CHAPTER SIX

Capital Budgeting and Investment Decisions

❑ Capital Budgeting
Introduction
▪ The word Capital refers to be the total investment of a company in money,
tangible and intangible assets.
▪ Whereas budgeting defined by the “Rowland and William” it may be said to
be the art of building budgets.
✓ Budgets are a blue print of a plan and action expressed in quantities.
Definitions
▪ According to Charles T. Hrongreen,
✓ Capital budgeting is a long-term planning for making and financing
proposed capital out lays.
▪ Capital Budgeting is the process of making investment decisions in long-term
assets.
▪ It is the process of deciding whether or not to invest in a particular project as
all the investment possibilities may not be rewarding.
Need and Importance of Capital Budgeting
1. Huge investments: Capital budgeting requires huge investments of funds,
but the available funds are limited, therefore the firm before investing
projects, plan are control its capital expenditure.
2. Long-term: Capital expenditure is long-term or permanent in nature.
Therefore financial risks involved in the investment decision are more. If
higher risks are involved, it needs careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not
changed back. Once the decision is taken for purchasing a permanent
asset, it is very difficult to dispose off those assets without involving huge
losses.
4. Long-term effect: Capital budgeting not only reduces the cost but also
increases the revenue in long-term and will bring significant changes in
the profit of the company by avoiding over or more investment or under
investment.
Therefore before making the investment, it is required carefully planning
and analysis of the project thoroughly.
Capital Budgeting Process
The ff steps followed for capital budgeting, then the process may be easier;
1. Identification of various investments proposals: The capital budgeting
may have various investment proposals. The proposal for
opportunities may be from the top management or may be even from
the lower rank.
▪ The heads of various departments analyze the various investment
decisions, and will select proposals submitted to the planning
committee of competent authority.
2. Screening or matching the proposals: The planning committee will
analyze the various proposals and screenings.
▪ The selected proposals are considered with the available resources
of the concern. This reduces the gap b/n the resources and the
investment cost.
3. Evaluation: After screening, the proposals are evaluated with the help
of various methods, such as PBP, NPV, IRR
▪ The proposals are evaluated as Independent or Exclusive proposals.
✓ Independent proposals are not compared with another proposal
and may be accepted or rejected.
✓ Mutually exclusive proposals are those which are compared with
another proposals.
4. Fixing property: After the evaluation, the planning committee will
predict which proposals will give more profit or economic
consideration.
✓ If the projects or proposals are not suitable for the concern’s
financial condition, the projects are rejected without considering
other nature of the proposals.
5. Final approval: The planning committee approves the final proposals,
with the help of the following:
(a) Profitability (c) Financial viability
(b) Economic components (d) Market conditions.
▪ The planning committee prepares the cost estimation and submits to
the management.
6. Implementing: The competent authority spends the money and
implements the proposals.
✓ While implementing the proposals, assign responsibilities to the
proposals, assign responsibilities for completing it, within the
time allotted and reduce the cost for this purpose.
7. Performance review of feedback: The final stage of capital budgeting
is actual results compared with the standard results.
✓ The adverse or unfavorable results identified and removing the
various difficulties of the project.
✓ This is helpful for the future of the proposals.
 Investment Decision Making
▪ Investment means an expenditure in cash or its equivalent during one
or more time periods in anticipation of enjoying a net cash inflows in
future time periods.
▪ 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.
▪ If the financial resources were in abundance, it would be possible to
accept several investment proposals which satisfy the norms of
approval or acceptability.
▪ Since, resources are limited; a choice has to be made among the
various investment proposals by evaluating their comparative merit
to select the relatively superior proposals with the limited available
resources.
▪ For this purpose, we have to develop some evaluating techniques
for the appraisal of investment proposals.
Importance of Investment Decisions
▪ The terms in financial management like investment decisions,
investment projects, and investment proposals are generally
associated with application of long-term resources.
▪ What is long-term?
✓ a period of ten years and above may be treated as long period.
▪ The decisions related to long-term investment is also known as
capital budgeting techniques.
It is important because of the following reasons:
1. The investment decisions are the vehicles of a company to reach its
desired destiny.
▪ An appropriate decision would yield fantastic results whereas
▪ A wrong decision
✓ May upset the whole financial plan and endanger the survival of
the firm.
✓ Even the firm may be forced into bankruptcy.
2. Capital budgeting techniques involve huge amounts of funds and
imply permanent commitment.
▪ Once you invest in the form of fixed assets it is not easy to reverse
the decision unless you incur heavy loss.
3. A capital expenditure decision has its effect over a long period of
time span and company’s future cost.
4. Investment decisions are among the firm’s most difficult decisions.
▪ The cash flow uncertainty is caused by economic, political, social
and technological forces.
Types of Investment Proposals
The long-term funds are required for the following purposes:
a) Expansion: To add capacity to its existing product lines or to
expand existing operations.
▪ For example, a manufacturing unit producing 100,000 units per
year may intends to double the output by 200,000, this will
obviously increase the need for funds for acquiring fixed and
current assets.
b) Diversification: To add new product line to the existing product
lines.
▪ Philips, a famous company for radio and electric bulbs etc.
diversified into production of other electrical applications and
television sets.
C) Replacements: Machines used in production may either wear
out or may be obsolete on account of new technology.
▪ The productive capacity of the enterprise and its competitive
ability may be adversely affected.
▪ Extra funds are required for modernization or renovation of
the entire plant.
D) Research and Development: The efficiency of production and
the total operations can be improved by application of new and
more sophisticated techniques of production and management.
▪ To acquire the technology huge funds are needed.
The useful way of classifying investments is as under
1. Accept-Reject Decisions
▪ Under this, if a project is accepted, the firm is going to invest,
otherwise it is not going to invest its funds.
▪ In general, the project proposals that yield a rate of return
greater than the certain required rate of return or cost of capital
are accepted and others are rejected.
▪ By applying this criteria more than one independent project are
accepted subject to availability of funds.
2. Mutually Exclusive Decisions
▪ These are the projects which compete with each other in such a
way that the acceptance of one will exclude/reject/ the other
one.
▪ If the alternatives are mutually exclusive one may be chosen.
3. Capital Rationing
▪ We are aware that the financial resources are limited.
▪ But, a large number of investment proposals compete for those
limited funds.
▪ Thus, capital rationing refers to the situation in which the firm
has more acceptable investments, requiring a greater amount of
finance than is available within the firm.
▪ Capital rationing refers to a situation where a firm is not in a
position to invest in all profitable projects due to the constraints
on availability of funds.
▪ It is for this reason the firm cannot take up all the projects
though profitable, and has to select the combination of
proposals that will yield the greatest profitability.
▪ The projects are ranked and selected as per their merits of
acceptance basing on certain predetermined criteria.
Data required for investment decisions
Initial Investment: The total amount of cash required to buy various
assets like land, buildings, plant, machinery, equipment, etc and
there installation expenses have to be estimated.
✓ In addition to fixed cost, the cost of maintaining stocks,
contingency reserves to cover the cost of supporting the
additional receivables.
Subsequent Investment: The cost of maintenance, replacement and
updating are to be treated as outflows during the period expected to
be incurred.
Economic Life of the project: The economic life of a project is to be
distinguished from the life of an individual asset.
✓ The economic life of the project is determined by the duration
of the “earnings flow” generated by the project.
The economic life may end:
✓ The cost of replacement becomes uneconomical in relation to
the likely benefits.
✓ When the viability is adversely affected due to obsolescence.
✓ When maintenance costs exceed the disposable value, and
✓ When the development of new technology need new investment
Salvage Values: The plant assets may have value for the enterprise at
the end of the life of the project or there may be some anticipated
sales value of the plant.
✓ Such amount is to be treated as an inflow at the end life of the
project.
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.
✓ Care has to be taken to forecast accurately and the additional
revenue generated by the investment should be taken into
account.
✓ The investment must also result into the reduction of
operating cost either by modernization or replacement
models where the savings benefit or cash flows will increase.
 In simple terms annual cash flow is equivalent to net profit after
tax plus depreciation. Procedurally,

