CHAPTER - 4

LONG TERM INVESTMENTS

Long-term investments are also called capital budgeting. The term capital according to Weston
and Brigham, 1985, refers to the fixed assets used in production, while a budget is a detailed plan
of projected cash flows during some future period. Thus, the capital budget of the firm outlines
the planned expenditures o the fixed assets, and capital budgeting is the whole process of
analyzing projects whose returns are expected to extend beyond the period of one year and
deciding which project should be included in the capital project. Capital budgeting expenditures
include expenditures for land, building, equipment, and for permanent additions to working
capital associated with plant expansion, for advertising and promotion campaigns, and for
research and development programs.

The optimum capital budget is simultaneously determined by the interaction of supply and
demand forces under conditions of uncertainty. The forces of supply refer to the supply of
capital to the firm, or its cost of capital schedule. The forces of demand on the other hand, refer
to the investment opportunities available for the firm, as measured by the stream of revenues that
will result from an investment decision. Uncertainty of conditions enters the decisions because it
is impossible to know exactly either the cost of capital or the stream of revenues that will be
derived from a project.

The Importance of Capital Budgeting

The following are some of the importance of capital budgeting:

1. It has along-term effects. The result of capital budgeting decisions continues over an
extended period. This enables the firm to be competitive in the market by keeping its
existing customers.
2. Effective capital budgeting will improve both the timing of assets acquisitions and the quality
of the acquired assets. Capital assets must be ready at the time they are needed. If the firm
forecasts its demand properly and plans its required capacity increases, it will be able to
maintain its market, (even to obtain a larger share of the market.) A firm which forecasts its
capital assets requirements advance will have the opportunity to purchase and install the asset
before its sales exceeds its capacity.
3. Capital budgeting enables the firm to raise funds early before the sales approach the
maximum capacity levels. Before the firm spends a large amount of money, it must take the
proper plans. Large amounts of funds are not available over night. A firm that contemplates
a major capital expenditure program may need to arrange its financing several years in
advance to be sure of having the funds required for the program.

Approaches to Capital Budgeting

A systematic approach to capital budgeting requires the following procedures to follow:
1. The formulation of long-term strategy and goals
2. The creative search and identification of new investment opportunities.
3. The estimation and forecasting of current and future cash-flows.
4. A set of decision rules that can differentiate acceptable from unacceptable alternatives.
5. The building of suitable administrative framework that is capable of transferring the
required information to the decision level.
6. The controlling of expenditures and the careful monitoring of project implementation.
If the financial managers under take all the 6-step under the capital budgeting approach, they are
able to make effective capital budgeting decisions.

1. Formulation of Long-term Goals

Long-term goals serve as the guide for managerial decisions. A systematic approach to capital
budgeting decisions, thus, requires the formulation of a set of long-term goals. Management
will be concerned with both the expected returns and the risks assumed on its capital investment.

2. Generating Investment Proposals (Ideas):

A good investment proposal is not just born; some one has to suggest it. In addition, someone
within the firm must be willing to listen to such proposals. In the absence of creative search for
new investment opportunities, even the most sophisticated evaluation techniques may be
worthless.
In a firm with well equipped research and development division, sophisticated new products, or
processes are created by the division. In a small firm, the search for investment possibilities may
be less structured. It often takes the form of employee suggestion box, or informal discussions
during a coffee break.
The search for opportunities should include the acquisition of existing production and marketing
facilities by means of a merger with another company, as well as, the expansion of the company's
own facilities or the creation of an entirely new division.

The long-term investment proposals may be classified as follows:

a) Replacement (Maintenance of Business):- This refers to the expenditures necessary to
replace worn out or damaged fixed assets of the business firm.
b) Replacement (cost reduction):- It refers to expenditures that are made to replace
serviceable but obsolete (outdated) equipments in order to lower the cost of labor,
materials, or other items such as electricity.
c) Expansion of Existing Products or Markets: - These are expenditures necessary to
produce new product or to expand into a geographic area not currently being surveyed.
d) Safety and/or Environmental Projects: - These are expenditures necessary for
complying with government orders, labor agreements, and insurance policy terms. These
expenditures are often called mandatory investments, non-revenue producing investment.
In general, capital budgeting projects can be classified into three categories:
a) Cost Reduction Projects
These projects are intended to reduce the firm's operating costs such as cost of labor, materials
electricity and so on. Cost reduction is achieved through the replacement of plants or fixed
assets. The benefit from cost reduction projects is cost savings.

b) Revenue Expansion Projects

The main purpose of these projects is to increase the volume of sales (revenue) through the
increased level of output of the existing product, expanding product distribution outlets the
markets current served, introducing new products (product development, expanding (searching)
the market into new geographical areas (market development), and/or introducing new products
for new markets (diversification). The benefits are realized in the form of increased net cash
inflows.
c) Non-Revenue Producing (Mandatory) Investments:
These projects are safety and/or environmental protection projects are safety and/or
environmental protection projects that are necessary for complying with government orders,
labor agreements, or insurance policy terms.

3. Forecasting Cash Flows:

Once the investment proposals are identified, the next step is to forecast the cash flows (for
revenue expansion or cost saving projects.) This is accomplished by determining expected
revenues and costs for each project. Even though the timing and size future cash flows usually
remain uncertain throughout the budgeting process, the proper estimation of the cash flows is
vital.

