Ellertone Ndalama

MBA, FCCA, ACMA,

CGMA, Bcom (Acc.), Dip.
Bus
Assistant Professor

IB9AX0

Capital Budgeting Decisions

WBSLive Lecture 9
Outline Capital
budgeting

What it is, why Complications

and its practical (further Project
use considerations)
in investment Evaluation
decisions Techniques

Qualitative Other Financial

(non- Factors:
financial) Project financing;
Factors Inflation &
Taxation
Capital budgeting (CB)
• CB is evaluation of proposed long-range projects.
• Addresses two problems:
Which projects should be undertaken? A project
should be undertaken on a balance of financial and
non financial considerations (Lyons et al., 2003; Mills
and Mercken, 2003).
 How much should be spent on projects? Need for
project financing and capital rationing (given limited
project funding).
Why appraise long term investments?
• Decisions involve large amounts of money.
• Financial Resources are limited.
• Long term implications:
Once project undertaken, other choices may
not be made.
Huge spending now, but future benefits.
Not easy to reverse decision once
implemented.
Practical application of capital budgeting

AstraZeneca: BPP & Rio:

BAA: Lease
R&D, Exploration
or buy
expansion projects

Banks: Cost Car (Jaguar)

reduction Manufacturer:
(ATMS, etc.) new model
Project evaluation techniques

2. Payback 3. Net Present

1. Accounting Value (NPV) or
rate of return Period
(PBP) Discounted
(ARR) Cash flow
method

5. Profitability 4. Internal
Index or NPV rate of
Index return (IRR)

Note: for each method you should know - calculations, decision criteria,
advantages and disadvantages (for more refer to topic materials).
Example
Project ‘A’ requires initial investment in plant £20,000 (UEL
4 years, RV=0, depreciated SLM).
Additional project details:
Year Net Cash Depreciation Profit
Flow (£) (£)
(£)
1 9,000 5,000 4,000
2 8,000 5,000 3,000
3 7,000 5,000 2,000
4 5,500 5,000
500
29,500 20,000 9,500
The standard non discounted payback period (PBP) set by directors
is 3 years. The required rate of return (RRR) or cost of capital is 18%.
Accounting rate of return (ARR)
Project A:
• ARR = (Average Annual Profits /Average Capital
Employed) x 100%
• Average Annual Profits years 1 to 4 = 4,000 + 3,000 +
2,000 + 500 =9,500 / 4 =£2,375;
• Average CE=(£20,000+0)/2 =£10,000
• ARR = (2,375 / 10,000) x 100% = 23.75% (> 18% RRR;
so accept project A)
NPV or DCF approach – how to get the 18% DFs?
NPV or DCF approach
Project A:
Year Net Cash 18% PV
Present
Flow Factor Value
0 (20,000) 1.000
(20,000)
1 9,000 0.847
7,623
2 8,000 0.718
5,744
3 7,000 0.609
4,263
4 5,500 0.516
2,838
Non- discounted payback period (PBP) method
Project A:
Year Net Cash Cumulative Net
Flow Cash Flow
0 (20,000) (20,000)
1 9,000 (11,000)
2 8,000 (3,000)
3 7,000 4,000
4 5,500 9,500
Payback period is: 2 years plus in year 3, (£3,000/£7,000) x
12 months=2+ (3,000/7000) x 12m = 2 years 5 months
(within standard set by management, so accept project
A).
Discounted Payback Period (DPB)
Net cash flows are first discounted to PV.

Project A:
Year Net Cash 18% PV PV
Cum. PV
Flow Factor
0 (20,000) 1.000 (20,000)
(20,000)
1 9,000 0.847 7,623
(12,377)
2 8,000 0.718 5,744
(6,633)
3 7,000 0.609 4,263
(2,370)
4 5,500 0.516 2,838
Profitability index (or NPV index)
Project A:
• Initial investment = £20,000; PV of project cash
flows = £20,468; NPV=+468.
• PI = NPV/investment=(468/20,000)=0. 023; PI is
+, accept project A.
• PI=PV of CFs/Initial Investment
(20,468/20,000)=1.023; PI>+1 accept project A.
Internal Rate of Return – Project A
LRNPV = Project NPV at LDR (18%) = £468 (as calculated)

HRNPV = Project NPV at HDR (20%) = - £247 (Given)

IRR = LDR + [ {LRNPV / (LRNPV – HRNPV)} x {HDR – LDR}]

IRR = 18 + [{468 / (468 – (- 247) } x {20 -18}] = 19.3% OR

IRR = HDR - [ {HRNPV / (LRNPV – HRNPV)} x {HDR – LDR}]

IRR = 20 - [{247 / (468 – (- 247) } x {20 -18}] = 19.3%

IRR (19.3%) > 18% RRR (cost of capital), so project A is potentially viable,
accept project A.
IRR Solution (Project A & B): using graphical approach.

