CHAPTER – FIVE

CAPITAL BUDGETING
DECISIONS

By Honelign E. (Ph.D)
Department of Accounting and Finance,
Bahir Dar University
 Chapter Outline:
 5.1. Investment Decisions:
(Nature, Feature, importance and Types of
Investment Decisions)
 5.2. Investment Evaluation:
(Criteria and Rule)
 5.3. Investment Evaluation Methods:
 NPV
 IRR
 PI
 PB
 APB
 ARR
Dr Honelign E.,BDU 2
 Introduction
 The overall objective of a company is to maximize
the wealth of shareholders through maximization
of its revenues and minimizing operation and
investment costs.
 To attain this objective, a firm invests its scarce
financial resources on available opportunities.
 Any investment decision depends upon the
decision rule that is applied under circumstances.
 Estimation of cash flows requires immense
understanding of the project before it is
implemented.

Dr Honelign E.,BDU 3
 Cost of capital is being considered as discounting
factor which has undergone a change over the
years.
 Hence determination of cost of capital would carry
greatest impact on the investment evaluation.
 This chapter focuses on various techniques
available for evaluating capital budgeting projects.
 We shall discuss some investment evaluation
criteria from its economic viability point of view and
how it can help in maximizing shareholders’ wealth.

Dr Honelign E.,BDU 4
5.1. Investment/ Capital Budgeting
Decisions:
 One of the major decisions made by firms is
investment decisions or capital budgeting
decisions.
 Capital refers to be the total investment of a
company or firm in money, tangible and intangible
assets.
 Budgeting is art of preparing budgets.
 Capital budgeting is a process that involves the
identification of potentially desirable projects for
capital expenditures, the subsequence of
evaluating capital expenditure proposals, and the
selection of proposals that meet certain criteria.
Dr Honelign E.,BDU 5
 Capital budgeting is a long-term planning for
making and financing proposed capital out lays.
 It is concerned with the allocation of the firm’s
source financial resources among the available
opportunities.
 Capital budgeting involves acquiring inputs with
long-term return.
 Capital budgeting consists in planning
development of available capital for the purpose of
maximizing the long-term profitability of the
concern.

Dr Honelign E.,BDU 6
 The examples of capital expenditure include :
 1. Purchase of fixed assets such as land and
building, plant and machinery, good will, etc.
 2. The expenditure relating to addition, expansion,
improvement and alteration to the fixed assets.
 3. The replacement of fixed assets.
 4. Research and development project.
 The consideration of investment opportunities
involves the comparison of the expected future
streams of earnings from a project with the
immediate and subsequent streams of earning
from a project, with the immediate and subsequent
streams of expenditure.
Dr Honelign E.,BDU 7
 Let us have a brief overview of their nature, feature,
importance and types before discussing about their
evaluation.

Dr Honelign E.,BDU 8
 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.
Dr Honelign E.,BDU 9
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.

Dr Honelign E.,BDU 10
Importance of Investment Decisions
 Growth
 Risk
 Funding
 Irreversibility
 Complexity

Dr Honelign E.,BDU 11
 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

Dr Honelign E.,BDU 12
 5.2. Investment Evaluation:
 Capital budgeting process has the following
steps:
1) Estimating cash flows (inflows & outflows).
2) Assessing riskiness of cash flows.
3) Determining the appropriate cost of capital.
4) Evaluate the investment based on some criteria.
5) Decide on the project to implement or not
(Apply the decision rule of the criteria used)
 Our focus here is understanding the
investment decision rule, criteria and methods:
Dr Honelign E.,BDU 13
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

Dr Honelign E.,BDU 14
 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.
 .

Dr Honelign E.,BDU 15
 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 that project
which maximises the shareholders’
wealth.
 It should be a criterion which is
applicable to any conceivable
investment project independent of
others
Dr Honelign E.,BDU 16
 Evaluation Criteria
 1. Discounted Cash Flow (DCF) Criteria
(Modern Method)
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
 2. Non-discounted Cash Flow Criteria
(the Traditional Methods)
 Payback Period (PB)
 Discounted Payback Period (DPB)
 Accounting Rate of Return (ARR)
Dr Honelign E.,BDU 17
 1) Net Present Value Method
 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).

Dr Honelign E.,BDU 18
 Net Present Value Method
 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:

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

n
Ct
NPV    C0
t 1 (1  k )
t

Dr Honelign E.,BDU 19
Example:
 Calculate NPV for a Project X with an initial cost of
Br. 250,000 and a 10% cost of capital. It generates
following cash flows:

Year Cash inflows

1 90,000
2 80,000
3 70,000
4 60,000
5 50,000
Dr Honelign E.,BDU 20
 Solution:
Year Cash flows PV @10% PV
1 90,000 0.909 81,810
2 80,000 0.826 66,080
3 70,000 0.751 52,570
4 60,000 0.683 40,980
5 50,000 0.621 31,050
ΣPV 272,490

Less: Initial cost 250,000

Dr Honelign E.,BDU 21

NPV ( Br.) 22,490

 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.
 As the project in the example has positive NPV,
i.e. present value of cash inflows is greater than
the cash outlays, it should be accepted.
Dr Honelign E.,BDU 22
Evaluation of the NPV Method
 NPV is most acceptable investment rule for the
following reasons:
 Time value
 Measure of true profitability
 Value-additivity
 Shareholder value
 Limitations:
 Involved cash flow estimation
 Discount rate difficult to determine
 Mutually exclusive projects
 Ranking of projects

Dr Honelign E.,BDU 23
 2) 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 after one period.
 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

Dr Honelign E.,BDU 24
 Calculation of IRR
 Uneven Cash Flows: Calculating IRR by
Trial and Error
The approach is to select any discount rate to
compute the present value of cash inflows.
 If the calculated present value of the expected
cash inflow is lower than the present value of
cash outflows, a lower rate should be tried.
 On the other hand, a higher value should be
tried if the present value of inflows is higher than
the present value of outflows.
 This process will be repeated unless the net
present value becomes zero.