ACF = Sales – (Operating expenses + Non-operating expense) + Depreciation

▪ Example: The following is the information related to ABC Ltd.
Machine A Machine B
Birrs Birrs
Cost of machine 15, 000 24, 000
Estimated life in years 5 years 6 years
Estimated income 1, 000 1, 500
Estimated material cost 800 900
Estimated supervision cost 1, 200 1, 600
Estimated maintenance cost 500 1, 000
Estimated savings in wages 9, 000 12, 000

Additional Information
✓ Depreciation may be charged on straight line method
✓ The tax rate may be assumed 50%
Required:
Calculate Annual Cash Flows?
 Machine A Machine B
Birrs Birrs
Income: 1, 000 1, 500
Savings in wages 9, 000 12, 000
Total income / sales 10, 000 13, 000
Cost: Material costs 800 900
Maintenance 500 1, 000
Supervision 1, 200 1, 600
Profit before Depreciation & Tax 7, 500 10, 000
Depreciation 3, 000 4, 000
Profit Before tax 4, 500 6, 000
Tax @ 50% 2, 250 3, 000
Profit after tax (Net profit) 2, 250 3, 000
Add back depreciation 3, 000 4, 000
Annual cash flows 5, 250 7,000
Project Appraisal Methods
There are two important methods of evaluating the investment
proposals
1. Traditional methods
A. Payback Period
B. Accounting Rate of Return
2. Discounted cash flow method
A. Net Present Value
B. Internal Rate of Return
C. Profitability Index
1. Traditional Methods
A. Payback Period:
▪ This is one of the widely used methods for evaluating the
investment proposals.
▪ Under this method the focus is on the recovery of original
investment at the earliest possible period.
▪ It determines the number of years to get back the original cash
out flow, disregarding the salvage value and interest.
▪ This method does not take into account the cash inflows that
are received after the payback period.
Decision rule: accept the project if it’s payback period is shorter than
the target (planed period) set by the management.
There are two methods in use to calculate the payback period
1) Where annual cash flows are not consistent (vary from year to year)
2) Where the annual cash flows are uniform
1) Unequal cash flows
P=E+ B
C
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: The following is the information related to a company
Project A Project B
Year Cash flow $ Cash flow $
0 -700 -700
1 100 400
2 200 300
3 300 200
4 400 100
5 500 0
Calculate payback period of two projects?
Project A Cumulative Project B Cumulative
Year Cash flow cash flow Year Cash flow Cash flow
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 -

Solutions;
P=E+ B
C B
P=E+ C
100
=3+
400 = 2 + 0/200
= 3.25 year = 2 years
2. Uniform cash flows:
▪ Where the annual cash flows are uniform
Original Investment
PBp = Annual cash flows

Example: A project requires an investment of $ 100, 000, it will

generate annual cash flow of $25,000 per year.
▪ Calculate the payback period?

Original Investment 100,000

PBp = Annual cash flows =
25,000
= 4 years
B. Accounting Rate of Return (keep on reading)
▪ 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

