Page 1 of 10

TOPIC: CAPITAL BUDGETING

Introduction
Firstly, let us understand capital budgeting (investment appraisal) for a company as it is a key part of
building up a business. It can be defined as the planning process to identify, analyze and select
long terminvestment of an asset or time that is purchased with the hope that it will generate
income or appreciate in value at some point in the future, beyond one year.

The efficient use of an organization’s funds for capital investment is of significant importance as it
will involve commitment of large funds over a long period and it tends to influence the value of the
company due to impact on growth, profitability and risk, thus impacting shareholder value.

One of primary goals of capital budgeting/investments is to increase shareholder value, through

increasing the value of the company via expansion, acquisition, modernization and replacement of
long-term assets. Investment is a monetary asset purchased with the idea that the asset will
generate income in the future or appreciate in value and be sold for a higher price.

Capital investment
It is the investment made to buy non-current assets or to improve the earning capacity of non-
current assets already held in the business.as a result of the capital investment, the non-current
asset works more efficiently, last longer or improves revenue generation. Hence, a capital
investment increases the value of a non-current asset and the value to shareholders.

Types of capital investment

i) Purchase of non-current assets plus Legal and professional fees paid for purchasing non-current
assets
ii) Improvement to existing non-current assets

Usually, capital investment decisions involve commitment of huge sums of money with immediate
payments and benefit from it in a number of years.

Capital investment planning and control

Capital investment planning and control allows the management to assess the effectiveness of the
capital investment decision-making process that is used by it. It allows the management to refine
its policies and procedures for appraising and implementing capital investment projects. This
ensures that the capital investments made by an organization:
i) Are in line with its long term goals/objectives
ii) Support the business needs of the organization
iii) Minimize the risk and maximize the returns throughout the non-current asset’s life.

Role of capital investment planning and control

i) Maximizing shareholders’ wealth
ii) Taking strategic decisions
iii) Minimizing cost structure
 Page 2 of 10
iv) Avoiding loss
v) Avoiding fraud
vi) Growth through diversification
vii) Correcting discrepancy between planning and actual results

Capital budgeting
Definition:
Capital Budgeting is the process of Identifying, analyzing and selecting investments projects,
whose return (cash flows) extends beyond” one year.

Capital budgeting process is the process through which an organization generates, evaluates and
selects various capital investment proposals. It allows the organization to assess the financial
viability of a capital investment proposal.

Capital Budgeting involves the following steps

1) Generating Investment projects proposal, consistent to the firm’s strategic’ objectives.
2) Estimating the relevant cashflows for the project
3) Analyzing the relevant cash flows using “approved capital budgeting techniques
4) Selecting investment project based on the value maximization decision criteria.
The one which increases the value shall be selected
5) Re-evaluating investment project.

INVESTMENT APPRAISL TECHNIQUES / ANALYSIS OF RELEVANT CF’s

To analyze the CFs, we use the called “Capital budgeting Techniques”
There are various techniques, the basis techniques include:-
i) Payback Period -‘ PBP’
ii) Accounting Rate of Return – ‘ARR’
iii) Profitability Index – ‘PI’
iv) Net Present Values – ‘NPV’
v) Internal Rate of Return ‘IRR’

Accounting Rate of Return ‘ARR’

The method uses “Income flows” the ARR is calculated as

ARR = Average annual operating profit

Average Investment
Decision:
If ARR calculated is greater” than the minimum acceptable rate” then the project will be
“ACCEPTED” otherwise will be “REJECTED”

E.g. ARR = 8% minimum accepted rate = 10% project will be rejected.

This method is not commonly used because:-
i) Doesn’t apply cashflows
ii) Ignores time value of money
 Page 3 of 10
ILLUSTRATION 1
Rough Ltd has the opportunity to invest in an investment with the following initial costs and returns:
($000s)
Initial investment (100)
Cash flows Yr 1: 50
Yr 2: 40
Yr 3: 30
Yr 4: 25
Yr 5: 20
Residual value Yr 5: 5
Cost of capital is 10%. The target ARR is 20% and target PBP is 3 years.
Company uses the straight line method for depreciation.
Required:
Calculate the ARR based on Average Investment
 Page 4 of 10
Pay –Back period – ‘PBP’
Payback is the time it takes the cashflows from a capital investment project to equal the cash
outflows, usually expressed in years.

Payback is often used as a first screening method. By this we mean that when a capital investment
project is being considered, the first question to ask is: how long will it take to pay back its cost?
The organization might have a target payback, and so it would reject a capital project unless its
payback period were less than a certain number of years.

