INVESTMENT DECISIONS

(CAPITAL BUDGETING).

MR. DENIS MASSAWE 1

 INVESTMENT DECISION.
This is the process of identifying, analyzing and selecting the investment projects
whose returns (cash flows ) are anticipated to be accrued over series of years.
CAPITAL INVESTMENT
 It is the investment to buy non-current assets or improve earning capacity of a
non current assets already held in the business.
Types of Capital Investments
1. Purchase of Non-Current Assets: Computers, Vehicles, Building, Land, Plant and
Machinery
2. Legal and professional fees paid for purchasing non current assets: Stamp duty,
registration fees, solicitor’s fees, architect's fees and consultant’s fees
3. Improvement to existing non-current assets: Fitting of air conditioner, extension
of site etc 2

MR. DENIS MASSAWE

Capital budgeting
 Is the process through which an organization generates, evaluate and
selects various capital investment proposals.
 It allows the organization to assess the financial viability of a capital
investment proposal.
 It involves the decision to invest the current funds for addition,
disposition, modification or replacement of fixed assets.
 The large expenditures include the purchase of fixed assets like land and
building, new equipment's, rebuilding or replacing existing equipment's,
research and development, etc.

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FEATURES OF CAPITAL BUDGETING
1) It involves high risk
2) Large profits are estimated
3) Long time period between the initial investments and
estimated returns

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 Stages involved in the project appraisal process of a capital
investment project
a) Initial evaluation:
• Decision evaluating the technical feasibility and commercial viability
of the project must be taken.
• An entity should consider whether the project is in line with the
company’s long term strategic objectives.
• There could be various reasons for taking up investments in the
entity.
• It could be addition of a new product line or expanding the existing
one. It could be a proposal to either increase the production or reduce
the costs of outputs.
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b) Project screening and evaluation (Detailed Assessment):
• This step mainly involves selecting all correct criteria’s to judge the
desirability of a proposal.
• The entity should consider whether the cash flows generated from the
projects would add value to the company/organization.
• The tool of time value of money comes handy in this step.
• The total cash inflow and outflow along with the uncertainties and risks
associated with the proposal has to be analyzed thoroughly and
appropriate provisioning has to be done for the same. (This involves
sensitivity analysis and analyzing the available sources of finance)

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c) Project Selection (Management’s approval):
 The management should prove the project which have a material
impact on the functioning and cash flow of the company.
• The management should be satisfied that:
1) A detailed evaluation has been carried out
2) The project conforms to the organization’s long term strategy
3) The project will contribute to profitability of the organisation
• That is why, the approval of an investment proposal is done based on
the selection criteria and screening process which is defined for every
firm keeping in mind the objectives of the investment being undertaken.

MR. DENIS MASSAWE

d) Implementation:
• During this stage the project is assigned to a party who will
assume the responsibility for the project and oversee its
development.
• The resources will be available for implementation and
specific targets will be set.
• The management will take up the task of monitoring and
containing the implementation of the proposals.

MR. DENIS MASSAWE

e) Monitoring the project
 It is necessary to monitor the progress of a project by checking
whether or not it is on schedule.
 It is necessary to check whether or not the cost of the project is
within the budget.
 In case any unforeseen events occur all the costs and benefits
associated with the project should be re- assessed.

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f) Post completion audit:
• The final stage of capital budgeting involves comparison of actual
results with the standard ones.
• It involves conducting enquiry into the benefits, costs, wastages, and
deviations from the initial project plan.
• The unfavorable results are identified and removing the various
difficulties of the projects helps for future selection and execution of
the proposals.

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IMPOTANCE OF CAPITAL INVESTMENT
PLANNING AND CONTROL
The following are the role/importance of capital investment planning and control.
I. Maximizing the shareholders wealth. The goal of the commercial organization
is to increase the wealth of the shareholders. Appropriate capital investment
planning and control ensures that a commercial organization successfully
chooses and implements the capital investment that adds the maximum value
to its net worth. An increase in the net worth of an organization increases the
value of its shares. This results in an increase in the wealth of its shareholders.
II. Taking strategic decisions. Capital investments involve huge sums of money.
An organization receives the benefit of capital investments for several years.
Hence, capital investments have a huge effect on the profits earned by the
organization. An opportune capital investment can yield spectacular results for
an organization. On the other hand a wrong capital investment can force the
organization into bankruptcy.

