Chapter 4

Long Term Investment

Decision/
Capital Budgeting Decision
 Nature of Investment Decisions
• The investment decisions of a firm are generally
known as the capital budgeting, or capital
expenditure decisions.
• The firm’s investment decisions would generally
include expansion, acquisition, modernisation and
replacement of the long-term assets. Sale of a
division or business (divestment) is also as an
investment decision.
• Decisions like the change in the methods of sales
distribution, or an advertisement campaign or a
research and development programme have long-
term implications for the firm’s expenditures and
benefits, and therefore, they should also be evaluated
as investment decisions.
 Meaning of Capital Budgeting
Capital budgeting addresses the issue of
strategic long-term investment decisions.
Capital budgeting can be defined as the
process of analyzing, evaluating, and deciding
whether resources should be allocated to a
project or not.
Process of capital budgeting ensure optimal
allocation of resources and helps management
work towards the goal of shareholder wealth
maximization.
 Features of Investment Decisions

➢The exchange of current funds for future

benefits.
➢The funds are invested in long-term
assets.
➢The future benefits will occur to the firm
over a series of years.
 Why Capital Budgeting is so Important?
✓ Involve massive investment of resources
✓ Are not easily reversible
✓ Have long-term implications for the firm
✓ Involve uncertainty and risk for the firm

➢ Therefore, Due to the above factors,

❖capital budgeting decisions become critical and must
be evaluated very carefully.
❖Any firm that does not follow the capital budgeting
process will not be maximizing shareholder wealth and
 Importance of Investment Decisions

❖Growth
❖Risk
❖Funding
❖Irreversibility
❖Complexity
 Capital budgeting process
❑ The major process in capital budgeting process includes

a. Proposal generation/ Finding projects

b. Review and analysis/ Estimating the incremental

cash flows associated with projects

c. Decision making/ Evaluating and selecting projects

d. Implementation

e. Follow up/ Monitoring projects

 Components of capital budgeting

➢ Regarding the cash flow of a project, There are three main

components of capital budgeting.

1. The initial investment

2. Incremental cash flow

3. The terminal cash flows (shut down cash flows)

 1.Initial cash outflow

➢ The initial investment refers the relevant cash out flows

to be considered when evaluating a prospective capital
expenditure.

➢ It occurs at a time zero i.e. the time at which the

expenditure is made.
➢ the initial net cash investment.
 Compute Initial Cash Outflow
a) Cost of “new” assets
b) + Capitalized expenditures
(installation costs)
c) + (-) Increased (decreased) NWC
d) - Net proceeds from sale of
“old” asset(s) if replacement
e) + (-) Taxes (savings) due to the sale
of “old” asset(s) if replacement
f) = Initial cash outflow
 Con’t…

• Ex. ABC co. proposed new machine purchase price is

birr 380,000 and an additional birr 20,000 will be
required to installed it. The old machine was purchased 3
years ago at a cost of birr 240,000 which will depreciate
under a straight line method with no salvage value over
a life of 6 years. After three years the firm has found a
buyer willing to pay birr 200,000 for the old machine
and remove it as the buyers expense. The firms expects
that birr 35,000 increases incurrent assts & birr 18,000
increase in current liabilities and subject to a tax rate of
40%.
Required :
▪ determine the initial investment.
 2. Incremental Cash Inflows
➢ Incremental or operating cash inflows are those cash
inflows that the project generates after it is in
operation.
➢ Incremental operating cash flows also include tax
changes, including those due to changes in
depreciation expense, opportunity cost and
externalities.
➢ Incremental after tax cash inflows can be computed
using the following formula.
After – tax incremental cash inflows =
(increase in revenues) (1-tax rate)
- (Increase in cash) (1-tax rates)
+ (increase in depreciation) (tax rate expense)
 Con’t…
• Example; - KK Corporation has provided its revenue and
cash operating costs (excluding depreciation) for the old
and the new machine as follows.