In the analysis of capital budgeting decisions, annual cash flows are used instead of the
accounting profits, cash flows and accounting profits can be very different because accounting
profits include non-cash revenues and non-cash expenses. In fact, accounting profits are
important, but cash flows are often more important for the purpose of setting a value of a firm.
In the entire capital budgeting procedures, probably nothing is of greater importance than a
reliable estimate of the cost savings of revenue increase that will be achieved from the
prospective outlays of capital funds. All the subsequent analysis's we will discuss in this chapter
are based on the cash flow figures not the accounting profit figures.

All the capital budgeting analyses are as successful as the data input you are using. The old
saying of "the garbage in the garbage out, GI.Go" is certainly applicable to the capital budgeting
analysis. Capital budgeting procedures are performed by the group of experts such as engineers,
accountants, economists, cost analysts, and other qualified persons. The method of determining
the cash flows of the project will be discussed in this chapter later.
4. Ranking Investment Proposals
This activity involves the setting of decision rule(s) that help us to differentiate projects that are
acceptable and un-acceptable. Then we choose (make decision) the project alternative that is
ranked first as it will maximize the value of the firm. The main objective of the financial
manager while undertaking capital budgeting is to answer the following questions.

a) Which of the several mutually exclusive investment alternatives have to be chosen for
implementation? and
b) How many projects (independent and not mutually exclusive) in total, have to be
accepted?

Different techniques are used to rank and choose among many project alternatives. Some of
these techniques are the payback period, t he accounting rate of return, the net present value
method, the internal rate of return, and the profitability index. Each one of these techniques will
be discussed in greater details later in this chapter.

5. The Administrative Framework

Capital budgeting is a multidimensional activity that demands a high degree of cooperation
among various departments. The final approval of major capital expenditures, however, rests on
the shoulder of the board of directors of the company.
6. The Post-Completion Audit (Monitoring)
This step refers to the implemented project alternative(s). The post-completion audit involves
the careful monitoring of project implantation. The post-implementation audit is a necessary
managerial tool. A careful analysis of the deviation of actual performance from planned
performance may prevent history from repeating itself. The post-completion audit can be
sobering and rewarding experience for the decision-maker. The post-completion audit has two
principal objectives. These are to improve the accuracy of forecasts and to improve the firms
operation.

Assumptions that underlie Capital Budgeting

A number of assumptions must be introduced in order to concentrate on the managerial aspect of
capital budgeting. The effect of these assumptions is to exclude non-financial considerations and
to remove some complications that obscure the major points under capital budgeting. These
assumptions constitute a general set of conditions within which the financial aspects of long-term
alternatives can be evaluated. You can use any one of the capital budgeting criteria and
techniques presented in this chapter when the following assumptions are fulfilled.

1. Shareholders' Wealth Maximization is the Basic Motive of Capital Budgeting Decision.

All capital budgeting alternatives considered here are accepted or rejected on the basis of their
effect on shareholders' wealth. No other company's goals influence the investment selection
decisions.

2. Costs and Revenues are Known With Certainty. The costs and revenues associated with
each investment alternative are known with certainty, or there exists a fore casting technique that
can generate the values with a very small error. It may be very difficult to estimate revenues and
costs more than two or three years into the future. However, if a proposed investment has a ten
year economic life, accurate fore costs must be available for all ten years.
3. Inflows and Outflows of Cash Occur once a Year: This assumption was also made in the
previous chapter when we were computing the present and future values of cash flows. The
assumption is also important here because capital budgeting criteria use discounting techniques.
Cash inflows or out flows are assumed to occur only once a year (i.e. either at the end of a given
year of at discrete yearly intervals. Hence, compounding or/ and discounting occur only once a
year.
4. Inflows and Out flows are Based on Cash: The data required for evaluating investment
proposals must be stated in cash as opposed to the accounting income. This is because of the
fact that the company uses cash to pay its bills and to pay cash dividends on common and
preferred stock. If the business firm does not generate cash returns from its investments, it will
sooner or later become insolvent.
5. Cash Flows Exhibit a Conventional Pattern: The fund that is required to undertake an
investment represents inflows to the company, and the returns from the investment represents out
flows from the company. if we represent the cash outflows with the minus "-" sign and the cash
inflows with the plus "t" sign, then the conversion cash flows under capital budgeting is defined
as the time series of cash flows that contains only one change in sign. For example, if an
investment alternative has one cash flow followed by three cash inflows can be represented as: -,
+, +, +. This is considered to have a conventional cash flow pattern. Investment alternatives are
assumed to exhibit conventional cash flows. Evaluating an investment alternative that violates
this assumption can become very difficult.
6. The Required Rate of Return is Known and Constant. The required rate of return is
generally looked at as minimum rate return that the company must earn if shareholders' wealth is
not to decrease. Here, the minimum required rate of return on investment alternatives is assumed
to be known and constant over the life of the proposed investment. Arriving at the required rate
of return is important for two reasons:
1) if the rate is too high, the company will end up in rejecting quite profitable project s, and
2) If the rate is too small or low, the company will end up in accepting projects that are not
profitable and decrease shareholders wealth.
7. Capital Rationing doesn't exist. Whenever a company is not able to finance its entire
capital budgeting (investment), capital rationing is said to exist. In such a situation some
investments will have to given up. The capital budgeting techniques assumed in the chapter
considers that there is no any capital problem or limitation. However, capital rationing or capital
shortage does contain important implications for financial managers.
Part of Investment
There are parts of long-term investments. These are.
1. The initial investment. The initial investment is an outlay of cash that takes place at the
beginning of the life of the project.
2. The operating cash flows. The operating cash inflows from revenue sources and the cash
out flows for different expenditures.
3. The terminal cash flows. These are the cash inflows and out flows that take place at the
end of the project life.
Initial Investment
The components of the initial investment are:
a) Gross investment. The gross investment of a project or asset is its purchase price and
other incidental costs. Gross investment the base for depreciation of the entire project
alternatives.
b) Investment tax Credit. It is the specified percentage of the Birr amount of new
investments in each of certain categories of assets which business firms deduct as a
credit against their income taxes. This percentage is applied to the gross investment
amount. The purpose of such tax credit is to provide an incentive for new investment
projects. For instance, assume that a firm is considering a project that entails the
purchase of new equipment for 500,000 Birr with an expected duration of 10 years.
If the asset acquisition qualifies for tax credit of 10- percent, the investment tax credit
is 50,000 Birr (i.e. 500,000 x 10% = 50,000 birr). Although the practice varies from
country to country, it is assumed that the tax authorities force the firm to reduce the
value of the asset by the amount of investment tax credit for depreciation purpose.
This is to avoid double benefits. The investment tax credit is the direct reduction of
taxes. Suppose that a firm estimates that its taxable income next year will be 80,000
birr and that its profit tax is 40 percent. The company expects to acquire an
equipment costing 60,000 birr. If the investment tax credit is 10 percent, the amount
of income tax to be paid to the taxing authority is only 26,000 birr i.e. (80,000) (0.40)
- (60,000) (0.10) = 26,000.

