Chapter One: Capital Budgeting Decisions

Long-term investments are also called capital budgeting. The term capital 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 of 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.
1.1. The Importance of Capital Budgeting
The following are some of the importance of capital budgeting:
1. It has a long-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.

1.2. Classification of Projects

Independent Verses Mutually Exclusive Projects
Independent projects are project where the acceptance or rejections of one project does not
have a positive or negative impact on the fate of the other project. The acceptance of one does
not eliminate the other(s) from consideration. If the firm has unlimited funds to invest, all the
independent projects that meet its minimum investment criteria can be implemented.

1
Mutually exclusive projects that have the same function and thus compete with one another. The
acceptance of one of a group of mutually exclusive projects eliminates all other projects from
further consideration. If a corporation accepts competitive bids for a given project, the bids are
mutually exclusive because the winning bid excludes all other bids from being accepted.
Contingent Investment are dependent projects; the choice of one investment necessitates
undertaking one or more other investments.
1.3. Approaches/process 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;
someone 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.
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.
2
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. Cash flows, not accounting profits,
are used as a measurement tool. the firm receives and is able to reinvest cash flows, where as
accounting profits are shown when they are earned rather than when the money is actually in
hand. Cash flows correctly reflect the timing of benefits and costs, that is, when the money is
received, when it can be reinvested and when it must be paid out.
4. Ranking Investment Proposals
This activity involves the setting of decision rule(s) that help us to differentiate projects that are
acceptable and unacceptable. 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.
1.4. 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. 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.
2. Costs and Revenues are Known With Certainty.
3. Inflows and Outflows of Cash Occur once a Year.
4. Inflows and Out flows are Based on Cash.

3
 5. Cash Flows Exhibit a Conventional Pattern.
6. Capital Rationing doesn't exist.
Part of Investment
The parts of long-term investments 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 an incentive that might be granted by the government in order
to encourage investment. It is a reduction allowed by the government to reduce tax
liabilities by a stated fraction of the new capital investment the company has made in a
given year. For instance, assume that a firm is considering a project that entails the
purchase of new equipment for Br. 500,000 with an expected duration of 10 years. If the
asset acquisition qualifies for tax credit of 10 percent, the investment tax credit is Br.
50,000 (i.e. 500,000 x 10% = 50,000 birr).
c) Net Working Capital Increases: 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.

4
 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 from 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.
To illustrate suppose that XYZ Share Company is considering replacing an old equipment with
the new one. The new equipment has an original cost of Br. 900,000. The original cost and
accumulated depreciation of the old equipment are Br. 400,000 and Br. 280,000 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 (given ordinary income tax rate is 40 percent and the income tax rate on the capital
gain is 20 percent).
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
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 Br. 120,000 (i.e. 400,000 - 280,000 = 120,000).
 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) = Br. 45,000.
Therefore, initial investment is:
Original cost of new equipment 900,000
Proceed from sale of old equipment (120,000)
Investment tax credit (45,000)
Ordinary income tax 0____
Initial investment 735,000
ii) Gain on sale of old equipment is Br. 30,000 (i.e. 150,000 - 120,000).
Ordinary income tax is Br. 12,000 that is the ordinary income tax rate of 40 percent
multiplied by the amount of recapitulated depreciation of Br. 30,000.
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

5
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 income tax on capital gain which 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 Br. 280,000, that is 400,000, the original cost
minus 120,000, the book value of the old equipment.
 Ordinary income tax is Br. 112,000, that is 40 percent ordinary income tax rate multiplied by
280,000 the ordinary gain on sale of the old equipment.
 Capital gain is Br. 60,000, that is 460,000, the selling price of the old equipment on the date
of replacement minus 400,000, the original cost of the old equipment.
 Capital gain income tax is Br. 12,000, that is the capital gain tax rate of 20 percent multiplied
by 60,000, 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 Br. 40,000, that is the selling price of 80,000 minus the
book value of 120,000 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
Br. 16,000 which is computed by multiplying the ordinary income tax rate of 40 percent by
the loss.