Annual
Machine Revenue Operating cost EBDT Depreciation
Old $150,000 $70,000 $80,000 30,000
New 180,000 60,000 120,000 50,000

Compute: Compute the after tax incremental cash inflows

 3. Terminal cash flows
➢ Cash flows associated with the net cash generated from the
sale of the assets; tax effects from the termination of the
asset and the release of net working capital.

➢ If a project is expected to have a positive salvage value at

the end of its useful life, there will be a positive
incremental cash flow at that time.

➢ However, this salvage value incremental cash flow must be

adjusted for tax effects.
 Types of projects

 Investment projects can be classified in to three

categories on the basis of how they influence the
investment decision process;

1. independent projects

2. mutually exclusive projects and

3. contingent projects.
 1. Independent projects
➢ are projects whose cash flows are unrelated or independent
of the other.

➢ Do not compute one with each other.

➢ the acceptance or rejection of one project does not directly

eliminate other projects from further consideration or affect
the likelihood of their selection.

➢ If a firm has unlimited funds to invest, all the independent

projects that meets its minimum acceptance criteria can be
implemented.
 2. Mutually exclusive projects
➢ Are projects that compute with each other, so that the
acceptance of one eliminates the others from further
consideration.

➢ Are all projects in the same function.

➢ The selection of one project immediately rejects the

other projects .
 3. Contingent projects

➢ The choice of one investment project necessitates

undertaking one or other projects.

➢ is one the acceptance or rejection of one project is

dependent on the decision to accept or reject one or more
other projects.
 Techniques of Capital Budgeting Analysis
(investment evaluation)

➢ A sound technique should be used to measure the

economic worth of an investment project. The capital
budgeting techniques are grouped in to two major
categories. These are:

1. Non discounted methods (traditional approach) and

2. Discounted methods (Modern approach)

 Investment evaluation method
A) Non Discounted cash flow Method includes
1. Pay back period (PBP)
2. Accounting rate of return(ARR)
B) Discounted Method of valuation
1. Discounted Payback Period (DPBP)
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
4. Profitability Index (PI)
5. Modified Internal Rate of Return (MIRR)
 A) Non Discounted cash flow Method

1. Pay back period ( payable period, PBP)

❖ The payback period is the number of years needed to

recover the initial investment of a project. Or

❖ It is the number of years required for an investment’s

cumulative cash flows to equal its net investment.

❖ The PBP measures the time it takes to recoup the cost of

the investment.
 Decision Rule PBP

❖ To apply the payback decision method,

✓ firms must first decide what payback time period is

acceptable for long term projects and the calculated
payback period should be less than some pre-
specified (decided) num `ber of periods.

✓ The rationale behind is that the shorter the payback

period, the less risky the project and the greater the
liquidity.
Methods of Calculation of Payback Period (PBP)
❑ There are two ways to determine the PBP
1. On the basis of uniform cash inflow (annuity form)
2. On the basis of non uniform cash inflow (non annuity
form)
1. on the basis of Uniform cash inflows PBP is to be
determine by
PBP = net initial investment
uniform increase in annual cash flows
e.g.1 if birr 2,000 is invested to earn birr 500 per annum, If
the project has a maximum desired payback period of 5
years. Determine the PBP?
PBP=2000/500= 4 years, Accepted because before the
standard of 5 years
 Con’t…
2.If cash flow is unrelated or different through out the
period, we subtract the cash flows from the cost until the
remainder is zero.
Number of year Amount of inves remaining to be retun
PBP = before re cov ery +
Total cash flow at the pay back P.
of original investment

0 1 2 3 4 5

-$40 $10 $12 $15 $10 $7

10+12+15=37 with 3 years so remaining 3 and 10income in
Forth year then
PBP= 3years+3/10=3.3 years
 Merits of PBP
✓ It is simple to determine/ calculate and
understand
✓ Rapidly changing if new plant is to be scrapped
in a short period
✓ Improving investment condition
✓ Provides an indication of a project’s risk,
liquidity and Cost effective
 Drawbacks of pay back period
✓ It ignores time value of money

✓ it ignores all cash flows beyond the pay back period.

✓ No objective way to determine the standard pay back

period

✓ It does not measure the profitability of an investment

alternative.