c) Net Working Capital Increases

Net working capital is the difference between the total current assets and total current liabilities.
Investment in new long-term asset may increase the amount of net working capital if the project
is the revenue expansion investment. Cost reduction investment will not affect the amount of net
working capital required. Increase in the amount of net working capital is added to the gross
investment while determining the amount of initial investment.
d) Opportunity Costs:
Opportunity cost is the highest return that will not be earned if the funds are invested in a
particular project type. In other words, opportunity cost is the income generated by the
alternative use of an asset that is forgone when a new project is adopted. The relevant
opportunity costs associated with an investment proposal should be included in the initial
investment.
e) Tax Increase or Shield
The tax both ordinary income tax and capital gain tax will be added to the original costs of long-
term assets in order to determine the initial investment. In the case of replacement projects, if
the old assets (i.e. assets to be replaced) are sold at amounts less than their book values, there
will be losses on sales of these assets. The ordinary income tax rate is applied to these loss
amounts to determine the amount of tax shield which will be deducted from the original cost of
new fixed assets to determine the amount of the initial investment.
Suppose that Brehan Share Company is considering replacing an old equipment with the new
one. The new equipment has an original cost of 900,000birr. The original cost and accumulated
depreciation of the old equipment are 400,000birr and 280,000 birr respectively. The investment
tax credit on the new equipment is assumed to be 5 percent. Determine the amount of the initial
investment of the new equipment under each one of the following assumptions.
i) The selling price of the old equipment is 120,000 birr
ii) The selling price of the old equipment is 150,000 birr
iii) The selling price of the old equipment is 460,000 birr
iv) The selling price of the old equipment is 80,000 birr
Assume also that the ordinary income tax rate is 40 percent and the income tax rate on the capital
gain is 20 percent. We say there is a capital gain when the old asset is sold at a selling price
greater than its original cost. Hence, capital gain is equal to the excess of the selling price of the
old fixed asset over its original cost at the time of replacement.
Solutions
i) The book value of the old equipment is 120,000 birr (i.e. 400,000 - 280,000 =
120,000 birr).
 Loss/gain on sale of the old equipment is zero (i.e. 120,000-120,000 = 0).
 Ordinary income tax is also zero, that is (0.40) (0) = 0.
 Investment tax credit is 45,000 birr, that (900,000) (0.05) = 45,000birr.
Therefore, initial investment is:
Investment tax credit (45,000)
Ordinary income tax 0____
Initial investment 735,000
ii) → Gain on sale of old equipment is 30,000 birr, that is 150,000 birr selling price
minus 120,000 birr, its original cost.
→ Ordinary income tax is 12,000 birr that is the ordinary income tax rate of 40
percent multiplied by the amount of recapitulated depreciation of 30,000 birr.

Hence, initial investment is:

Original cost of the new equipment 900,000
Proceed from sale of old equipment (150,000)
Investment tax credit (45,000)
Ordinary income tax 12,000
Initial investment 717,000 birr
iii) When the old asset is sold above its original cost, two types of taxes are paid on the
proceed. The first type of tax is the ordinary income tax which is based on the difference
between the original cost and the book value of the old asset, or on the balance of the
accumulated depreciation as on the date of replacement. This amount is also known as
the recapitulated total depreciation. The second type of tax is based on the difference
between the selling price of the old asset and its original cost. Note that, in most of the
cases the ordinary income tax rate and the income tax rate of capital gain are not the
same. Thus, these income taxes and the initial investment under this investment are
computed as follows.
→ Ordinary gain on sale of old equipment is 280,000 birr, that is 400,000, the original cost
minus 120,000 birr, the book value of the old equipment.
→ Ordinary income tax is 112,000 birr, that is 40 percent ordinary income tax rate multiplied
by 280,000 birr the ordinary gain on sale of the old equipment.
→ Capital gain is 60,000 birr that is 460,000 birr, the selling price of the old equipment on the
date of replacement minus 400,000birr, the original cost of the old equipment.
→ Capital gain income tax is 12,000 birr that is the capital gain tax rate of 20 percent multiplied
by 60,000 birr, the total amount of capital gain on the sale of the old equipment.

