Chapter Four

Investment/Project Appraisal – Capital Budgeting

 Chapter problem
ABC Company is a medium sized factory that is currently
contemplating two projects: Project A requires an initial
investment of $42,000, Project B an initial investment of
$45,000. The relevant operating cash flows for the two
projects are presented as follows.
Period Project A Project B
1. 14,000 28,000
2. 14,000 12,000
3. 14,000 10,000
4. 14,000 10,000
5. 14,000 10,000
 Nature of Investment Decisions
 The investment decisions of a firm are generally known as
the capital budgeting, or capital expenditure decisions.
 The firm’s investment decisions would generally include
expansion, acquisition, modernisation and replacement of
the long-term assets. Sale of a division or business
(divestment) is also as an investment decision.
 Decisions like the change in the methods of sales
distribution, or an advertisement campaign or a research
and development programme have long-term implications
for the firm’s expenditures and benefits, and therefore, they
should also be evaluated as investment decisions.
 Features of Investment Decisions
 The exchange of current funds for future benefits.
 The funds are invested in long-term assets.
 The future benefits will occur to the firm over a series
of years
 Why Investment Decisions/appraisal?

 Growth / return  
 Risk 
 Funding  
 Irreversibility
 Complexity
 Types of Investment Decisions
 One classification is as follows:
  Expansion of existing business
  Expansion of new business
  Replacement and modernisation
 Yet another useful way to classify investments is as
follows:
  Mutually exclusive investments
  Independent investments
  Contingent investments
 Investment Evaluation Criteria
 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 rule for making the
choice
 Investment Decision Rule
 It should maximise the shareholders’ wealth.
 It should consider all cash flows to determine the true
profitability of the project.
 It should provide for an objective and unambiguous way of
separating good projects from bad projects.
 It should help ranking of projects according to their true
profitability.
 It should recognise the fact that bigger cash flows are preferable
to smaller ones and early cash flows are preferable to later ones.
 It should help to choose among mutually exclusive projects
which maximises the shareholders’ wealth.
 Evaluation Criteria
 1. Discounted Cash Flow (DCF) Criteria
   Net Present Value (NPV)
   Internal Rate of Return (IRR)
   Profitability Index (PI)
 2. Non-discounted Cash Flow Criteria
   Payback Period (PB)
     Accounting Rate of Return (ARR)
 Net Present Value Method
 NPV is the difference between an investment’s market value
and its cost . In other words, NPV is a measure of how much
value is created or added today by undertaking an investment
 Cash flows of the investment project should be forecasted
based on realistic assumptions.
 Appropriate discount rate should be identified to discount the
forecasted cash flows. The appropriate discount rate is the
project’s opportunity cost of capital.
 Present value of cash flows should be calculated using the
opportunity cost of capital as the discount rate.
 The project should be accepted if NPV is positive (i.e., NPV
> 0).
 Cont’d
 Net present value should be found out by subtracting
present value of cash outflows from present value of
cash inflows. The formula for the net present value
can be written as follows:

 C1 C2 C3 Cn 
NPV      n 
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3

n
Ct
NPV    C0
t 1 (1  k )
t
 Acceptance Rule
 Accept the project when NPV is positive NPV > 0
 Reject the project when NPV is negative NPV < 0
  May accept the project when NPV is zero NPV
=0
 The NPV method can be used to select between
mutually exclusive projects; the one with the higher
NPV should be selected.
 Evaluation of the NPV Method
 NPV is most acceptable investment rule for the following
reasons:
 Time value
 Measure of true profitability
 Shareholder value
 It is the best method for the selection of mutually exclusive
projects.
 Limitations:
 Involved cash flow estimation
 Discount rate difficult to determine
 It is not suitable for the projects having different effective
lives.
 Internal Rate of Return Method
 The internal rate of return (IRR) is the rate that
equates the investment outlay with the present
value of cash inflow received. This also implies
that the rate of return is the discount rate which
makes NPV = 0.
C1 C2 C3 Cn
C0    
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) n
n
Ct
C0  
t 1 (1  r )t
n
Ct

