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NOTES ON BUSINESS FINANCE

THE INVESTMENT DECISIONS/


CAPITAL BUDGETING DECISIONS

General Definitions
Capital budgeting (investment) decisions may be defined as the firm’s decision to invest
its current funds most efficiently in the long term assets in anticipation of an expected
flow of benefit over a series of years.

Specific Definitions
i) It is essentially a list of what management believes to be worthwhile projects for the
acquisition of new capital assets together with the estimated cost of each project” –
Robert N. Anthony
ii) It is long-term planning for making and financing proposed capital outlay- Charles
T. Horngreen
iii) It refers to acquiring inputs with long-returns - Richards & Greenlaw
iv) It is concerned with the allocation of the firm’s scare financial resources among the
available market opportunities. The consideration of investment opportunities
involves the comparison of the expected future streams of earnings from a project
with the immediate and subsequent expenditures for it. G.C Philippatus
v) It consists in planning for development of available capital for the purpose of
maximizing the long-term profitability (return on investment) of the firm - Milton
H. Spencer

From the above definitions, it is clear that capital budgeting correlates the planning of
available financial resources and their long-term investment in order to maximize the
profitability of the firm

INTRODUCTION
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An efficient allocation of capital is the most important finance function in the modern
times. It involves decisions to commit the firm’s funds to the long-term assets. Capital
budgeting or investment decisions are of considerable importance of the firm since they
tend to determine its value by influencing its growth, profitability and risk.

In this chapter we focus on the nature and evaluation of capital budgeting decisions.

Nature of Investment Decisions


The investment decisions of a firm are generally known as the capital budgeting, or
capital expenditure decisions. A capital budgeting decision may be defined as the firm’s
decisions to invest its current funds most efficiently in the long-term assets in anticipation
of an expected flow of benefits over a series of years. The long-term assets are those that
affect the firm’s operations beyond the one-year period. The form’s investment decisions
would generally include expansion, acquisition, modernization 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 expenditure and benefits, and therefore, they should also be
evaluated as investment decisions. It is important to note that investment in the long-
term assets invariably requires large funds to be tied up in the current assets such as
inventories and receivable. As such, investment in fixed and current assets is one single
activity.

The following are the features of investment decisions:


o The exchange of current funds for future benefits
o The funds are invested in long-term assets
o The future benefits will occur to the firm over a series of years

It is significant to emphasize that expenditure and benefits of an investment should be


measured in cash. In the investment analysis, it is cash flow, which is important, not the
accounting profit. It may also be pointed out that investment decisions affect the firm’s
value. The firm’s value will increase if investments are profitable and add to the
shareholder’s wealth. Thus, investments should be evaluated on the basis of a criterion,
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which is compatible with the objective of the shareholders’ wealth maximization. An
investment will add to the shareholders’ wealth if it yields benefits in excess of the
minimum benefits as per the opportunity cost of capital.

In this chapter, we assume the investment project’s opportunity cost of capital is known.
We also assume that the expenditures and benefits of the investment are known with
certainty. Both these assumption are relaxed to later chapters.

Importance of Investment Decisions


Investment decisions require special attention because of the following reasons:
o They influence the firm’s growth in the long run
o They affect the risk of the firm
o They involve commitment of large amount of funds
o They are irreversible, or reversible are substantial loss
o 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 decision to invest in long-term assets has a decisive
influence on the rate and direction of its growth. A growth 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 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 programmes very carefully and
make an advance arrangement for procuring finances internally or externally.

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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.
Complexity: Investment decisions are among the firm’s most difficult decisions. They
are an 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.

TYPES OF INVESTMENT DECISIONS


There are many ways to classify investments. One classification is as follows:
o Expansion of existing business
o Expansion of new business
o Replacement and modernization

Expansion and Diversification


A company may add capacity to its existing product lines to expand existing operations.
For example, the Gujarat State Fertilizer Company (GSFC) may increase its plant
capacity to manufacture more urea. It is an example of related diversification. A firm
may expand its activities in a new business. Expansion of a new business requires
investment in new products and a new kind of production activity within the firm. If a
packaging manufacturing company invests in a new has not manufactured before, this
represents expansion of new business of unrelated 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 product may also
be called as revenue-expansion investment.