Thus the amount of initial investment is:

Original cost of the new equipment 900,000
Proceeds from sale of old equipment (460,000)
Investment tax credit ( 45,000)
Ordinary income tax 112,000
Income tax on capital gain 12,000
Initial investment 519,000

iv) → Loss on sale of the old equipment is 40,000 birr, that is the selling price of
80,000 birr minus the book value of 120,000 birr both corresponding to the old
equipment.
→ The loss on sale of the old equipment has an effect of tax saving. Therefore, the tax shield
is 16,000 birr which is computed by multiplying the ordinary income tax rate of 40 percent by
the total amount of initial investment is:

Hence, the amount of initial investment is:

Original cost of the new equipment……………… 900,000
Proceed from sale of old equipment (80,000)
Income tax saving (shield) (16,000)
Income tax credit (45,000)
Initial investment 759,000

f) Salvage Proceed of the Old Asset

If the project is involves the replacement of the old fixed assets with the new ones, the proceeds
form the sale of the old assets should deducted from the gross investment to be made in the new
assets to determined the amount of the initial investment

Add: Tax savings on non cash expenses xxx

After-tax Cash flow xxx
  The after-tax cash revenue is cash revenue minus the income tax on cash revenue
(i.e tax rat e multiplied by cash revenue)
 The after tax cash expense is cash expense minus the income tax on cash expense
(i.e income tax rate multiplied by the amount of cash expense).
 Tax savings on non-cash expense is computed by multiplying the income tax rate by
the total amount of non-cash expense.
To illustrate suppose that Wanza Share company is considering or project that requires an
investment I fixed assets of 200,000 birr. The project is expected to generate annual cash
revenue of 72,000 birr for the coming five years. Annual cash expenses are estimated at 27,000
birr over the five years. The project is also expected to have the salvage value of 45,000birr at
the end of year 5. In addition to the investment in fixed assets mentioned above, the project
requires a net working capital of 25,000 birr at the beginning of year 1. This amount of working
capital will be recovered at the end of the life of the project (i.e end of year 5). The income tax
rate and the investment tax credit are 40 percent and 10 percent respectively. Use the straight-
line method of depreciation to depreciate the project's fixed assets compute the initial investment
and the annual cash flows for each one of the five years for the project.

Solution:
The initial investment of this project is:
Investment in fixed assets 200,000
Investment tax credit (20,000)
Net working capital required 25,000
Initial investment 205,000

To determine the after-tax cash flows during each one year of the coming five year, we have to
compute the annual depreciation. The depreciable amount is not the initial investment; rather it
is the 200,00 as illustrated with the help of the previous cases for Brehan Share Compnay.
Terminal Cash Flows:
The terminal cash flows are those cash flows associated with end of the project. These are:
1. The salvage precedes fro the sale of assets, net of the relevant income taxes when the
project is completed.

2. The recovery of net working capital at the end of the projects life. An increase in the
net working capital during the time of investment is expected to be recovered when the
project terminates. The recovery of net working capital is tax-free because this amount
is neither an ordinary gain nor a capital gain. Rather it is the recovery of the funds
placed in the project for the day to day operation of the project when the project comes
to an end.
Therefore, the net cash flows from the project during the final year of the project's life comprise
of the operating cash flows, the proceeds from the sale the used assets, and the recovery of net
working capital.
Capital Budgeting Project Evaluation Techniques:

This topic is concerned with the ranking of projects for the decision of whether or not they
should be accepted for inclusion in the capital budget. It is assumed that projects to be covered
in this topic are equally risky. All cash flows are assumed to occurs at the end of the designated
year. Generally, the project evaluation techniques are classified into two categories. These are:
 1. The Traditional Criteria (technique)
They are called the traditional techniques because they do not consider the time value the time
value of money concepts in ranking investment proposals. Two methods are included under the
traditional technique, namely the payback period ad the accounting rate of return.

a) The payback period: - The payback period is the number of years that is required for
the business firm to recover from the project the amount of the initial investment in
total. If the cash floes from the project are in an annuity form, the payback period can
easily be determined by dividing the initial investment by the annual cash flow in the
annuity. That is,

Payback period (in years) = Initial investment

Annual Cash flows

When the cash flows from the project are not in an annuity, the payback period is computed as
follows:
Payback period = year before full recovery + UN recovered cost
Annual flow during the next year
To illustrate the computation of the payback period when the cash flows from the project is an
annuity form, suppose the project requires an initial investment of 24,000Birr and the annual
after-tax cash flows of 6,000 Birr for five years. The payback period is, therefore,
Pay back period = 24,000/6000 = 4 years
This is to mean that the initial investment amount of this particular project will be recovered with
in the first four years of the project life (i.e. 6,000 for four years is 24,000).

To illustrate the computation of the payback period when the cash flows from the project are not
in an annuity form assumes the project requires an initial investment of 60,000 Birr. The after-
tax cash flows from the project are 8,000Birr during year 1, 15,000Birr during year 2 22,000Birr
during year 3, 20,000Birr during year 4, and year 5 each. Here, the cash flows are not uniform.
In this case, we first need to compute the cumulative cash flows of the project.

