Chapter-3: Capital Budgeting

Chapter-three
Capital Budgeting/Investment Decision
3.1. Definition of Capital budgeting
Capital Budgeting is the process of evaluating specific investment decisions. Here the term capital
refers to operating assets used on production, while a budget is a plan that details projected cash flows
during some future period. Thus the capital budget is an outline of planned investment in operating
assets, and capital budgeting is the whole process of analyzing projects and deciding which ones to
include in the capital budget.
Capital budgeting is vital in marketing decisions. Decisions on investment which take time to mature
have to be based on the returns which that investment will make. Unless the project is for social reasons
only, if the investment is unprofitable in the long run, it is unwise to invest in it now. Often, it would be
good to know what the present value of the future investment is, or how long it will take to mature
(give returns). It could be much more profitable putting the planned investment money in the bank and
earning interest, or investing in an alternative project.
3.2. Importance of capital budgeting
Investment decisions require special attention because of the following reasons:
 They influence the firm’s growth in the long run
 They affect the risk of the firm
 They involve commitment of large amount of funds
 They are irreversible, or reversible at substantial loss
 They are among the most difficult decisions to make
Growth the effects of investment decisions extend into the future and have to be endured for a longer
period than the consequences of the current operating expenditure. A firm’s decision to invest in long-
term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove
disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will
result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would
make it difficult for the firm to compete successfully and maintain its market share.
Risk a long-term commitment of funds may also change the risk complexity of the firm. If the adoption
of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will
become more risky. Thus, investment decisions shape the basic character of a firm.
Funding investment decisions generally involve large amount of funds, which make it imperative for
the firm to plan its investment programs very carefully and make an advance arrangement for procuring
finances internally or externally.
Irreversibility Most investment decisions are irreversible. It is difficult to find a market for such capital
items once they have been acquired. The firm will incur heavy losses if such assets are scrapped.

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 Chapter-3: Capital Budgeting
Complexity investment decisions are among the firm’s most difficult decisions. They are in assessment
of future events, which are difficult to predict. It is really a complex problem to correctly estimate the
future cash flows of an investment. Economic, political, social and technological forces cause the
uncertainty in cash flow estimation.
3.3. Classifications of investments
There are many ways to classify investments. One classification is as follows:
 Expansion of existing business
 Expansion of new business
 Replacement and modernization
 Expansion and Diversification: A company may add capacity to its existing product lines to
expand existing operations. Expansion of a new business requires investment in new products
and a new kind of production activity within the firm. If a package manufacturing company
invests in a new plant and machinery to produce a product, which the firm has not manufactured
before, this represents expansion of new business or diversification. Sometimes a company
acquires existing firms to expand its business. In either case, the firm makes investment in the
expectation of additional revenue. Investments in existing or new products may also be called as
Revenue –expansion investments.
 Replacement and Modernization: The main objective of modernization and replacement is to
improve operating efficiency and reduce costs. Costs savings will reflect in the increased
profits. The firms must decide to replace those assets with new assets that operate more
economically.
For example; if a cement company changes from semi-automatic drying equipment to fully
automatic drying equipment. Replacement decisions help to introduce more efficient and
economical assets and therefore, are also called cost-reduction investment. However,
replacement decisions which involve substantial modernization and technological
improvements expand revenue as well as reduce costs.
Yet another useful way to classify investment is as follows:
 Mutually Exclusive investment
 Independent investment
 Contingent investment
 Mutually Exclusive Investments serve the same purpose and compete with each other. If one
investment is undertaken, others will have to be excluded. A company may, for example, either
use a more labor-intensive, semi-automatic machine, or employ a more capital-intensive, highly