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
Terminal Cash Flows
The terminal cash flows are those cash flows associated with end of the project. These are:
1. The salvage proceeds from the sale of assets, net of the relevant income taxes when the
project is completed.

6
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 of the used assets, and the recovery of net
working capital.
Annual cash flow for the five years/Operating Cost Flows
For revenue expansion long-term investment projects, operation cash flows represent the net
cash flows after tax.
To illustrate suppose that Wanza Share company is considering a project that requires an
investment of fixed assets of Br. 200,000. The project is expected to generate annual cash
revenue of Br. 72,000 for the coming five years. Annual cash expenses are estimated at
Br.27,000 over the five years. The project is also expected to have the salvage value of Br. 5,000
at the end of year 5 and assuming the assets are sold for Br. 10,000 at the end of year 5. In
addition to the investment in fixed assets mentioned above, the project requires a net working
capital of Br. 25,000 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 straight line method of
depreciation).
Required: 1. Compute the initial investment
2. Compute 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 200,000. Therefore, annual depreciation is Br. 39,000 (i.e (200,000 - 5,000)/5). The book
value at the end of year 5 is Br. 5,000. Assuming the assets are sold for Br. 10,000 at the end of
year 5 there would be a Br. 5,000 gain on sale of old assets of the same amount. This gain
amount is subjected to the ordinary income tax rate of 40 percent and it amounts to Br. 2000 and
the net proceed from the sale of the old assets at the end of year 5 will be only Br. 8,000 (i.e.
10,000 - 2,000 = 8,000).

7
Then, the annual after-tax cash flows for the five years computed year by year as follows.
Year 1 Year 2 Year 3 Year 4 Year 5
Cash revenue 72,000 72,000 72,000 72,000 72,000
Less: Cash expenses 27,000 27,000 27,000 27,000 27,000
Cash flows before dep. & taxes 45,000 45,000 45,000 45,000 45,000
Less: Depreciation 39,000 39,000 39,000 39,000 39,000
Income before Income tax 6,000 6,000 6,000 6,000 6,000
Less: Income tax (40%) 2,400 2,400 2,400 2,400 2,400
Net Income 3,600 3,600 3,600 3,600 3,600
Add: Depreciation 39,000 39,000 39,000 39,000 39,000
Proceeds from sales - - - - 8,000
Recovery of Net W.C. ____-__ ___-_ __-__ ___-___ 25,000
After-tax cash flows Br. 42,600 Br. 42,600 Br. 42,600 Br. 42,600 Br. 75,600

The after-tax cash flows are constant 42,600 birr every year for the first four years and 75,600
Birr for the fifth year which was increased by the proceed from sales of old assets and the
recovery of net working capital. This method is called accounting income approach.
Using the decomposition approach, the after-tax cash flow is computed to be the same as the one
computed above using the accounting income approach. That is Br. 42,600 as show below.
After-tax cash revenue 72,000 - (0.4) (72,000) = 43,200
Less: after tax cash expenses 27,000 - (0.4) (27,000) = 16,200
Subtotal 27,000
Add: tax savings on non-cash expresses (0.4) (39,000) = 15,600
After-tax cash flow = 42,600

The other type of long-term investment project is the cost Reduction Project. To illustrate the
after-tax cash flow determination for this type of projects assume XYZ Company which has
purchased a machine 5 years ago at a cost of Br. 100,000. This machine has an expected life of
10 year at the time of its purchase, and an expected salvage value of Br. 10,000 at 'the end of its
useful life of 10 years. The machine is being depreciated on the straight line basis.