t 1 (1  r ) t
 C0  0
 Acceptance Rule
 Accept the project when r > k.
 Reject the project when r < k.
 May accept the project when r = k.
 In case of mutually exclusive projects, accept
the one with the highest IRR (note that the IRR
should be higher than the cost of capital).
 Evaluation of IRR Method
 IRR method has following merits:
 Time value
 Profitability measure
 Acceptance rule
 Shareholder value
 IRR method may suffer from:
 Multiple rates
 Profitability Index
• Profitability index is the ratio of the present value of
cash inflows, at the required rate of return, to the
initial cash outflow of the investment
PI=Present value of cash inflows / initial investment
 Acceptance Rule
 The following are the PI acceptance rules:
 Accept the project when PI is greater than one.
PI > 1
 Reject the project when PI is less than one.
PI < 1
 May accept the project when PI is equal to one.
PI = 1
 The project with positive NPV will have PI greater
than one. PI less than one means that the project’s
NPV is negative.
 Evaluation of PI Method
 It recognises the time value of money.
 It is consistent with the shareholder value maximisation
principle.
 A project with PI greater than one will have positive
NPV and if accepted, it will increase shareholders’
wealth.
 In the PI method, since the present value of cash inflows
is divided by the initial cash outflow, it is a relative
measure of a project’s profitability.
 Like NPV method, PI criterion also requires calculation
of cash flows and estimate of the discount rate. In
practice, estimation of cash flows and discount rate pose
problems.
 NPV Versus PI
 A conflict may arise between the two methods if
a choice between mutually exclusive projects
has to be made. Follow NPV method:

Project C Project D
PV of cash inflows 100,000 50,000
Initial cash outflow 50,000 20,000
NPV 50,000 30,000
PI 2.00 2.50
 Payback
 Payback is the number of years required to recover
the original cash outlay invested in a project. If the
project generates constant annual cash inflows, the
payback period can be computed by dividing cash
outlay by the annual cash inflow. That is:
Initial Investment C0
Payback = =
Annual Cash Inflow C
 Cont’d
Unequal cash flows
 In case of unequal cash inflows, the payback period
can be found out by adding up the cash inflows until
the total is equal to the initial cash outlay.
 P=E+B/C, where, P=payback period, E=number of
years immediately preceding the year of final
recovery, B=balance amount still to be recovered and
C=cash flow during the year of final recovery.
 Example
 Suppose that a project requires a cash outlay of $
20,000, and generates cash inflows of $ 8,000; $
7,000; $ 4,000; and $ 3,000 during the next 4 years.
What is the project’s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
 Discounted Pay-Back Period

• Discounted Pay-Back Period is computed

after all the cash flows are discounted to
present time at appropriate discount
rate.
 Acceptance Rule
 The project would be accepted if its payback period is
less than the maximum or standard payback period
set by management.
 As a ranking method, it gives highest ranking to the
project, which has the shortest payback period and
lowest ranking to the project with highest payback
period.
 In case of mutually exclusive projects, select the one
which has the shortest recovery period.
 Evaluation of Payback
 Certain virtues:
 Simplicity
 Cost effective
 Pay-back method reduces the possibility of loss on
account of obsolescence.