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 Chapter-3: Capital Budgeting
automatic machine for production. Choosing the semi-automatic machine precludes the
acceptance of the highly automatic machine.
 Independent Investments serve different purposes and do not compete with each other. For
example, a heavy engineering company may be considering expansion of its plant capacity to
manufacture additional excavators and addition of new production facilities to manufacture a
new product. Depending on their profitability and availability of funds, the company can
undertake both investments.
 Contingent Investments are dependent projects; the choice of one investment necessitates
undertaking one or more other investments. For example, if a company decides to build a
factory in a remote, backward area, it may have to invest in house, roads, hospitals, schools etc
for employees. The total expenditures will be treated as one single investment.
3.4. Capital budgeting processes
Capital budgeting is a complex process which may be divided into five broad phases:
I. Planning
The planning phase of a firm’s capital budgeting process is concerned with the articulation of its broad
investment strategy and the generation and preliminary screening of project proposals. The investment
strategy of the firm delineates the broad areas or types of investments the firm planning to undertake.
This provides the framework which shapes, guides, and circumscribes the identification of individual
project opportunities.
Once a project proposal is identified, it needs to be examined. To begin with a preliminary project
analysis is done. A prelude to the full blown feasibility study, this exercise is meant to assess
 Whether the project is prima face worthwhile to justify a feasibility study and
 What aspects of the project are critical to its viability and hence warrant an in-depth
investigation.
II. Analysis
If the preliminary screening suggests that the project prima facie worthwhile, a detailed analysis of the
marketing, technical, financial, economic, and ecological aspects is undertaken. The questions and
issues raised in such a detailed analysis are described in the following section. The focus of this phase
of capital budgeting is on gathering, preparing and summarizing relevant information about various
project proposals which are being considered for inclusion in the capital budget. Based on the
information development in this analysis, the stream of costs and benefits associated with project can
be defined.
III. Selection
Selection or rejection of a project follows analysis phase. It addresses the question – is the project
worthwhile? The worth whileness of Projects are evaluated by using a wide range of evaluation

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 Chapter-3: Capital Budgeting
techniques. Selection or rejection of a project depends on the techniques used to evaluate and its
acceptance rule.
IV. Implementation
The implementation phase for an industrial project, which involves setting up of manufacturing
facilities, consists of several stages:
 Project and engineering designs
 Negotiations and contracting
 Construction
 IV. Training, and plant commissioning
V. Review
Once the project is commissioned the review phase has to be set in motion. Performance review should
be done periodically to compare actual performance with project performance. As feedback device, it is
useful in several ways:
 It throws light on how realistic were the assumptions underlying the project
 It provide a documented experience that is highly valuable in future decision making
 It suggests corrective action to be taken in the light of actual performance
 It helps in uncovering judgmental biases
 It induces a desired caution among project sponsors
3.5. Capital Budgeting Evaluation Techniques
There are two important methods of evaluating the investment proposals
Traditional methods
 Payback period
 Accounting rate of return(ARR)
Discounted cash flow method
 Net present value(NPV)
 Profitability Index method / Benefit cost Ratio
 Internal Rate of Return (IRR)
3.5.1. Traditional methods
a) Payback Period
Payback period is the number of years required to recover the original cash outlay invested in a project.
When deciding between two or more competing projects, the usual decision is to accept the one with
the shortest payback.
a) Payback Period with equal cash inflows: 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:

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 Chapter-3: Capital Budgeting
initial investment
Pay back period=
Anual cash inflow

Illustration
A project requires an investment of $ 100,000; it will generate annual cash flow of $25,000 per
year. Calculate the payback period.
Initial Investment
Pay Back period = Annual cash inf lows
100,000
= 25 ,000
= 4 years
b) Payback Period with unequal cash inflows: 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.
Unrecoverd cost at start of year
Pay back period= year before recovery +
cash flow during the next year

Illustration
The following is the information related to a company
Project A Project B
Year Cash flow $ Year Cash flow $
0 -700 0 -700
1 100 1 400
2 200 2 300
3 300 3 200
4 400 4 100
5 500 5 0