Average annual profits after taxes

ARR = Average investment over the life of project  100
2. Discounted Cash Flow Method
▪ This concept is based on the time value of money.
▪ The real value of Birr in your hand today is better than value of
birr you earn after a year.
▪ The future income, therefore, has to be discounted in order to
be associated with the current out flow of funds in the
investment.
▪ Two methods of appraisal of investment project are based on
this concept.
✓ These are NPV and IRR method.
C. Net Present Value (NPV)
▪ It is an investment project proposals evaluating and ranking
method using the net present value, which is the difference
between the present values of future cash inflows and the present
value of cash outflows, discounted at the given cost of capital, or
opportunity cost of capital.
In order to use this method properly, the following procedures are
followed.
1. Find the present value of each cash flow (both inflows and out
flows) using the cost of capital of the project for discounting.
2. Sum the discounted cash inflows and the discounted cash
outflows separately.
3. Obtain the difference between the sum of the cash inflows and
the sum of the cash outflows.
▪ If all the cash outflows for the project occur at time zero, i.e. at the
beginning of year 1, the present value of the cash out flows is the
same as to the net investment amount.
Decision Rule; The decision rule here is; accept a project if the NPV is
positive and reject if it is negative
 NPV > Zero Accept
 NPV = Zero Indifference
 NPV < Zero Reject
 If the projects are independent, the projects with positive net present
values are the ones whose implementation maximizes the wealth of
shareholders.
✓ Hence, such projects should be accepted for implementation.
 If the projects, on the other hand, are mutually exclusive, the one
with the higher positive NPV should be accepted leading to the
rejection of the projects with lower positive NPV.
 NPV of zero imply that the cash flows of the project are just
sufficient to repay the invested capital and to provide the required
rate of return, no more, no less.
 Projects with negative NPV should not be considered for
acceptance in the first place.
 NPV = + + - Io

n
CFt
NPV =  (1 + K ) t − Io
Where; NPV = Net present value
CFt = Cash inflows at different periods
Io = Cash outflow in the beginning (initial investment)
K = Cost of capital
t = time period
Example; Assume that a given project is expect to have an initial investment
and project life of 40,000Birr and 5 years respectively. The annual after-tax
cash flow is estimated at 12,000Birr for each of the five years.
1. Using the required rate of return of 10 percent, what is the net present
value (NPV) of the project?
2. How do you judge the acceptability of this project?
▪ To answer these question, it is wise to identify the cash inflows and outflows.
In this project, there are annuity cash inflows of 12,000 every year for five
years and single cash out flow of 40,000 at time zero.
▪ The present value of the annuity cash inflows is:
Present value of annuity = (12,000*Annuity factor)
▪ The annuity factor given the period of 5 years and discount rate of
10 percent is 3.791 substituting the factor I the equation above
PVA = (12,000) (3.791) = 45,492 Birr or
= [12000/ (1.1)] + [12000/ (1.1)2] + ---+ [12000/ (1.1)5] = 45,492Birr
Present Value of Cash out flow = 40,000Birr
Net Present value (NPV) = 5,492Birr
Hence,
The Net Present value (NPV) = Present Value of inflows less(-) present value of
outflows
NPV = 45,492 - 40,000 = 5,492 Birr
✓ Since the project makes the net present value (NPV) of positive
5,492 Birr, the project should be accepted.
✓ Consequently, the wealth of the shareholders would increase by
5,492 Birr in total as the result of accepting and running this project.
To further illustrate the NPV method, consider the following mutually
exclusive project alternatives, together with their cash flows.

Alternative Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

A (80,000) 20,000 25,000 25,000 30,000 20,000
B (100,000) 25,000 20,000 30,000 35,000 40,000

▪ The required rate of return on both projects is 12 percent.

