CHAPTER FOUR

CAPITAL BUDGETING/INVESTMENT DECISIONS

Capital budgeting is the process of evaluating specific investment decisions. Here the term
capital refers to operating assets used in 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
investments in operating assets, and capital budgeting is the whole process of analyzing projects
and deciding which ones to include in the capital budget. The term “capital” also has come to
mean the funds used to finance the firm’s assets. In this sense, capital consists of notes, bonds,
stock, and short-term financing. We use the term “capital structure” to refer to the mix of these
different sources of capital used to finance a firm’s assets. Under this chapter capital is
understood according to the first definition.

An investment requires an immediate expenditure and provides benefits in the form of cash
flows received in the future. If benefits are received only within the current period—within one
year of making the investment—we refer to the investment as a short-term investment. If these
benefits are received beyond the current period, we refer to the investment as a long-term
investment and refer to the expenditure as a capital expenditure. An investment project may
comprise one or more capital expenditures. For example, a new product may require investment
in production equipment, a building, and transportation equipment.

Short-term investment decisions involve, primarily, investments in current assets: cash,

marketable securities, accounts receivable, and inventory. The objective of investing in short-
term assets is the same as long-term assets: maximizing owners’ wealth. Nevertheless, we
consider them separately for two practical reasons: 1. Decisions about long-term assets are
based on projections of cash flows far into the future and require us to consider the time value of
money. 2. Long-term assets do not figure into the daily operating needs of the firm. Therefore,
this chapter is deals about the importance, process and techniques for capital budgeting or long
term investment decisions particularly.

4.1. Definition, Importance of capital budgeting

Capital budgeting is the process of identifying and selecting investments in long-lived assets, or
assets expected to produce benefits over more than one year. The investment decisions are the
vehicles of a company to reach the desired destiny of the company. An appropriate decision
would yield spectacular results whereas a wrong decision may upset the whole financial plan and
endanger the very survival of the firm. Even firm may be forced into bankruptcy. Investment
decision is among the firm’s most difficult decisions. They are the predictors of future events
which are difficult to predict. It is a complex problem investment. The cash flow uncertainty is
caused by economic, political, social and technological forces.

[1]
First, a firm’s capital budgeting decisions define its strategic direction, because moves into
new products, services, or markets must be preceded by capital expenditures. Second, the results
of capital budgeting decisions continue for many years, reducing flexibility. Third, poor capital
budgeting can have serious financial consequences. If the firm invests too much, it will incur
unnecessarily high depreciation and other expenses. On the other hand, if it does not invest
enough, its equipment and computer software may not be sufficiently modern to enable it to
produce competitively. Also, if it has inadequate capacity, it may lose market share to rival
firms, and regaining lost customers requires heavy selling expenses, price reductions, or product
improvements, all of which are costly.

The same general concepts that are used in security valuation are also involved in capital
budgeting. However, whereas a set of stocks and bonds exists in the securities market, and
investors select from this set, capital budgeting projects are created by the firm. For example, a
sales representative may report that customers are asking for a particular product that the
company does not now produce. The sales manager then discusses the idea with the marketing
research group to determine the size of the market for the proposed product. If it appears that a
significant market does exist, cost accountants and engineers will be asked to estimate
production costs. If they conclude that the product can be produced and sold at a sufficient profit,
the project will be undertaken.

A firm’s growth, and even its ability to remain competitive and to survive, depends on a constant
flow of ideas for new products, for ways to make existing products better, and for ways to
operate at a lower cost. Accordingly, a well-managed firm will go to great lengths to encourage
good capital budgeting proposals from its employees. If a firm has capable and imaginative
executives and employees, and if its incentive system is working properly, many ideas for capital
investment will be advanced. Some ideas will be good ones, but others will not. Therefore,
companies must screen projects for those that add value, the primary topic of this chapter.

