FINANCIAL MANAGEMENT MODULE

DR T. CHINODA
2020
 CAPITAL BUDGETING
• A capital expenditure is an expenditure on fixed
assets and other long-term infrastructure
necessary for the implementation of projects.
• The assets bought for the project are expected to
generate cash flows. The appraisal of capital
projects is done in two steps.
• Firstly, we must determine the cash flows that are
expected to be generated by the project. Secondly,
we must estimate the cost of capital that have been
used in the project. Finally, we subject the
expected cash flows to certain appraisal
techniques.
• Capital budgeting involves long-term decision
making on the use of funds.
• This implies the evaluation of investment
opportunities, making consideration of expected
future cash flows.
• A cash flow may be defined as the receipt or
expenditure of cash during an interval of time.
• It is a budget that deals with Capital Expenditure,
eg the purchase of plant and equipment,
construction of a building. It is expenditure that is
not easily reversible due to the values committed. .
Importance of capital budgeting.
• the goal of financial management is to maximize
shareholders wealth by acquiring funds at the least
possible cost and utilizing them to obtain the highest
possible return for the shareholders.
• Capital budgeting techniques are used to make an
appraisal of the company’s investment projects,
whereby assets are acquired in order to carry out
approved investment projects. It is expected that a
project will generate cash flows .
• In project appraisal, it is the project’s cash flows that
are subjected to a series of tests in order to find out
whether the wealth of the shareholders is being
maximized by embarking on a particular project.
 Classification of Capital Projects
 Mutually exclusive projects cannot be carried out
at the same time. If project A and project B are
mutually exclusive, for example, accepting one of
them means the rejection of the other.
 Independent projects, the acceptance of one may
not necessarily mean the rejection of other
projects that may be under consideration.
 there are two types of decision that we face.
 1. We either have to accept or reject decisions, for
mutually exclusive projects.
 2. We have to rank independent projects.
 Project appraisal techniques
Payback period.
Discounted payback period.
Net Present Value [NPV] method
Internal Rate of Return [IRR] method.
Modified Internal Rate of Return [MIRR]
method.
Profitability Index [PI].
 The Payback method
• The payback period, defined as the expected
number of years required to recover the original
investment.
Example:
• A firm is considering a project whose expected net,
after-tax cash flows are as follows:
• Initial Investment = $ 18 000.00
• Annual cash flows = $ 5 600.00 per year for the next 5
years. What is the payback period?
Solution
• The payback period = 18 000 / 5 600 = 3.2 years.
• Example:
A project has the following expected annual net,
after-tax cash flows :
Year Expected Net Cash flow Cumulative Cash
Flow
0 ($ 18 000) ($ 18 000)
1 $ 4 000 ($ 14 000)
2 $ 6 000 ($ 8 000)
3 $ 6 000 ($ 2 000)
4 $ 4 000 $ 2 000
5 $ 4 000 $ 600
• To get the actual payback period, we use the
following formula:
• Payback = Year before full recovery +
[unrecovered cost at start of year / cash flow during
year]
• Therefore the payback period = 3 + [ 2 000 / 4
000 ] = 3.5 years.
 Criticism of payback period
• The regular payback does not take into account the
time value of money- it ignores the cost of capital.
• It suffers from “Fish-bait criteria” i.e. (the size of the
fish matters, not just catching something). It focuses
only on the covering the initial investment than
profitability.
• it ignores cash flows beyond the payback period, as
is evident from the above examples.
Example Discounted Payback Method

A project has the following net after tax cash

flows;

Year 0 1 2 3 4

Cash -1000 500 400 300 100

flows

Calculate the discounted payback period if the cost of

capital is 10%.
• Solution
Year 0 1 2 3 4
Cash -1000 500 400 300 100
flows Solution
Discount -1000 =454.55 =330.5 =225.39 =68.30
ed Cash
flows
Cumulati -1000 -545.45 -214.89 10.5 78.8
ve cash
flow

Discounted Payback Period=2 years + 214.89/225.39

= 2.95 years
The discounted payback shows the break-even year
after covering the cost of debt and equity.
 General critique of payback methods

• The payback discriminates against longer term

projects, which may turn out to be more
profitable for the shareholders, by ignoring the
cash flows after the payback period.
 The Net Present Value (NPV)
• The decision rule is:
• 1.Invest: if NPV >0,
• 2.Do not invest: if NPV <0

• It should be noted that positive NPV

investments are wealth increasing whilst
negative NPV investments are wealth
decreasing.
Example: Calculating NPV with Constant Cash
flows
A project is expected to generate net cash flows of
$600.00 per year for the next three years. The
initial investment in the project is $ 1000.00 and
the cost of capital is 10%.
Since this is an annuity, the NPV will be found as
follows :
NPV = [ 600.00 ( PVIFA10%,3years ) ] - 1 000.00
= [ 600.00 ( 2.487 ) ] - 1 000.00.
= $ 492.00.
 Internal Rate of Return (IRR)
• The IRR is the yield or rate of return generated
by the project’s internal cash flows. It is an
internally generated rate of return. It can also be
defined as a discount rate that makes the
present value of the future after tax cash flows of
a project equal to the initial outlay. It yields an
NPV of zero (NPV=0).
• At the IRR,NPV=0
• Therefore IRR is a rate of return generated by
the internal cash flows of a project.
 Decision Rules for IRR
• It is such that: Accept the project: if IRR
>Required Rate of Return
• : Reject the project: if IRR < Required
Rate of Return
• The Required Rate of Return is equivalent
to the Weighted Average Cost of Capital.
• How do we find the IRR?
• We find the IRR using the Iterative Methods-
specifically Estimation by Interpolation
• Example
• An investment with an initial outlay of
$12000 returns a constant after tax cash
flows of $24000 per annum for 10 years.
What is the IRR for the project?
 Example
• An investment has an initial capital outflow
of $600000 and is going to generate the
following successive yearly cash flows of
$50000, $70000, $150000, $200000,
$250000 and $300000. If theinvestor
RRR is 14%. Determine whether the
project is worthwhile using the IRR
method.
 The Modified Internal rate of return [MIRR]

• Example: Calculating the MIRR

Suppose we have the following time line for a
particular project with a cost of capital of 10%
year 0 ($1000)
1 $500
2 $400
3 $300
4 $100

Calculate the MIRR

 Profitability index (PI)
• The profitability index is the ratio between
the present value and the cash outlay on
the project.
• The PI is a measure of the present value
per dollar of capital invested. A project
should be accepted if the PI is greater
than 1.
• If we have capital rationing, projects
should be ranked according to their PIs.