However, a project should not be evaluated on the basis of payback alone. If a project gets through the
payback test, it ought then to be evaluated with a more sophisticated investment appraisal
technique.

In summary,
PBP defines number of year required to recover the initial cash investment (ICO) through net
cashflows.
Decision:
If PBP calculated “Less” than some “minimum acceptable PBP” the project will be “ACCEPTED”
otherwise will be REJECTED.

E.g. Computed PBP = 6yrs

Max accepted PBP = 8yrs
Project will be accepted.
Drawbacks:
i. It ignores the timing of cash flows within the payback period, the cash flows after the end
of payback period and therefore the total project return.
ii. It ignores the time value of money
iii. Payback is unable to distinguish between projects with the same payback period.
iv. The choice of any cut-off payback period by an organization is arbitrary
v. It may lead to excessive investment in short-term projects
vi. It takes account of the risk of the timing of cash flows but not the variability of those cash
flows.

Advantages
i. It is simple to calculate and simple to understand
ii. It uses cash flow rather than accounting profits
iii. It ca be used as a screening device as a first stage in eliminating obviously inappropriate
projects prior to more detailed evaluation
iv. The fact that it tends to bias in favour of short-term projects means that it tends to minimize
both financial and business risk.
v. It can be used when there is a capital rationing situation to identify those projects which
generate additional cash for investment quickly.

PBP = ICO ← For constant cash flows

CF’s
ILUSTRATION 2
Required:
Using the data of ILUSTRATION 1, calculate the Payback Period?
 Page 5 of 10
DISCOUNTED CASH FLOW TECHNIQUES
The application of the idea that there is a TIME VALUE OF MONEY. What this means is that
money received today will have more worth than the same amount received at some point in the
future.

Net Present Value – NPV’s

This is common technique.
This method uses CF’s
It discounts all cash flows to Present.
We are discounting the CF’s using predetermined minimum acceptable rate of return.
This rate is usually “Cost of Capital” of the company undertaking the project.
The cost of capital is estimated as the Weighted Average Cost of Capital “WACC”.
Sometime cost of capital/WACC of the project can be used.

What is NPV?
The NPV of the investment is found as the DIFFERENCE between the;
 Present values of CF’s and,
 Initial cash Investment (ICO).
NPV = [CF1/(1+k)1 + CF2/(1+k)2 +…+ CFn/(1+K)n ] – ICO
DECISION
If an investment projects has NPV equal to ZERO or greater than ZERO then the project is
accepted. Otherwise shall be rejected.

Assumption:-
NPV assume that all cashflows occur at the “END” of each period.
How is the rate of discount determined to calculate the present values???

Advantages
1. A project with a positive NPV increases the wealth
of the company’s, thus maximize the shareholders
wealth.
2. Takes into account the time value of money.
3. Discount rate can be adjusted to take account of
different level of risk inherent in different projects.
4. Unlike the payback period, the NPV takes into
account events throughout the life of the project.
5. Better than accounting rate of return because it
focuses on cash flows rather than profit.
Disadvantages
1. Determination of the correct discount rate
can be difficult.
2. Non-financial managers may have difficulty
understanding the concept.
3. The speed of repayment of the original
investment is not highlighted.
4. The cash flow figures are estimates and
may turn out to be incorrect.
5. NPV assumes cash flows occur at the
beginning or end of the year, and is not a
technique that is easily used when
complicated, mid-period cash flows are
present

ILUSTRATION 3
Required:
Using the data of ILUSTRATION 1, Calculate the NPV of the Project?
 Page 6 of 10
Internal Rate of Return – IRR
The IRR of a project is defined as the discount rate that equates the present values of the CF’s
with initial cash investments (ICO).

PI = CF1 + CF2 +………+ CFn

(1 + K)1 (1 + K)2 (1 + K)n

There are three methods of computing IRR;

i) computer programs
ii) Financial calculator
iii) Trial and error method

TRIAL AND ERROR METHOD

The method involves the following steps
Select “Any Discount rate” and calculate NPV
 If NPV calculated is POSITIVE then try another rate which is greater than the 1st
one
 If NPV calculated is NEGATIVE then try another rate which is lowest than the 1st
one
Note
The objective of this trial and error is to get discount rates, one providing “Positive NPV” and
another one “Negative NPV” so that we can use the number in interpolation

Interpolation
-Interpolation is the finding unknown number from known numbers

IRR can be approximated as:

IRR = LR + NPVLR (HR –LR)

NPVLR – NPVHR

Where;
LR = Lower Rate
HR Higher Rate
NPV/ LR = NPV of lower Rate
NPV HR = NPV of higher Rate

DECISION
The decision used is to compare the IRR computed to required rate of return (RRR), which is
usually cost of capital.
RRR is referred as Hurdle Rule/Cutt off Rate.
If IRR>RRR then ACCEPT, otherwise REJECT the Project.