A new machine can be purchased for Br. 150,000, including an installation costs. During its five
years of services the new machine will cut the cash operating costs (expenses) by Br. 50,000 per
year. Sales volume is not affected by this investment decision. The new machine will depreciate
at a rate of 20 percent every year. The new machine is expected to have the salvage value of
Br.3,000 at the end of the fifth year. The selling price of the old machine after being depreciated
for five years is Br. 65,000. This firm's ordinary income tax rate is 35 percent. Compute the
initial investment and the net after tax cash flows if the company has decided to replace the old
machine with the new one.

To compute the amount of the initial investment, we first need to know the amount of gain or
loss on the sale of the old machine. The book value of the old machine at the end of year 5 is its
original cost of Br. 100,000 minus the accumulated depreciation balance at the end of year 5 of
45,000 (i.e. 9000 annual depreciation multiplied by 5 years) which is Br. 55,000. Since the
selling price of the old machine of Br. 65,000 birr is greater than its book value of 55,000, there

8
 is a gain on sale of old machine of Br. 10,000. This gain on sale of the old assets will expose
XYZ company to an addition income tax of Br. 3,500 (i.e. 35 percent multiplied by 10,000).
Therefore, the initial investment of this cost reduction project is as follows:

Cost of the new machine 150,000

Proceed from the sale of the new machine (65,000)
Income tax on gain of sale 3,500
Total investment costs 88,500
The after-tax cash flows as a result of implementing this cost reduction project over the project
life are computed as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
Cost Saving before tax 50,000 50,000 50,000 50,000 50,000
Depreciation (new) 29,400 29,400 29,400 29,400 29,400
Depreciation (old) 9,000 9,000 9,000 9,000 9,000
Increase in Dep. 20,400 20,400 20,400 20,400 20,400
Taxable income 29,600 29,600 29,600 29,600 29,600
Income taxes (35%) 10,360 10,360 10,360 10,360 10,360
Income after tax 19,240 19,240 19,240 19,240 19,240
Add: Increase in Dep. 20,400 20,400 20,400 20,400 20,400
Salvage value of new - - - - 3,000
Total net cash flows 39,640 39,640 39,640 39,640 42,640
Annual depreciation on:
The new machine is (150,000 - 3,000)/5 years = 29,400
The old machine is (100,000 - 10,000) / 10 years = 9,000
Therefore, the increment in the annual depreciation is = 20,400
1.5. 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 and 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 flows 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

9
When the cash flows from the project are not in an annuity, the payback period is computed as
follows:
Unrecov ered Cost
Payback period = year before full recovery + 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 Br. 24,000 and the annual
after-tax cash flows of Br. 6,000 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 Br. 60,000. The after-tax
cash flows from the project are Br. 8,000 during year 1, Br. 15,000 during year 2, Br. 22,000
during year 3, Br. 20,000 during year 4, and year 5 each. To determine the payback period, 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.
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, 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, both the projects can be accepted as long as their pay back periods are less than
the planned payback 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
1. It ignores the cash flows beyond the computed payback period though they are important
for acceptance or rejection decisions.

10
 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 Annual Net Pr ofit

ARR = Average Cost of Investment
Original costs +Salvage Value
Average cost of Investment = 2
To illustrate consider the project that has the original investment of Br. 70,000, the life of 4
years, and the salvage value of Br. 6,000 at the end of year 4. The straight line method of
depreciation is used. Income before depreciation and taxes are Br. 40,000 for year 1, Br. 42,000
for year 2, Br. 36,000 for year 3, and Br. 50,000 for year 4. Determine the accounting rate of
return if income tax rate on the project is 40 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 = Br. 38,000
Annual depreciation = (70,000 - 6,000)/4 = Br. 16,000
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
Net Income 14,400 15,600 12,000 20,400

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.

