CAPITAL BUDGETING
DECISIONS
1
Rosemary Nakkazi
LEARNING OBJECTIVES
By the end of this topic, students should be able to:
 Understand the key motives for capital
expenditure
 Define basic capital budgeting terminology
 Understand the role of capital budgeting
techniques in the capital budgeting process
 Calculate, interpret and evaluate the NPV, IRR,
and other capital budgeting techniques
2
Definition of capital budgeting
Capital budgeting is the process of evaluating and
selecting long term investments (capital expenditure
decisions) that are consistent with the firm’s goal of
maximizing owner wealth.
 Capital budgeting relates to the capital expenditure
decisions.
 Capital expenditure decisions may be defined as the
firm’s decisions to invest its current funds most
effectively in the long term activities in anticipation of
an expected flow of future benefits over a series of
years.
 The long term activities are those activities that affect
the firm’s operations beyond one year period.
3
Examples of capital expenditure include:
1.
Additions or extensions to the existing plant to increase
production.
2.
Replacing worn out machinery to increase the capacity
of existing facilities.
3.
Renewal, an alternative to replacement, may involve
rebuilding or overhauling an existing fixed asset.
4.
Addition of a new line of production or developing a
new product.
4
Steps in the capital budgeting process
1.
2.
3.
4.
5.
Generation of investment proposals.
Developing relevant data.
Evaluation and selection.
Implementation of the project.
Control and monitoring of the project.
5
Importance of capital budgeting decisions
1.
Such decisions affect the profitability of a firm.
2.
They involve significant amounts of capital known as
initial capital or cash outlay.
3.
The resources that are invested in a project are often
committed for a long period of time.
4.
They are irreversible due to the specialized nature of
assets acquired and the cost involved.
5.
The success or failure of the company may depend on
a single investment decision.
6.
These decisions involve relatively high levels of
uncertainty since they are future oriented.
7.
The majority of firms have limited capital resources.
6
Objectives of capital budgeting
1.
To evaluate the relative worth of capital projects and
to rank them in order of preferences.
2.
To ensure efficient control over large investments and
expenditures.
3.
To provide cash for meeting capital project programs.
4.
To analyze the impact of capital expenditure on the
profitability of the enterprise.
7
BASIC TERMINOLOGY
Independent versus mutually exclusive project
Independent projects are those whose cash flows
are unrelated or independent of one another, the
acceptance of one does not eliminate the others from
further consideration.
Mutually exclusive projects are those that have
the same function and therefore compete with one
another. The acceptance of one eliminates from
further consideration all other projects that serve a
similar function.
1.
8
CON’T
2.
Unlimited funds versus capital rationing
‘Unlimited funds’ is the situation in which a firm
is able to accept all independent projects that
provide an acceptable return. Typically though,
firms operate under capital rationing instead.
This means that they have only a fixed amount of
shillings available for capital expenditures and
that numerous projects will compete for these
shillings.
9
CON’T
3.
Accept-reject versus ranking approach
Two basic approaches to capital budgeting
decisions are available. The accept- reject
approach involves evaluating capital expenditure
proposals to determine whether they meet the
firm’s acceptance criterion. Here only acceptable
projects should be considered. The ranking
approach involves ranking projects on the basis
of some predetermined measure, such as the rate
of return. The project with the highest return is
ranked first. Only acceptable projects will be
ranked.
10
CASH FLOWS
Initial
 Operating
 Terminal

11
CAPITAL BUDGETING METHODS
(TECHNIQUES)
The best methods for evaluating projects should have
the following attributes:
i.
They must give minimum requirements of when
to accept or reject a project
ii.
They must be able to rank projects in order of
desirability
iii. They must consider all cash flows
iv. They must discount cash flows at the appropriate
determined discount rate
v.
They must allow managers to consider projects
independently from all others
12
TRADITIONAL METHODS
1.
These methods are traditional since they do not
give consideration to the time value of money.
They however are popular and are still widely
used.
i.
Payback period method
ii. Average rate of return (ARR) method or
return on investment method (ROCE).
13
AVERAGE RATE OF RETURN (RETURN ON
CAPITAL EMPLOYED)
This method utilizes information obtained in
financial statements to assess the viability of an
investment. This method divides the average
profits over the average book value of
investment after allowing for depreciation.
Average rate of return =
Average profit
x 100
Average investment
or
=
Average profits
x 100
Initial investment
This method is concerned with profit not simply cash flows.
14
DECISION CRITERIA


