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General Definitions
Capital budgeting (investment) decisions may be defined as the firm’s decision to invest
its current funds most efficiently in the long term assets in anticipation of an expected
flow of benefit over a series of years.
Specific Definitions
i) It is essentially a list of what management believes to be worthwhile projects for the
acquisition of new capital assets together with the estimated cost of each project” –
Robert N. Anthony
ii) It is long-term planning for making and financing proposed capital outlay- Charles
T. Horngreen
iii) It refers to acquiring inputs with long-returns - Richards & Greenlaw
iv) It is concerned with the allocation of the firm’s scare financial resources among the
available market opportunities. The consideration of investment opportunities
involves the comparison of the expected future streams of earnings from a project
with the immediate and subsequent expenditures for it. G.C Philippatus
v) It consists in planning for development of available capital for the purpose of
maximizing the long-term profitability (return on investment) of the firm - Milton
H. Spencer
From the above definitions, it is clear that capital budgeting correlates the planning of
available financial resources and their long-term investment in order to maximize the
profitability of the firm
INTRODUCTION
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An efficient allocation of capital is the most important finance function in the modern
times. It involves decisions to commit the firm’s funds to the long-term assets. Capital
budgeting or investment decisions are of considerable importance of the firm since they
tend to determine its value by influencing its growth, profitability and risk.
In this chapter we focus on the nature and evaluation of capital budgeting decisions.
In this chapter, we assume the investment project’s opportunity cost of capital is known.
We also assume that the expenditures and benefits of the investment are known with
certainty. Both these assumption are relaxed to later chapters.
Growth: the effects of investment decisions extend into the future and have to be
endured for a longer period than the decision to invest in long-term assets has a decisive
influence on the rate and direction of its growth. A growth decision can prove disastrous
for the continued survival of the firm: unwanted or unprofitable expansion of assets will
result in heavy operating costs to the firm. On the other hand, inadequate investment in
assets would make it difficult for the firm to compete successfully and maintain its
market share.
Risk: A long-term commitment of funds may also change the risk complexity of the
firm. If the adoption of an investment earnings, the firm will become more risky. Thus,
investment decisions shape the basic character of a firm.
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Irreversibility: Most investment decisions are irreversible. It is difficult to find a market
for such capital items once they have been acquired. The firm will incur heavy losses if
such assets are scrapped.
Complexity: Investment decisions are among the firm’s most difficult decisions. They
are an assessment of future events, which are difficult to predict. It is really a complex
problem to correctly estimate the future cash flows of an investment. Economic, political,
social and technological forces cause the uncertainty in cash flow estimation.
Independent Investments
Independents investments serve different purposes and do not compete with each other.
For example, a heavy engineering company may be considering expansion of its plant
capacity to manufacture additional excavators and addition of new production facilities to
manufacture a new product – light commercial vehicles. Depending on their profitability
and availability of funds, the company can undertake both investments.
Contingent Investments
Contingent investment are dependent projects, the choice of one investment necessitates
undertaking one or more other investment. For example, if a company decides to build a
factory in a remote, backwards area, it may have to invest in the houses, roads, hospitals,
schools etc. for employees to attract the work force. Thus, building of factory also
requires investment in facilities for employees. The total expenditure will be treated as
one single investment.
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o Estimation of cash flows
o Estimation of the required rate of return (the opportunity cost of capital)
o Application of a decision rule for making the choice
The first two steps, discussed in the subsequent chapters, are assumed as given. Thus,
our discussion in this chapter is confined to the third step. Specifically, we focus on the
merits and demerits of various decision rules.
o It should consider all cash flows to determine the true profitability of the project
o It should provided for an objective and unambiguous way of separating good
projects from bad projects
o It should help ranking of projects according to their true profitability
o It should recognize the fact that bigger cash flows are preferable to smaller ones
and early cash flows are preferable to later ones
o It should help to choose among mutually exclusive projects that project which
maximizes the shareholders’ wealth
o It should be a criterion which is applicable to any conceivable investment project
independent of others
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a) Estimation of cash flows
b) Estimation of the required rate of return (the opportunity cost of capital)
c) Application of a decision rule for making the choice.
a. To consider all cash flows to determine the true profitability of the project
b. To for an objective and unambiguous way of operating good projects from bad
ones
c. Should help in the ranking of the projects according to their true profitability etc
Note: If the NPV =O, use other methods to make the decision.
Illustrations
Ill 1. Assume that project x costs $ 2500 now and its is expected to generate year end
cash inflows of $ 900, $800, $700, $ 600, and $ 500 in years 1 and 5. The opportunity
cost of capital may be assumed to be 10%.
Required:
Solution:
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NPV= [900X.909+800X.826+700X.751+600X.683+500X.620]-2500
NPV= $2725-$500
NPV=+225
Project x’s PV of cash inflows (.2725) is greater than that of cash outflow (2500).
Therefore it generates a positive NPV (+225)
Note that project x adds to the wealth of owners hence it should be accepted.
Ill. 2. Suppose ban investment requires an initial outlay of $4000 with an expected cash
inflow of $ 1000 per year for the five years, should the proposal be accepted if the rate of
discount is (a) 15% and, (b) 6%.
Solution:
Year
Year cash flows Total Pv of 6% Total pv @
pv at @15% pv@15% 6%
(1) (2) (3) (2)x(3) (2)x(5)
1 1000 .870 870 .943 943
2 1000 .756 756 .890 890
3 1000 .668 668 .840 840
4 1000 .572 572 .792 792
5 1000 .497 497 .747 747
3353 4212
Note that the proposal can not be accepted as the total PV of $3353 at a discount rate of
15% is less than $ 400 which is the initial investment; even we ignore the other non-
quantitative consideration.