11
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
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 discounted
payback period. The expected future cash flows are discounted by the project's cost of capital.
To illustrate suppose that a given capital budgeting alternative is expected to have an initial
investment of Br. 30,000 and the life of 5 years. The after-tax cash flows from the project during
years 1, 2, 3, 4 and 5 are Br. 15,000, 18,000, 12,000, 20,000, and 22,000 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. 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 0.9091 13,636 13,636
2 18,000 0.8265 14,877 28,513
3 12,000 0.7513 9,016 37,529
4 20,000 0.6830 13,660 51,189
5 22,000 0.6209 13,660 64,849
As you can see from the cumulative discounted cash flows the discounted payback period for
project is between 2 and 3 years. The exact payback period (discounted) can be computed as:
Discounted Payback period = 2 years + (1,487/9,016) years
= 2 years + 0.16 years = 2.16 years
= or 2 years + (0.16) (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.
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
2. Sum the discounted cash inflows and the discounted cash outflows separately.
3. Obtain the difference between the cash inflows and the sum of the cash outflows.
Decision Rule for the Net Present Value (NPV) Method: f 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

12
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.
To illustrate assume that a given project is expect to have an initial investment of Br. 40,000
and project life of 5 years. The annual after-tax cash flow is estimated at Br. 12,000 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 case 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 inflows 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) = Br. 45,492
Or Present Value of Annuity is:

PVA = Annual Cashinflow X

(
1−(1+i)−n
i
= )
12,000 X
1−(1.1)−5
0.1 ( )
= 12,000 x 3.791=Br . 45,492

Present Value of Cash out flows = Br. 40,000

Hence,
The Net Present value (NPV) = Present Value of inflows less present value of outflows
= 45,492 - 40,000 = Br. 5,492
Since the project makes the net present value (NPV) of positive Br. 5,492, it should be accepted.
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. 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

13
 Net Present Value (NPV) Br, 6,005

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) Br. 4,565
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.
c) The Internal Rate of Return (IRR)
The internal rate of return is the discount rate which equates the present value of 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 to 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 assume that a project has a net investment of Br. 20,000 and annual net cash
inflows of Br. 5,200 for five 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 = 20,000 = 3.8462
5,200

14
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 5 years (i.e
n).
The discount factor of 3.8897 appears in the 9 percent column and the discount factor of 3.7908
appears in the 10 percent column on the line/row of 5 years.
Therefore, the IRR is between 9 percent and 10 percent. Thus, compute the NPV for each of
these two closest rates:
(NPV@9%) = Br. 5,200 x (3.8897) - 20,000 = 226
(NPV@10%) = Br. 5,200 x (3.7908) - 20,000 = (288)
Then, compute the sum of the absolute values of the NPV's obtained:
The absolute sum of the NPVs = |226| + |-288| = 226 + 288 = 514
Thus,
Pr esent Value of Smaller rate
IRR = Smaller rate + Absolute Sum of NPV (larger rate - smaller rate)
226
IRR = 9% + 514 (10 - 9) = 9% + 0.44 = 9.44% or
Pr esent Value of l arg er rate
IRR = Larger rate - Absolute Sum of NPV (larger rate - smaller rate)
288
IRR = 10% - 514 (10 - 9) = 10% - 0.56 = 9.44%
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 assume a project that has an initial investment of Br. 40,000 and the following net
cash inflows:

15
Year 1, Br. 15,000; year 2, 10,000; Year 3, 10,000; year 4, 15,000; and year 5, 15,000. 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 towards 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
1 190,000
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: Compute the sum of the absolute values of the NPV's obtained:
The absolute sum of the NPVs = |270| + |-640| = 270 + 640 = 910
Thus,
Pr esent Value of Smaller rate
IRR = Smaller rate + Absolute Sum of NPV (larger rate - smaller rate)
270
IRR = 18% + 910 (19 - 18) = 18% + 0.3 = 18.3% or

