Capital Budgeting

Capital budgeting, also called investment appraisal decision is without a doubt the most important
decision a financial manager can make.

 It is the process by which decisions are taken on how limited capital resources of funds
will be allocated to competing needs or projects.
 It includes the appraisal of proposed investments with reference to their expected returns
and to the cost of capital.

Investment decisions influence the ability of a firm to generate future cash flows, hence undertaking
projects that generate higher future cash flows will lead to maximization of the value of a firm.

The capital budgeting decisions are essentially aimed at an increase in revenues, a decrease in costs
or improvements in both areas that lead to higher efficiency. An increase in revenues is usually
achieved by expansion of current production facilities or an expansion into different product/industries
of setting up completely new or self-contained projects.

Cost decreases and increased efficiency are often a consequence of improvement in production
technologies and typically involve the replacement of, or improvements to, assets or groups of assets
already in use.

Capital budgeting decision

These look at the criteria of judging weather an investment project should be undertaken or not.
The availability of funds is likely to be limited; consequently organisations may not be able to
undertake all available, feasible projects. Consequently comprehensive analysis is required so
that alternatives can be assessed, choices made and projects prioritised.

The decision making criteria are classified in to two (2) broad categories as follows:

1. Discounting criteria (time value is attached)

I. Net Present Value (NPV)
II. Benefit Cost Ratio (BCR or Profitability Index PI)
III. Internal Rate of return
 2. Non Discounting criteria (No time value- taken as nominal values)
I. Pay Back Period
II. Accounting Rate of Return

The discounting criteria makes use of discounted or adjusted future time values while non
discounting criteria do not take or make use of time.

Discounting methods

Net Present Value

 It is the sum of all the cash flows both negative and positive including the initial
investment that are expected over the life of the project.
 Ross et al, say NPV is the difference between an investments value and its costs.
 Net present value calculates the present value of the future cash flows generated by the
project and compares this present value of the cash inflow with the present value of any
outflows.
 If the PV of the cash inflow is greater than the PV of the cash outflow the project will
have a positive net present value (NPV).
 A positive NPV indicates that the investment earns more for the firm than it has to pay
for its funds. By taking into account the time value of money and discounting cash flows
according to when monies are paid out or received, projects can be appraised before the
investment decision is made.
 It is important to note that it is the cash flows of the project that are discounted, not the
profits.

Net Present Value

- Where
Ct is Cash flow at Period of years

R is the discount rate

I is the initial investment

N is the Life of the project / years to maturity

The basic decision rule associated with NPV is:

  Accept the project if the NPV is positive
 Reject the project if NPV is negative
 Be indifferent if the NPV is Zero

Example: A project has the following cash flows

Year 0 1 2 3 4

Cf (800) 360 240 240 250

Marginal cost of capital is 10%

NPV= – 800 = 76.7

The advantages and disadvantages of NPV as a method of project appraisal are set out below:

Advantages

 Shareholder wealth is maximised; (the NPV of the project is the number of dollars by which
the present value of the firm is increased as a result of adopting the project.)
 It takes into account the time value of money; and
 It is based on cash flows, which are less subjective than profits.

Disadvantages

 It can be difficult to identify an appropriate discount rate;

 Some managers are unfamiliar with the concept of NPV; and
 Cash flows are usually assumed to occur at the end of a year, but in practice this is over
simplistic.

Benefit Cost Ratio (BCR) or Profitability Index (PI)

The profitability index (PI), or benefit-cost ratio, is the ratio of the present value of expected
net cash flows over the life of a project to the net investment

The relationship between Benefits and Costs can be depicted in 2 ways:

BCR = PI = OR

NBCR = = BCR – 1 where

PVB Present Value of Benefit
 I Initial Investment
NBCR Net Benefit Cost Ratio
N.B The decision rule associated with the benefit cost measures are as follows:

Where BCR or NBCR Rule

>1 >0 Accept
=1 0 Indifferent
<1 <0 Reject

Example: A project with an initial investment 80000, cost of capital 10% has the following
benefits or cash flow

Year 1 2 3 4

Cash flows 20000 32000 32000 40000

Calculate the benefit cost ratio measures for this project in other words calculate BCR and
NBCR

BCR = =

BCR =

NBCR = BCR – 1

= 1.2 – 1 = 0.2

Advantages

 It is argued that as a relative measure PI is better than NPV as it can discriminate

better between large and small investments
 However it has been empirically proved, that it is like NPV in that
I. Under conditions of unlimited capital the BCR criteria accepts and rejects the
same projects as NPV
II. Under conditions of limited capital, the BCR ratio decision ranks projects
correctly in order of decreasing efficient use of capital

Disadvantages

 it provides, No means for aggregating several smaller projects into a package which can
then be compared to a larger project
  if cash flows occur beyond the period the BCR decision rule is insufficient as a selective
basis

Internal Rate of Return

IRR is defined as the discount rate that equates the present value of a project’s expected cash
inflows to the present value of the project’s costs:
Or, equivalently, the IRR is the rate that forces the NPV to equal zero:

The IRR method is similar to the NPV method. It is based on the principle of discounting future
cash flows and will normally give the same accept/reject decisions and will rank investment
projects in the same way as the NPV method. However, the IRR method has difficulty in
handling unconventional cash flows and does not address the issue of wealth maximisation as
well as the NPV method.