Calculate payback period

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 -

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 Chapter-3: Capital Budgeting
Project-A
Unrecoverd cost at start of year
Pay back period= year before recovery +
cash flow during the next year
100
= 3 + 400
= 3.25 year
Project-B
Unrecoverd cost at start of year
Pay back period= year before recovery +
cash flow during the next year
=2+0
= 2 years
Advantages of the payback method
 Payback can be important: long payback means capital tied up and high investment risk.
 The method also has the advantage that it involves a quick, simple calculation and an easily
understood concept.
Disadvantages of the payback method
 It ignores the timing of cash flows within the payback period, the cash flows after the end of
payback period and therefore the total project return.
 It ignores the time value of money. This means that it does not take into account the fact that $1
today is worth more than $1 in one year's time.
 It is unable to distinguish between projects with the same payback period.
 It may lead to excessive investment in short-term projects.
b) Accounting Rate of Return (ARR)
This method is based upon accounting information rather than cash flows. It is a measure of a project’s
profitability from a conventional accounting stand point. The ARR method (also called the return on
capital employed (ROCE) or the return on investment (ROI) method) of appraising a capital project is
to estimate the accounting rate of return that the project should yield.
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
×100
ARR = Average investment over the life of project
1
Average investment = Net working capital + Salvage value + 2 (Initial cost of plant – salvage value)
Net working capital = current assets – current liabilities
Total of annual profits
Average profits = Number of years

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 Chapter-3: Capital Budgeting
Illustration
Initial investments of plant $ 10,000
Installation costs $ 1,000
Salvage value $ 1,000
Working capital $ 2,000
Life of plant 5 years
Annual profit per year $ 2,500
Required: Calculate ARR

Solution
12,500
Average profit = 2, 500 x 5 = 5 = 2,500
1
Average investment = Wc + Sal.V. + 2 (Cost + Inst. Charges – Salv. Val)
1
= 2,000 + 1,000 + 2 (10,000 + 1,000 – 1,000)
1
= 3,000 + 2 (10,000)
= 3,000 + 5,000
= 8,000
2,500
ARR = 8,000 x 100
= 31.25%
The ARR is compared to the predetermined rate. The project will be accepted if the actual ARR is
higher than the desired ARR. Otherwise it will be rejected.

Advantages of ARR
 This technique is simple to understand and can be easily calculated using the accounting data.

 It considers the entire stream of income over the life of the project for evaluating the profitability
of the project.
Disadvantage of ARR
 It implicitly assumes stable cash receipts over time.
 It is based on accounting profits and not cash flows. Accounting profits are subject to a number of
different accounting treatments.
 It is a relative measure rather than an absolute measure and hence takes no account of the size of
the investment.
 It takes no account of the length of the project.
 It ignores the time value of money.

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3.5.2. Discounted cash flow techniques
This concept is based on the time value of money. The flow of income is spread over a few years. 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
net present value and internal rate of return method.

a) Net Present Value

Net present value method is one of the modern methods for evaluating the project proposals. In this
method cash inflows are considered with the time value of the money. Net present value describes as
the summation of the present value of cash inflow and present value of cash outflow. Net present value
is the difference between the total present value of future cash inflows and the total present value of future
cash outflows.
FCF t
NPV =∑ −IO
(1+k )t
Where:
 FCFt = the annual free cash flow in time period t (this can take on either positive or negative
values)
 k =the appropriate discount rate; that is, the required rate of return or cost of capital
 IO = the initial cash outlay
 n = the project's expected life
The projects net present value gives a measurement of the net value of an investment proposal in terms
of today's dollars. Because all cash flows are discounted back to the present, comparing the difference
between the present value of the annual free cash flows and the investment outlay is appropriate.
Whenever the project's NPV is greater than or equal to zero, we will accept the project; whenever the
NPV is negative, we will reject the project. Note that if the project's net present value is zero, then it
returns the required rate of return and should be accepted. This accept-reject criterion can be stated as:
 NPV'≥ 0: Accept
 NPV< 0: Reject

Illustration
ABC PLC is considering investing in a cement project. It has on hand Birr180,000. It is expected that
the project may work for seven years and likely to generate the following annual cash flows.

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 Chapter-3: Capital Budgeting
Year ACF
1 30,000
2 50,000
3 60,000
4 65,000
5 40,000
6 30,000
7 16,000
The cost of capital is 8%
Required: Calculate the Net present value.

Solution:
Year ACF PV factor Present value
1 30, 000 0.926 27, 780
2 50, 000 0.857 42, 850
3 60, 000 0.794 47, 640
4 65, 000 0.735 47, 775
5 40, 000 0.681 27, 240
6 30, 000 0.630 18, 900
7 16, 000 0.583 9, 328
221, 513
- Original investment (180, 000)
Net present value 41, 513
In the above problem the NPV is greater than zero hence, it may be accepted. Hence, you may directly
use the present value factors from tables.
1 1
n
= 1
Present value of birr 1 = (1+r) (1+.10 )
Advantages of NPV
 NPV criterion provides the most acceptable investment rule and has the following advantages:

 It takes into account the time value of money.