Year Annual Cash flow Cumulative cash flow

1 8,000 8,000
2 15,000 23,000
3 22,000 45,000
4 20,000 65,000*
5 20,000 85,000

Looking at the cumulative cash flows, the cumulative cash flows at the end of year 3, which is
45,000, is less than the initial investment where as the cumulative cash flows at the end of year 4
that is 65,000 is slightly greater than the initial investment. This implies that the payback period
for this project is greater than 3 years but less than 4 years. The exact payback period can be
computed as follows:
Payback period = 3 years + (15,000/20,000) years
= 3 years + 0.75 years = 3.75 years, or
= 3 years + (0.75) (12 months) = 3years and
9months.
This is true if the cash flows of 20,000Birr during year four are uniformly distributed over the
entire year. Otherwise, the payback period is different from 3 years and 9 months. For instance
if the cash flows of 20,000Birr is expect to occur only once at the end of year 4, the payback
period will be 4 years.

As a general rule, the shorter the payback period, the better the project. Thus, the project is
accepted if its payback period is less or equal to the period required by the management of the
business firm. If two projects are mutually exclusive (i.e. if the acceptance of one project
precludes the acceptance of the other), a project with the shorter payback period is selected even
if both of them fulfill the acceptance criteria. On the other hand, if two project are independent
(i.e. the cash flows of one of the project do not influence the cash flows of the other), both the
projects can be accepted as long as their pay back periods are less than the planned pay back
period.

Advantages of Payback Period:

The payback period is an easy and an inexpensive method to evaluate and rank project
alternatives

Disadvantage of Payback Period

The disadvantages of the payback period are:
1. It ignores the cash flows beyond the computed pay back period though they are important
for acceptance or rejection decisions.

2. It ignores the time value of money which is an important variable that demands
consideration in evaluating the desirability of a given project.

b) The Accounting Rate of Return (ARR)

The accounting rate of return (ARR) is the rate of return that is calculated by dividing the
projects expected annually net profit by the average investment outlays. The average investment
outlays, on the other hand, are computed by dividing the sum of original cost of the project and
the salvage value of return (ARR) can be expressed with an algebraic equation as follows.

Expect Average AnnualNet Pr ofit

ARR = Average Cost of Investment

Average cost of Investment = Original costs + salvage value

2

To illustrate the accounting rate of return consider the project that has the original investment of
70,000Birr, the life of 4 years, and the salvage value of 6,000 Birr at the end of year 4. The
straight line method of depreciation is used. Income before depreciation and taxes are
40,000Birr for year 1, 42,000Birr for year 2, 36,000 Birr for 3 year 3, and 50,000 Birr for year 4.
Determine the accounting rate of return if income tax rate on the project is 4- percent. To
compute the accounting rate of return (ARR) for this project, first we have to determine the
average investment and the annual depreciation amount.
Average investment = (70,000 + 6000)/2 = 38,000Birr
Annual depreciation = (70,000 - 6,000)/4 = 16,000Birr

Then compute the new profit for each year during the four years.
 Year 1 Year 2 Year 3 Year 4
Income before depr. & taxes 40,000 42,000 36,000 50,000
Less: Annual depreciation 16,000 16,000 16,000 16,000
Income before taxes 24,000 26,000 20,000 34,000
Less: Income taxes (40%) 9,600 10,400 8,000 13,600

Then we compute the average Net Profit during the four years.

That is:
Average net profit = (14,400 + 15,600 + 12,000 + 20,400)/4
= 15,600 Birr

Hence, ARR = Average Annual net profit = 15,600 = 0.41 or 41%.

Average cost of investment 38,000

This is to mean that for an average of 1 Birr invested in this project, there is an average return of
41 cents in the form of net profit per year over the entire four years of the life of the project.

The accounting rate of return method of project evaluation, like the payback period method,
ignores the timing of cash flows or the time value of money. Moreover, the accounting rate of
return ignores the fluctuations of the cash flows over the life of the life of the project as it
assumes an average cash flows every during the project's life.

2. The Discounted Cash flow (DCF) Criteria (Techniques):

The discounted cash flow techniques are other methods of evaluating and ranking investment
project proposals. These techniques employ the time value of money concept, unlike the
traditional methods. Four DCF techniques are discussed in the sections that follow.
a) The discounted Payback period
The discounted payback period is defined as the number of years that is required to recover the
amount of money invested in a project at the beginning after discounting the future cash flows to
their present values. Discounted payback period is computed in the same manner as that of the
regular payback period except the discounted cash flows are used in the case of the former on.
The expected future cash flows are discounted by the projects cost of capital.

To illustrate the computation of the discounted payback period suppose that a given capital
budgeting alternative is expected to have an initial investment of 30,000Birr and the life of 5
years. The after-tax cash flows from the project during years 1,2,3,4 and 5 are 15,000Birr,
18,000Birr, 12,000Birr, 20,000Birr, and 22,000Birr respectively. The cost of capital (the
required rate of return) is 10 percent. What is the discounted payback period for this project? To
answer this question, first we have to compute the discounted cash flows and the cumulative cash
flows for each year which helps to locate the discounted payback period of this project. Hence,
the discounted cash flows and the cumulative cash flows year by year are show as follows.

Year Cash flows Discount Factor Present Value Cumulative

CF
1 15,000 0.909 13,635 13,635
2 18,000 0.826 14,868 28,503
3 12,000 0.751 9,012
4 20,000 0.683 13,660
5 22,000 0.621 13,662

As you can see from the cumulative discounted cash flows the discounted payback period for
project is between 2 and 3 years. This is because the cumulative discounted cash flow at the end
of year 2 is less than the initial investment of 30,000Birr and the cumulated discounted cash
flows at the end of year 3 is greater than the same initial net investment. The exact payback
period (discounted) can be computed as:
Discounted Pay back period = 2 years + (1,497/9,0120) years
= 2 years + 0.17 years = 2.17 years
= or 2 years + (0.17) (12 months)
= 2 years and 2 months.

