Capital Budgeting: An Overview

 Capital budgeting (CB) is the entire process of

planning for investments whose cashflows/
returns are expected to extend beyond one
year
 Current funds are exchanged for future benefits
 Funds are invested in long-term assets
 The future benefits accrue over a series of years
 The expenditures and benefits of an investment are
expressed in cash
 CB is an investment decision
November 1, 2023 1
 Capital Budgeting: An Overview
 CB is, in essence, an application of a classical
proposition from the economic theory of the
firm
 A firm should operate at the point where its
marginal revenue (MR) is just equal to its marginal
costs (MC)
 MR is taken to be the (percentage) rate of return
on investment
 MC is the firm’s (percentage) marginal cost of
capital (MCC)

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 The Capital Budgeting Process
 Determine alternative investments available
 Weigh the strategic aspects of each
alternative
 Collect data and information on viable
alternatives
 Develop assumptions and forecast cash flows
 Set a benchmark
 Measure net benefit
 Perform risk analysis
 Communicate to management
 Perform post audit review
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 The Capital Budgeting Process
 Thus, capital budgeting involves:
 The generation of investment proposals;
 The estimate of cash flows for the proposals;
 The evaluation of cash flows;
 The selection of projects based upon an acceptable
criterion; and
 The continual reevaluation of investment projects
after their acceptance

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 CB decisions: Importance/Characteristics
 Have long-term implications for a firm
 Results into loss of flexibility (involve commitment)
 Influence firm’s risk complexion
 Important for future well-being of a firm
 CB decisions enable a firm to compete with others
(something that is important for long term survival)
 They involve commitment of large amounts of
funds
 There is a need for a firm to make proper plans to
for raising the required funds
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 CB decisions: Importance/Characteristics
 They are often complex
 Often affect more than one segment (department/
area) of the firm
 Need to have proper sequencing of activities and
timing of the availability of funds
 They are often irreversible
 Where reversible the cost can be astronomical
 Implies that all factors have to be considered
carefully before a decision is made
 They are among the most difficult to make!
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 CB decisions: Types
 Classification on the basis of their relationship
with the existing operations
 Expansion of the existing business
 Expansion into new business
 Replacement and modernization
 Others (“unrelated”) such as
 those addressing environmental concern (e.g. construction
of a waste disposal plant out of the firm’s own volition)
 Research and development
 Exploration

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 CB decisions: Types
 Classification in relation to other contemplated
decisions
 Independent investments
 Mutually exclusive investments
 Contingent investment – dependent project (such
as training, infrastructure, housing)
 NOTE: The terms “investment” and “project”
will often be used interchangeable though they
often have different meanings

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 Investment Evaluation
 Measuring Net Benefit of a project must be
consistent with primary goal of maximizing
firm’s value
 Consider explicitly time value of money
 Consider explicitly risk and return
 Evaluate cash flows

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 Investment Evaluation
 There are three broad tasks in
investment evaluation/appraisal:
 Estimation of investment’s relevant
CASHFLOWS
 Estimation of the REQUIRED RATE OF
RETURN applicable to the particular
investment
 Application of a DECISION RULE for making
a choice
 Ranking the investment proposals
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 Investment Evaluation: Cashflow
Estimation
 Cashflow refer to the investment’s outlays and
the periodic inflows after the investment goes
into operation
 Cashflow is the actual net cash (as opposed to
accounting net income) that flows into or out of a
firm as a result of the investment
 Only incremental cashflows are relevant
 Efforts need to be made to reduce forecasting
errors
 Need for consistent assumptions and coordination
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 Cashflow Estimation: Things to Note
 Incremental cashflows
 Incremental cashflows are the net cashflow
that result directly from a decision to accept a
project
 They are attributable to the investment project
 The represent the change in the firm’s total
cashflow that occurs a a direct result of accepting
the project

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 Cashflow Estimation: Things to Note
 In determining incremental cashflows attention
should be paid on:
 SUNK costs – Outlays that have already been
committed or that have already occurred and
hence are not affected by the decision under
consideration
 Most feasibility study/consulting costs are sunk
 Are NOT incremental
 Are NOT relevant
 should not be included in the analysis of a project