▪ Then, Evaluate these projects using Net Present Value method?
✓ The evaluation of these two projects requires the computation of
the net preset values for both projects.
✓ Thus, we need to discount each of the cash flows individually.
✓ Then, the individual discounted cash flows are added.
✓ The cash out flows at time zero will be deducted from the sum of
the discounted cash inflows in order to get the net present value
of the project.
The net present value (NPV) for project A is:
Year Cash flows Discount Factor (12%) Present Values
1 20,000 0.893 17,860
2 25,000 0.797 19,925
3 25,000 0.712 17,800
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Present values of cash inflows (sum) 86,005
Present values of cash outflows 80,000
Net Present Value (NPV) 6,005 Birr
The net present value (NPV) for project B is:
Year Cash flows Discount Factor (12%) Present Values
1 25,000 0.893 22,325
2 20,000 0.797 15,940
3 30,000 0.712 21,360
4 35,000 0.636 22,260
5 40,000 0.567 22,680
Present values of cash inflows (sum) 104,565
Present values of cash outflows 100,000
Net Present Value (NPV) 4,565 Birr
▪ Since the two projects are mutually exclusive, the one with the
higher NPV has to be accepted.
▪ Thus, project A is selected as its NPV is higher than that of project
B.
▪ Had the two project been independent of one another, both of
them would be accepted because both projects have positive NPVs
D. Internal Rate of Return (IRR)
▪ The internal rate of return is the discount rate which equates the
present value of the expected cash flows with the initial
investment outlays.
▪ In other words, IRR is a method of ranking investment project
proposals using the rate of return on an asset (investment).
▪ At IRR, the sum of the present values of all cash inflows is equal
to the sum of the present values of all cash outflows.
▪ That is:
PV (cash inflows) = PV (cash outflows).
▪ Hence, the net present value of any project at a discount rate that
is equal to the IRR is zero.
Io =
Decision rule for the IRR technique is;
If the IRR ≥ r (the cost of capital) = Accept project
IRR < r (the cost of capital) = Reject the project
Example;
Year 0 1 2 3 4 5
After tax cash flow - $10,000 2,000 4,000 3,000 3,000 1,000
Required; Calculate IRR and decide whether to accept or reject the
project, since the firm has a cost of capital of 8%?
Solution; in order to solve for IRR, we need to solve the following
equation;
10,000 = + + + +

Assume IRR = 10%; first trial and error

10,000 = + + + +
 10,000 = + + + +

= 1,818.18 + 3,305.79 + 2,253.94 + 2,049.04 + 620.92

= 10,047.87
IRR = 11%; second trial and error
10,000 = + + + +

= 1,801.80 + 3,246.49 + 2,193.57 + 1,976.19 + 593.45

= 9,811.5
To find out the exact IRR, we can use interpolation system

IRR = I1+ (I2-I1) │ │

= 10 %+( 11%-10%) │ │

= 10 % + ( 1%*0.2025)
= 10% + 0.002025
= 0.10205
= 10.205%
If the cash flow in Annuity form;
The following steps can be followed to calculate IRR for constant cash inflows.
Step 1: Find the critical value of discount factor
Discount factor = Initial investment
Annual Cash inflow
Step 2: Find the IRR by looking along the appropriate line (year) of the present
value of annuity table until the column which contains the critical discount
factor (i.e. the discount factor computed under step 1) is located.
▪ Illustrate:- Assume that a project has a net investment of 26,030 Birr and
annual net cash inflows of 5000 Birr for seven years. What is the IRR of
this project?
Step 1 Compute the critical discount factor. That is
Discount factor = 26,030 = 5.206
5,000
Step 2 look for the value that is equal to this discounting factor in the present
value of annuity table across the line corresponding to 7 years (i.e. n=7). The
discount factor of 5.206 appears in the 8 percent column on the line/row of 7
years. Therefore, the IRR = 8 %.
E. Profitability Index (PI)
▪ Profitability index is the ratio of the present value of the expected
net cash flow of the project and its initial investment outlay.
PV Where; PV = Present value of expected net cash flows
PI = = I0 = Initial investment outlay
I0
PI = Profitability Index

▪ Profitability index measure of profitability in a more readily

understandable terms.
▪ It simply converts the NPV criterion into a relative measure.
Consider the following two mutually exclusive projects.
Present Value Initial Profitability
of cash Flow Investment Index (PI)
Project A 200 100 2.0
Project B 3000 2000 1.50
▪ From the above example project A is accepted using profitability
index because its PI is greater than that of project B.
Methods of Capital Budgeting of Evaluation
▪ By matching the available resources and projects it can be invested.
▪ The funds available are always existing funds.
▪ There are many considerations taken for investment decision
process such as environment and economic conditions.
The methods of evaluations are classified as follows:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(ii) Post Pay-back Methods
(iii) Accounts Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method