It requires the project a period of 2 years and 2 months to recover its initial net investment taking
the time value of money into account. This is true only if the cash flows assumed to occur
uniformly throughout the year. But the cash flows are discounted back to their present cash
equivalents by considering that the cash flows are occurring at the end of every year. Hence, the
project needs to wait for one more years after year 2 in order to recover the remaining present
value equivalent amount of 1,497Birr at the end of year 2. Therefore, the discounted pay back
period of this project is 3 years instead.

b) The Net Present Value (NPV) Method

The net present value (NPV) method is an investment project proposals evaluating and ranking
method using the net present value, which is the difference between the present values of future
cash inflows and the present value of cash outflows, discounted at the given cost of capital, or
opportunity cost of capital.

In order to use this method properly, the following procedures are followed.
1. Find the present value of each cash flow, including both inflows and out flows using the
cost of capital of the project for discounting.
2. Sum the discounted cash outflows and the discounted cash outflows separately.
3. Obtain the difference between the sum of the cash inflows and the sum of the cash flows.

If all the cash outflows for the project occur at time zero, i.e. at the beginning of year 1, the
present value of the cash our flows is the same as to the net investment amount.

Decision Rule for the Net Present Value (NPV) Method:

If the projects are independent, the projects with positive net present values are the ones whose
implementation maximizes the wealth of shareholders. Hence, such projects should be accepted
for implementation. If the projects, on the other hand, are mutually exclusive, the one with the
higher positive NPV should be accepted leading to the rejection of the projects with lower
positive NPV. Projects with negative NPV should not be considered for acceptance in the first
place.
The rationale for the NPV method is that an NPV of zero signifies that the cash flows of the
project are just sufficient to repay the invested capital and to provide the required rate of return,
no more no less. If the project has a positive NPV, it is generating more cash than needed to
service its debts and to provide the require rate of return to the shareholders, and this excess cash
accrues solely to the firm's shareholders. Therefore, if the firm takes on a project with a positive
NPV, the wealth of the shareholders will be improved as indicated above.
To illustrate the NPV as a method of project proposals ranking assume that a given project is
expect to have an initial investment and project life of 40,000Birr and 5 years respectively. The
annual after-tax cash flow is estimated at 12,000Birr for each one of the five years. Using the
required rate of return of 10 percent, What is the net present value (NPV) of the project? How do
you judge the acceptability of this project?

In order answer these question, it is wise to identify the cash inflows and outflows. In the cse of
this project, there are annuity cash inflows of 12,000 every year for five years and a single cash
out flow of 40,000 at time zero.

The present value of the annuity cash outflows is:

Present value of annuity = (12,000) )Annuity factor)
The annuity factor given the period of 5 years and discount rate of 10 percent is 3.791
substituting the factor I the equation above
PVA = (12,000) (3.791) = 45,492Birr
Present Value of Cash out flows = 40,000Birr
Hence,
The Net Present value (NPV) = Present Value of inflows less present value o
of out flows
= 45,492 - 40,000 = 5,492Birr
Since the project makes the net present value (NPV) of positive 5,492Birr, it should be accepted.
Consequently, the wealth of the shareholders would increase by 5,492Birr in total as the result of
accepting and running this project. Thus, the project can be judged as an acceptable one.

To further illustrate the NPV method, consider the following mutually exclusive project
alternatives, together with their cash flows.

Alternative Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

A (80,000) 20,000 25,000 25,000 30,000 20,000

B (100,000) 25,000 20,000 30,000 35,000 40,000

The required rate of return on both projects is 12 percent. Then, evaluate these projects using the
net present value method.

The evaluation of these two projects requires the computation of the net preset values for both
projects. As you can see the cash flows from both projects are not in annuity forms. The cash
flows are irregular for both projects. Hence, we need to discount each of the cash flows
individually. Then the individual discounted cash flows are added. The cash out flows at time
zero will be deducted from the sum of the discounted cash inflows in order to get the net present
value of the project. The net present value (NPV) for project A is:

Year Cash flows Discount Factor (12%) Present Values

1 20,000 0.893 17,860
2 25,000 0.797 19,925
3 25,000 0.712 17,800
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Present values of cash inflows (sum) 86,005
Present values of cash outflows 80,000
Net Present Value (NPV) 6,005 Birr

The net present value (NPV) for project B is:

Year Cash flows Discount Factor (12%) Present Values

1 25,000 0.893 22,325
2 20,000 0.797 15,940
3 30,000 0.712 21,360
4 35,000 0.636 22,260
5 40,000 0.567 22,680
Present values of cash inflows (sum) 104,565
Present values of cash outflows 100,000
Net Present Value (NPV) 4,565 Birr

Since the two projects are mutually exclusive, the one with the higher NPV has to be accepted.
Thus, project A is selected as its NPV is higher than that of project B. Had the two project been
independent of one another, both of them would be accepted because both projects have positive
net present values (NPVs)

The NPV Profile

As indicated above, the net present value of the project depends solely on the size and timing of
the cash flows, the investment out lays, and the discount rate. A simple graphic device that
visualizes this dependence is called the NPV profile.

