and Benefits: In capital budgeting decisions, cost and
benefits are spread over a long period of time. This creates difficulty in
estimating discount rates and hence in equating cost and benefits.

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 Cont ….
• There are two aspects of Capital Budgeting Decision viz. Financing
Decision and Investment Decision.

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Cont …

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 2.2. Investment appraisal techniques

• Methods of Evaluating Capital Investment Proposals

• There are number of appraisal methods which may be recommended for
evaluating the capital
I. Traditional Methods/Non-Discounting method
• Traditional methods are grouped in to the following :
(1) Pay-back period method or Payout method.
(2) Improvement of Traditional Approach to Pay-back Period Method
(a) Post Pay-back profitability Method.

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 Cont ….
(b) Discounted Pay-back Period Method.
(c) Reciprocal Pay-back Period Method.
(3) Accounting Rate of Return Method.
II. Time Adjusted Method or Discounted Cash Flow Method
(1) Net Present Value Method.
(2) Internal Rate of Return Method.
(3) Profitability Index Method.

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 Cont …
• 2.2.1. Non Discounted cash flow techniques
1. Payback Period Method
• The payback period method is the easiest investment evaluation method to
perform, but the theoretically worst method available. The payback is
simply the number of years it takes to recover the initial investment. The
timing and riskiness of the cash flows are ignored. The reason it continues
to be used is that it is easy to understand and explain to others. Small
businesses are especially likely to use the payback method if the owners or
managers are not well versed in financial principles.

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 Cont ….
• Computation
• The calculation of the payback is very easy if the annual cash flows are
annuities (remember that annuities are equal payments received at equal
intervals). The payback is found by dividing the initial investment by the
annual annuity.
• Payback = Initial investment
• Annual cash inflow
• Case 1: Lindeman’s wants to expand production to take advantage of the
increased sales. Assume that expansion of its winery will cost $1,000,000. If
this will generate after-tax cash inflows of $235,000 for 6 years, what is the
payback?
• Pp= 1000, 000/235,000= 4.25 years
•

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 Cont …

• If the cash flows vary from year to year, they must be accumulated until
the sum equals the initial investment. Partial years can be estimated.
• Case 2: Suppose after reviewing its cash flow estimates, Lindeman’s
decides that the publicity provided by the Consumer will wear off over
time. As a result, cash inflows would decline 10% the first year and then
15% per year thereafter. What is the payback?

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 Cont …
Year Initial Cash inflow Accumulated Balance
investment inflow
0 -1000,000 0 0 -1000,000

1 $235,000 235,000 -765,000

2 211,500 446,500 -553,000

3 179,775 626,275 -373,725

4 152,808.75 779,083.75 -220,919.25

5 129,887.44 908,971.19 -91,028.81

6 110,404.32 1,019,375.51 +19,375.51

PP= 5year + (91,028.81/110,404.32)*12months =5years +9.89months

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 Cont …
• Decision Rule:
• The PBP can be used as a decision criterion to select investment proposal.
1. If the PBP is less than the maximum acceptable payback period, accept the project.
2. If the PBP is greater than the maximum acceptable payback period, reject the project.
• Advantages
• The principal advantage of the payback method is its simplicity. It also provides
information about how long funds will be tied up in a project. The shorter the payback,
the greater the project’s liquidity, and the higher probability of acceptance.
• Disadvantages
• There are many problems with the payback method.
• No clearly defined accept/reject criteria: Is a 4-year payback good or bad? We do not
have a method to determine this. Often a payback of 2 or 3 years is required, but
clearly this is arbitrary.
• No risk adjustment: Risky cash flows are treated the same way as low-risk cash flows.
The required payback period could be lengthened for low-risk projects, but the exact
adjustment is still arbitrary.
• Ignores cash flows beyond the payback period: Any cash inflows that occur after the
payback period are excluded from the analysis. This is clearly a short-sighted way to
view investments.
• Ignores time value of money: 18
 Class Activity 1:
• Years 0 1 2 3
• Project x cash flow in birr -1000 500 300 200
• Project y cash flow -1000 200 300 500

Which project is preferable ? 2.5 pts

Why ? 2.5 pts

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 Cont …
(b) Discounted Pay-back Method: This method is designed to overcome the
limitation of the payback period method. When savings are not levelled, it is
better to calculate the pay-back period by taking into consideration the present
value of cash inflows. Discounted pay-back method helps to measure the
present value of all cash inflows and outflows at an appropriate discount rate.
The time period at which the cumulated present value of cash inflows equals
the present value of cash outflows is known as discounted pay-back period.
• Example
• The company is considering investment of birr 100,000 in a project. The
following are the income forecasts, after depreciation and tax, 1st year birr
10,000, 2nd year birr 40,000, 3rd year birr 60,000, 4 th year birr 20,000 and 5th
year birr Nil.
• From the above information you are required to calculate: (1) Pay-back Period
(2) Discounted Pay-back Period at 10% interest factor.