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 Cashflow Estimation: Things to Note
 OPPORTUNITY costs – cashflows that could be
generated from assets the firm already own
provided they are not used for the project
under consideration
 The return on the best alternative use of an asset
 They are relevant and should be considered
 AUXILLIARY costs – that are associated with
acquisition or disposal of an asset
 Shipping, installation and removal costs
 Are incremental and relevant

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 Cashflow Estimation: Things to Note
 EXTERNALITIES – Effects of a project on
cashflows in other parts of the firm
 Negative externalities – “stealing” from
existing products/department
CANNIBALIZATION
 Positive externalities – bringing customers
into the show room
 Adjustments need to be made for
externalities
 Negative are outflows and positive are
inflows
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 Cashflow Estimation: Things to Note
 CHANGE IN NET WORKING CAPITAL
represents the increased current assets minus
the spontaneous increase in current liabilities
 Additional WC is needed if increased current assets
is more than the spontaneous increase in current
liabilities
 Additional WC is an outlay at the beginning of a
project
 At the end of the project it represents a return OF
capital since it will no longer be needed

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 Cashflow Estimation: Things to Note
 DEPRECIATION is an allocation of the costs of
an asset and does not involve any cash outflow
 The cash outflow has occurred when the asset was
initially acquired
 DEPRECIATION is a deductible expenses for
computing taxes
 It indirectly influence cash flow since it reduces tax
liability
 The tax saving is an INFLOW of cash and is often
called A DEPRECIATION TAX SHIELD
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 Cashflow Estimation: Things to Note
 The computation of depreciation for tax shield
purpose should comply with the tax legislation
of the country
 INTEREST EXPENSES should not be deducted
in the computation of cashflow
 Interest is implicitly included in the discounting
process (excluding avoids double counting)
 Moreover, the investment decision is taken
independent of the method of financing

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 Cashflow Estimation: Things to Note
 Accounting income need to be adjusted to
arrive at cashflows
 Adjustment for non cash items including
depreciation
 Adjustment for interest expenses

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 Accounting income versus Cashflow:
Example
Computing cashflows from accounting income
Gross Revenues 750,000
Costs (before Deprec. & Interest) 300,000
Earning before Deprec. Interest and taxes (EBDIT) 450,000
Depreciation 150,000
Earning before Interest and taxes (EBIT) 300,000
Interest Expense (INT) 50,000
Earning before taxes (EBT) 250,000
Tax (at 40%; i.e. TC =0.4) 100,000
Net Income (NI) 150,000
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 Cashflow Estimation: Adjusting
Accounting Income
 The project’s cashflow can be computed from
the accounting income using one of the
following approaches:
 CF=NI+(1-T C)*INT + Depreciation
 Where TC is the corporate tax rate
 CF=EBIT*(1-T C) + Depreciation

 CF=EBDIT*(1-T C) + TC*Depreciation

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 Investment Evaluation Techniques
 Also known as capital budgeting techniques
 Criteria or decision rules for making the choice
 Whether or not an investment should be made
 The position (rank) of an investment in a list of
possible investment
 Two categories
 Non discounting criteria
 Discounting criteria

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 The payback period Method
 The payback period method
 The payback period is the length of time (e.g.
number of years) required to recoup the project’s
investment
 The payback period decision rule
 Accept a project if its payback period is less than or
equal to a predetermined threshold period
 The shorter the payback period the higher the
project’s rank

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 The Payback period method: Example
Year Investment A Investment B
Year Cashflow Cashflow
0 (Initial Outlay) (100million) (100 million)
1 50million 15million
2 50million 20million
3 20million 25million
4 50million
5 50million
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 The payback period Method
 Arguments for the payback period method
 Ideal for investments where time is the main
uncertain factor
 Simple to understand and easy to compute
 Costs less and can be used as a starting point
 Arguments against the payback period method
 Ignores cashflows after the payback period (i.e.
does not consider all cashflows of an investment)
 It is non-discounting – gives equal weight to all CFs
 The predetermined threshold can be subjective
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 The discounted payback period Method
 The discounted payback period method
 The length of time required for discounted
cashflows to recoup the project’s investment
 The shortfall is that it considers cashflow for the
payback period only
 Use the earlier example but assuming a 10
percent cost of capital