As the pv of the $ 4212 at a discount rate of 6% exceeds the initial investment of $ 4000,
the proposal may be accepted.
INTERNAL RATE OF RETURN (IRR)
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Internal Rate of Return is also known as Time adjusted rate of return, Discounted rate of
Return, Yield rate, Investor’s Method, Marginal efficiency of capital method etc
Rate of interest of discount is calculated. IRR is the rate at which the PV of expected cash
flows is equal to the total investment outlay. This rate is usually found by (Trial and
Error) Method.
Formula:
n Ct -Co =O
O= ∑ (1+r)
t=1
Where:
Ct- the cash flow generated in year t
Co-the initial cost of the project
n- the life of the project in years
r-the internal rate of return of the project
Illustrations
Ill. 3. A project costs $ 16000 and is expected to generate cash inflows of $8000, $7000
and $ 6000 at the end of each year for the next 3 years.
Further information:
1. The IRR is the rate at which project will have a zero NPV
2. Try a 20% discount rate
3. The project’s 20%
Solution:
NPV= -16000+8000X.833+7000X.694+6000X.579
= -16000+14996 =1,004
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Note that a positive NPV at 20% indicates that the project’s true rate of return is lower
than 20%
Try 16%
NPV=-16,000+8000X.862+7000X.743+6000X.641
= -16000+15943 =-57
Note that –ve NPV means we should try a lower rate i.e. 15%
This is the ratio of PV of cash inflows, at the required rate of return, to the initial cash
outflow of investment.
=n Ct ÷ Co
∑ (1+k) t
t=1
Or
Investments Investments
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Decision Rule
Illustrations
Ill 4. The initial investment of a project is $ 100,000 and it can generate cash inflow of $
40,000, $ 30,000, $50, 000, and 20, 000 in year 1 through year 5. Assume a 10% rate of
discount. The PV of cash inflows at 10% discount rate is:
Solution:
Illustrations
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Ill.5. A project will cost $ 4000. Its stream of earnings before depreciation, interest rate
and taxes (EBDIT) during 1st year through five years is expected to be $ 10,000, $
12,000, $ 14,000, $ 16,000 and $ 20,000. Assume a 50% tax rate and depreciation on
straight-line basis.
Solution
Computable Table on Project’s ARR
Period 1 2 3 4 5 Average
Earnings Before 10,000 12,000 14,000 16,000 20,000 14,400
Depreciation $
Taxes(EBDIT)
Depreciation 8000 8000 8000 8000 8000 8000
Earnings Before 2000 4000 60000 8000 12000 6400
Interest Taxes
`(EBIT)
Taxes at 50% 1000 2000 3000 4000 6000 3200
Earnings before 1000 2000 3000 4000 6000 3200
Interest and after
Taxes(EBIT1-T)
Book Value of
Investment:
Beginnings 40,000 32000 24000 16000 8000 ---------
Ending 32000 24000 16,000 8000 --------- -------
Average 36000 28,000 20,000 12,000 4000 20,000
Solution:
ARR
Project A: (10,000-10,000) ½ =0
(10,000)
B :( 15,000-10,000) ½ =50%
(10,000)½
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C :( 18,000-10,000) ⅓ = 53%
(10,000) ½
D: (16,000-10,000) ⅓ =40%
(10,000) ½
Acceptance Rule:
As an accept or reject criterion, this method will accept all those projects whose ARR is
higher than the rate established by the management and reject those projects which have
ARR less than the minimum rate.
ARR ranks a project as a number one if it has higher ARR and lowest rank would be
given to the project with lowest ARR.
This is defined as the time taken by the project to recoup cash outlay.
The decision rule depends on the firms target payback period (i.e. the maximum period
beyond which the project should not be accepted.)
If the project generates constant annual cash inflows the payback period can be computed
by dividing cash outlay by the annual cash inflow.
Formula:
Illustrations
Ill .6. XYZ is offered two options for investments with the following cash flows. Its
decision criteria are a payable of 3 years.
Calculate payback
Option I Option II
Required Investment 8,000 7,000
4,000 2500
3000 2500
2000 2500
1000 2500
Ill 7: Calculate the pay back period for a project which requires an initial outlay of $
10,000 and generates year ending cash flows of $ 6000, $3000, $ 2000, $ 5000 and $5000
from the first year to the end of the 5th year
Solution:
Payback Period =4000+2500+2000=8,500 for 3 yrs
Balance =10,000-85,000=1500
4th year =1500 = 3/7
3,500
Pay back = 3 3/7
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PROBLEMS
Q1.A project requires an initial outlay of $ 10,000 and generates year ending cash flows
of $ 6000, 30000, 2000, $ 5000 and $5,000 from the end of the first year to the 5th year.
The required rate of return is 10% and pays tax at 50%. The project has a life of 5 years
and depreciated on straight line basis.
Required:
Calculate
i.Payback period
ii.Average rate of return
iii.Net Present value
Q2.A Company is considering two mutually exclusive projects requiring an initial cash
outlay of 10,000 each and with a useful life of 5 years. The company required rate of
return is 10% and the appropriate corporate tax rate is 50%. The projects will depreciate
on a straight-line basis. The before depreciation and taxes cash flows expected to be
generated by the projects are as follows:
YEAR 1 2 3 4 5
Project A $4,000 4,000 4,000 4,000 4,000
Project B $6,000 3,000 2,000 5,000 5,000
Required:
Calculate for each project:
i.the pay back period
ii.The average rate of return
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iii.The net present value
iv.Profitability index
v.The internal rate of return
vi.Which project should be accepted? And why?
………………………END……………………….
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