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 Cont …
Year (1) Cash inflow (2) PVCF@10%(3) PV cash inflow(4) =2*3 Cumulative value of
cash in flow (5)

1 10,000 0.9091 9091 9091

2 40,000 0.8265 33,060 42,151

3 60,000 0.7513 45,078 87,229

4 20,000 0.6830 13,660 100,889

5 - 0.6209 - 100,889

Discounted pay back period = 3years + 100,000-87229/13,660= 3.935 years

pay back period = 2+ (50,000/110,000)*12= 2.9

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 Cont …
• (3) Average Rate of Return Method (ARR) or Accounting Rate of Return Method:
• Average Rate of Return Method is also termed as Accounting Rate of Return
Method. This method focuses on the average net income generated in a project
in relation to the project's average investment outlay. This method involves
accounting profits not cash flows and is similar to the performance measure of
return on capital employed. The average rate of return can be determined by the
following equation:
• Average Rate of Return (ARR) = Average Income x 100
Average Investments
• Where,
• Average investment would be equal to the Original investment plus salvage value
divided by Two
• Average Investment = Original Investment
2
• (or)
• Original Investment - Scrap Value of the Project
• 2
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 Cont …
• Advantages
(1) It considers all the years involved in the life of a project rather than only pay-
back years.
(2) It applies accounting profit as a criterion of measurement and not cash flow.
• Disadvantages
(1) It applies profit as a measure of yardstick not cash flow.
(2) The time value of money is ignored in this method.
(3) Yearly profit determination may be a difficult task.
• Example
• From the following information you are required to find out Average Rate of
Return: An investment with expenditure of $ l, 000,000 is expected to
produce the following profits (after deducting depreciation)
Cash in flows :
• 1st Year………….. $80,000
• 2nd Year …………..$ 160,000
• 3rd Year ……………$180,000
• 4th Year ………………$60,000 23
 Cont …
• Required:
• Calculate the Accounting Rate of Return
• Average annual profit = 80,000+160,000+180,000+60,000 =$120,000
4
• Average Investment = begging investment + Investment at end
2
• =1000,000 + 0 = $50,000
2
• Average rate of return =120,000/50,000*100%=24%

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 2.2.2. Discounted cash flow techniques

• 1. Net Present Value Method (NPV): This is one of the Discounted Cash
Flow techniques which explicitly recognize the time value of money. In this
method all cash inflows and outflows are converted into present value (i.e.,
value at the present time) applying an appropriate rate of interest (usually
cost of capital).
• The NPV is the difference between the present value of future cash inflows
and the present value of the initial outlay, discounted at the firm’s cost of
capital. The procedure for determining the present values consists of two
stages. The first stage involves determination of an appropriate discount rate.
With the discount rate so selected, the cash flow streams are converted into
present values in the second stage.
• Equation for Calculating Net Present Value:
• In the case of conventional cash flows. i.e., all cash outflows are entirely
initial and all cash inflows are in future years, NPV may be represented as
follows:
• NPV=∑ [CF1 + CF2 +…CFn] –I (initial investment)
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• (1+k)1 (1+k)2 (1+k)n
 Cont ….
• Decision Rule:
• If the NPV is greater than 0, accept the project.
• If the NPV is less than 0, reject the project.
• Advantages of Net Present Value Method
(1) It recognizes the time value of money and is thus scientific in its approach.
(2) All the cash flows spread over the entire life of the project are used for
calculations.
(3) It is consistent with the objectives of maximizing the welfare of the owners as
it depicts the positive or otherwise present value of the proposals.
• Disadvantages
(1) This method is comparatively difficult to understand or use.
(2) When the projects in consideration involve different amounts of investment,
the Net Present Value Method may not give satisfactory results.
•

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 Cont …
• Example 1:
• A project cost birr 25,000 and it generates cash inflows through a period of
five years birr 9,000, 8,000, 7,000, 6,000 and 5,000. If the required rate of
return is assumed to be 10%. Find out the Net Present Value of the project.

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 Cont …
Year Cash in flows PV Discounted CF
PV
1 9,000 0.9091 8,181

2 8,000 0.8265 6,608

3 7,000 0.7513 5,257

4 6,000 0.6830 4,098

5 5,000 0.6209 3,100

∑total PV 27,244

NPV= 27,244-25,000=2,244

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 Cont…
• The NPV of the project is positive and it can be accepted for investment.
• Note :
• When using the net present value method of capital budgeting, one of most
important factors is the estimation of net cash flows from an investment. The net
cash flow is the difference between cash outflows and cash inflows over the life
of the investment. First, cash flows should be calculated on an incremental
basis, and include changes in operating cash flows and changes in investment
cash flows. Second, cash flows must be measured on an after-tax basis. Third,
non-cash expenses are also considered; for example, depreciation is an expense
item but not a cash flow.

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 Self Exercise 1

• NP Ltd is considering an initial investment of $100,000 in order to open a new

production line for a new product. The expected life of the production line is
four years. Sales are estimated to be $100,000 during the first year and to
increase by 10% per year until the fourth year. The variable costs of the
producing the product are 50% of sales and the additional fixed costs are
$15,000 per year. The simplified straight-line depreciation method is used to
calculate depreciation. NP Ltd is subject to tax rate of 40% and also expects to
recover $10,000 of its working capital at the end of the fourth year.
• Required:
1. Determine the net cash flow of the firm during each year ,If NP Ltd expected
cost of capital is 12%, Determine the NPV of
2. Decide whether the production line should be accepted or rejected

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 Hint ….
Estimated CF Year 1 Year 2 Year 3 Year 4

Sales 100,000 110,000 121,000 133,100

(Vc) (50,000) (55,000) (60,500) (66,550)

(Fc) (15,000) (15,000) (15,000) (15,000)

(Depriciation) (22,500) (22,500) (22,500) (22,500)

EBT 12,500

(Tax) (5,000)

EAT 7,500

+ Depriciation 22,500 22,500 22,500 22,500

=NoCF 30,000

+Terminal Cash - - - +Salvage value

flow (recovery in WC)

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 End of chapter V
Thank you for your attention !

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