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 Accounting rate of return (ARR)
 Accounting rate of return (ARR)
 also known as return on funds employed (ROFE),
accounting return on investment, return on capital
employed (ROCE).
 ARR is a ratio of the accounting profit to the
investment in the project, expressed as a
percentage
 Often based on profit after depreciation
 Increases in working capital is added to the
investment
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 Accounting rate of return (ARR)
 The decision rule: Accept an investment if its
ARR is greater than, or equal to, a huddle rate
 The huddle rate is often set by management
 Notice that the investment and profit changes
over-time
 This raises a question: Which values of
investment/profit to use?

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 Accounting rate of return (ARR)
 There are several alternatives when selecting
the investment/profit to use
 Compute ARR for each period using beginning book
value of the investment (then find average ARR)
 Use average profits over the life of the investment
relative to total investment
 Use average profit and average investment (i.e.
projects ARR is equal to average profit divided by
average investment)

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 Accounting rate of return (ARR)
 ARR: Example
 ABC Ltd is to invest Tshs 30 million in
machinery for a project which has a life of
three years. The machinery will have a zero
scrap value and will be depreciated on a
straight-line basis. The annual profit before
depreciation is 15million (assume no taxes)
 Suppose we assume 8m scrap value?
 Suppose we assume a 20% tax on profits?

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 Accounting rate of return (ARR)
 ARR: Drawbacks
 It is non discounting
 Subjective in terms of defining profit and
investment
 ARR’s popularity
 Ideal as performance evaluation and control
measure
 A darling of accountants as it uses accounting
information
 Simple to understand and is also familiar to most
users of accounting information
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 The Net Present Value Method (NPV)
 The Net Present Value (NPV)
 It is a discounted cash flow (DCF) technique
 NPV is the difference between the present
value of inflows and that of outflows
 Find the present value of each cash flow, including
both inflows and outflows, discounted at the
project’s cost of capital
 The sum of these discounted cash flows is the
project’s NPV

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 The Net Present Value Method (NPV)
 The rationale for NPV
 A zero NPV: the project’s cash flows are just
sufficient to repay the invested capital and to provide
the required rate of return on that capital
 The project breaks even
 A positive NPV: the project is generating more cash
than is needed to service its debt and to provide the
required return to shareholders
 A negative NPV: the project is not generating enough
cash flows to break even

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 The Net Present Value Method (NPV)
 The NPV decision rule
 Accept if the NPV is positive
 return is greater than cost
 Reject if the NPV is negative
 return is less than cost
 If the NPV is zero the decision is indeterminate
 For zero NPV other criteria (qualitative etc) are used
as supplements
 Most of investments with zero NPVs are often
accepted (due to the anticipated externalities)

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 The Net Present Value Method (NPV)
 Changing the discounting rate changes the
NPV
 NPV is sensitive to change in the discount rate
 A project’s NPV profile is a graph which plots a
project’s NPV against the discount rates
 The pattern of the cashflow and the life of the
investment determine the extent in which the
NPV changes for a given change in the
discount rate

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 The Net Present Value Method (NPV)
 NPV profile