✓ Has no relationship with the wealth maximization

principle.

✓ It is a rough measure of liquidity not profitability.

 2. Accounting rate of return(ARR)
➢ ARR measures the rate of return on a project in terms of
income,
➢ It is an accounting measure of income(cash inflows)
divided by average investment
➢ It is also known as return on capital employed (ROCE)
or return on investment(ROI)
➢ The accounting rate of return can be determined by

ARR= Average income after tax

Average investment
 Con’t…
 An investment have a value of $500 (the initial cost) and
the net income is $100 in the first year, $150 in the
second year, $50 in the third year, $0 in Year 4, and -$50
in Year 5.
 Required; compute the ARR
 Soln: average income =100+150+50+0-50=250
250/5=50 so
ARR= Average income/ Average inevt. =50/500=.1
Inter. From $1 investment it average return is 10 cents or 10%
Advantages of ARR

1. It is simple to calculate.

2. It is based on accounting information, which is readily

available, and familiar to business man.

3. It considers benefits over the entire life of the Project.

Disadvantages
1. Not a true rate of return, time value of money is ignored.
2. Based on accounting (book) values not cash flows and
market value
B) The discounted methods or modern approach
1. Discounted Payback Period (DPBP)
✓ The discounted payback period is the length of time it
takes for the discounted cash flows equal to the amount of
initial investment.

✓ It overcomes the payback period method problem, which

is not consider time value of money

✓ To determine the DPBP, we can use the present values of

the future cash flows to compute the discounted payback
and simply apply the concept of the traditional payback to
the present values of the future cash flows.
DPBP
Example: ABC co. investing Birr 100 in a
project that has the 10, 40, 60, 80, 10 cash
flows each year respectively at 10 % required
rate/ cost of capital Compute the discounted
payback period.
Soln: 10/1.1+40/1.12+60/1.13+80/1.14+10/1.15
9.090909 33.05785 45.07889 54.64108 6.209213
The Cash flow(CF) of year 1to 3 was 87.22 and
remaining 12.78 so the DPBP is
DPBP= 3 years +12.78/54.64
=3.23 years
 Con’t…
Problems with Discounted Payback Period:

✓ The discounted payback period solves the time value

problem, but it still ignores the cash flows beyond the
payback period.

✓ You may reject projects that have large cash flows in the
outlying years that make it very profitable.

✓ Not consistent with wealth maximization

 2. Net present value(NPV)
❑ It is the sum of the present values of the net investments
i.e. it is the difference between the present value of the
cash inflows (the benefits) and the cost of the investment
(ICo).

❑ The project selection method of NPV is most consistent

with the goal of owner wealth maximization

NPV= The sum of the present value (PV) of after tax

cash flows – initial investment

 Con’t…
 CF 2   CF 3   CF 4   CFn 
 CF1   
NPV =  +   + +  (1 + k )4  +……. + (1 + k )n  - Ico
 (1 + k )1   (1 + k )2   (1 + k )3 
Where
CF = cash inflow per period
ICO= Initial cash outlay (initial investment)
K = Discount rate/ Investors required rate of return
Decision rule:
For Independent Project: Accept the project if the NPV > 0
Reject the project if the NPV < 0
For Mutually Exclusive Projects: choose projects with the
highest NPV.
 Con’t…

NPV=118.7829-100=18.78287
 Con’t…
Example 2: Given the following cash flow, and investors
required rate of return (K) is 10%
Investment initial cost CF1 CF2 CF3
A Br 100 10 60 80
B Br 100 70 50 30
Compute the NPV if,
(a) Project A and B are independent projects.
(b) Project A and B are mutually exclusive.
(C) Comment on the Decision rule.
Sol: A=NPR 18.78(see slide 35)
B) 70/1.1+50/1.21+30/1.331=127.49
=127.49-100=27.49
C) If independent both, because NPV> 0
If mutually exclusive, Project “B”, because highest NPV
 Evaluation of the NPV Method
• NPV is most acceptable investment rule
for the following reasons:
❖Time value
❖Measure of true profitability
❖Value-additivity
❖Shareholder value
• Limitations:
– Involved cash flow estimation
– Discount rate difficult to determine
– The NPV is expressed in absolute terms rather than relative
terms and hence does not factor is the scale of investment.
– The NPV does not consider the life of the project correctly .
 3. Internal rate of return
➢ Internal rate of return : is the discount rate at which the
NPV value equals zero.