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IMPOTANCE OF CAPITAL INVESTMENT
PLANNING AND CONTROL
iii. Minimizing cost structure: An organization commits itself to certain fixed
costs while making capital investment e.g. lease rental, wages, insurance charges
etc. These fixed costs are not tied to the outcome of the project. The
organization has to bear these fixed costs irrespective of the success/failure of
the project. Proper control ensure over the implementation of the investment
ensures that the organization is able to minimize the fixed costs associated with
the investment.
iv. Avoiding loss: A capital decision once is made is not easily reversible. The
organization may be unable to dispose or find another use for the newly
purchased asset such a new plant and machinery. As a result the organization will
have to write off the investment in the non-current asset. Proper planning
ensures that the organization avoid making imprudent capital investment. Proper
control ensures that the capital investment gets implemented and works
according to the plan.
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IMPOTANCE OF CAPITAL INVESTMENT
PLANNING AND CONTROL
v. Avoiding fraud: Usually huge sums of money are involved in capital investment
decisions. A fraud may result in heavy monetary loss to an organization. In certain cases,
it can even lead to irrecoverable injury to the reputation of the organization. An
organization can prevent the occurrence of the fraud by implementing strict capital
investment control measures and ensuring the monitoring of such controls on a regular
basis.
vi. Growing through diversification. Proper planning and control ensure that an
organization is successfully able to implement various types of capital investment
projects. This allows the organization to diversify its risks by investing in several types of
capital investment.
vii. Correcting discrepancy between planning and actual results. Proper planning
ensures that the management foresees and prepares for the various challenges that
capital investment project may face. Proper control ensures that the discrepancy
between expected and actual results is quickly discovered and rectified. This allows an
organization to achieve the desired goals.
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 CAPITAL BUDGETING DECISIONS
• The crux of capital budgeting is profit maximization. There are two
ways to it; either increase the revenues or reduce the costs.
• The increase in revenues can be achieved by expansion of operations
by adding a new product line. Reducing costs means representing
obsolete return on assets.
Accept / Reject decision – If a proposal is accepted, the firm invests in
it and if rejected the firm does not invest.
Generally, proposals that yield a rate of return greater than a certain
required rate of return or cost of capital are accepted and the others are
rejected. All independent projects are accepted.
Independent projects are projects that do not compete with one another
in such a way that acceptance gives a fair possibility of acceptance of
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another.
MR. DENIS MASSAWE
Mutually exclusive project decision
• Mutually exclusive projects compete with other projects in such a way
that the acceptance of one will exclude the acceptance of the other
projects.
• Only one may be chosen. Mutually exclusive investment decisions
gain importance when more than one proposal is acceptable under
the accept / reject decision.
• The acceptance of the best alternative eliminates the other
alternatives.

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 Capital rationing decision
• In a situation where the firm has unlimited funds, capital budgeting
becomes a very simple process.
• In that, independent investment proposals yielding a return greater
than some predetermined level are accepted.
• But actual business has a different picture. They have fixed capital
budget with large number of investment proposals competing for it.

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 INVESTMENT APPRAISAL TECHNIQUES/METHODS
Payback period
• Is the time in which the initial outlay of an investment is expected to
be recovered through the cash inflows generated by the investment.
• It is one of the simplest investment appraisal techniques.
• Projects having larger cash inflows in the earlier periods are generally
ranked higher when appraised with payback period, compared to
similar projects having larger cash inflows in the later periods.

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• The formula to calculate the payback period of an
investment depends on whether the periodic cash inflows
from the project are even or uneven.
a) If the cash inflows are even (constant annual cash flow) the
formula to calculate payback period is:
Payback period= Initial Investment
Net Cash flow per period

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b) When cash inflows are uneven, we need to calculate
the cumulative net cash flow for each period and then use the
following formula:
Payback period = A+(B/C)
Where,
A is the last period number with a negative cumulative cash flow;
B is the absolute value (i.e. value without negative sign) of
cumulative net cash flow at the end of the period A; and C is the
total cash inflow during the period following period A
Cumulative net cash flow is the sum of inflows to date, minus the
initial outflow.
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Class Activity 1
Even Cash Flows
1. Company C is planning to undertake a project requiring
initial investment of $105 million. The project is expected to
generate $25 million per year in net cash flows for 7 years.
Calculate the payback period of the project.
2. If a project requires an investment of Tsh 1,000,000 and is
expected to provide an annual cash flow of Tsh 250,000.
Calculate the payback period

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MR. DENIS MASSAWE

Class Activity 2
Uneven Cash Flows
A project is expected to have the following cash flow.
Calculate the pay back period
Year Cash flow
Tsh ‘000’
0 (19,000)
1 3,000
2 5,000
3 6,000
4 8,000
5 5,000
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 Decision Rule
• The longer the payback period of a project, the higher the risk.
Between mutually exclusive projects having similar return, the
decision should be to invest in the project having the shortest
payback period.
• When deciding whether to invest in a project or when
comparing projects having different returns, a decision based
on payback period is relatively complex.
• The decision whether to accept or reject a project based on its
payback period depends upon the risk appetite of the
management
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 Advantages
• Payback period is very simple to calculate.
• It is useful under certain situations
• It considers the cashflow, not accounting profit which are
subject to manipulation
• It can be a measure of risk inherent in a project. Since cash
flows that occur later in a project's life are considered more
uncertain, payback period provides an indication of how
certain the project cash inflows are.
• For companies facing liquidity problems, it provides a good
ranking of projects that would return money early.
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 Disadvantages of payback period are
• Payback period does not take into account the time value of
money, which is a serious drawback since it can lead to
wrong decisions.
• It does not take into account, the cash flows that occur after
the payback period. This means that a project having very
good cash inflows but beyond its payback period may be
ignored.
• It ignores the project profitability; the overall profitability of
the project is an important factor that determines the risk and
volume of returns.
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MR. DENIS MASSAWE