 Serious limitations:
 Cash flows after payback
 Cash flow patterns
 It is one of the misleading evaluations of capital
budgeting.
 Inconsistent with shareholder value
 Accounting Rate of Return Method
 The accounting rate of return is the ratio of the
average after-tax profit divided by the average
investment. The average investment would be equal to
half of the original investment if it were depreciated
constantly.
Average income
ARR =
Average investment
 A variation of the ARR method is to divide average
earnings after taxes by the original cost of the project
instead of the average cost.
 Acceptance Rule
 This method will accept all those projects whose
ARR is higher than the minimum rate established by
the management (RRR) and reject those projects
which have ARR less than the minimum rate.
 This method would rank a project as number one if it
has highest ARR and lowest rank would be assigned
to the project with lowest ARR.
 Evaluation of ARR Method
 The ARR method may claim some merits
 Simplicity
 Accounting data
 Accounting profitability
 Serious shortcoming
 Cash flows ignored
 Time value ignored
 Arbitrary cut-off
Specific Investment Decisions: Capital
Rationing; Lease or Buy; and Asset
Replacement
• This section considers three further project
appraisal topics – capital rationing, Asset
Replacement and leasing.
• We will consider specific investment decisions such
as whether to lease or buy an asset, when to
replace an asset and how to assess projects when
capital is a scarce resource.
• The following slides provide you with brief
description of each of these topics i.e. capital
rationing, Asset Replacement and leasing.
 Capital Rationing
• Firm’s may operate under conditions of capital rationing
—they have more acceptable independent projects than
they can fund-Budget.
• In theory, capital rationing should not exist—firms
should accept all projects that have positive NPVs.
• Capital rationing: a situation in which a company has a
limited amount of capital to invest in potential projects,
such that the different possible investments need to be
compared with one another in order to allocate the
capital available most effectively.
• Capital rationing may occur due to internal factors (soft
capital rationing) or external factors (hard capital
rationing).
 Cont’d
1. Hard capital rationing or “external” rationing occurs
when the company faces problems in raising funds in
the external equity markets. This can lead to the
shortage of capital to finance the new projects in the
company.
2. On the other hand, soft capital rationing or “internal”
rationing is caused due to the internal policies of the
company. The company management may
voluntarily have certain restrictions that limit the
number of funds available for investments in
projects. However, these restrictions can be modified
in the future; hence, the term ‘soft’ is used for it.
 Cont’d
• If an organization is in a capital rationing situation it
will not be able to enter into all projects with positive
NPVs because there is not enough capital for all of the
investments or due to other internal factors.
• Research has found that management internally
imposes capital expenditure constraints to avoid
what it deems to be ―excessive levels of new
financing, particularly debt.
• Thus, the objective of capital rationing is to select
the group of projects within the firm’s budget that
provides the highest overall NPV or IRR.
Leases Financing- Another Source of Financing
for Investments (Lease or Buy Decision)
The Basics of Lease:
– A lease is a contractual agreement between a
lessee and lessor.
– The agreement establishes that the lessee has the
right to use an asset and in return must make
periodic payments to the lessor.
– The lessor is either the asset’s manufacturer or an
independent leasing company.
 Reasons to Consider Leasing (valid)
• May be lower interest rate
• Way to avoid risk of technological change
• Way to avoid transactions costs associated with
buying and selling
• Way to avoid restrictions (covenants) of debt
financing
• Way to conserve capital
 Operating Leases

• It is a type of lease
• Usually not fully amortized - the payments
required under the terms of the lease are not
enough to recover the full cost of the asset for
the lessor.
• Usually require the lessor to maintain and insure
the asset.
• Lessee enjoys a cancellation option. This option
gives the lessee the right to cancel the lease
contract before the expiration date.
 Capital/Financial Lease

• Another type of lease

• A lease must be capitalized if any one of the
following is met:
– The present value of the lease payments is at least 90-
percent of the fair market value of the asset at the start
of the lease.
– The lease transfers ownership of the property to the
lessee by the end of the term of the lease.
– The lease term is 75-percent or more of the estimated
economic life of the asset.
– The lessee can buy the asset at a bargain price at
expiry.
 Sale and Lease-Back

• A particular type of financial lease.

• Occurs when a company sells an asset it
already owns to another firm and
immediately leases it from them.
• Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease
payments to the lessor, thereby retaining the
use of the asset.
 Leveraged Leases
• A leveraged lease is another type of financial lease.
• Leveraged lease is a three-party lease contract under which a lessor
borrows some or most of the funds to finance the asset to be leased
to a lessee. In this arrangement,
(1) financing provided by the lender is without recourse to the lessor.
This means that the lessor is not obligated to the lender in case of a
default by the lessee.
(2) the lender holds the title to the leased asset, and
(3) the lessee's payments are assigned to the lender who can repossess
the leased asset in case of a default.
• Leveraged leases are true (tax oriented) leases because the lessor
enjoys all the tax benefits of ownership (such as depreciation)
whereas the lessee can claim the full amount of lease payment as
expenses.