 It considers the entire stream of cash flows arising over the entire life of the project.

 The NPV criterion does not use any subjective cut-off rate but uses objectively estimated cash
flows and discount rate to evaluate the various investment decisions.

 It is always consistent with the objective of maximizing the shareholders wealth.

Limitations
 It is difficult to estimate the cash flows associated with project due to the uncertainty
associated with them. Also, the precise discount rate cannot be measured easily.

 Sometimes this method gives inconsistent results in case of projects with unequal lives.
b) Profitability Index Method / Benefit Cost Ratio B/C Ratio

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 Chapter-3: Capital Budgeting
Profitability index method is the relationship between the present values of net cash inflows and the
present value of cash outflows. The PI indicates the increase in the value of the firm created by each
birr invested in the project. It can be worked out either in unitary or in percentage terms. The formula is
Present value of cash inflows
Profitability Index = Pr esent value of cash outflows
 PI > 1→Accept
 PI = 1→indifference
 PI < 1→reject
 Higher the profitability index more is the project preferred.
From the above example we can calculate the profitability index as below
Present value of cash out flows $ 180, 000
Present value of cash inflows $ 221, 513
221,513
Profitability Index = 180,000 = 1.23
The Advantage of PI Method
 It recognizes the time value of money.
 It is consistent with the shareholder value maximization 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.
The Disadvantage of PI method
 Like IRR it is a percentage and therefore ignores the scale of investment
 Profitability index is difficult to understand. Moreover PI may conflict with NPV method when
dealing with mutually exclusive projects.
c) Internal Rate of Return (IRR)
The internal rate of return is also known as yield on investment, marginal efficiency of capital,
marginal productivity of capital, rate of return time adjusted rate of return and so on. Internal rate of
return is nothing but the rate of interest which equates the present value of future earnings with the
present value of present investment. Therefore, IR depends entirely on the initial outlay and the cash
proceeds of the project which is being evaluated for acceptance or rejection. The computation of IRR is
difficult one; you have to start equating the two values i.e., present value of future earnings and present
value of investment. It is possible through trial and error method.

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 Chapter-3: Capital Budgeting
IRR can be calculated basing on the payback period where annual cash flows are uniform, in case the
annual cash inflows are different for the periods, the fake payback period is calculate then adopt trial
and error procedure.
PB−DFr
r−
IRR = DFrL−DFrH
Where;
PB = Payback period
DFr = Discount Factor for interest
DFrL = Discount Factor for lower interest rate
DFrH = Discount Factor for higher interest rate
r = either of the two interest rates used
Or
NPVL
×R
IRR = LRD + PV
Where;
IRR = Internal Rate of Return
LRD = Lower Rate of Discount
NPVL = Net present value at lower rate of discount
(i.e., difference between present values of cash)
PV = the difference in present values at lower and higher discount values at lower.
R = the difference between two rates of discount.
Illustration
Nissan Plc. has $100, 000 on hand. This amount is invested in a project, where the annual benefits after
taxes are as below. It would like to know the rate of return earned by the company at the end of the life
of the project.
Year ACFS
1 $ 40, 000
2 35, 000
3 30, 000
4 25, 000
5 20, 000

Solution
At Discount Factor 20% At Discount Factor 10%
Year ACFS PV Factor PV in $ PV Factor PV in $
1 40, 000 .833 33, 300 .909 36, 400
2 35, 000 .694 24, 300 .826 28, 900
3 30, 000 .579 17, 400 .751 22, 500

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4 25, 000 .482 12, 100 .683 17, 100
5 20, 000 .402 8, 000 .621 12, 400
95, 100 117, 300
NPVL
×R
IRR = LRD + PV
17,300
×10
= 10 + 22,200
= 17.8
Advantages:
 It considers the time value of money.
 It considers the entire stream of cash flows associated with the project.
Limitations:
 IRR does not provide a unique value while dealing with projects that have one or more cash
out flows interspersed with cash inflows.

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