4.2. Project classifications

Analyzing capital expenditure proposals is not a costless operation—benefits can be gained, but
analysis does have a cost. For certain types of projects, a relatively detailed analysis may be
warranted; for others, simpler procedures should be used. Accordingly, firms generally
categorize projects and then analyze those in each category somewhat differently:

1. Replacement: maintenance of business: Replacement of worn-out or damaged equipment is

necessary if the firm is to continue in business. The only issues here are (a) should this operation
be continued and (b) should we continue to use the same production processes? If the answers
are yes, maintenance decisions are normally made without an elaborate decision process. For
instance, if the electric line of the machine is damaged and if the management decided to use that

[2]
machine and the production and sales will be the same, the company should maintain the electric
line of the machine.

2. Replacement: cost reduction: These projects lower the costs of labor, materials, and other
inputs such as electricity by replacing serviceable but less efficient equipment. These decisions
are discretionary, and require a detailed analysis.

3. Expansion of existing products or markets: Expenditures to increase output of existing

products, or to expand retail outlets or distribution facilities in markets now being served, are
included here. These decisions are more complex because they require an explicit forecast of
growth in demand, so a more detailed analysis is required. Also, the final decision is generally
made at a higher level within the firm. For example, a manufacturing unit producing one hundred
thousand units per year if it intends to double the output by two hundred thousands, this will
obviously increase the need for funds for acquiring fixed and current assets.

4. Expansion into new products or markets/Diversification: These projects involve strategic

decisions that could change the fundamental nature of the business, and they normally require
the expenditure of large sums with delayed paybacks. Invariably, a detailed analysis is required,
and the final decision is generally made at the very top—by the board of directors as a part of the
firm’s strategic plan. For instance, a company in Ethiopia want to enter the global market, the
company should expand its capacity (expansion in to new market). Or Philips, a famous
company for radio and electric bulbs etc. diversified into production of other electrical
appliances and television sets (expansion in to new product line).

5. Safety and/or environmental projects: Expenditures necessary to comply with government

orders, labor agreements, or insurance policy terms are called mandatory investments, and they
often involve non-revenue-producing projects. How they are handled depends on their size,
with small ones being treated much like the Category 1 projects described above.

6. Research and development: The expected cash flows from R&D are often too uncertain to
warrant a standard discounted cash flow (DCF) analysis. Instead, decision tree analysis and the
real options approach are often used.

7. Long-term contracts: Companies often make long-term contractual arrangements to provide

products or services to specific customers. For example, IBM has signed agreements to handle
computer services for other companies for periods of 5 to 10 years. There may or may not be
much up-front investment, but costs and revenues will accrue over multiple years, and a DCF
analysis should be performed before the contract is signed.
Note: Larger investments require increasingly detailed analysis and approval at a higher level
within the firm.

[3]
4.3. Stages in the Capital Budgeting Process
There are five stages in the capital budgeting process.
Stage 1: Investment screening and selection
Projects consistent with the corporate strategy are identified by production, marketing, and
research and development management of the firm. Once identified, projects are evaluated and
screened by estimating how they affect the future cash flows of the firm and, hence, the value of
the firm.
Stage 2: Capital budget proposal
A capital budget is proposed for the projects surviving the screening and selection process. The
budget lists the recommended projects and the dollar amount of investment needed for each. This
proposal may start as an estimate of expected revenues and costs, but as the project analysis is
refined, data from marketing, purchasing, engineering, accounting, and finance functions are put
together.
Stage 3: Budgeting approval and authorization
Projects included in the capital budget are authorized, allowing further fact gathering and
analysis, and approved, allowing expenditures for the projects. In some firms, the projects are
authorized and approved at the same time. In others, a project must first be authorized, requiring
more research before it can be formally approved. Formal authorization and approval procedures
are typically used on larger expenditures; smaller expenditures are at the discretion of
management.
Stage 4: Project tracking
After a project is approved, work on it begins. The manager reports periodically on its
expenditures, as well as on any revenues associated with it. This is referred to as project
tracking, the communication link between the decision makers and the operating management of
the firm. For example: tracking can identify cost overruns and uncover the need for more
marketing research.
Stage 5: Post-completion audit
Following a period of time, perhaps two or three years after approval, projects are reviewed to
see whether they should be continued. This re-evaluation is referred to as a post-completion
audit. Thorough post-completion audits are typically performed on selected projects, usually the
largest projects in a given year’s budget for the firm or for each division. Post-completion audits
show the firm’s management how well the cash flows realized corresponds with the cash flows
forecasted several years earlier. A post-investment audit compares the actual results for a project
to the costs and benefits expected at the time the project was selected. It provides management
with feedback about performance.
4.4. Data required for investment decisions
Initial Investment: The total amount of cash required buying various assets like land, buildings,
plant, machinery, equipment, etc and there installation expenses have to be estimated. In addition
to fixed cost, the cost of maintaining stocks, contingency reserves to cover the cost of supporting
the additional receivables. Benefit of credit from suppliers will have the effect of reducing the
quantum of additional working capital required.
[4]
Subsequent Investment: The cost of maintenance, replacement and updating are to be treated as
outflows during the period in which they are expected to be incurred.