Dr Honelign E.,BDU 25
 Example:
 A project costs Br. 32,000 and is expected to
generate cash inflows of Br. 16,000, Br.14,000
and Br. 12,000 at the end of each year for next 3
years. Calculate IRR.
 Solution:
 Let us take first trial by taking 10% discount rate
randomly.
 A positive NPV at 10% indicates that the project’s
true rate of return is higher than 10%.
 So another trial is taken randomly at 18%.
 At 18% NPV is negative. So the project’s IRR is
between 10% and 18%.
Dr Honelign E.,BDU 26
Year Cash flows PV @ 10% PV PV @ PV
18%
1 16000 0.909 14544 0.847 13552

2 14000 0.826 11564 0.718 10052

3 12000 0.751 9012 0.609 7308

ΣPV 35120 ΣPV 30912

NCO 32000 NCO 32000

NPV 3120 NPV (1088)

Dr Honelign E.,BDU 27
 Where,
 PVco = Present value of cash outlay
 PVCFAT = Present value of cash inflows at lower
rate
 r = Lower rate
 Δr = Difference between higher and lower rate
 ΔPV = Difference between PV of CFAT at lower
rate and higher rate

Dr Honelign E.,BDU 28
Difference in IRR Difference in CFAT at
Lower Rate & Lower rate & Higher rate
Higher Rate
10% PV at Lower Br.35, 120
rate 3120 4208
8% ? PV Required 32,000
18% PV at Higher 30, 912
rate

= 10% + (35,120-32,000) (18%-10%)

(35,120-30,912)

IRR = 15.95% = 16%

Dr Honelign E.,BDU 29
 Acceptance Rule
 When IRR is used to make accept-reject
decisions, the decision criteria are as follows:
 If the IRR is greater than the cost of capital,
accept the project. (r >k)
 If the IRR is less than the cost of capital, reject
the project. (r<k)

Dr Honelign E.,BDU 30
Evaluation of IRR Method
 IRR method has following merits:
 Time value
 Profitability measure
 Acceptance rule
 Shareholder value

 IRR method may suffer from:

 Multiple rates
 Mutually exclusive projects
 Value additivity

Dr Honelign E.,BDU 31
 3) 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.

Dr Honelign E.,BDU 32
 Profitability Index
 The initial cash outlay of a project is Rs 100,000
and it can generate cash inflow of Rs 40,000,
Rs 30,000, Rs 50,000 and Rs 20,000 in year 1
through 4. Assume a 10 per cent rate of
discount. The PV of cash inflows at 10 per cent
discount rate is:
PV  Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF 2, 0.10 ) + Rs 50,000(PVF 3, 0.10 ) + Rs 20,000(PVF 4, 0.10 )
= Rs 40,000  0.909 + Rs 30,000  0.826 + Rs 50,000  0.751 + Rs 20,000  0.68
NPV  Rs 112,350  Rs 100,000 = Rs 12,350
Rs 1,12,350
PI   1.1235 .
Rs 1,00,000

Dr Honelign E.,BDU 33
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 means that the
project’s NPV is negative.

Dr Honelign E.,BDU 34
 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.
Dr Honelign E.,BDU 35
 4) 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 C
Payback = = 0
Annual Cash Inflow C
 Assume that a project requires an outlay of Rs
50,000 and yields annual cash inflow of Rs 12,500
for 7 years. The payback period for the project is:
Rs 50,000
PB = = 4 years
Rs 12,000

Dr Honelign E.,BDU 36
Payback of 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.
 Suppose that a project requires a cash outlay of
Rs 20,000, and generates cash inflows of Rs
8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during
the next 4 years. What is the project’s payback?
 Solution:
3 years + 12 × (1,000/3,000) months
3 years + 4 months

Dr Honelign E.,BDU 37
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.

Dr Honelign E.,BDU 38
Evaluation of Payback
 Certain virtues:
 Simplicity
 Cost effective
 Short-term effects
 Risk shield
 Liquidity
 Serious limitations:
 Cash flows after payback
 Cash flows ignored
 Cash flow patterns
 Administrative difficulties
 Inconsistent with shareholder value

Dr Honelign E.,BDU 39
 5) Discounted Payback Period
 The discounted payback period is the number of
periods taken in recovering the investment outlay
on the present value basis.
 The discounted payback period still fails to
consider the cash flows occurring after the
payback period.
3 DISCOUNTEDPAYBACKILLUSTRATED
CashFlows
(Rs) Simple Discounted NPVat
C0 C1 C2 C3 C4 PB PB 10%
P -4,000 3,000 1,000 1,000 1,000 2yrs – –
PVofcashflows -4,000 2,727 826 751 683 2.6yrs 987
Q -4,000 0 4,000 1,000 2,000 2yrs – –
PVofcashflows -4,000 0 3,304 751 1,366 2.9yrs 1,421
Dr Honelign E.,BDU 40
6) 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.

Dr Honelign E.,BDU 41
Acceptance Rule
 This method will accept all those projects
whose ARR is higher than the minimum rate
established by the management 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.

Dr Honelign E.,BDU 42
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

Dr Honelign E.,BDU 43