 Discounted Cash Flow
 Is a method of estimating what an asset is worth today by using
projected cash flow.
 It tells you how much money you can spend on the investment right
now in order to get the desired return in the future.
 Discounted cash flow calculation can help determine if an
investment is worthwhile.
 The discounted cash flow technique calculates the cash inflow and
outflow through the life of an asset.
 These are then discounted through a discounting factor. The
discounted cash inflows and outflows are then compared. This
technique takes into account the interest factor and the return after
the payback period. 25

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 The Discounted Cash Flow analysis operates under the time value of
money principle.
 This concept assumes that money is worth more today than it is in the
future. For example, $100 is worth more now than it would be a year
from now because of interest and inflation rates.

 DCF=CF1+ CF2…………+CF3
(1+r)^1 (1+r)^2 (1+r)^3

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MR. DENIS MASSAWE

DCF is the sum of all future discounted cash flows that the
investment is expected to produce.
CF is the total cash flow for a given year. CF1 is for the first
year, CF2 is for the second year, and so on.
r is the discount rate in decimal form. The discount rate is
basically the target rate of return that you want on the
investment.

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Class Activity Three
Suppose you’re a financial analyst at a company, and you are
recommending whether the company should invest in Project A
or Project B.
Each of the two projects has been proposed by a lead
engineer, but the company can only invest in creating one of
them this year, and so your manager wants you to give her
advice on which one to invest in. Your company’s WACC is 9%,
so you’ll use 9% as your discount rate.

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MR. DENIS MASSAWE

Project A
Year Cash flow
0 -3 Million Initial Investment
1 2 Million
2 4 Million
3 4 Million
4 2 Millio
5 0-Project close up

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 Project B
Year
0 -3 Million
1 0 Million
2 0 Million
3 0 Million
4 0 Million
5 14 Million project

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 Year Cash flow Discounted Cash
flow
1 2 Million
2 4 Million
3 4 Million
4 2 Millio
5 0-Project close up

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 Net present Value (NPV) Method
 This is one of the widely used methods for evaluating
capital investment proposals.
 In this technique the cash inflow that is expected at
different periods of time is discounted at a particular rate.
 The present values of the cash inflow are compared to the
original investment. If the difference between them is
positive (+) then it is accepted or otherwise rejected.

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 Net present value calculations require the following three
inputs:
• Projected net after-tax cash flows in each period of the
project.
• Initial investment outlay
• Appropriate discount rate
 Net after-tax cash flows equals total cash inflow during a
period, including salvage value if any, less cash outflows
(including taxes) from the project during the period.

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 The present value of net cash flows is determined at a
discount rate which is reflective of the project risk. In most
cases, it is appropriate to start with the
weighted average cost of capital (WACC) of the company
difference between the risk of the specific project and
average risk of the company as a whole.
 The initial investment outlay represents the total cash outflow
that occurs at the inception (time 0) of the project.

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When net cash flows are even, i.e. when all net cash flows
are equal:
NPV=R* 1-(1+i)^-n
i
Where
R= Estimated periodic net cash flow
i= required rate of return per period
n=Life of the project in months, years etc

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When net cash flow are uneven, i.e. when net cash flows vary
from period to period

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Where By:
A1, A2 represent cash inflows,
K is the firm’s cost of capital,
C is the cost of the investment proposal and n is the expected life of the
proposal. It should be noted that the cost of capital, K, is assumed to be
known, otherwise the net present, value cannot be known.
NPV = PVB – PVC
where,
PVB = Present value of benefits
PVC = Present value of Costs

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Decision rule
In case of standalone projects, accept a project only if its NPV
is positive, reject it if its NPV is negative and stay indifferent
between accepting or rejecting if NPV is zero.
In case of mutually exclusive projects (i.e. competing projects),
accept the project with higher NPV.

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Class Activity Four
An initial investment in a project is Tsh 100,000,000. The
required rate of return is 12%. Calculate NPV
Given the expected cash flows as follows;

YEAR Tshs
1 60,000,000
2 50,000,000
3 45,000,000

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Class Activity Five
An initial investment of $8,320 thousand on plant and
machinery is expected to generate net cash flows of $3,411
thousand, $4,070 thousand, $5,824 thousand and $2,065
thousand at the end of first, second, third and fourth year
respectively. At the end of the fourth year, the machinery will be
sold for $900 thousand. Calculate the net present value of the
investment if the discount rate is 18%. Round your answer to
nearest thousand dollars.

