CAPITAL BUDGETING – Part 1

1.0 Introduction
Capital budgeting is the process of identifying and evaluating real investment projects with a
useful life greater than one year. It is sometimes defined as the process of planning expenditures
on assets whose returns are expected to extend beyond one year. The objective of capital
budgeting is to select projects that maximize the value of the firm.
The capital budgeting process involves five basic steps:
 Identify the potential projects
 Estimate the initial cost of a project
 Estimate the expected benefits from the project
 Evaluate the acceptability of the project
 Review the project periodically
1.1 Types of projects
A project is an alternative way of investing finds by various firms, and can be classified as;
a) Pre-requisite project – investment that must be undertaken in order to benefit the
subsequent investments e.g. exploration before extraction, land clearing before farming
b) Mutually exclusive projects – projects that cannot be undertaken at the same time. In
this case the second projects causes the benefits of the first projects to disappear.
c) Complimentary projects – this is where the second projects increase the benefits or
reduces the costs of the first project e.g. a products assemblers decides to produce his
own parts; products and part are complimentary.
d) Substitute projects – this is when the second projects decreases the benefits or increases
the costs of the first project and vice versa. e.g. construction of a bridge will reduce the
benefits of a ferry project
e) Independence projects – when the costs and benefits of one project do not affect the
cost and benefits of another projects. e.g. investment in dairy farming and milling
machine.
1.2 Cash flows and relevant costs
For all methods of capital budgeting only relevant cash flows should be considered. Relevant
costs are future costs that will be incurred or saved as a direct consequence of undertaking the
investment. These are;
 Future costs and benefits
 Incremental costs and benefits
 Cash-based
 Opportunity costs.
In investment appraisal the following should be ignored
 Past costs or sunk costs
 Committed costs

Page 1 of 6
  Non-cash items
 Allocated costs
Example 1
A manufacturing company is considering the production of a new type of widget. Each widget
will take two hours to make. Fixed overheads are apportioned on the basis of TZS 1,000 per
labour hour. If the new widgets are produced, the company will have to employ an additional
supervisor at a salary of TZS 15,000,000 pa. The company will produce 10,000 widgets pa.
What are the relevant cash flows?
1.3 Methods of evaluation
1.3.1 Payback Method
The payback period is the time a project will take to pay back the money spent on it. It is based
on expected cash flows and provides a measure of liquidity.
Decision rule:
 Only select projects that pay back within the specified time period
 Choose between options on the basis of the fastest payback
Constant annual cash flows
Initial Investment
Payback period =
Annual Cash flow
Example 2
An expenditure of TZS 2 million is expected to generate net cash inflows of TZS 500,000 each
year for the next seven years. What is the payback period for the project?
Example 3
A project will involve spending TZS 1.8 million now. Annual cash flows from the project
would be TZS 350,000. What is the expected payback period?
Uneven annual cash flows
In practice, cash flows from a project are unlikely to be constant. Where cash flows are uneven,
payback is calculated by working out the cumulative cash flow over the life of the project
A project is expected to have the following cash flows: (figures in TZS 000)
Year Cash flow Year Cash flow
0 (1,900) 3 600
1 300 4 800
2 500 5 500
What is the expected payback period?
Advantages of Payback period
 It is easy to calculate
 It is easy to understand

Page 2 of 6
  It uses cash flows, not accounting profit.
Dis-advantages of Payback Period
 It ignores returns after the payback period
 It ignores the timings of the cash flows
 It does not have the objective criterion for selecting projects - there is no objective
measure as to what length of time should be set as the minimum payback period.
Investment decisions are therefore subjective
1.3.2 The Average Accounting Return (AAR)
AAR is also known as ROCE.
Average annual profit before interest and tax
AAR =
Initial capital costs
Average annual profit before interest and tax
OR AAR =
Average capital investments
Initial Investment + Scrap value
Average capital investment =
2
Decision rule:
If the expected ROCE for the investment is greater than the target or hurdle rate (as decided by
management) then the project should be accepted
Example 4
A project involves the immediate purchase of an item of plant costing TZS 110,000. It would
generate annual cash flows of TZS 24,400 for five years, starting in Year 1. The plant purchased
would have a scrap value of TZS 10,000 in five years, when the project terminates.
Determine the project’s ROCE using:
(a) Initial capital costs
(b) Average capital investment
Test your understanding 1
A project requires an initial investment of TZS 800,000 and then earns net cash inflows as
follows:
Year 1 2 3 4 5 6 7
Cash inflows (TZS 000) 100 200 400 400 300 200 150
In addition, at the end of the seven-year project the assets initially purchased will be sold for
TZS 100,000. Determine the project’s ROCE using:
(a) Initial capital costs
(b) Average capital investment.
The initial capital cost could comprise any or all of the following:
 Cost of new assets bought

