Financial Management I

(ACFN 3041)

Chapter VI
Capital Budgeting Decisions

1/20/2023 Compiled By Habtamu B. (PhD) 1

 Capital Budgeting
◼ Capital budgeting is the process that companies use for
decision making on capital projects—those projects with a
life of a year or more.

◼ It is the process of identifying, analyzing, and selecting

investment projects whose returns (cash flows) are
expected to extend beyond one year.

◼ To evaluate capital budgeting processes, their consistency

with the goal of shareholder wealth maximization is of
utmost importance.
The Concept of Capital Budgeting
✓ capital budgeting – long-term for capital expenditures i.e.,
investment in productive assets (tangible and intangible long-
term assets)
➢ huge investments – large amount of money involved
➢ long-term commitment (permanent in nature) with long-term
effects
➢ irreversible – decision difficult or impossible to reverse
➢ uncertainty – surrounding outcomes
➢ Affect the risk structure of the firm
➢ Influence the growth and prospect of the firm in the long run
Capital budgeting decision process: Steps
✓ Steps
➢ identifying investment opportunities/options – search for
alternatives
➢ evaluating investment opportunities/options – use of different
evaluation criteria
➢ selection and approval
▪ Make the accept/reject decision.
▪ Independent projects: Accept/reject decision for a project is not
affected by the accept/reject decisions of other projects.
▪ Mutually exclusive projects: Selection of one alternative
precludes another alternative.
➢ investment/implementation
➢ performance review (monitoring and evaluation)
Categories of Capital Budgeting: Types
◼ The following decisions would qualify as projects:
a. Major strategic decisions to enter new areas of business or
new markets
b. Decisions on new ventures within existing businesses or
markets,
c. Acquisitions of other firms
d. Decisions that may change the way existing ventures and
projects are run [policy changes]
e. Decisions on how best to deliver a service that is necessary
for the business to run smoothly.
The Position of Capital Budgeting
The Position of Capital Budgeting

Financial Goal of the Firm:

Wealth Maximisation

Investment Decison Financing Decision Dividend Decision

Long Term Assets Short Term Assets Debt/Equity Mix Dividend Payout Ratio

Capital Budgeting
The Concept of Cash Flows
◼ From a project organization’s point of view, effective cash
flow management can mean the difference between project
success and failure.
◼ Because: the amount of cash inflow and outflow, and the
timing of these flows during the course of a project, can have
a significant influence on project costs and schedule.
◼ Hence, simply defined, cash flow is:
❑ the movement of funds in and out of a project, while

◼ Cash flow management focuses on:

❑ the timing of moving funds.
The Concept..
◼ This is often a matter of great importance to project
managers, because even if a project is making good
technical progress and is on schedule, it will be
considered a financial failure if it runs out of money.
◼ Projects that suffer from poor cash flow ultimately
incur additional costs and, possibly, significant delays
as well.
◼ Sometimes, however, even borrowing additional
money or stopping work until funds are received may
not be viable options.
Cash Flow Patterns
◼ Cash flow patterns associated with capital investment projects can
be classified as: conventional or nonconventional.
◼ A conventional cash flow pattern consists of an initial outflow
followed only by a series of inflows.

◼ A nonconventional cash flow pattern is one in which an initial

outflow is followed by a series of inflows and outflows.
 Conventional

Non-conventional
 Capital Budgeting: Processes
▪ Search for investment opportunities. This process will
obviously vary among firms and industries.
▪ Estimate all cash flows for each project.
▪ Evaluate the cash flows. a) Payback period. b) Net Present
Value. c) Internal Rate of Return. d) Modified Internal rate of
Return.
▪ Make the accept/reject decision.
▪ Independent projects: Accept/reject decision for a project
is not affected by the accept/reject decisions of other
projects.
▪ Mutually exclusive projects: Selection of one alternative
precludes another alternative.
▪ Periodically reevaluate past investment decisions.
Capital budgeting techniques
✓ capital budgeting techniques – methods for
evaluating investment options
✓ classified into tradition and modern ones
➢ traditional/non-discounted methods
❖ do not consider time value of money and timing difference in
cash flows
❖ include payback period and accounting rate of return
➢ modern/discounted methods
❖ consider time value of money
❖ include Discounted PBP, NPV, IRR, profitability-index (benefit-
cost ratio) and discounted payback period
 Non- Discounted Cash flow Methods
(Traditional Approaches)