16
 Pr esent Value of l arg er rate
IRR = Larger rate - Absolute Sum of NPV (larger rate - smaller rate)
640
IRR = 19% - 910 (19 - 18) = 19% - 0.7 = 18.3%
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.
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.
Pr esent Value
PI = Initial Investment
Profitability index provides or measure of profitability in a more readily understandable terms. It
simply converts the NPV criterion into a relative measure.
Decision rule:
When BCR Decision rule
>1 Accept
=1 Indifferent
<1 Reject
Illustration:
The project which has a cost of capital of 12%, initial investment and cash flows are given below
Project Year 0 Year 1 Year 2 Year 3 Year 4
A (100,000) 25,000 40,000 40,000 50,000
Then, evaluate these projects using the profitability index.
The present value (PV) for the project is:
Year Cash flows Discount Factor (12%) Present Values
1 25,000 0.893 22,325
2 40,000 0.797 31,880
3 40,000 0.712 28,480
5 50,000 0.636 31,800
Present values of cash inflows (sum) 114,485
The benefit cost ratio measures for this project are:

17
 114 , 485
=1.145
PI = 100 , 000
Since the project have a Profitability index of 1.145 which is > 1, it should be accepted.
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 inflow 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 for different size are being considered.
Projects With Unequal Lives
There are many situations in which alternative investments have unequal lives. The most
common example of such situation is unequal replacement decision. Since it is not appropriate
to compare projects of unequal lives, adjustment must be made. Even though there are different
methods (approaches) of dealing with mutually exclusive alternatives with different lives, three
of them are introduced in this chapter.
1. The Replacement Chain Approach:
Replacement chain, which is called common life approach, is the method of comparing projects
of unequal lives which assumes that each project can be repeated as many times as necessary to
reach a common life span. Then, the NPV or the other method is used to evaluate the project. To
illustrate the comparison of projects with unequal lives consider two mutually exclusive projects
whose cash flows are summarized below. The discount rate for both project is 10 percent.
0 1 2 3 4 5 6
Project A (40,000) 10,000 12,000 15,000 11,000 9,000 11,000
Project B (30,000) 12,000 14,000 13,000 - - -
The two projects are incomparable. Thus, according to replacement chain approach, project B
will be repeated in three years. Assuming that annual cash flows and the discount rates will not
change. Thus, if project B is repeated, its year 4, year 5, and year 6 cash flows are Br. 12,000,
Br. 14,000, and Br. 13,000 respectively. In this way, the two projects have the same life. If
project B is repeated, its cash flows will be:
0 1 2 3 4 5 6
(30,000) 12,000 14,000 13,000 12,000 14,000 13,000
The present value computation of the repeated project B requires a two-step process. These are:

18
Step 1: you compute the present values at t = 0 and at t = 3 for the repeated project B.
Present value at time zero (t = 0) = (12,000)(0.909) + (14,000)(0.826)+(13,000)(0.751)
= Br. 32,235
Present value at time 3 (t = 3) = (12,000)(0.909) + (14,000)(0.826) + (13,000)(0.751)
= Br. 32,235
Step 2: Discount the present value of the repeated project at time 3 (t=3) to the present value at
time zero (t = 0).
That is, present value of repeated project B at time zero = (32,235)(0.751) = Br. 24,208
Then, add the present value of the first three years cash flows to the present value of the repeated
project after three years. That is:
Total present value = 32,235 + 24,208 = Br. 56,443.
Hence, the NPV of the repeated project B = 56,443 – 30,000 = Br. 26,443
The NPV of project A is calculated as follows.
Year Discount factor Cash flow present value
1 0.909 10,000 9,090
2 0.826 12,000 9,912
3 0.751 15,000 11,265
4 0.683 11,000 7,513
5 0.621 9,000 5,589
6 0.564 11,000 10,204
Present value of cash flows 49,573
Less. Present value of initial investment 40,000
NPV of project A 9,573
Therefore, using the NPV method for project comparison of the two projects, project B should be
selected.
Under the replacement chain approach of comparing projects with unequal lives, the least
common factor of the projects lives is used to find the common useful life. For instance, if the
life of project A is 5 years and that of project B is 3 years, project A is repeated 3 times and
project B is repeated 5 times because the least common factor for the two project lives (i.e 3 and
5) is 15 years.
2. Equivalent Annual Annuity (EAA) Method:
This method enables us to calculate the annual payments a project would provide if it were an
annuity. When comparing projects of unequal lives, the one with higher equivalent annual
annuity should be chosen. Three steps are flowed under this method.
Step 1: Find each project’s NPV over its initial life. The NPV for the above projects are as
follows:
Project A = Br. 9,573 birr (as computed before)
Project B = (12,000) (0.909) + (14,000) (0.826) + (13,000) (0.751) – 30,000
= 32,235 – 30,000 = 2,235 birr
Step 2: Find the equivalent annual annuity that has the same present value as the projects’
NPV.
Equivalent annual annuity can be calculated as follows.
For project A:
NPV = PV of cash flows – PV of initial out lays.