Project A
600
500

PROJECT DATA 400

300 IRR

NPV
DF 18 20 A 200
NPV 468 -247 A
100
0
DF 18 16 B
17.5 18 18.5 19 19.5 20
NPV -202 715 B -100
-200
-300
Discount factor

Project B
800

600

400 IRR
IRR
NPV

200

0
15.5 16 16.5 17 17.5 18
-200

-400
Discount factor
Mutually exclusive projects

You are given summary of results for projects A and B below.

The RRR (cost of capital) is 18%, Standard PBP is 3 years. Which project
will be preferred?
Preferred
Project A Project B Project
Payback 2 yrs 5 mths 2 yrs 9 mths A
ARR 23.8% 25% B
NPV (@18%) 468 -202 A
IRR 19.3% 17.6% A
PI 0.023 -0.009 A

Conclusion: All methods (except ARR) suggest project A is

preferable to project B; project B is rejected under NPV, IRR
and PI; so project A should be undertaken.
Complications: further considerations in investment decisions

Other financial factors to consider

Project financing Inflation & Taxation

How do we deal How to deal in Impact

Equity or Debt
with limited project NPV on NPV –
Financing -
funding – use PI or calculations: incorrect
issues?
NPV index other readings NPV?
Complications: further considerations in
investment decisions – qualitative factors
Strategic Value of real
importance of options of project
Post-
project (MacDougall and
completion
(Alkaraan and Pike, 2003;
Northcott, audit for
Alkaraan and
2006). projects
Northcott, 2006)

Project risk
attributes (Abdel-
Sustainability Kader and
performance of the Dugdale, 2001;
project: social, ethical
Alkaraan and
and environmental
impact of project. Northcott, 2006).
Investment Appraisal in Practice: What the
researchers have found?
Methods Graham & Brounen et al. (2004)-European study Alkaraan
Harvey &
Survey on 313 CEOs Northcott
(2001) (2006)-
US study UK Netherlands Germany France ranking
Payback 57% 70% 65% 50% 51% 2

NPV 68% 40% 70% 48% 35% 1

IRR 61% 53% 56% 42% 44% 3

Investment Appraisal in Practice: What the
researchers have found?
• Most companies use more than one financial
analysis technique in investment appraisal (Abdel-
Kader and Dugdale, 1998).
• The most popular one is the NPV followed by PBP.
Simple financial analysis techniques still dominate
the appraisal of all categories of capital investment
projects (Alkaraan and Northcott (2006).
• Businesses use more than one method to assess
each investment decision. An increased use of the
discounting methods (NPV and IRR) over time.
Continued popularity of ARR and payback period. A
tendency for larger businesses to use the
discounting methods and to use more than one
method (Atrill and McLaney, 2004)
Suggested Reading:
• Atrill and McLaney, (2022, 12th edition), Accounting and Finance for Non-
Specialists, Pearson, Chapters 10, 11
• EQLUMA: Module 7
References:
• Drury, C., (2015) Management and Cost Accounting, (9th edition), Cengage
Learning, Hampshire.
• Bhimani, A, Horngren, C.T., Datar, S.M., and Rajan, M., (2015), Management
and Cost Accounting, Pearson.
Useful Articles:
• Abdel-Kader, M.G. and Dugdale, D. (1998) ‘Investment in advanced
manufacturing technology: a study of practice in large U.K. companies’.
Management Accounting Research, 9 (3), 261–284.
• Alkaraan, F. and Northcott, D. (2006) ‘Strategic capital investment decision-
making: A role for emergent analysis tools? A study of practice in large UK
manufacturing companies’, The British Accounting Review, 38,149-173.
• Arnold, G.C. and Hatzopoulos, P.D. (2000) ‘The theory-practice gap in capital
budgeting: evidence from the United Kingdom’. Journal of Business Finance
and Accounting, 27 (5&6), 603–626.
• Brounen et al. (2004) ‘Corporate finance in Europe: confronting theory with
practice’, Financial Management; 33, 4.
• Graham, J.R. and Harvey, C.R. (2001). ‘Theory and practice of corporate
finance: evidence from the field’, Journal of Financial Economics, 61, 187-243.