ILUSTRATION 4
Required:
Using the data of ILUSTRATION 1, Calculate the IRR ofthe Project?

Advantages
1. Like the NPV method, IRR recognises the time
value of money.
2. It is based on cash flows, not accounting profits.
3. More easily understood than NPV by non-
accountant being a percentage return on
investment.
4. For accept/ reject decisions on individual projects,
the IRR method will reach the same decision as the
NPV method
Page 7 of 10
Disadvantages
1. Does not indicate the size of the
investment, thus the risk involve in the
investment.
2. Assumes that earnings throughout the
period of the investment are reinvested at the
same rate of return.
3. It can give conflicting signals with mutually
exclusive project.
4. If a project has irregular cash flows there is
more than one IRR for that project (multiple
IRRs).

Profitability Index “PI”

The PI is defined as the ratio of the present value of the Net cashflow to the Initial cash investment
(ICO).
PI = CF1 + CF2 .......+.. CFn
(1 + K)1 (1 + K)2 (1 + K)n
ICO

Where: ICO = initial cash investment

K = Cost of capital of the company (Project)
CF’s = Net cash flows

Decision.
As long as the PI is one or greater than one the Investment shall be accepted.
Otherwise shall be REJECTED.

ILLUSTRATION 5:
Required:
Using data obtained from ILLUSTRATION 3, calculate the PI of the Project?

DISCOUNTED PAYBACK PERIOD

 The time period in which initial investment is recovered in terms of present value is known
as payback period.
 It is same as simple payback period. The only difference is that the discounted cash flows
are used instead of simple cash flows for calculation.
 Decision Rule
 If Discounted Payback Period < Target Discounted Payback, Accept the Project. Else
Reject the Project

ILUSTRATION 6
Required:
Using the data of ILUSTRATION 1, Calculate the Discounted payback of the Project?
 Page 8 of 10
RELEVANT CASH FLOWS
A cash flow is the net cash that flows into/out of the firm during some specified period.
In evaluating projects, the cash flows should be properly evaluated because the final results
depend on these cash flows.
In order to be able to estimate the relevant CF’s, you need to know/understand Characteristics/
Features of Relevant CF’s

i) Relevant CF’s are “Incremental’ CF’s and not Total CF’s

ii) Take only “operating CF’s and not financing CF’s
iii) Consider “cash Income” and not accounting Income
iv) Take after Tax CF’s and not before tax CF’s(unless you are told to ignore taxation)
NB: If Tax rate has been provided, then use “After Tax CF’s”

EFFECT OF TAXATION IN INVESTMENT APPRAISAL:

Timing of Tax Cash flows: Either in the same year or in arrears.
Calculation of cash flows
 Tax on Operating Cash flows: Operational Cash flows X Rate of Tax
 Tax Savings on Capital Allowances: Calculate the capital Allowances/Balancing
Allowances and then multiply with Tax Rate.
Taxation rules
If no other assumptions about the timing of tax payment are given, the following should be
considered;
 Corporation tax is payable in the year following the one in which the taxable profit arise.
 Net cash flows from a project should be considered as the taxable profit arising from the
projects unless otherwise stated.
 Capital allowances are used to reduce tax payment and this deduction in tax payment
should be treated as cash inflow arising from the acceptance of the project.

ILLUSTRATION 7:
Initial Investment = 2000m
Capital Allowances = 25% reducing balance
Useful life = 4 years, Tax rate = 30% payable in arrears, Scrap Value = 500m
Required: Compute Tax allowable depreciations and Tax savings for each year

ILLUSTRATION 8:
An asset is bought for $10,000 and will be used on a project for four years after which it will be
disposed of. Tax is payable at 30%, one year in arrears, and tax allowable depreciation is available
at 25% reducing balance.
Required:
a) Calculate the tax allowable depreciation and hence the tax savings for each year if the
proceeds on disposal of the asset are $2,500.
b) How would your answer change if the asset was sold for $5,000?
c) If net trading income from the project is $8,000 pa, based on your answer to part (a) and a
cost of capital of 10%, calculate the NPV of the project.
Page 9 of 10