19
 9,573 = PV of cash flows – 40,000
9,573 + 40,000 = PV of cash flows
PV of cash flows = 49,573. By looking up in the present value of annuity table at n = 6 and
i=10%, the discount factor is 4.355.
Thus, PV of cash flows = cash flows x Discount factor
49,573 = (4.355) (x) where x is the equivalent annual annuity.
X = 49,573/4.355 = Br. 11,383
For project B:
NPV = PV of cash flows – PV of initial out lays
2,235 = PV of cash flows – 30,000
PV of cash flows = 2,235 + 30,000 = 32,235
By looking up in the present value of annuity table for the discount factor that corresponds to
n=3 and i=10% is 2.487. Hence
(y) = 32,235/2.487 where y represents the equivalent annual annuity amount for the project.
Solving for y we get.
Y = 32,235/2.487 = Br. 12,961
Thus, PV of cash flows = cash flows x Discount factor
32,235 = (2.487) (y) where y is the equivalent annual annuity.
Y = 32,235/2.487 = Br. 12,961
Step 3: The project with the higher equivalent annual annuity will always have the higher NPV
when extended out to any common life. Therefore, project B’S equivalent annual
annuity (EAA) is larger than project A’S, project B would be chosen.
3. Abandonment Value Approach
This approach presumes that the larger-lived investment alternative is prematurely terminated at
the end of the life of the shorter project alternative. This presumption requires us to estimate an
abandonment value for long-lived investment at the end of the life of the shorter project
alternative. Assume the above example and the estimated abandonment value of Br. 15,000 for
project A at the end of year 3, which is the end of the life of project B. Then, compute the NPV
for both projects at the required rate of return of 10 percent. Hence,
The NPV for project A if it abandoned at the end of year 3 is:
NPV = (10,000) (0.909) + (12,000) (0.826) + (30,000) (0.751) - (40,000). Here the cash
flow of 30,000 birr considered for year 3 is the sum of the cash flow during the year from project
A (i.e 15,000) and the abandonment value of the project of Br. 15,000.

The NPV for project A = 41,532 – 40,000 = 1,532 birr.

The NPV for project B = (12,000) (0.909) + 914,000) (0.826) + (13,000)
(0.751) – 30,000 = 32,235 – 30,000
= 2,235 birr
According to the above analysis, therefore, project B is better than project A.
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 fund to undertake all of them. Two main reasons can be

20
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 cannot 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 suppose that a firm has a fixed capital budget of Br. 600,000 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 E-C-A-B-
D. Therefore, given the capital budge constraint of Br. 600,000, projects E, 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 cannot be implemented because
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 + 70,000 + 40,000 = Br. 170,000.
4.5. Capital Budgeting Under Uncertainty
Up to this point, we have ignored risk in capital budgeting; that is we have discounted expected
cash flows back to their present values and ignored any uncertainty that might surround the
expected cash flows. In reality, the future cash flows associated with the introduction of a new
sales outlet or a new product are estimates of what is expected to happen in the future, not