To illustrate the NPV profile suppose that a project is expected to have an initial investment of
200Birr and the first year cash flow of 230Birr. The net present value of this simplified project
using four alternative discount rates of 0, 10,, 15, and 20 percents is shown as follows.
Present value Net Present
Discount Rate Discount Factor of 230Birr Less net Investment Value
0 1.000 230.00 200 30.00
10% 0.909 209.07 200 9.07
15% 0.870 200.01 200 0.00
20% 0.833 191.59 200 -8.41

The NPV profile can shown with the help of the X-y coordinate plane where the Y-axis is to
represent the NPVs and the X-axis is to represent the discount rates.

30*
20
10 *
*
-10 10 15 20 25
*
The discount factor is 1 when the discount rate is zero. This reflects the fact that 0 Birr received
tomorrow is equal to a birr received today in a world where there is no other profitable
alternative of using money. At the discount rate of 15 percent the NPV is zero, which means that
this project is earning exactly 15 percent returns.

The above graph indicates that the NPV of the project under consideration is positive when the
discount rates are less than 15 percent, and negative when the discount rates are greater than 15
percent. Therefore, this project should be accepted if and only if the opportunity cost of is below
15 percent.

C) The Internal Rate of Return (IRR)

The internal rate of return is the discount rate which equates the present value the expected cash
flows with the initial investment outlays. In other words, IRR is a method of ranking investment
project proposals using the rate of return on an asset (investment). At IRR, the sum of the
present values of all cash inflows is equal to the sum of the present values of all cash outflows.
That is:

Pv )cash inflows) = PV (cash outflows). Hence, the net present value of any project at a
discount rate that is equal too the IRR is zero.

Computing the Internal Rate of Return

1. Uniform Cash Inflows over the Life of the Project:

In this case, the present value table of an annuity can be used to calculate the IRR since the cash
inflows are in annuity form. The following steps can be followed to calculate IRR for constant
cash inflows.
Step 1: Find the critical value of discount factor
Discount factor = Initial investment
Annual Cash inflow

Step 2: Find the IRR by looking along the appropriate line (year) of the present value of
annuity table until the column which contains the critical discount factor (i.e.
the discount factor computed under step 1) is located.

To illustrate the calculation of IRR when the cash flows are in an annuity form, assume that a
project has a net investment of 26,030 Birr and annual net cash inflows of 5000Birr for seven
years. What is the IRR of this project? In order to answer this question, we need to follow the
two steps discussed above.

Step 1 Compute the critical discount factor. That is

Discount factor = 26,030 = 5.206
5,000

Step 2 After determining the critical discount factor, we look for the value that is equal
to this factor in the present value of annuity table across the line corresponding
to 7 years (i.e n=). The discount factor of 5.206 appears in the 8 percent
column on the line/row of 7 years. Therefore, the IRR is 8 percent.
2. Fluctuating Cash Inflow over the Life of the Project

When the cash inflows from the project are not in an annuity form, IRR is calculated through an
iterative process or through "trial and error". It may be difficult to identify from which discount
rate to start. A good first guess can be made by estimating the discount factor.

In general, the following procedures are used to calculate the IRR of the non-uniform net cash
flows.

Step 1:Find the estimated discount factor. In fact, if the fluctuations I the cash inflows
is very large, the estimated discount factor doesn't not help you much in
locating the IRR in the present value of annuity table.
Estimated discount factor = Net investment
Average cash inflows

Step 2:Look at the present value of annuity table to obtain the nearest discount
rate for the estimated discount factor determined in step 1.

Step 3:Calculate the NPV using the discount rate identified in step 2.

Step 4:If the resulting NPV is positive, choose the higher discount rate and repeat the
procedure. Choose the lower discount rate if the NPV is negative, and repeat
the same procedure until you find the discount rate that equates the NPV to
zero.

To illustrate the IRR computation under fluctuating cash inflows from the project assume a
project that has an initial investment of 40,000 Birr and the following net cash inflows:

Year 1, 15,000Birr; year 2, 10,000Birr; Year 3,, 10,oooBirr; year 3, 15,000 Birr; and year 5,
15,000Birr. What is the IRR of this project.

In order to estimate the discount factor, you need to give weight to the cash flows over the life
of the project. Larger weights should be given to the cash flows towards the beginning of the life
of the project than to the cash flows that occur to wards the end of the project life.

Hence,
Year Weight Cash flow x weight
1 5 75,000
2 4 40,000
3 3 30,000
4 2 30,000
5 1 15,000
15 190,000
Average net cash flow= 190,000 = 12,667
15

Estimated discount factor = 40,000 = 3.158

12,667
By looking up in the present value table for annuity, the approximate the discount factor of 3.158
online 5 (n=5) is 18 percent. Thus, the starting point of the iterative process is 18 percent. The
NPV of the project using the discount rate of 18 percent is:

NPV = (15,000) (0.847) + (10,000) (0.718) + (10,000) (0.609) + (15,000) (0.516) +

(15,000) (0.437) - 40,000 = 40,270 - 40,000 = 270

Since the NPV computed using a discount rate of 18 percent is positive, are have to take a
discount rate higher than 18 percent in search for the NPV of zero. So the second guess can be
19 percent. The NPV of the project using the discount rate of 19 percent is:
NPV = (15,000) (0.840) + (10,000) (0.706) + (10,000) (0.593) + (15,000) (0.499) +
(15,000) (0.419) - 40,000 = 39,260 - 40,000 = -640

As per the above calculations, NPV is negative when the discount rate of 19 percent is used and
positive when the discount rate of 18 percent is used. Thus, the IRR for this project falls
between 18 percent and 19 percent. If the exact IRR is needed, the interpolation method is can
be used. That is:

Step 1: Obtain the NPV of the smaller rate by the absolute sum and add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute sum
and subtract the resulting quotient from the larger rate.