Economic Life of the project: The economic life of a project is to be distinguished from the life
of individual assets. The building may have life of fifty years, plant may have ten years, and
some equipment may have five years only. The economic life of the project is determined by the
duration of the “earnings flow” generated by the project.

The economic life may end:

 The cost of replacement becomes uneconomical in relation to the likely benefits.

 When the viability is adversely affected due to obsolescence.
 When maintenance costs exceed the disposable value, and
 When the development of new technology necessitates new investment

Salvage Values: Sometimes the plant assets may have value for the enterprise at the end of the
life of the project or there may be some anticipated sales value of the plant. Such amount is to be
treated as an inflow at the end of the life of the project.

Relevant cash flow: Determining relevant cash flows is the first and most important step in the
analysis of long-term investments. Relevant cash flows are expected future cash flows that differ
among the alternatives. Financial analysts focus on net cash flow. A business’s net cash flow
generally differs from its accounting profit.
Analysts often make errors in estimating cash flows - two basic rules help to minimize mistakes:
(1) Capital budgeting decisions must be based on cash flows, not accounting income. (2) Only
incremental cash flows are relevant.

(1) Project cash flow Vs accounting income: Points of Difference between accounting income
and project cash flows:
 Cost of fixed assets

Purchase of assets represents negative cash flows under investment analysis. Purchase of fixed
assets not deducted in the determination of accounting income; only periodic depreciation
expense is deducted each year throughout the life of the asset. Full cost of fixed assets includes
any shipping and installation costs … used as the depreciable basis.
 Depreciation and tax shield
Depreciation shelters income from taxation has impact on cash flow but depreciation itself is not
a cash flow. Depreciation must be added to NOPAT (net operating profit after tax) when
estimating a project’s cash flow.

 Interest expense excluded from project cash flows

[5]
A project’s cash flows should be discounted by its cost of capital. The cost of capital is a
weighted average of component costs (WACC) adjusted for the project’s risk. WACC is the rate
of return necessary to satisfy all of the firm’s investors, both stockholders and debt holders.

Cash flows associated with the investment side and financing side should be separated. Cash
flows on the investment side should not include financing costs & expenses (i.e., interest &
dividend payments). Financing costs are included in the cash flows on the financing side &
reflected in the cost of capital. It is a mistake to deduct interest expense from project cash flows
because as the cost of debt it is already included in the WACC. Subtracting interest payments
amount to double counting interest costs. If interest (or interest plus principal payments)
subtracted from the project’s cash flows, then we are calculating cash flows available to equity
holders alone. These cash flows should be discounted at the cost of equity, not by the WACC.
Process of estimating project cash flows differs from procedure used to calculate accounting
income. Accountants measure profit available for stockholders - so interest expenses are
subtracted. Project cash flow is the cash flow available for all investors - so interest expenses are
not subtracted.

(2) Incremental cash flows: Focus on those cash flows that occur if and only if we accept the
project. Incremental cash flows represent the change in the firm’s total cash flow that occurs
as a direct result of accepting the project. Considerations in determining incremental cash
flows: Ignore sunk costs, Consider opportunity costs, Consider incidental effects (effects on
other parts of the firm: externalities) and Allocate only relevant overheads.