Page 3 of 6
  Net book value (NBV) of existing assets to be used in the project
 Investment in working capital
 Capitalised R&D expenditure
Advantages of ROCE include:
 Simplicity
 Links with other accounting measures.
Disadvantages include:
 No account is taken of project life
 No account is taken of timing of cash flows
 It varies depending on accounting policies
1.3.3 Net present value
NPV of the project is the sum of the PVs of all flows that arise as a result of doing the project.
The NPV represents the surplus funds (after funding the investment) earned on the project,
therefore:
 If the NPV is positive – the project is financially viable
 If the NPV is zero – the project breaks even (just returning enough money to cover the
funding costs)
 If the NPV is negative – the project is not financially viable
If the company has two or more mutually exclusive projects under consideration it should
choose the one with the highest NPV.
The NPV gives the impact of the project on shareholder wealth.
NPV of the project is calculated as;
n
CFt
Vs = ∑ − Initial Investment
t
(1+K)
t=1

Decision rule
 If NPV>0, accept the project
 If NPV<0, reject the project
 If NPV=0, this is breakeven point.
Example 5
The cash flows for a project have been estimated as follows:
Year TZS
0 (25,000)
1 1 6,000
2 10,000
3 8,000

Page 4 of 6
 4 7,000
The cost of capital is 6%.
Calculate the net present value (NPV) of the project to assess whether it should be
undertaken
Test your understanding 2
You have been asked to evaluate the following two projects for Arusha Safari Rally Plc.
Using the NPV method, which project would select? Use a discount rate of 10%.
Year Project X (TZS 000) Project Y (TZS 000)
0 -10,000 -20,000
1 4,000 10,000
2 5,000 9,000
3 4,000 6,000
4 3,000 7,000
Advantages of NPV
 It has an objective decision rule
 If applied correctly it can leads to selection of projects which maximize value of a firm
 Considers all operating cash flows
 Considers time value for money
Dis-advantages of NPV
 Some inputs are difficult to calculate or construct and
 Risk may not be correctly accounted for.
1.3.4 Internal Rate of Return (IRR)
The IRR of a project is the discount rate that sets the NPV of the project equal to zero. That is:
n
CFt
∑ t
− Initial Investment =0
(1+K)
t=1

Decision rules for IRR are:

 If the IRR>k, where k is a firm’s cost of capital, accept the project
 If the IRR<k, reject the project.
Do you remember the trial and error method? Then the same should be applied here.
Advantages of IRR
 It has an objective decision rule
 It considers all relevant cash flows
 Considers time value for money
Disadvantages of IRR

Page 5 of 6
  It is difficult to solve IRR
 There may be more than one IRR for a project, which makes the decision process more
complicated
1.3.5 Profitability Index
PI is the ratio of the present value of the future expected cash flows after initial investment
divided by the amount of the initial investment. It can be represented as
PV of cash flows after initial investment
PI =
Initial Investment
Decision rule for PI are;
 If PI>1, accept the project.
 If PI<1, reject the project.
Example 6
The treasurer of Nyamanoro Canned Fish plc has projected the cash flows of projects A, B and
C as follows (Figures in TZS 000)
Year Project A Project B Project C
0 -100,000 -200,000 -100,000
1 70,000 130,000 75,000
2 70,000 130,000 60,000
Should the relevant discount rate is 12 per cent a year, should the company accept the project(s)
based on the PI rule?
Test your understanding 3 (Combined Example)
Suppose a project has a net investment (NINV) and depreciable basis of TZS 100,000,000. It
will generate additional earnings before depreciation and tax of TZS 50,000,000 for the next 4
years. A firm is in the 40% tax bracket and its costs of capital is 10%.
Calculate the cash flows for each of the next 4 years and then evaluate the acceptability of the
project using each of the methods given above.
Assume depreciation rate is 25% (reducing balance method).

Page 6 of 6