1/20/2023 Compiled By Habtamu B. (PhD) 14

Capital budgeting techniques …
a)payback period
➢ number years needed for a project to recover its costs
➢ selection criterion – select a project with a payback
period
❖ less than a cutoff or

❖ shorter than that of an alternative project

➢ strength – simple to apply, biased towards liquidity, adjusts for

uncertainty of later cash flows, and considers cash flows instead of
income and expenses
 Capital budgeting techniques …
◼
Payback Period …
➢ Limitations:
➢ Ignores risk
➢ Ignores TVM and timing difference of cashflows
➢ Ignores cash flows beyond the payback period
➢ Doesn’t give a precise acceptance rule and based on
arbitrary cut-off point
➢ Biased against long-term projects
 Capital budgeting techniques …
Example 1
ABC Co is considering to purchase a new machine for
Br.360,000. The life of the machine is 10 years. The machine
will reduce annual costs by Br.50,000.
Required:
a) Compute the payback period for the machine.
b) Would the company purchase the new machine if the
maximum desired payback period of the management is 8
years?
c) Would the company purchase the new machine if the useful
life of the machine is 5 years instead of 10 years? Why?
d) Answer: Answers: a) 7 years, 2 months & 12 days, b) yes!, c) no!, the machine ends
without recovering its cost
 Capital budgeting techniques …
Example 2
ABC Co is considering to purchase a
new machine having a life of 6 years.
The investment and expected cash
inflows related to the machine are
given below.

Required:
a) Compute the payback period for the machine.
b) Would the company purchase the new machine if the maximum desired
payback period of the management is 4 years?
c) Answer: a) 4 years & 8 months b) No!
 Capital budgeting techniques …
Example 2
ABC Co is considering to purchase a
new machine having a life of 6 years.
The investment and expected cash
inflows related to the machine are
given below.

Required:
a) Compute the payback period for the machine.
b) Would the company purchase the new machine if the maximum desired
payback period of the management is 4 years?
c) Answer: a) 4 years & 8 months b) No!
 Capital budgeting techniques …
◼
Capital budgeting techniques …
➢ strength
❖ easily understandable
❖ simple to compute
❖ recognizes profitability factor
❖ uses usually available information (Why? It uses data from financial
accounting reports)

➢ limitations
❖ uses accounting data /book values instead of cash flows/market
values
❖ ignores time value of money, thus, it is not a true rate of return
❖ uses an arbitrary benchmark/cutoff rate
Capital budgeting techniques …
Example 3
ABC Co uses ARR to analyze investment in plant assets. The
company wants to reduce its total annual cost by purchasing a new
equipment to be installed in its factory. The relevant information
about investment in the new equipment is presented below:

Required:
a) Compute accounting rate of return
of the equipment.
b) Is this investment desirable
according to ARR analysis?
c) Answer: 9.33%, and not desirable.
 ARR= Average annual net income
Average investment or average book value

Example
Consider a company that is evaluating whether to buy a
new store in a new mall. The purchase price is $500,000.
We will assume that the store has an estimated life of 5
years. We assume that the store will worth nothing at the
end of the lifetime. Use straight line depreciation.

Annual revenue for the five years is: Br. 460,000, Br.
450,000, Br. 270,000, Br. 165,000 and Br. 250,000 and
operating expenses are 35% of the annual revenue.
Assume further that the firm is 25% income tax bracket.
Compute the ARR and indicate your decision assuming
further that the target ARR is 30%:
24
 Description Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5
Revenue (in Br.) 460,000 450,000 270,000 165,000 250,000
-Expenses (35%) 161,000 1575,500 94,500 57,750 87,500
Income before D & T 299,000 292,500 175,500 107,250 162,500
- Depr. 100,000 100,000 100,000 100,000 100,000
Income Before T 199,000 192,500 75,500 7,250 62,500