21
necessarily what will happen in the future. But, these cash flows discounted to their present
values have only been our best estimate of the expected cash flows.
In this section, we will assume that under conditions of risk we do not know beforehand what
cash flows will actually result from the new project. However, we do have expectations
concerning the outcomes and are able to assign probabilities to these outcomes. Staled in another
way, although we do not know the exact cash flows resulting from the acceptance of a new
project, we can formulate the probability distributions from which the flows will be drawn. Risk,
here, is defined as the potential variability in the future cash flows.
Relevant Risks in Capital Budgeting
In capital budgeting, a project’s risk can be looked at in three levels. First, there is a total project
risk, which is a project’s risk ignoring the fact that much of this risk will be diversified away as
the project is combined with the firm’s other projects and risks. Second, we have the project’s
contribution to firm’s risk, which is the amount of risk that the project contributes to the firm as a
whole; this measure considers the fact that some of the project’s risks will be diversified away as
the project is combined with the firm’s other projects and assets, but ignores the effects of
diversification of the firm’s shareholders. Finally, there is what is known as a systematic risk,
which the risk of the project from the viewpoint of a well diversified shareholder; this measure
considers the fact that some of the project’s risk will be diversified away as the project is
combined with the firm’s other projects, and in addition some of the remaining risk will be
diversified away by shareholders as they combine this stock with other stocks in the portfolio.
Risk, Return and Net Present Value
When a financial manger is considering a set of risky alternatives, one important consideration
involves the choice of the required rate of return. Given the risk aversion nature of mangers, the
required rate of return of each project is the function of its risk. The riskier the project, the
higher the required rate of return.
Selecting the appropriate required rate of return involves subjective judgments. Given the
general patterns of managerial risk aversion, which shows the direct relationship between risk
and return, the following guidelines can be established.
1. The coefficient of variation can be used as the measure of risk per birr of return. As such,
it can be used to rank the riskiness of probability distributions of cash values.
2. The required rate of return can be set to the sum of the risk-free rate plus some additional
return to compensate for risk.
The Risk Adjusted Net Present Value (RANPV)
The risk adjusted net present value (RANPV) service as a capital budgeting decision criterion
under conditions of risk and is defined as the sum of the present values of the expected cash
values discounted at the required rate of return.
The RANPV coefficient that is positive or zero indicates that the project earns at least the risk
adjusted required rate of return and that adopting such a project can increase the value of the firm
and thus the shareholders’ wealth.
When a risky investment is to be evaluated on an accept or reject basis, the RANPV criterion
provides the following decision rule: Accept the risky project if its RANPV is positive or zero;
reject it if the project’s RANPV is negative.