Thus, from a theoretical viewpoint, the IRR method is inferior to the NPV method. However, it
seems that managers prefer the IRR method to the NPV method. This is perhaps because it
provides an answer that is expressed as a percentage figure, which is easier to understand than
present value Dollar or Kwachas.

NB. Unlike in NPV where it is assumed that the cost of capital or discount rate is known, in this
case the discount rate has to be determined and this is done by assuming an NPV of Zero. The
decision rule of IRR is as follows:

 Accept if IRR is greater than cost of capital

 Reject if IRR is less than cost of capital

=∑ where

Cf is the cash flow for year t and r equals to the IRR

IRR is calculated using trial and error plus interpolation

Where

.a = lower rate of return

 .b = higher rate of return
A= +NPV calculated using a
B= -NPV calculated using b
Lower % of NPV + Difference between higher and lower NPV % rate (

Example a project whose initial investment is 200,000 has the following cash
flows
Year 1 2 3 4
Cash flow 60000 60000 80000 90000
Calculate IRR

At 15%

At 16% = -2727.27

15% + (16% - 15%)*( = 15.369%

Advantages

 It takes into account the time value of money, which is a good basis for decision-making;
 Results are expressed as a simple percentage, and are more easily understood than some
other methods; and
 It indicates how sensitive decisions are to a change in interest rates.

Disadvantages

 Projects with unconventional cash flows can have either negative or multiple IRRs - this can
be confusing to the user;
 IRR can be confused with ARR or Return on Capital Employed since all methods give
answers in percentage terms - hence, a cash-based method can be confused with a profit-
based method;
 It may give conflicting recommendations to NPV;
 Some managers are unfamiliar with the IRR method;
 IRR cannot accommodate changes in interest rates over the life of a project; and
 It assumes funds are re-invested at a rate equivalent to the IRR itself, which may be
unrealistically high.

Non Discounting methods

Payback Period

It refers to the length of time required to recover the initial cash outlay on the project.
This is a very simple method of investment appraisal which looks at how quickly the cash flows
arising from a project exactly equal the amount of the initial investment.

The payback period can be based on either:

 The cash flows prior to discounting for the time value of money; or
 The discounted cash flows.

The basic decision rule for payback period is the shorter the payback period, the more desirable
the project.

Advantages

 Simple both in concept and application and has few assumptions

 Gives a rough and ready guide for evaluating projects and dealing with risk, favours projects
that generate substantial cash inflows in earlier years and discriminates against projects that
generate substantial cash inflows in later years
 Comes in as a handy criterion for decision making especially when the firm is experiencing
liquidity problems as it emphasis on quick pay back

Disadvantages

 It fails to consider time value. That is future cash flows are simply added without
discounting to present values
 It ignores cash flows beyond the payback period and as such, it discriminates against
projects which generate substantial cash flows in future years. It is a measure of a project s
capital recovery as opposed to its profitability

Discounted Payback Period

Some firms use a variant of the regular payback, the discounted payback period, which is similar
to the regular payback period except that the expected cash flows are discounted by the project’s
cost of capital. Thus, the discounted payback period is defined as the number of years required to
recover the investment from discounted net cash flows.

Example: A project has the following nominal cash flows:

Year 0 1 2 3 4 5 6

Cash flows 100000 30000 30000 40000 40000 50000 20000

Calculate the projects discounted payback period if the firm cost of capital is 10%

year Cash Factor Discount factor Present Value Cum. Present Va

0 -100,000 1 -100000 -100000
1 30000 .909 27270 -72730
2 30000 0.826 24780 -47950
3 40000 0.751 30040 -17910
4 40000 0.683 27320 9410
5 50000 0.621 31050 40460
6 20000 0.564 11280 51740

From the last column we can determine that the payback period lays between 3 and 4th year

=3+
Return on capital employed (ROCE) / ARR
This is also known as Accounting Rate of Return or Return on Investment. This is the method of
investment which uses accounting methods to estimate the return on capital employed. If the
calculated rate of return is more than the expected rate of return, then the project is viable and it
must be accepted.
Example, The Company expects a return of 15% on its projects. The project has the following
cash flows over the period of 6 years.