➢ This rate shows that the PV cash flows for the project
would be equal to the PV of its cash out flows.

➢ IRR is the break even discount rate.

➢ It is the rate of return that discount rate that equates the

PV of the cash flows and the cost of the investment.

➢ Usually, we can not calculate the IRR directly: instead

we must use a trial and error process.
 Internal Rate of Return Method
• The internal rate of return (IRR) is the rate that
equates the investment outlay with the present
value of cash inflow received after one period.
This also implies that the rate of return is the
discount rate which makes NPV = 0.
C1 C2 C3 Cn
C0 = + + + +
(1 + r ) (1 + r ) 2 (1 + r )3 (1 + r ) n
n
Ct
C0 = 
t =1 (1 + r )t
n
Ct
 t =1 (1 + r )t
− C0 = 0

39
 Calculation of IRR

• Level Cash Flows

–Let us assume that an investment
would cost Rs 20,000 and provide
annual cash inflow of Rs 5,430 for 6
years.
–The IRR of the investment can be
found out as follows:
 NPV Profile and IRR
A B C D E F G H

1 N P V P r o file

D is c o u n t
2 C a s h F lo w r a te NPV

3 -2 0 0 0 0 0% 1 2 ,5 8 0
IR
4 5430 5% 7 ,5 6 1
R
5 5430 10% 3 ,6 4 9

6 5430 15% 550

7 5430 16% 0

8 5430 20% ( 1 ,9 4 2 )

9 5430 25% ( 3 ,9 7 4 )

F i g u r e 8 .1 N P V P r o f i l e
 NPV Versus IRR
Which Method is better: the NPV or the IRR?
The NPV is superior to the IRR method for at least
two reasons.
1. Reinvestment of Cash flows: The NPV method
assumes that the projects cash in flows are
reinvested to earn the hurdle rate; the IRR
assumes that the cash inflows are reinvested to
earn the IRR of the two. NPV’s assumption is
more realistic in most situations since the IRR
can be very high on some projects.
2. Multiple Solutions for the IRR: It is possible
for the IRR to have more than one solution. If
the cash flow experience a sign change, the IRR
method will have more than one solution.
4. Profitability index(PI)
✓ PI is the ratio of the present value of cash flows
(PVCF) to the initial investment of the project.
✓ Some times they are called benefit cost ratio
✓ It compares the present value of future cash inflows
with the initial investment on a relative basis.
✓ It is used as a means of ranking profits in
descending order of attractiveness.
PVCF
PI =
Initial investement
Con’t….

➢ E.g. the initial cash out lay of a project is birr 100,000

and it can generate cash inflows of birr 40,000, birr
30,000, birr 50,000 and birr 20,000 from year 1 to year 4,
by assuming a 10%rate of discounts

➢ Required: Determine the profitability index of the firm?

Soln: PI =sum PV/ICO

SUM PV= 40000/1.1+30,000/1.21+ 50,000/1.331+20000/1.462

=112,383/100000=1.21, so Accepted, Because PI>1

5. The modified internal rate of return (MIRR)
➢ MIRR is the average annual rate of return that will be
earned on an investment, if the cash flows are at the
specified rate of return (usually reinvested WACC)
✓ MIRR is obtained by 1st obtained the future value of
the future cash flow at the reinvestment rate.
✓ After obtained the future cash flows, the MIRR is
obtained by
FVC
n −1
Io
 Con’t…

❑ E.g. the projects of ABC initially invests birr 10,000 and

will gets annual cash flows of year1,year2, year3, year4
and year5, birr 2,000, birr 2,500,birr 3,000, birr 3,500
and birr 4,000 respectively with a life of 5 years at 12%
minimum rate of return (WACC),
Then determine the modified rate of return( MIRR)?