22
To illustrate how to evaluate a project under a condition of risk (i.e. when the cash flows are not
certainly know rather given probability distributions under different state of the economy)
suppose a risky project that has a life of four years. The estimated risk adjusted rate of return is
10 percent. The initial investment of the project is Br. 29,000.
Year State of Economy Cash flows Probability
1 Boom 12,000 0.20
Average 10,000 0.50
Recession 7,000 0.30
2 Boom 18,000 0.10
Average 15,000 0.50
Recession 13,000 0.40
3 Boom 15,000 0.30
Average 14,000 0.40
Recession 12,000 0.30
4 Boom 19,000 0.30
Average 16,000 0.50
Recession 14,000 0.20
Compute the payback period for this risky project. What is the RANPV of the project? Compute
the IRR of the project. Calculate the profitability index of the project. Before we answer each
one of the questions, let us computed the expected cash flows for each year of the project life as
follows:
Year 1: (12,000) (0.20) + (10,000) (0.50) + (7,000) (0.30) = 9,500 birr
Year 2: (18,000) (0.10) + (15,000) (0.50) + (13,000) (0.40) = 14,500 birr
Year 3: (15,000) (0.30) + (14,000) (0.40) + (12,000) (0.30) = 13,700 birr
Year 4: (19,000) (0.30) + (16,000) (0.50) + (14,000) (0.20) = 16,500 birr
Using these expected cash flows for the project, the payback period can be computed as follows:
Year Expected Cash flows Cumulative cash flows
1 9,500 9,500
2 14,500 24,000
3 13,700 37,700
4 16,500 54,200
The payback period for this project is longer than 2 years and shorter than 3 years because the
initial investment of Br. 29,000 is greater than the cumulative cash flows at the end of year 2 of
Br. 24,000 and less than the cumulative cash flows at the end of year 3. If the expected cash
flows occur uniformly throughout the year, the payback period will be between 2 year and 3
years. The exact payback period is computed as follows.
Payback period = 2 years + Amount of initial investment not paid back
Expected cash flow during year 3
= 2 years + 5,000
13,700
= 2 years + 0.36 = 2.36 years, or
= 2 years + (0.36) (12 months) = 2 years and 4 months
The Risk adjusted Net present value (RANPV) of the project can be computed by using the
expected cash flows determined above. These expected cash flows are discounted at the risk
adjusted discounting rate of 10 percent. The initial investment amount is subtracted from the sum
23
of the discounted expected cash flows and difference is what is known as the risk adjusted net
present value (RANPV).
RANPV = (9500) (0.909) + (14,500) (0.826) + (13,700) (0.751) + (16,500) (0.683) – 29,000
= 8,635.50 + 11,977 + 10,288.70 + 11,269.50 – 29,000 = 42,170.70 – 29,000
= 13,170.70
The IRR of this project is determined through an iterative process because the expect cash flows
are not in an annuity form. To identify the starting point, we assign a weight, the highest weight
to the cash flows of the first year and the lowest weight to the cash flows of the last year in the
project life.
Year Expected cash flows Weight Expected cash flow X weight
1 9,500 4 38,000
2 14,500 3 43,500
3 13,700 2 27,400
4 16,500 1 16,500
10 125,000
The weighted average cash flows = 125,400/10 =12,540
The estimated discount actor = 29,000
12,540
The estimated discount factor of 2.313 is near to the present value of annuity table value of
2.320, which is found in the 26 percent column in year 4 row. Hence, the first guess is 26
percent.
The RANPV using 26 percent as the risk adjusted discounting factor:
RANPV = (9,500) (0.794) + (14,500) (0.630) + (13,700) (0.500) + (16,500) (0.397) – 29,000
= 7,543 + 9,135 + 6,850 + 6,550.50 – 29,000
= 30,078.50 – 29,000 = Br. 1,078.50
Since the RANPV using a discount rate of 26 percent is a large positive, we have to try larger
discount rates. Second guess. Let us try 29 percent because the NPV corresponding to 26
percent is far from zero.
RANPV (29%) = (9,500) (0.775) + (14,500) (0.601) + (13700) (0.446) + (16,500) (0361) –29,000
= 7,362.50 + 8,714.50 + (6384.20 + 5956.50 – 29,000 = 28,417.70 – 29,000
= Br. (582.30)
Since the Net present value at a discount rate of 29 percent is negative, the IRR for this project
must be less than 29 percent and greater than 26 percent. Hence, the IRR of this project can be
computed as follows.
Step 1: Compute the sum of the absolute values of the NPV's obtained:
The absolute sum of the NPVs = |1078.5| + |-528.3| = 1,669.8
Thus,
Pr esent Value of Smaller rate
IRR = Smaller rate + Absolute Sum of NPV (larger rate - smaller rate)
1,078.5
IRR = 26% + 1,669.8 (29 - 26) = 26% + 1.93 = 27.93% or

24
 Pr esent Value of l arg er rate
IRR = Larger rate - Absolute Sum of NPV (larger rate - smaller rate)
582.3
IRR = 29% - 1,669.8 (29 - 26) = 29% - 1.07 = 27.93%

25