Tax effects: Cash flows should be measured on after-tax basis. Firms sometimes ignore tax
payments and try to compensate this mistake by discounting the pre-tax cash flows at higher
discount rate … incorrect. Always use after-tax cash flows along with after tax discount rate
because no reliable way of adjusting the discount rate. The tax implications of losses & non-cash
charges should be taken into account. Non-cash charges can have impacts on cash flows if they
affect tax liability. Example: depreciation … periodic write-off of the cost of an asset.
Generally we have the following assumptions for capital budgeting:
- Shareholders' Wealth Maximization is the Basic Motive of Capital Budgeting Decision
- Costs and Revenues are Known with Certainty
- Inflows and Outflows are based on Cash
- Inflows and Outflows of Cash Occur once a year
- Cash Flows Exhibit a Conventional Pattern (–, +, +, + ... +)
- The Required Rate of Return is Known & Constant
- Capital Rationing Does Not Exist (for simplicity)

4.5. Capital budgeting evaluation techniques

[6]
Capital budgeting techniques (Investment appraisal criteria) under certainty can also be divided into
following two groups:

Non-Discounted Cash Flow Criteria: -

a) Pay Back Period (PBP)

b) Accounting Rate Of Return (ARR)

Discounted Cash Flow Criteria: -

a) Net Present Value (NPV)

b) Internal Rate of Return (IRR)
c) Profitability Index (PI)
a) Payback period
The payback period, defined as the expected number of years required to recover the original
investment, was the first formal method used to evaluate capital budgeting projects.
Decision rules:
The shorter the payback period, the better is a project. Therefore, if the firm required a payback
of three years or less, if the projects were mutually exclusive, a project which has shorter
payback would be ranked over a project which has longer payback. Mutually exclusive means
that if one project is taken on, the other must be rejected. For example, the installation of a
conveyor-belt system in a warehouse and the purchase of a fleet of forklifts for the same
warehouse would be mutually exclusive projects—accepting one implies rejection of the other.
Independent projects are projects whose cash flows don’t affect one another.
Unequal annual cash flows:
unrecovered cost at start of year
payback period= yearsbefore full recovery +
cas h flow during year
Uniform annual cash flows:
Original Investment
Payback period = Annual cash flows

Illustration:
You are a financial analyst for the Hittle Company. The director of capital budgeting has asked
you to analyze two proposed capital investments, Projects X and Y. These projects are equally
risky, and the cash flows for each year, CFt, reflect purchase cost, investments in working
capital, taxes, depreciation, and salvage values. Also assume that all cash flows occur at the end
of the designated year, both projects have a cost of capital of 12%. Expected net cash flows of
Project X and Y is provided on the next slide.

Expected After Tax

Net Cash Flows, CFt

[7]
 Year (t) Projects S Projects L
0 (Birr 10,000) (Birr 10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500

Required:
Evaluate the two projects under the capital budgeting methods/criteria.
unrecovered cost at start of year ( B)
payback period ( P )= years before full recovery (E)+
cas h flow during year (C)
Payback period for project S = 2 + 500/3,000 = 2.167 years
Payback period for project L = 2 + 3,000/3,500 = 2.857 or birr 10,000/birr 3,500 = 2.857 years
Payback period for project S is going to be the cumulative cash flow at t = 0 is just the initial cost
of birr 10,000. At Year 1 the cumulative cash flow is the previous cumulative of (birr 10,000)
plus the Year 1 cash flow of birr 6,500: (birr 1,000) + birr 6,500 = (birr 3,500). Similarly, the
cumulative for Year 2 is the previous cumulative of (birr 3,500) plus the Year 2 inflow of birr
3,000, resulting in birr 500. We see that by the end of Year 3 the cumulative inflows have more
than recovered the initial outflow. Thus, the payback occurred during the third year.
B). Accounting/Average Rate of Return (ARR):
This method is also known as the return on investment (ROI), return on capital employed
(ROCE) and is using accounting information rather than cash flow. The ARR is the ratio of the
average after tax profit divided by the average investment.
There are a number of alternative methods for calculating ARR. The most common method of
computing ARR is using the following formula:

The average profits after tax are determined by adding up the PAT for each year and dividing the
result by the number of years. The average investment is calculated by dividing the net
investment by two. Thus,

Where, EBIT is earnings before interest and taxes, T tax rate, I 0 book value of investment in the
beginning, In book value of investment at the end of n years.
For example, A project requires an investment of br 10,00,000. The plant & machinery required
under the project will have a scrap value of br 80,000 at the end of its useful life of 5 years. The
profits after tax and depreciation are estimated to be as follows:
YEAR 1 2 3 4 5
PAT (BR) 50000 75000 125000 130000 80000

[8]
 Decision Rule:
The ARR can be used as a decision criterion to select investment proposal.
i. If the ARR is higher than the minimum rate established by the management, accept the
project.
ii. If the ARR is less than the minimum rate established by the management, reject the project

The ranking method can also be used to select or reject the proposal using ARR. It will rank a
project number one if it has highest ARR and lowest rank would be given to the project with
lowest ARR
Discounted Cash Flow Criteria:
These are also known as modern or time adjusted techniques because all these techniques take
into consideration time value of money
a. 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.

Note that the payback is a type of “breakeven” calculation in the sense that if cash flows come
in at the expected rate until the payback year, then the project will break even. However, the
regular payback does not consider the cost of capital—no cost for the debt or equity used to
undertake the project is reflected in the cash flows or the calculation. The discounted payback
does consider capital costs—it shows the breakeven year after covering debt and equity costs.

Net cash flows Discounting factor Discounted

Years (t) Project S Project L 1 Project S Project L

¿
( 1+ r ) t
0 (Birr 10,000) (Birr 10,000) (Birr 10,000) (Birr 10,000)
1
1 6,500 3,500 1/1.12 = 0.8929 5,803.85 3,125.15
2 3,000 3,500 1/1.122 = 0.7972 2,391.6 2,790.2
3 3,000 3,500 1/1.123 = 0.7119 2,135.7 2,491.65
4 1,000 3,500 1/1.124 = 0.6355 635.5 2,224.25

Discounted payback period (S) = 2 + birr 1,804.55/birr 2,135.7 = 2.845

Discounted payback period (L) = 3 + birr 1,593/birr 2,224.25 =3.716

[9]
An important drawback of both the payback and discounted payback methods is that they ignore
cash flows that are paid or received after the payback period. Although the payback methods
have serious faults as ranking criteria, they do provide information on how long funds will be
tied up in a project. Thus, the shorter the payback period, other things held constant, the greater
the project’s liquidity. Also, since cash flows expected in the distant future are generally riskier
than near-term cash flows, the payback is often used as an indicator of a project’s riskiness.
b. Net Present Value (NPV)

As the flaws in the payback were recognized, people began to search for ways to improve the
effectiveness of project evaluations. One such method is the net present value (NPV) method,
which relies on discounted cash flow (DCF) techniques. To implement this approach, we
proceed as follows:

Decision rules:

1. Find the present value of each cash flow, including all inflows and outflows, discounted at the
project’s cost of capital.

2. Sum these discounted cash flows; this sum is defined as the project’s NPV.

3. If the NPV is positive (>= 0), the project should be accepted, while if the NPV is negative, it
should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the
higher NPV should be chosen.