Replacement and Modernization


The main objective of modernization and replacement is to improve operating efficiency
and reduce costs. Cost savings will reflect in the increased profits, but the firm’s revenue
may remain unchanged. Assets become outdated and obsolete with technological
changes. The firm must decide to replace those assets with new assets that operate more
economically. If a cement company changes from semi-automatic drying equipment to
fully automatic drying equipment, it is an example of modernization and replacement.
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Replacement decisions help to introduce more efficient and economically assets and
therefore, are also called cots-reducing investments. However, replacement decisions
that involve substantial modernization and technological improvements expand revenues
as well as reduce costs.
Yet another useful way to classify investments is as follows:
o Mutually exclusive investments
o Independent investments
o Contingent investment

Mutually Exclusive Investment


Mutually exclusive investment serves the same purpose and competes with each other. If
one investment is undertaken, others will have to be excluded. A company may, for
example, either use a more labour-intensive, semi-automatic machine, or employ a more
capital-intensive, highly automatic machine for production. Choosing the semi-automatic
machine precludes the acceptance of the highly automatic machine.

Independent Investments
Independents 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 – light commercial vehicles. Depending on their profitability
and availability of funds, the company can undertake both investments.

Contingent Investments
Contingent investment are dependent projects, the choice of one investment necessitates
undertaking one or more other investment. For example, if a company decides to build a
factory in a remote, backwards area, it may have to invest in the houses, roads, hospitals,
schools etc. for employees to attract the work force. Thus, building of factory also
requires investment in facilities for employees. The total expenditure will be treated as
one single investment.

INVESTMENT EVALUATION CRITERIA


Three steps are involved in the evaluation on an investment:

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o Estimation of cash flows
o Estimation of the required rate of return (the opportunity cost of capital)
o Application of a decision rule for making the choice

The first two steps, discussed in the subsequent chapters, are assumed as given. Thus,
our discussion in this chapter is confined to the third step. Specifically, we focus on the
merits and demerits of various decision rules.

Investment Decision Rule


The investment decision rules may be referred to as capital budgeting techniques, or
investment criteria. A sound appraisal technique should be used to measure the economic
worth of an investment project. The essential property of a sound technique is that it
should maximize the shareholders’ wealth. The following other characteristics should
also be possessed by a sound investment evaluation criterion.

o It should consider all cash flows to determine the true profitability of the project
o It should provided for an objective and unambiguous way of separating good
projects from bad projects
o It should help ranking of projects according to their true profitability
o It should recognize the fact that bigger cash flows are preferable to smaller ones
and early cash flows are preferable to later ones
o It should help to choose among mutually exclusive projects that project which
maximizes the shareholders’ wealth
o It should be a criterion which is applicable to any conceivable investment project
independent of others

REVIEW OF CAPITAL BUDGETING TECHNIQUES

Investment Evaluation Criteria

There are three steps involved in the evaluation of an investment:

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a) Estimation of cash flows
b) Estimation of the required rate of return (the opportunity cost of capital)
c) Application of a decision rule for making the choice.

Investment decision rules may be referred to as capital budgeting techniques or


investment criteria. A sound appraisal technique should be used to measure the economic
worth if an investment project i.e. it should maximize the shareholder’s wealth:

Characteristics of a sound investment evaluation:

a. To consider all cash flows to determine the true profitability of the project
b. To for an objective and unambiguous way of operating good projects from bad
ones
c. Should help in the ranking of the projects according to their true profitability etc

The investment techniques can categorize into 2 groups:.

1. Discounted Cash flows methods

a. Net Present Value method


b. Internal rate of return
c. Profitability index
2. Non-Discounted Cash Flow

a. Accounting rate of return


b. Payback Period

Net Present Value (NPV)


This is defined mathematically as the present value of cash flow less the initial outflow
n
NPV= Σ Ct - Co
t=1 (1+k) t

Where: Ct- cash flow


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k-opportunity cost of capital
Co-Initial cash outflow
n-useful life of the project

Decision rule using NPV


• Accept the project if the NPV is +ve
• Reject the Project if the NPV is –ve

Note: If the NPV =O, use other methods to make the decision.

Illustrations

Ill 1. Assume that project x costs $ 2500 now and its is expected to generate year end
cash inflows of $ 900, $800, $700, $ 600, and $ 500 in years 1 and 5. The opportunity
cost of capital may be assumed to be 10%.