NPV
IRR

November 1, 2023 36
 The Net Present Value Method (NPV)
 Given two projects
 If both have the same life, the NPV for the
project whose cashflows come late into its life
will be more sensitive to change in the
discount rate
 It has a steeper NPV profile than the one whose
cashflows come early
 Given the same cashflow pattern (e.g. the
same annual cashflow) the NPV for the project
with longer life will be more sensitive to
change in the discount rate
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 The Internal Rate of Return (IRR)
 The internal rate of return (IRR) seeks to
determine just what it is (in percentage terms)
that a project will earn
 IRR is the discount rate which equates the
present value of a project’s expected cash
inflows to the present value of the project’s
costs. It is the
 discount rate that will set the NPV equal to zero
 discount rate where the NPV profile crosses the
horizontal axis
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 The Internal Rate of Return (IRR)
 The IRR decision rule
 Accept if the IRR (or yield) exceeds the
required rate of return (or required yield).
 The required yield is the opportunity cost of capital
(also called the hurdle rate of return)
 The hurdle rate is the discount rate (cost of capital)
that the IRR must exceed if a project is to be
accepted.
 This circumstance will also result in a value-adding
positive NPV.

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 IRR & NPV: Similarities and differences
 The IRR and the NPV are related
 Both use cashflows and employ the concept of
discounting
 The IRR is also called the discounted cash-flow
(DCF) rate of return
 If the IRR is higher than the discount rate
(cost of capital) the project has a value-adding
positive NPV
 If the IRR is equal to the discount rate (cost of
capital), the project breaks even

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 IRR & NPV: Similarities and differences
 The IRR and the NPV are also different
 NPV and IRR differ in the assumption of the
rate of return at which cash flows from a
project can be reinvested
 NPV assume reinvestment at the cost of capital (i.e.
the discount rate).
 IRR assume reinvestment at the IRR
 i.e. Cash inflows can be reinvested at a yield similar to that
from the investment being evaluated

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 IRR & NPV: Similarities and differences
 The reinvestment assumption under the NPV is
more consistent though conservative
 Cashflows from all projects being evaluated are
assumed to have the same investment opportunity
with return equal to the opportunity cost of capital
 The reinvestment assumption is crucial when
evaluating mutually exclusive projects,
especially those that differ in scale and/or
timing of cashflows
 In such situation, the NPV method should be used
November 1, 2023 42
 IRR & NPV: Similarities and differences
 NPV is an absolute measure while IRR is a
relative measure
 Being a percentage return makes IRR easier to use,
understand and communicate to other managers
and employees than NPV
 NPV takes into account investment size – absolute
amounts of wealth change
 It is the absolute change in wealth that matters most
 NPV is consistent with wealth maximization and
hence the better of the two

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 IRR & NPV: Similarities and differences
 Non-conventional cashflows are easier to
handle with NPV than IRR
 A project with non-conventional cashflows can have
multiple IRRs
 For a project with multiple IRR the NPV profile
crosses the horizontal axis more than once
 With more than one project, additivity is
possible for NPV but not for IRR
 Additivity is crucial when evaluating a group of
projects
 NPVs are in monetary value at common time
(present) and can be added together.
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 IRR & NPV: Similarities and differences
 Changing discounting rate can lead to
conflicting decisions for NPV and IRR
 This is especially true when the cashflow
timing/ patterns of the investments being
evaluated are significantly different
 For example, given two projects
 The NPV profiles can cross each other
 The cross-over rate is the discount rate that results
into equal NPVs
 The NPV and IRR decisions before and after the
cross-over rate will be in conflict (**)
November 1, 2023 45
 The Net Present Value Method (NPV)
 NPV profiles

NPV IRRb
IRRa

i
NPV Project B

Crossover rate NPV Project A

November 1, 2023 46
 Modified IRR (MIRR)
 It was noted earlier that the percentage nature
make IRR the favorite of most executives
 MIRR is a evaluator that is better than the
regular IRR
 MIRR is the discount rate at which the present
value of a project’s cost is equal to the present
value terminal value
 the terminal value is the sum of the future values of
the cash inflows, compounded at the firm’s cost of
capital
November 1, 2023 47
 Modified IRR (MIRR)
 MIRR somehow takes care of the difference
between the regular IRR and NPV arising from
the reinvestment assumption

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 Profitability Index (PI)
 PI is a variation of NPV
 It is the ratio of the present value of cash inflows,
at the required rate of return, to the cash outflows
of an investment
 Decision Rule: Accept projects whose PI is
greater than 1
 (and reject those with PI less than 1)
 The higher the PI, the higher the project’s rank