Yr 0 1 2 3 4 5 6
Cf 350000 75000 90000 105000 120000 135000 150000
Required: calculate the return of capital employed and assess whether the project should be
accepted
ROCE can be calculated using any of the following

ROCE = OR

ROCE OR

ROCE =

Note: any of the 3 methods can be used as long s it is applied consistently. However for the
purpose of financial examination, formula one is recommended.
N.B. To calculate the value of the average investment you must first add the initial investment
cost to the residual value. This gives the total amount of money tied up and it should be divided
by two to find the average.
Solution:
Step 1
Calculate straight line depreciation per year

Depreciation =

Step 2
Calculate the profits after depreciation each year
Year Cash flow Depreciation Profit after deprecia.
1 75000 58333 16667
2 90000 58333 31667
3 105000 58333 46667
4 120000 58333 61667
5 135000 58333 76667
6 150000 58333 91667
325002

Step 3 calculate Average Profits

You should NOTE that the average investment is calculated by dividing 2 into the initial
investment and NOT the period of life of the project

Therefore

The project should be taken because the calculated ARR is more than the expected return of 15%

Class exercise

The figures below will be used to illustrate accounting rate of return: Assume Depreciation of K20, 000 per year on
a straight line basis.

K’000 Profit after Dep

Investment (100)

Cash inflows:

Year 1 20 0

Year 2 30 10

Year 3 40 20

Year 4 40 20

Year 5 10 (10)

Average profits would be K8, 000 per year. Average investment would be K50,000 (as the
investment declines in value over the five years due to depreciation charges and ARR would
therefore be computed as:
K8, 000 / 50,000 = 16%
Note: Average profit = total profit/ project life = 40,000/5 = K8, 000.

Advantages
 It is quick and simple to calculate
 It involves a familiar concept of a percentage return
 It looks at the entire project life
 Based on accounting information that is readily available and familiar to business people
Disadvantages
 it is based on accounting profits which are easily manipulated by accounting policies (and
not cash flows)
 it ignores time value of money
 it takes no account of the length of the project

Capital Rationing
Capital rationing is a situation in which a company has 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 in a most effective way
 According to Ross, the situation that exists if a firm has positive NPV projects but cannot
find the necessary financing
The projects are ranked to the level of contribution using either the Net present value or
profitability index (PI).

Profitability index
The PI is used when the project involved is divisible

Net Present Value

The NPV is used were projects are not divisible. The NPV is calculated the normal way. Where
projects are not divisible, the order of profitability or variability of each project is ranked
according to NPV.

Soft Capital Rationing

For many firms the limits on capital funds are soft. By this we mean that the capital rationing is
imposed by top management of the firm. Soft rationing is brought by internal factors which
management can control. The internal factors may include the following:
 Management might be reluctant to issue additional share capital because of the concern that
outsiders might take control of the business
 Management may lack skills in risk management and capital evaluation
 The budget may restrict spending

If the limits on investment become so tight that truly good projects are being passed up, then
upper management should raise more money and relax the limit it has imposed on capital
spending.

Hard Capital Rationing

It is brought about by external factors which are beyond management control. It simply means
that the firm actually cannot raise the money it needs.
In this case the firm is forced to give up positive NPV projects. Factors which may cause hard
capital rationing include the following:
  Lending institutions may consider an organisation to be too risky to be granted a loan
facility
 The cost associated with the issue of capital may be too much for the company to manage
 There may be restriction on bank lending due to government control
Example
Sky-Tee Ltd is considering four projects, W, X, Y and Z. Relevant details are as follows:
Project Investment required P Value of Cash flow Net Present Value
W (10,000) 11240 1240
X (20000) 20991 991
Y (30000) 32230 230
Z (40000) 43801 3801

Without capital rationing all 4 projects are viable for investment. Suppose that only K60, 000
was available for capital investment. Determine the most appropriate capital investment plan
assuming that;
a. All projects are divisible
b. Projects are not divisible
Where projects are divisible we will use the PI to rank

Available Project Capital Required NPV Ranking

60, 000 W 10000 1240 1ST
Z 40000 3801 2ND

Y 10000 743.3 3RD

X ---- ---- 4TH
Assuming that all the projects are divisible and using the available capital of 60,000, we will
undertake W first, Z second and Y third.

B. Where the projects are not divisible

Where the projects are not divisible, the project are ranked using NPV

Project Capital required NPV Ranking

Z 40, 000 3801 1st

Y 20, 000 14861 2nd

Where the projects are not divisible, we should undertake project Z and Y because they are the
most profitable based on NPV