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Advantages include:
• NPV provides an unambiguous measure.
• NPV is straightforward to calculate (especially with a
spreadsheet).
• NPV uses cash flows rather than net earnings (which
includes non-cash items such as depreciation).
• NPV recognizes the time value of money.
• NPVs are additive. If you have multiple projects and excess
capital, you can add up projects to get a sense of aggregate
wealth creation from all investable projects.
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 Disadvantages include
• A discount rate must be selected.
• NPV also assumes the discount rate is the same over
the life of the investment or project. Discount rates,
like interest rates, can and do change year-to-year.
• NPV assumes you can accurately assess and predict
future cash flows. For some, it is an intuitively difficult
concept to grasp.

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 INTERNAL RATE OF RETURN
 An internal rate of return is the discounting rate, which brings
discounted future cash flow at par with the initial investment.
 In other words, it is the discounting rate at which the company will
neither make loss nor make a profit.
 The IRR cannot be derived easily. The only way to calculate it by
hand is through trial and error because you are trying to arrive at
whatever rate which makes the NPV equal to zero

 We can also state that IRR is the rate at which the NPV of the
project will be zero. i.e. Present value of cash inflow – Present
value of cash outflow = zero
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 Profitability index
 Defines how much you will earn per Sh of investment.
 The present value of an anticipated future cash flow divided by
initial outflow gives the profitability index (PI) of the project.
PI = PV cash inflows
Initial cash outlay

 Since NPV equals the present value of cash flows minus initial
investment, we can write the present value of future value as
the sum of net present value and initial investment:
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PI = Initial cash outlay+PV cash inflows
Initial cash outlay
This gives us another formula for profitability index:

PI = 1+ PV Cash inflows
Initial cash outlay

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Class Activity Six
 Suppose, the present value of anticipated future cash flow is
$ 120,000 & Initial outflow is $ 100,000. Calculate the
profitability index
 Then the profitability index is 1.2. i.e. $ 120,000 / $ 100,000.
 Which means each invested dollar is generating revenue of
1.2 dollars.
 If the profitability index is more than 1, the project should be
accepted & if it is less than 1 it should be rejected.

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Class Activity Seven
Your company has $100 million available for investment in the
following potential investment opportunities:
Project NPV Initial Investment
A $5 million $15 million
B $15 million $50 million
C $10 million $10 million
D $20 million $60 million
E $12 million $35 million

Rank the projects based on profitability and identify the projects

that should be accepted keeping in view the company’s capital
budget constraints.
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Advantages of a Profitability Index
 It will take into consideration all cash flows from a project.
All the cash flows that are generated from the business, even the one
which are not classified on the books as outgoing or incoming cash flows,
to determine what your NPV will be.
 It will take the time value of money into consideration in the
calculation.
The value of money from 2010 is different than the value of 2018 money
because of inflation. In 2010, if you were to purchase something for Tshs1,
then that same item would cost Tshs1.16 today, according to a standard
inflation calculator. Profitability index will take these changes into account
to ensure your information is as accurate as possible.
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 It considers the risks which are involved with future cash flows.
Cash flows are uncertain, even if there are incoming or outgoing cash
flows which happen regularly. If this risk is not accounted for, then it
becomes difficult to fully understand what may occur over the life of the
investment. A better picture of the risks will also give you an idea of the
profits that can be earned over time while understanding what the final
costs may be at the end of the calculated period.
 It is an investment tool that is easy to understand.
The formula used to create the profitability index is one that uses simple
division only. As long as you know the present value of all cash flows and
the initial investment, then you can determine the answer that this tool
provides.
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 It may not provide correct decision-making criteria for certain
projects.
The NPV creates an investment figure that is based on short-term
projects more than long-term results. If a company were to evaluate a
project looking at the short-term profit potential, then it may undervalue
what the long-term profitability of a project may be. The profitability index
tends to score short-term gains better than long-term gains, which means
some companies may choose the wrong project to complete what
comparing their options.
 The tool ignores what is called the “sunk cost.”
When a project is being started, capital budgeting classifies the costs that
are incurred before the starting date as a “sunk cost.” If you have
research and development costs for a project before you reach the
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groundbreaking stage, then the R&D would qualify.

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 It can be difficult to estimate opportunity costs.
The cash inflows and outflows are not the only estimates which
are used when calculating a profitability index figure.
The opportunity cost, which is defined as a cost which occurs
by not accepting alternatives which could have generated a
positive cash inflow.
Some agencies may not even attempt to calculate these costs.

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