CAPITAL SELECTION TECHNIQUES

CLASS ILLUSTRATIONS:

Illustration.1

Kampala Capital City Authority (KCCA) is considering the construction of

Southern Bypass to ease the traffic jam in the city. When the Bypass is
completed it will be a commercial express highway where the user pays a
service fee for using the facility.

KCCA has approached the African Development Bank to fund this project with
a five-year loan with a cost of 15% per annum. This project is expected to cost
US $ 100,000,000. When completed, the Bypass will generate net cash inflows
from the user fees as follows:

Net cash inflows in

Year
US $
Required:
Year 1 20,000,000
Compute the Pay Back Year 2 25,000,000 Period and
Net Present Value of Year 3 30,000,000 the project,
given that the Year 4 50,000,000 maximum
acceptable payback Year 5 60,000,000 period is 4
years, and advise KCCA on
whether the project can be acceptable or not and why?

SOLUTION: 1

1) Computation of the Pay Back Period

Cumulative Cash
Year Cash Inflow inflow
1 20,000,000 20,000,000
2 25,000,000 45,000,000
3 30,000,000 75,000,000
4 50,000,000 125,000,000
5 60,000,000 185,000,000

PBP = 3 years + (Initial Investment –Cumulative Cash inflows x 12 months

Next period Cash Inflow
 PBP = 3 years + (100,000,000-75,000000) X 12 months
50,000,000

PBP = 3 years + (25,000,000) x 12 months

50,000,000

= 3 years + (0.5 x 12)

PBP = 3 years and 6 months

Advise:

2) Computation of Net Present Value

Period/Item Supermarket PVF @ 15% PV(000)

Year 0 (100,000,000) 1.000 (100,000)
Year 1 20,000,000 0.870 17,400
Year 2 25,000,000 0.756 18,900
Year 3 30,000,000 0.658 19,740
Year 4 50,000,000 0.572 28,600
Year 5 60,000,000 0.497 28,820
NPV = 13,460

NPV = Sum of the PV-Initial Investment

NPV = (17,400+ 18,900+ 19,740+ 28,600+ 28,820) – 100,000
NPV = 113,460 - 100,000
NPV = 13,460

Advise:

Illustration. 2
Devine Enterprises has identified two possible areas of investment, a printer
and a super market with defined life spans. The two projects are mutually
exclusive. They are expected to generate the following net cash flows.
 Period/Item Supermarket Printery
Initial cost 80,000,000 50,000,000
Cash inflows
Year 1 15,000,000 15,000,000
Year 2 20,000,000 15,000,000
Year 3 25,000,000 15,000,000
Year 4 30,000,000 15,000,000
Year 5 30,000,000 15,000,000

Required:
a) Advise the management of the company on the best project to invest using:
i. Net present value method (NPV) at a cost of capital is 13%.
ii. Using the payback period method (non-discounted).

SOLUTION:2

i. NET PRESENT VALUE OF SUPERMARKET

Period/Item Supermarket PVF @ 13% PV(000)

Year 0 (80,000,000) 1.000 (80,000)
Year 1 15,000,000 0.885 13,275
Year 2 20,000,000 0.783 15,660
Year 3 25,000,000 0.693 17,325
Year 4 30,000,000 0.613 18,390
Year 5 30,000,000 0.543 16,290
NPV = 940

NET PRESENT VALUE OF PRINTERY

Period/Item Printery PVF @ 13% PV(000)

Year 0 (50,000,000) 1.000 (50,000)
Year 1 15,000,000 0.885 13,275
Year 2 15,000,000 0.783 11,745
Year 3 15,000,000 0.693 10,395
Year 4 15,000,000 0.613 9,195
Year 5 15,000,000 0.543 8,145
2,755 NPV = 2,755
Advise: the best project is Printery as it offers the higher NPV of 2,755
compared to NPV of 940 of the Supermarket

ii. USING PAY BACK PERIOD:

Period/Item Supermarket Accumulated

 Cash flows
(Shs 000)
Year 1 15,000,000 15,000
Year 2 20,000,000 35,000
Year 3 25,000,000 60,000
Year 4 30,000,000
Year 5 30,000,000

PBP = 3 Years + (20/30) * 12 months = 3 Years and 8Months

Note: 20,000,000 is the difference between the cumulative 60,000,000 and the
Initial investment of 80,000,000; and 30,000,000 is the next year cash flow.