Required:

Calculate the NPV of this project.

Solution:

NPV=900 +800 +700 +600 +500 -2500


(1+.10) (1+.10)² (1+.10)³ (1+.10) 4 (1+.10)5

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NPV= [900X.909+800X.826+700X.751+600X.683+500X.620]-2500

NPV= $2725-$500
NPV=+225

Project x’s PV of cash inflows (.2725) is greater than that of cash outflow (2500).
Therefore it generates a positive NPV (+225)

Note that project x adds to the wealth of owners hence it should be accepted.

Ill. 2. Suppose ban investment requires an initial outlay of $4000 with an expected cash
inflow of $ 1000 per year for the five years, should the proposal be accepted if the rate of
discount is (a) 15% and, (b) 6%.

Solution:
Year
Year cash flows Total Pv of 6% Total pv @
pv at @15% pv@15% 6%
(1) (2) (3) (2)x(3) (2)x(5)
1 1000 .870 870 .943 943
2 1000 .756 756 .890 890
3 1000 .668 668 .840 840
4 1000 .572 572 .792 792
5 1000 .497 497 .747 747
3353 4212

Note that the proposal can not be accepted as the total PV of $3353 at a discount rate of
15% is less than $ 400 which is the initial investment; even we ignore the other non-
quantitative consideration.

As the pv of the $ 4212 at a discount rate of 6% exceeds the initial investment of $ 4000,
the proposal may be accepted.
INTERNAL RATE OF RETURN (IRR)
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Internal Rate of Return is also known as Time adjusted rate of return, Discounted rate of
Return, Yield rate, Investor’s Method, Marginal efficiency of capital method etc

Rate of interest of discount is calculated. IRR is the rate at which the PV of expected cash
flows is equal to the total investment outlay. This rate is usually found by (Trial and
Error) Method.

Formula:

n Ct -Co =O
O= ∑ (1+r)
t=1

Where:
Ct- the cash flow generated in year t
Co-the initial cost of the project
n- the life of the project in years
r-the internal rate of return of the project

Illustrations

Ill. 3. A project costs $ 16000 and is expected to generate cash inflows of $8000, $7000
and $ 6000 at the end of each year for the next 3 years.

Further information:
1. The IRR is the rate at which project will have a zero NPV
2. Try a 20% discount rate
3. The project’s 20%

Solution:

NPV= -16000+8000X.833+7000X.694+6000X.579
= -16000+14996 =1,004
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Note that a positive NPV at 20% indicates that the project’s true rate of return is lower
than 20%

Try 16%

NPV=-16,000+8000X.862+7000X.743+6000X.641
= -16000+15943 =-57

Note that –ve NPV means we should try a lower rate i.e. 15%

NPV= -16000+8000X.870+7000X.756+. 658


=16000+16200=200

The true rate of return should be between 15- 16%


PROFITABILITY INDEX (PI) (BENEFIT COST RATIO)

This is the ratio of PV of cash inflows, at the required rate of return, to the initial cash
outflow of investment.

PI = PV of cash inflows = PV (Ct)


Initial cash outflow Co

=n Ct ÷ Co
∑ (1+k) t
t=1

Or

PI= NPV x 100 or GPV X 100

Investments Investments

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Decision Rule

1. Reject the project when PI is less than 1 PI< 1


2. Accept the project when PI is greater than 1 PI>1
3. May accept the project when PI is equal to 1 PI=1

Illustrations

Ill 4. The initial investment of a project is $ 100,000 and it can generate cash inflow of $
40,000, $ 30,000, $50, 000, and 20, 000 in year 1 through year 5. Assume a 10% rate of
discount. The PV of cash inflows at 10% discount rate is:

Solution:

PV = 40,000 X.909 +30,000X.826 +50,000X.751 +20,000X.68


NPV=112,350-100,000
=112,350
100,000
PI= 1, 1235

NON-DISCOUNTED CASH FLOW

ACCOUNTING RATE OF RETURN (AAR)

Where Average income=Average cash flows-Average Depreciation


Average Investment=1/2(cost of investment-Salvage Value)
(Assuming straight line depreciation method)

Projects with higher ARR are preferable.