- Tax (25%) 49,750 48,125 18,875 1,812.50 15,625

NI after Tax 149,250 144,375 56,625 5,437.50 46,875

Br.149250+ 144375+ 56625+ 5437.5 + 46875 Br.402562.50

Average NI = Br. 80,512.50 = = Br.80,512.50
5

Initial Investment + SV Br .500000+ 0

Average Investment (BV) = = = Br .250,000
2 2

1/20/2023 ARR = Compiled By Habtamu B. (PhD)

Br. 80512.50/Br. 250000 = 32.21% 25
Discounted Cash Flow Methods
(Modern Approaches)
 a. Discounted PBP

◼ Example
Take the information given below and compute the discounted
PBP if the required rate of return is 10%. Should the project be
accepted?
Year Annual CF Discount factor Present Cumulative
(10%) value Present CF

1 30,000
2 35,000
3 40,000
4 50,000
5 65,000
b. PBP
Year Annual CF Discount factor Present Cumulative
(10%) value Present CF

1 30,000 0.909 27,270 27,270

2 35,000 0.826 28,910 56,180
3 40,000 0.751 30,040 86,220
4 50,000 0.683 34,150 120,370
5 65,000 0.621 40,365 160,735

◼
Advantages and Disadvantages of Discounted
Payback Period

Advantages
1. Considers the time value of money.
2. Considers the project’s cash flows’ risk through the
cost of capital.
Disadvantages
1. No concrete decision criteria that indicate whether
the investment increases the company’s value.
2. Requires an estimate of the cost of capital in order to
calculate the payback.
3. Ignores cash flows beyond the discounted payback
period
b. Net Present Value /NPV/
◼ The net present value (NPV) of an investment proposal is
defined as the sum of the present values of the cash
flows minus the sum of the present values of the net
investments.

NPV= the sum of the PV of NCF – initial investment

Decision Rule
• Accept the project if NPV is positive

• Reject the project if NPV is negative

 c. NPV
◼ Example 1:
◼ Assume that the project requires initial investment of Br.
215,500. Annual net cash flows are expected to be Br. 70,000
for 5 years. If the required rate of return is 10%, what is NPV?
◼ Solution
Year Cash Discount Present
Flow (in Factor (10%) Value (in
Birr) Birr) NPV= Br. 265,300 – 215,500
1 70,000 0.909 63,630 NPV= Br. 49,800
2 70,000 0.826 57,820
3 70,000 0.751 52,570
4 70,000 0.683 47,810
5 70,000 0.621 43,470
Total 265,300
◼ Exercise 1:
◼ Assume a Br. 50,000 investment and the following cash
flows for two alternatives. Assuming the cost of capital
or required rate of return is 7%, which alternative would
you select under:
a)Discounted Payback Period method
b)NPV method
c)Based on your answer in ‘a’ and ‘b’ above, which project
should be accepted
Year Investment A Investment B
1 Br. 10,000 Br. 20,000
2 11,000 25,000
3 13,000 10,000
4 16,000 5,000
5 30,000 0
Internal Rate of Return

1/20/2023 Compiled By Habtamu B. (PhD) 33

IRR
◼ The internal rate of return (IRR) is a metric used in
financial analysis to estimate the profitability of
potential investments.
◼ IRR is a discount rate that makes the net present
value (NPV) of all cash flows equal to zero in a
discounted cash flow analysis.
◼ Keep in mind that IRR is not the actual money
(birr) value of the project.
◼ Generally speaking, the higher an IRR, the more
desirable an investment is to undertake.

1/20/2023 Compiled By Habtamu B. (PhD) 34

Advantage and Disadvantages
◼ IRR measures the
quality or efficiency of an
investment, but not the
magnitude.
◼ Has intuitive appeal,
extremely widely used in
practice.
◼ Does not require a
discount rate.
◼ Many downsides – can
be extremely misleading.
Highly non-robust.
◼ Shunned by textbooks
and academics.
Prevailing wisdom: Use
NPV, avoid IRR!
◼ IRR may have multiple
solutions:
❑ Up to as many
solutions as there
are sign changes in
the cash flow.
◼ IRR may also have
zero solutions:
❑ E.g., Zero sign
changes.
❑ Common example:
Project never
reaches profitability.
IRR
◼
1. Determining IRR when Net Cash flows are annuity

Example 1: Assume that the project requires initial

investment of Br. 375,560. Annual net cash flows
are expected to be Br. 72,000 for 10 years. If the
required rate of return is 10%, what is IRR?