According to the ARR method, the higher the
ARR, the better the project.
In general, projects which have an ARR equal to
or greater than a target cut off rate of return are
accepted, others are rejected.(The target rate of
return will normally be the current return of
capital employed for the company ROCE)
15
EXAMPLE
A machine will cost $90,000.
It has an expected life of 5 years with a scrap value of
$10,000.
Expected net operating profits before depreciation and
tax each year are as follows:
 1
20,000
 2
22,000
 3
24,000
 4
26,000
 5
28,000
Depreciation is charged on straight line basis and the
tax rate is 40%.The return on capital employed is 13%
p.a.
16

i.
Required: Calculate :
the ARR of the investment and determine
whether or not it should be accepted.
17
ADVANTAGES
1.
2.
3.
By evaluating the project on the basis of a
percentage rate, it is a concept with which
management are familiar.
It evaluates the project on the basis of
profitability which management generally
believes should be the focus of project appraisal.
It considers benefits over the entire life of the
project.
18
DISADVANTAGES
1.
2.
3.
It is based on accounting profit, not cash flow.
It does not take into account the time value of
money because it lumps different profits
together regardless of their timing.
There is no universally acceptable way of
computing Accounting rate of return( Average
rate of return)
19
PAYBACK PERIOD
The payback period is the time required to recover
the initial cash outlay on the project. According to
the payback period method, the shorter the
payback period, the more desirable the project.
 In the case of an annuity, the payback period can
be found by dividing the initial investment by the
annual cash inflow.
 For an irregular stream of cash inflows, the yearly
cash inflows must be accumulated until the initial
investment is recovered.
20
DECISION CRITERIA
1.
2.
If the payback period is less than the maximum
acceptable payback period, accept the project.
If the payback period is greater than the
maximum acceptable payback period, reject the
project.
21
Illustration:
Assume maximum payback period is 3.5 years
Year
Cash flow of A
Cash flow of B
Cash flow C
0
SHS(100,000)
SHS(100,000)
(100,000)
1
50,000
20,000
25,000
2
30,000
20,000
25,000
3
20,000
20,000
25,000
4
10,000
40,000
25,000
5
10,000
50,000
25,000
6
-
60,000
Compute the payback period
22
SOLUTION:
The payback period for the projects will be as
follows:
Project A
50000+30000+20000= 100,000 this will be 3 years.
Project B
20000+20000+20000+40000 = 100000, this will be 4
years.
Project C
100,000/25,000 = 4 years
So project A will be preferred over B & C, because it
has a shorter payback period and it is also less
than the maximum acceptable payback period of
3.5 years
23
CLASS ACTIVITY 1
Year
Cash flow A
Cash flow B
Cash flow C
Cash flow D
0
(36,000)
(36,000)
(36,000)
(36,000)
1
18,000
20,000
24,000
16,000
2
6,000
16,000
6,000
20,000
3
12,000
0
12,000
2,000
4
4,000
0
0
2,000
24
REQUIRED:
 Assume maximum payback period is 2 years,
evaluate the acceptability of the different projects
using the payback period.

25
ADVANTAGES
1.
2.
3.
It is simple both in concept and application. It
does not use tedious calculations and has few
hidden assumptions and can be readily
understood by management.
It is a rough and ready method for dealing with
risk. It favours projects which generate
substantial cash inflows in earlier years.
Since it emphasizes earlier cash flows, it may be
sensible criterion when the firm is pressed with
problems of liquidity.
26
LIMITATIONS
1.
2.
3.
It fails to consider the time value of money
appropriately. Cash inflows are simply added
without suitable discounting. It may therefore
lead to misleading conclusions.
It ignores cash flows beyond the payback period
which implies that projects that mature in later
years may be rejected even though they may be
advantageous.
It may lead to a stalemate as there may be no
unique answer where there are two projects
with the same payback period.
27
THE TIME VALUE OF MONEY METHODS
Discounted cash flow methods
i.
ii.
Net present value (NPV) method.
Internal rate of return (IRR) method.
28
NET PRESENT VALUE (NPV)
The net present value (NPV) is found by subtracting a
project’s initial investment (CF0) from the present
value of its cash flows (CFt) discounted at a rate
equal to the firm’s cost of capital (k).
The rate often called the discount rate, required
return, cost of capital or opportunity cost is the
minimum return that must be earned on the project
to leave the firm’s market value unchanged. It
should reflect the risk of the project.