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 Capital Rationing
 Capital rationing involves allocation of limited
funds available for investment projects
 For investments that are not mutual exclusive,
some may not be allocated funds even when they
have passed the decision criteria
 Hard rationing is due to external circumstances
 E.g. Lenders unwilling to advance further funds
 Soft rationing is due to internal circumstances
 When management impose limits on investment
expenditure or borrowing limits
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 Capital Rationing
 The objective in Capital rationing: Maximization
of shareholder’s wealth within the constraint of
limited capital
 Capital needs to be allocated so as to maximize the
overall NPV of the investment project portfolio
 This is more important than the NPV of (any) individual
projects

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 Capital Rationing
 Capital rationing Criteria: Rank the projects on
the basis of the ratio of NPV to Capital laid out
in the period of rationing
 We use PI
 This criteria has some limitations
 It only works with a single constraint; Capital and
single period capital rationing
 In multiple periods tools such as L. Programming can help
 It looks at projects individually
 Does not take into account the overall portfolio where the
correlation among projects is crucial

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 Capital Rationing
 In practice most projects are not divisible
Project A B C D E F
IO 500m 150m 350m 450m 200m 400m
NPV 110m (7.5m) 70m 81m 38m 20m
 Determine the projects to be selected if the
capital constraint (total Io) is:
(a) 1100m (b) 1000m (In both assume that
projects are not divisible)
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 Uncertainty/Risk in capital budgeting
 It is almost impossible to know exactly the cost
of capital or the stream of project’s cash
outflows or inflows
 One needs to adjust the cost of capital and/or the
stream of project’s cash outflows or inflows
 The methods of dealing with risks and
uncertainty include:
 Sensitivity analysis
 Statistical methods
 Certainty equivalent adjustment (of cashflows)
 Using risk adjusted discount rates (RADRs)
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 Uncertainty/Risk in capital budgeting
 Sensitivity analysis: How sensitive a project is
to the uncertain factors
 What if:
 The cost of capital changes
 Cash inflow and/or outflow change
 When cost of capital is the uncertain factor the
NPV profile is a useful gauge

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 Uncertainty/Risk in capital budgeting
 Statistical methods involving assigning
probabilities to the cashflows and/or the cost
of capital can be used
 Various statistics can then be computed and
used/evaluated
 Expected values
 Standard deviations

 Coefficient of variation

 Statistical method are used in conjunction with (to

supplement) the different methods of investment
appraisal
November 1, 2023 56
 Uncertainty/Risk in capital budgeting
 Certainty equivalent adjustment adjusts the
cashflows with a factor reflecting the riskness
of the project
 The adjusted cashflows are then evaluated at a
risk-free rate
 Using risk adjusted discount rates (RADRs)
involves discounting cashflows of each project
with a rate reflecting its riskness
 A premium is added to reflect the project’s risk
(that can not be eliminated with diversification)
November 1, 2023 57
 Uncertainty/Risk in capital budgeting:
Inflation
 Inflation affect both cashflows (inflow and
outflow) and the cost of capital
 Specific inflation affect individual cashflow items
 General inflation reduced purchasing power of
money
 The required rate of return will rise if inflation rises

November 1, 2023 58
 Uncertainty/Risk in capital budgeting:
Inflation
 Adjustment is needed to account for inflation
 In addition one needs to ensure that:
 Money cash flows are discounted with nominal
discount rate
 Real cash flows are discounted with real discount

rate
 Discounting money cash flows with real discount rate
gives an NPV that is much larger than the true NPV
 Discounting real cash flows with the money discount
rate reduces the NPV from its true value

November 1, 2023 59
 Other issues in capital budgeting
 Comparing projects of unequal lives
 For projects that are mutually exclusive and have
unequal lives, the NPVs or IRRs are not directly
comparable
 Different ways of converting NPVs to
comparable terms
 Annual equivalence
 LCM for the replacement cycle
 Assuming a finite horizon

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