Illustrations

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Ill.5. A project will cost $ 4000. Its stream of earnings before depreciation, interest rate
and taxes (EBDIT) during 1st year through five years is expected to be $ 10,000, $
12,000, $ 14,000, $ 16,000 and $ 20,000. Assume a 50% tax rate and depreciation on
straight-line basis.

Solution
Computable Table on Project’s ARR
Period 1 2 3 4 5 Average
Earnings Before 10,000 12,000 14,000 16,000 20,000 14,400
Depreciation $
Taxes(EBDIT)
Depreciation 8000 8000 8000 8000 8000 8000
Earnings Before 2000 4000 60000 8000 12000 6400
Interest Taxes
`(EBIT)
Taxes at 50% 1000 2000 3000 4000 6000 3200
Earnings before 1000 2000 3000 4000 6000 3200
Interest and after
Taxes(EBIT1-T)
Book Value of
Investment:
Beginnings 40,000 32000 24000 16000 8000 ---------
Ending 32000 24000 16,000 8000 --------- -------
Average 36000 28,000 20,000 12,000 4000 20,000

ARR= 3200 x 100=16%


20,000
Note that a variation of ARR is to divide average earnings after taxes by original cost of
the project instead of average cost i.e. 32,00÷40,000x100=8%- however this version is
investment as earnings are average but investment is not.

Ill. 6 Refer Illustration 3

Solution:

ARR
Project A: (10,000-10,000) ½ =0
(10,000)

B :( 15,000-10,000) ½ =50%
(10,000)½

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C :( 18,000-10,000) ⅓ = 53%
(10,000) ½

D: (16,000-10,000) ⅓ =40%
(10,000) ½

Acceptance Rule:

As an accept or reject criterion, this method will accept all those projects whose ARR is
higher than the rate established by the management and reject those projects which have
ARR less than the minimum rate.

ARR ranks a project as a number one if it has higher ARR and lowest rank would be
given to the project with lowest ARR.

PAYBACK/PAY OUT/PAYOUT/REPLACEMENT METHOD

This is defined as the time taken by the project to recoup cash outlay.

The decision rule depends on the firms target payback period (i.e. the maximum period
beyond which the project should not be accepted.)

If the project generates constant annual cash inflows the payback period can be computed
by dividing cash outlay by the annual cash inflow.

Formula:

Pay back=initial/original investment = Co


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Annual Cash inflow C

Illustrations

Ill .6. XYZ is offered two options for investments with the following cash flows. Its
decision criteria are a payable of 3 years.

Calculate payback

Option I Option II
Required Investment 8,000 7,000
4,000 2500
3000 2500
2000 2500
1000 2500

Payback Periods: Option I: 2.5Years


] Option II: 2.8Years

Ill 7: Calculate the pay back period for a project which requires an initial outlay of $
10,000 and generates year ending cash flows of $ 6000, $3000, $ 2000, $ 5000 and $5000
from the first year to the end of the 5th year

Solution:
Payback Period =4000+2500+2000=8,500 for 3 yrs
Balance =10,000-85,000=1500
4th year =1500 = 3/7
3,500
Pay back = 3 3/7
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PROBLEMS

Q1.A project requires an initial outlay of $ 10,000 and generates year ending cash flows
of $ 6000, 30000, 2000, $ 5000 and $5,000 from the end of the first year to the 5th year.
The required rate of return is 10% and pays tax at 50%. The project has a life of 5 years
and depreciated on straight line basis.

Year Discounted Factor at 10%


1 .909
2 .826
3 .751
4 .683
5 .621

Required:
Calculate
i.Payback period
ii.Average rate of return
iii.Net Present value

Q2.A Company is considering two mutually exclusive projects requiring an initial cash
outlay of 10,000 each and with a useful life of 5 years. The company required rate of
return is 10% and the appropriate corporate tax rate is 50%. The projects will depreciate
on a straight-line basis. The before depreciation and taxes cash flows expected to be
generated by the projects are as follows:

YEAR 1 2 3 4 5
Project A $4,000 4,000 4,000 4,000 4,000
Project B $6,000 3,000 2,000 5,000 5,000

Required:
Calculate for each project:
i.the pay back period
ii.The average rate of return
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iii.The net present value
iv.Profitability index
v.The internal rate of return
vi.Which project should be accepted? And why?
………………………END……………………….

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