Step 2: Divide the NPV of the smaller rate by the absolute sum and add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute
sum and subtract the resulting quotient from the larger rate.

By following the above two steps, the exact IRR for this project is thus:
The absolute sum of the NPVs = |270| + |-640| = 270 + 640 = 910

Then, dividing the NPV of the smaller rate by the absolute sum, you get 270/910 = 0.30 to the
nearest two digits after the decimal point, and add this figure to the smaller rate
IRR = 18% + 0.30% = 18.30%
or you can divide the NPV of the larger rate by the absolute sum, and you get:
-640/910 = - 0.70 to the nearest two digits after the decimal point, and subtract this
figure from the larger rate to obtain the exact IRR.

IRR = 19% - 0.70% = 18.3%

In both cases, you arrive at the same IRR value of 18.3 percent.

The rational for the IRR method is that the IRR on a project is its expected rate of return. If the
IRR of a given investment project exceeds the cost of the funds used for financing the project
(cost of capital), there is the remaining surplus after paying for the capital, and this surplus adds
up on the wealth of the shareholders of the firm. Therefore, selecting the project whose IRR
exceeds its cost of capital increase the share holders' wealth. On the other hand, the project with
the IRR less than the cost of capital imposes an unnecessary cost on current shareholders. The
return from the project will to cover even the cost of capital.

Decision RuleS for IRR

A project whose IRR is greater than its cost of capital, or Required Rate of Return (RRR) is
accepted and whose IRR is less than the RRR of the project is rejected.

d. Profitability Index (PI):

Profitability index is the ratio of the present value of the expected net cash flow of the project
and its initial investment outlay.

PI = PV/IO where =
PV = Present value of expected net flows
IO = Initial investment outlay
PI = Profitability Index

Profitability index provides or measure of profitability in a more readily understandable terms. It

simply converts the NPV criterion into a relative measure.

NPV VS Profitability Index

The NPV and the profitability index criteria reach the same acceptance-rejection decisions for
independent projects. The profitability index is greater than 1 if the net present value of the
project is positive. However, in the case of mutually exclusive projects, NPV and profitability
index will result in different acceptance-rejection decision. One advantage of NPV in this case is
that it reflects the absolute size of alternative investment proposals profitability index does not
reflect difference in investment size. Therefore, the NPV is more appropriate for mutually
exclusive projects than profitability index.

Consider the following two mutually exclusive projects.

Present Value Initial Profitability
of cash Flow Investment NPV Index
Project A 200 100 100 2.0
Project B 3000 2000 1000 1.50

From the above example project A is accepted using profitability index because its PI is greater
than that of project B. However, NPV of project B is greater than that of the NPV of project A.
Thus, even though the profitability index of a project is a very useful tool, it should not be used
as a decision rule when mutually exclusive projects fo different size are being considered.
Capital Rationing
Capital rational is a situation in which a constraint is placed on the total size of the firm’s capital
budget. Capital ration is said to exist when we have profitable (positive NPV) investments
available but we can’t get the needed find to under take all of them. Two main reasons can be
mentioned. One is what is called soft rationing which is the situation that occurs when units are
allocated a certain amount of financing for capital budgeting. Such allocation is primarily a
means of controlling and keeping track of overall spending. Soft rationing doesn’t mean that the
business firm as a whole is not short of capital. The other reason is hard rationing. Hard
rationing is the situation that occurs when a business can not raising finance or funds for a
project under any circumstances. A business firm with a sound financial status does not face
hard rationing.
1. The timing and magnitude of the cash flows of all projects (all project alternatives) are
known.
2. The cost of capital is known
 3. All projects are strictly independent
4. The total investment outlay of all those projects that have a positive NPV exceeds the
firm’s budget constraints. Taking these assumptions into account, the problem under
capital rationing is how to choose a subset of desirable projects in such a way that total
investment does not exceed the budget. In order to solve this problem, the sound
procedures are as follows.

1. Rank all projects with positive NPVS in accordance with their profitability indeed.
2. Select projects from the top of the list (with the highest profitability index) until the fixed
budget is exhausted.

To illustrate how to select project alternatives when the company has a limited capital amount
(i.e. when there is capital rationing) suppose that a firm has a fixed capital budget of 600,000 birr
and has the following investment alternatives.

Project Initial Investment NPV Profitability Index

A 150,000 40,000 1.50
B 190,000 40,000 1.40
C 120,000 70,000 1.80
D 180,000 50,000 1.30
E 330,000 60,000 2.00

The question is that which of these projects should the firm select and implement give the fixed
amount of capital budget indicated above?

To answer this question, first we have to rank these project based on the value of their
profitability index. Hence, their arrangement according to their profitability index is F-C-A-B-
D. This is to mean that project F is with the highest profitability index and project D is with the
lowest profitability index. Therefore, given the capital budge constraint of 600,000 birr, projects
F,C and A are selected. The initial capital requirements for these projects are the sum of the
initial investment costs of these projects F,C and A are selected. The initial capital requirements
for these projects (i.e. 330,000 + 120,000 + 150,000 = 600,000). So the total initial investment
cost of the three projects is exactly equal to the total capital budget of the firm. This implies that
the rest of the project alternatives can not be implemented be cause of the lack of capital though
they are all acceptable ones. The total net present value (NPV) of the projects that were selected
is 60,000 birr + 70,000 birr + 40,000 birr = 170,000 birr.