Period/Item Printery Accumulated

Cash flows
(Shs 000)
Year 1 15,000,000 15,000
Year 2 15,000,000 30,000
Year 3 15,000,000 45,000
Year 4 15,000,000
Year 5 15,000,000
2,755

PBP = 3 Years + (5/15) * 12 months = 3 Years + 4 Months

Advise: The Printery has a shorter PBP of 3 years and 4 months compared to
the supermarket with 3 years and 8 months. So according to the decision
criteria for PBP which prefers a project with a shorter PBP, THE Printery
should be chosen for investment.

PRACTICE QUESTIONS:

Question 1.
(a) Briefly discuss the features and types of capital investment
projects

(b) Nagongera Millers Limited is considering the purchase of a modern

maize milling machine from China that will cost them US 150,000
inclusive of insurance, transport and installation.

When the machine is purchased, it will generate net cash inflows

as follows:
US $ US $
Year 1 25,000 Year 5 25,000
Year 2 30,000 Year 6 20,000
Year 3 30,000 Year 7 20,000
Year 4 25,000

At the end of year 4, the machine will require a capital overhaul costing
US $ 10,000 to maintain its operating capacity to be able to
generate cash flows projected above.
The machine is expected to be sold off at the end of year 7 to
realize US $ 25,000.

The funds to be used to purchase the machine will be accessed

from the Uganda Development Bank at annual interest of 10%.

Required:

(i) Using the Net Present Value technique advise the company
management accordingly.

(ii) Using the Internal Rate of Return and advise the company
management accordingly.

Question 2

(a) Outline the logical process of Capital Budgeting

 (b) Your company has just received a grant of US $ 80,000 to invest in
long-tern income generating projects. The company is considering
the purchase of the following machineries which have the
following cash flows:

MACHINERY A B C
Initial investment 80,000 30,000 50,000

Cash inflows
Year 1 24,000 10,000 0
Year 2 24,000 10,000 0
Year 3 24,000 10,000 30,000
Year 4 24,000 10,000 30,000
Year 5 24,000 10,000 30,000

At the end of the 5th year the equipment will be sold off and will
realize cash as follows: Machinery A US $ 20,000, machinery B US
$ 8,000 and machinery C US $ 15,000.

Required:

(a) If the prevailing rate of interest is 15%, using: the pay-back

period; and the Net Present Value advise the company on
which machinery they should invest.
(b) Using the IRR and the prevailing rate of interest of 15% given
above, advise the company on which machine they should
invest.

Question 3

Kampala City Transporters Limited (KCTL), a transport management company

in Kampala is proposing to purchase 200 buses to provide transport services
within Kampala and its surroundings. The buses are to be supplied by Spear
Motors Limited which has quoted Shs. 200,000,000 per bus to cover costs,
insurance, freight and all taxes. The project will also require KCTL to hire a
piece of land from KCCA to establish a bus park for their fleet. The cost of
hiring the land is Shs. 189,550,000= paid in advance for five years. KCTL
expects to generate net cash flows Shs. 7,500,000,000= annually for five years.
At the end of the fifth year, the park will revert to KCCA and all the buses will
be sold off at Shs. 50,000,000 each. The current cost of capital to KCTL is
20%.

Required:

Using each of the following techniques advise UTODA Ltd whether they should
undertake the project.

(a) The Pay Back Period;

(b) The Net Present Value;

(c) The Internal Rate of Return.

Question 4

Makerere University is considering a major investment project of renovating all

Students’ Halls of Residence and latter hiring them out to a private operator
who will provide accommodation services to students at a commercial rate.