Solution:

PBP =

PBP = Br. 375,560/Br. 72,000

PBP= 5.2161
1. Determining IRR when Net Cash flows are
annuity

◼ The leading discount factor is found under i =

14%. Thus, the IRR of the project is 14%.
◼ Decision:
◼ Accept the project as its IRR (14%) exceeds
the required rate of return (10%).

◼ What if the leading discount factor is not

exactly found the present value of an annuity
table? The following example illustrates this
case?
 IRR
Example 2: Assume that the project requires initial
investment of Br. 380,000. Annual net cash flows
are expected to be Br. 70,000 for 10 years. If the
required rate of return is 10%, what is IRR?

Solution:
Step 1: Compute the leading discount factor or Payback period

Initial Investment
PBP =
Annual NCF
380,000
= = 5.429
70,000
 IRR
Step 2: Locate the IRR by looking along the appropriate period (n) in the present value of
an annuity table until the column which includes the leading discount factor is
reached. The discount rate of this column is the IRR for the project. In this
example, the leading discount factor is not found in the table.
Step 3
◼ In the year row (n=10) of the present value of an annuity table, take
two discount factors closest to the leading discount factor but one
bigger and the other smaller than it.
Rate Discount factor
12% 5.6502
13% 5.4262
◼ This implies that the exact internal rate of return is found between
12% and 13%.
 IRR
Step 4 Determine the exact IRR using the following formula:

IRR = r – [ x 1%]

Where,
r = the taken discount rate (either 12% or 13%)
PBP = Payback period or leading discount factor
DFr = Discount factor of r
DFrL = Discount factor of the lower rate (i.e. 12%)
DFrH = Discount factor of the higher rate (i.e. 13%)
IRR

◼
IRR
◼ If r = 13%
2. Determining IRR when Net Cash Flows are not Annuity
Example: Assume that the project requires initial investment
of Br. 350,000. Annual net cash flows are expected to be as
follows:
Year Cash Flow
1 60,000
2 70,000
3 90,000
4 80,000
5 100,000
6 120,000

If the required rate of return is 10%, what is IRR?

IRR
◼ Use discount factors at 11% and 12%.
Year NCF Discount factor at Present Value
(2) 11% (3) (4) = (2) X (3)
1 60,000 0.901 54,060
2 70,000 0.812 56,840
3 90,000 0.731 65,790
4 80,000 0.659 52,720
5 100,000 0.593 59,300
6 120,000 0.535 64,200
Total Present Value of NCF 352,910
Deduct: Initial Investment 350,000
NPV 2910
IRR
◼ Using 11% and 12% (cont’d)
Year NCF Discount factor at Present Value
(2) 12% (3) (4) = (2) X (3)
1 60,000 0.893 53,580
2 70,000 0.797 55,790
3 90,000 0.712 64,080
4 80,000 0.636 50,880
5 100,000 0.567 56,700
6 120,000 0.507 60,840
Total Present Value of NCF 341,870
Deduct: Initial Investment 350,000
NPV (8130)
IRR
At 11%, NPV is Positive while at 12%, NPV is negative.
Hence, it indicates that IRR lies between 11% and 12%.
To determine the exact IRR, interpolation method can be
used:
◼ Obtain the absolute sum of NPVs of the two rates

= /2910/ + /-8130/
= 11,040
◼ Divide NPV of the smaller rate by the absolute sum,
multiply the quotient by 1% and add the result to the
smaller rate. Or
◼ Divide NPV of the bigger rate by the absolute sum,
multiply the quotient by 1% and subtract the result from
the bigger rate.
IRR – using the smaller rate

◼
Check for the bigger rate!