NPV
= PV of cash flows – initial investment
29
DECISION CRITERIA

The decision rule is that accept all projects with
positive NPV and reject all projects with negative
NPV.
30

Consider a project which has the following cash flow
stream with a cost of capital of 10% and initial outlay
of Shs 1,000,000.
Year
Cash flow
1
200,000
2
200,000
3
300,000
4
300,000
5
350,000
31
Illustration
Consider a project which has the following cash flow stream, the cost of capital for the firm is 10%.
Year
Cash flow
NPV FACTOR at PV of cash flow
10%
0
Shs (1,000,000)
1.000
(1,000,000)
1
200,000
0.909
181,800
2
200,000
0.826
165,200
3
300,000
0.751
225,300
4
300,000
0.683
204,900
5
350,000
0.621
217,350
NPV = (5,450)
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ADVANTAGES
1. It takes into account the time value of money.
2. It considers the cash flow stream in its entirety.
Limitation
1. It is expressed as an absolute number and may
not be appealing to decision makers who may
want to think in relative terms like rate of
return.
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CLASS ACTIVITY 1
Project M
Project N
28,500,000
27,000,000
1
10,000,000
11,000,000
2
10,000,000
10,000,000
3
10,000,000
9,000,000
4
10,000,000
8,000,000
Initial outlay
(Shs)
Year
34
REQUIRED
Amam ltd is in the process of choosing the better of
two equal risk, mutually exclusive capital
expenditure projects, M and N. The firm’s cost of
capital is 14%
a) Calculate the projects’ payback periods
b) Calculate the projects’ net present values
c) Calculate the projects’ internal rates of return
d) Which project would you recommend under each of
the above methods? Why?

35
INTERNAL RATE OF RETURN
This is probably the most widely used sophisticated
capital budgeting technique.
The internal rate of return of a project is the
discount rate which equates the net present
value of an investment to zero (the PV of cash
inflows equals the initial investment)
NOTE
 For NPV we assume the discount rate or cost of
capital is known and determine the NPV of the
project. In IRR we set the NPV to zero and
determine the discount rate(IRR) which satisfies
this condition.
36

The calculation involves a process of trial and
error. We try different values of k till we find the
right rate.
The steps in the trial and error technique
i.
Select any rate of interest at random and use it
to compute the NPV of cash flows.
ii.
If the NPV obtained in (1) above is lower than
the initial cost of investment, then try a lower
rate. Continue the process until the rate which
will equate the PV of such inflows to the PV of
the initial cost is obtained.
iii. If the chosen rate gives an NPV greater than
the initial cost of investment then a higher rate
is tried.
37
INTERPOLATION
Steps to follow
a) By trial and error, choose any rate at random that will generate a positive NPV.
b) Choose another rate that will generate a negative NPV of inflows.
The following formula will then be applied:
𝐿 +
𝐴
∗ (𝑈 − 𝐿)
𝐴+𝐵
L= Lower discount rate with a positive NPV
U = upper discount rate with a negative NPV
A = Amount of the positive NPV at the lower discount rate
B = Amount of the negative NPV at the upper discount rate
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DECISION CRITERIA
If the IRR is greater than the cost of capital or
the target rate of return for the firm, accept the
project.
 If the IRR is less than the cost of capital or the
target rate of return for the firm, reject the
project.

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ILLUSTRATION

Consider cash flows of a project A in the table.
The target return for the firm is 14%. Advise the
firm whether the project should be undertaken.
Year
0
1
2
3
4
Cash flow
(100,000)
30,000
30,000
40,000
45,000
40
Solution
Trial and error
Let us try 15% then 16%
Year
Cash flow
0
1
2
3
4
30,000
30,000
40,000
45,000
Discount factor NPV
@ 15%
(100,000)
0.8696
26,088
0.7561
22,683
0.6575
26,300
0.5718
25731
802
Therefore the IRR lies in between 15% and 16%
Discount factor NPV
@ 16%
(100,000)
0.8621
25,863
0.7432
22,296
0.6407
25,628
0.5523
24,854
(1,359)
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INTERPOLATION
Using interpolation the IRR can then be calculated
as follows:
IRR = 15% +
= 15% +
=15.37%
802
* ( 16%-15%)
802+1,359
0.37%
42
Advantages
1. It takes into account the time value of money
2. It considers the cash flow stream in its entirety
3. It makes sense to businessmen who prefer to
think in terms of rate of return and find an
absolute quantity like, NPV, somewhat difficult
to work with.
43
a) Hook industries is considering the replacement of one of its old machines. Two alternative machines
are under consideration. The relevant cash flows associated with each are shown below. The firm’s
cost of capital is 15%
Year
Machine A
Machine B
Initial investment
0
(8,500,000)
(6,000,000)
1
1,800,000
1,900,000
2
1,800,000
2,300,000
3
1,800,000
2,800,000
4
1,800,000
3,500,000
5
1,800,000
(1,000,000)
6
1,800,000
-
7
1,800,000
-
8
1,800,000
-
8
(1,000,0000
Using NPV, evaluate the acceptability of each machine.
44