The Estates Department of the University has estimated that renovating all the
University Halls of residence will cost the University US $ 25,000,000.

Bids have also been obtained from prospective Private Operators of these
facilities and the best evaluated bidder is proposing to pay the University US $
3,000,000 per annum.

The University is considering sourcing funding from the East African

Development Bank at an annual interest rate of 8% to implement this project.

When the funding is obtained and the Halls of Residence are renovated, the
University will sign a ten-year contract with the best evaluated private
operator.
Required:

(i) What is the Pay Back Period of this project?

(ii) Using the Net Present Value technique, advise the University whether or
not the project should be undertaken.

Question 5
a) Briefly describe the logical process of capital budgeting.
b) What are the key features of investment projects?
c) Kampala Capital City Authority (KCCA) is considering the construction of
Southern Bypass to ease the traffic jam in the city. When the Bypass is
completed it will be a commercial express highway where the user
pays a service fee for using the facility.
KCCA has approached the African Development Bank to fund this project with
a ten-year loan with a cost of 10% per annum. This project is expected to cost
US $ 250,000,000. When completed, the Bypass will generate net cash inflows
from the user fees as follows:

Net cash
Year inflows in US
$
Year 1 10,000,000
Year 2 25,000,000
Year 3 40,000,000
Year 4 50,000,000
Year 5 75,000,000
Year 6 75,000,000
Year 7 80,000,000
Year 8 80,000,000
Year 9 80,000,000
Year 10 80,000,000
Required:

(i) What is the Pay Back Period of the project?

(ii) Determine the Net Present Value of the project?
(iii) Determine the Internal Rate of Return of the Project.
(iv) What is the Profitability Index of the project?
(v) What advice would you give to KCCA in respect of this project?

(d) Briefly discuss any five non-numeric methods of investment

appraisal

PRESENT VALUE TABLE

INTEREST RATE
Year 1% 2% 4% 6% 8% 10% 12% 14% 15% 16% 18% 20% 25%
1 0.990 0.980 0.962 0.943 0.926 0.909 0.893 0.877 0.870 0.862 0.847 0.833 0.800
2 0.980 0.961 0.925 0.890 0.857 0.826 0.797 0.769 0.756 0.743 0.718 0.694 0.640
3 0.971 0.942 0.889 0.840 0.794 0.751 0.712 0.675 0.658 0.641 0.609 0.579 0.512
4 0.961 0.924 0.855 0.792 0.735 0.683 0.636 0.592 0.572 0.552 0.516 0.482 0.410
5 0.951 0.906 0.822 0.747 0.681 0.621 0.567 0.519 0.497 0.476 0.437 0.402 0.328
6 0.942 0.888 0.790 0.705 0.630 0.564 0.507 0.456 0.432 0.410 0.370 0.335 0.262
7 0.933 0.871 0.760 0.665 0.583 0.513 0.452 0.400 0.376 0.354 0.314 0.279 0.210
8 0.923 0.853 0.731 0.627 0.540 0.467 0.404 0.351 0.327 0.305 0.266 0.233 0.168
9 0.914 0.837 0.703 0.592 0.500 0.424 0.361 0.308 0.284 0.263 0.225 0.194 0.134
10 0.905 0.820 0.676 0.558 0.463 0.386 0.322 0.270 0.247 0.227 0.191 0.162 0.107
11 0.896 0.804 0.650 0.527 0.429 0.350 0.287 0.237 0.215 0.195 0.162 0.135 0.086
12 0.887 0.788 0.625 0.497 0.397 0.319 0.257 0.208 0.187 0.168 0.137 0.112 0.069
13 0.879 0.773 0.601 0.469 0.368 0.290 0.229 0.182 0.163 0.145 0.116 0.093 0.055
14 0.870 0.758 0.577 0.442 0.340 0.263 0.205 0.160 0.141 0.125 0.099 0.078 0.044
15 0.861 0.743 0.555 0.417 0.315 0.239 0.183 0.140 0.123 0.108 0.084 0.065 0.035