1/20/2023 Compiled By Habtamu B. (PhD) 49

Profitability Index
It is the ratio of the present value of cash inflows at the
required rate of return, to the initial cash out flows of the
investment.
n
Ci
◼ PI = 
i =1 (1 + i ) n = PV of Cash inflows/ PV of Cash outflows
C0

◼ Where: PI = Profitability Index

Ci = Periodic cash inflow
C0 = Cash outflows or Initial cash outlays or investments
i = Required rate of return
n = Number of periods
PI
◼ Decision Rule
◼ Accept the project when profitability index is grater than one;
PI>1
◼ Reject the project when profitability index is less than one;
PI<1
◼ May accept/reject the project when profitability index is one;
PI=1
Choosing between two different projects?
→ Higher PI is best choice

1/20/2023 Compiled By Habtamu B. (PhD) 51

Example:
◼ Assume that a machine will cost Br 100,000 and will
provide annual net cash inflows for the coming six years
are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

50,000 40,000 30,000 20,000 20, 000 20,000

◼ The cost of capital is 15%.

◼ Calculate the machine PI. Should the machine be
purchased?

1/20/2023 52
Solutions
Year Cash Discount factor of 15% Discounted cash inflow
1 50,000 0.8696 43,480
2 40,000 0.7561 30,244
3 30,000 0.6575 19,725
4 20,000 0.5718 11,436
5 20,000 0.4972 9,944
6 20,000 0.4323 8,646
V of cash inflows = 123,475
Br123,475
PI =Br100,000 = 1.235

Decision:

Since, the projects PI is greater than one (i.e. 1.235), the machine
should be purchased.
Advantages and Disadvantages of
Profitability Index
◼ Advantages ◼ Disadvantages
❑ Closely related to NPV, ❑ May lead to incorrect decisions in
generally leading to comparisons of mutually exclusive
identical decisions investments (can conflict with NPV)
◼ Considers all CFs
◼ Considers TVM
◼ Scale is not revealed ( 10/5 = 1000/500,
Would you rather make 100% or 50% on
❑ Easy to understand
your investments? What if the 100% return
and communicate
is on a $1 investment, while the 50% return
❑ Useful in capital is on a $1,000 investment?)
rationing
In summary

Pa yba ck Accounting Ne t pre se nt Inte rna l ra te

pe riod ra te of re turn va lue of re turn
Ba sis of Ca sh Accrua l Ca sh flow s Ca sh flow s
me a sure me nt flow s income Profita bility Profita bility
Me a sure Numbe r Pe rce nt Dolla r Pe rce nt
e x pre sse d a s of ye a rs Amount
Ea sy to Ea sy to Conside rs time Conside rs time
Unde rsta nd Unde rsta nd va lue of mone y va lue of mone y
Stre ngths Allow s Allow s Accommoda te s Allow s
compa rison compa rison diffe re nt risk compa risons
a cross proje cts a cross proje cts le ve ls ove r of dissimila r
a proje ct's life proje cts
Doe sn't Doe sn't Difficult to Doe sn't re fle ct
conside r time conside r time compa re va rying risk
va lue of mone y va lue of mone y dissimila r le ve ls ove r the
Limita tions proje cts proje ct's life
Doe sn't Doe sn't give
conside r ca sh a nnua l ra te s
flow s a fte r ove r the life
pa yba ck pe riod of a proje ct 55
Capital Rationing
Capital rationing − constraints that limit firms from
accepting all positive NPV projects.
Two forms:
1. Hard rationing − imposed by external forces

2. Soft rationing − internally imposed by management

◼ Rationale of Capital rationing

❑ reluctance to incur increasing levels of debt
❑ perhaps due to limits on external financing

❑ management may not want to add to equity in fear of diluting

control
Implication: capital rationing does not permit a company to achieve
its maximum value
Comparing NPV and IRR Techniques:
Conflicting Rankings
◼ Conflicting rankings are conflicts in the ranking given a
project by NPV and IRR, resulting from differences in the
magnitude and timing of cash flows.
◼ One underlying cause of conflicting rankings is the
implicit assumption concerning the reinvestment of
intermediate cash inflows—cash inflows received prior
to the termination of the project.
◼ NPV assumes intermediate cash flows are reinvested at
the cost of capital, while IRR assumes that they are
reinvested at the IRR.
IRR distorts apparent value of intermediate returns