CF 1 CF 2 −−−+CFn
NPV =CF 0+ + +
( 1+r ) 1 ( 1+r ) 2 ( 1+r ) n
n
CFt
NPV =∑
t=0 ( 1+ r ) n

Here CFt is the expected net cash flow at Period t, r is the project’s cost of capital, and n is its
life. Cash outflows (expenditures such as the cost of buying equipment or building factories) are
treated as negative cash flows. In evaluating Projects S and L, only CF0 is negative.
6,500 3,000 3,000 1,000
NPV ( S ) =( birr 10,000 )+ + + + =966.65
( 1+0.12 ) 1 ( 1+0.12 ) 2 ( 1+0.12 ) 3 ( 1+0.12 ) 4

3,500 3,500 3,500 3,500

NPV ( L )= ( birr 10,000 ) + + + + =631.25
( 1+0.12 ) 1 ( 1+ 0.12 ) 2 ( 1+ 0.12 ) 3 ( 1+0.12 ) 4

By a similar process, we find NPV(S) birr 966.65 and NPV (L) birr 631.25. On this basis, both
projects should be accepted if they are independent, but S should be chosen over L if they are
mutually exclusive.

[10]
The rationale for the NPV method is straightforward. An NPV of zero signifies that the project’s
cash flows are exactly sufficient to repay the invested capital and to provide the required rate of
return on that capital. If a project has a positive NPV, then it is generating more cash than is
needed to service the debt and to provide the required return to shareholders and this excess cash
accrues solely to the firm’s stockholders. Therefore, if a firm takes on a project with a positive
NPV, the wealth of the stockholders increases. In our example, shareholders’ wealth would
increase by birr 966.65 if the firm takes on Project S, but by only birr 631.25 if it takes on
Project L. Viewed in this manner, it is easy to see why S is preferred to L, and it is also easy to
see the logic of the NPV approach.

c. Internal Rate of Return (IRR)

In Chapter 3 we presented procedures for finding the yield to maturity, or rate of return, on a
bond—if you invest in a bond, hold it to maturity, and receive all of the promised cash flows,
you will earn the YTM on the money you invested. Exactly the same concepts are employed in
capital budgeting when the internal rate of return (IRR) method is used. The 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:
PV ( cash inflows ) =PV ( cash out flows )
Or, equivalently, the IRR is the rate that forces the NPV to equal zero:
CF 1 CF 2 −−−+CFn
NPV =CF 0+ + + =0
( 1+ IRR ) 1 ( 1+ IRR ) 2 ( 1+ IRR ) n
n
CFt
NPV =∑ =0
t=0 ( 1+ IRR ) n

How can we determine the IRR?

 Trial and error (guess)
 Interpolation
6,500 3,000 3,000 1,000
NPV ( S ) =( birr 10,000 )+ + + + =0
( 1+ IRR ) 1 ( 1+ IRR ) 2 ( 1+ IRR ) 3 ( 1+ IRR ) 4
IRR( S)=¿ 18%

6,500 3,000 3,000 1,000

NPV ( L )= ( birr 10,000 ) + + + + =0
( 1+ IRR ) 1 ( 1+ IRR ) 2 ( 1+ IRR ) 3 ( 1+ IRR ) 4

IRR (L) = 15%

If the internal rate of return exceeds the cost of the funds used to finance the project, a surplus
will remain after paying for the capital, and this surplus will accrue to the firm’s stockholders.
The higher the IRR, the better is the project. Therefore, project S is chosen over L because its
IRR is 18% which is more than IRR of L 15%.
Decision rule:
[11]
Accept the project if the IRR > Cost of Capital, Reject the project if the IRR < Cost of Capital.
When there is a need to choose between two projects, this criterion suggests selecting the one
with higher IRR. IRR is not recommended for choosing between mutually exclusive projects.
d. Profitability Index (PI):
Profitability Index (PI) or Benefit-cost ratio (B/C) is similar to the NPV approach. PI approach
measures the present value of returns per rupee invested. It is observed in shortcoming of NPV
that, being an absolute measure, it is not a reliable method to evaluate projects requiring different
initial investments. The PI method provides solution to this kind of problem.
It is a relative measure and can be defined as the ratio which is obtained by dividing the present
value of future cash inflows by the present value of cash outlays. Mathematically

This method is also known as B/C ratio because numerator measures benefits & denominator
cost.
Decision Rule:
Using the PI ratio,
 Accept the project when PI>1
 Reject the project when PI<1
 May or may not accept when PI=1, the firm is indifferent to the project.

[12]