◼ Appears as if your positive intermediate earnings

can be re-invested at IRR rate.
❑ Makes options with exceptionally high IRR look too good.
◼ Appears as if your negative intermediate expenses
are financed from the start at IRR rate.
❑ Makes bad projects look too good, good projects with late
cash flow look bad.
In practice, these distortions are often huge, and
highly relevant – compensating for them drastically
changes relative merits.
Comparing NPV and IRR Techniques: Timing
of the Cash Flow
Another reason why the IRR and NPV methods may
provide different rankings for investment options has to do
with differences in the timing of cash flows.
❑ When much of a project’s cash flows arrive early in its life, the
project’s NPV will not be particularly sensitive to the discount
rate.
❑ On the other hand, the NPV of projects with cash flows that arrive
later will fluctuate more as the discount rate changes.
❑ The differences in the timing of cash flows between the two
projects does not affect the ranking provided by the IRR method.
Comparing NPV and IRR Techniques: Magnitude of
the Initial Investment

The scale problem occurs when two projects are very different in
terms of how much money is required to invest in each project.
❑ In these cases, the IRR and NPV methods may rank projects differently.
❑ The IRR approach (and the PI method) may favor small projects with
high returns (like the $2 loan that turns into $3).
❑ The NPV approach favors the investment that makes the investor the
most money (like the $1,000 investment that yields $1,100 in one day).
 NPV & IRR

◼ NPV and IRR will generally give us the same decision if:

❑ Conventional Cash Flows = OK to use

IRR or NPV
◼ Cash flow time 0 is negative.
Both give
◼ Remaining cash flows are positive.
same
answer.
❑ Projects (investments) Are Independent:
◼ The decision to accept/reject this project does not affect the decision to
accept/reject any other project.

❖ Independent = “not mutually exclusive”.

DO NOT Use IRR, Instead Use NPV

◼ DO NOT use IRR for projects that have

non-conventional cash flows

◼ DO NOT use IRR for projects that are

mutually exclusive.
NOT OK to use IRR

Use NPV instead

Conflicts Between NPV and IRR
◼ NPV directly measures the increase in value to the firm
◼ Whenever there is a conflict between NPV and another decision
rule, you should always use NPV
◼ IRR is unreliable in the following situations
❑ Non-conventional cash flows
❑ Mutually exclusive projects
Comparing NPV and IRR Techniques: Which
Approach is Better?
On a purely theoretical basis, NPV is the better approach because:
❑ NPV measures how much wealth a project creates (or destroys if the NPV is
negative) for shareholders.
❑ Certain mathematical properties may cause a project to have multiple IRRs—
more than one IRR resulting from a capital budgeting project with a
nonconventional cash flow pattern; the maximum number of IRRs for a project
is equal to the number of sign changes in its cash flows.
Despite its theoretical superiority, however, financial managers prefer to
use the IRR approach just as often as the NPV method because of the
preference for rates of return.
The risk-adjusted discount rate method

A discount rate higher than the risk-free rate is used to allow

for the project’s risk (r is replaced with k. Here, k is the
required rate of return (RROR)). Other than that there is no
conceptual difference between the basic NPV formula under
certainty and the NPV formula under uncertainty which uses
the RADR to incorporate risk into the project analysis.

n CFt
NPV DR = ∑ - CF0
(1 + k) t
t=
1
Components of RORR (k)
◼ 1) a risk-free rate (r ) to account for the time value of money
◼ 2) an average risk premium (u) to compensate investors for the fact
that the company’s assets (or investments) are risky;
◼ 3) an additional risk factor (a), which could be zero, negative or
positive to account for the
◼ difference in the risk between the firm’s existing business and the
proposed project.
◼ Thus, conceptually, k may be expressed in an algebraic equation
form as:
◼ k = r + u + a.
The certainty equivalent method
The certainty equivalent (CE) method is an
alternative approach to incorporating risk into
project analysis. This approach incorporates risk
into the analysis by adjusting the expected cash
flows rather than the discount rate. The CE
approach thus involves adjustments to the
numerator of the NPV equation.

n Bt CFt
NPV ce= ∑ (1 + r) t
- CF0 bt = certainty equivalent
coefficient which
t= converts the expected
1 risky cash flows (Ct ) into
their perceived certainty
equivalent values
 End of Chapter Six

1/20/2023 Compiled By Habtamu B. (PhD) 68