GROUP 2

MEMBERS
2
1. JENIFFER GATUNE NDEKE ◈ 725565
2. MARION MAY MUDANY ◈ 639205
3. IFRAH YUSSUF SHEIKH ◈ 658722
4. AGGREY RATEMO ◈ 657045
5. JOHN NYAGAH ◈ 658336
6. PRAVALLIKA VALIVETI ◈ 657979
 CAPITAL
BUDGETING
 CASE STUDY
4
◈ The recent strike of Private-Owned Public Service Vehicles
(commonly known us ‘Matatus’) created a transport crisis and
which the government wants to solve trough The Ministry of
Transport and infrastructure.
◈ The government is looking at a possibility of investing KES
500 million after fixed costs and overheads in the transport
sector for a period of five years after which it will privatise the
sector to local companies.
5 ◈ However, The Ministry of Transport is keen to evaluate if indeed
the government can get a return on the major investment that it
intends to make before it hand’s over the project to private entities
whom it anticipates to create 10,000 new permeant jobs yearly.
Government expects payback before they privatise transport.
◈ Before the Government makes its final 5 year plan, The Ministry of
Transport has announced its decisions to accept tenders from
international and local companies to bid for consultancy services on
the proposed project and give a comprehensive report on the
surpluses/losses if any the government will make from such an
investment.
 The following companies have been shortlisted for the tenders
6 ◈ ◈ ◈
MMM Ltd – Initial JNG Ltd – Initial IYS Ltd – Initial
Investment - 100 Investment - 120 Investment - 200
Million. Double Million. Double Million. Metro rail.
decker buses. decker buses.

Expected Expected
Cashflows Cashflows
Expected
Years in millions Years in millions
Cashflows
1 35 Years in millions
1 30
1 50
2 35 2 45
2 60
3 40 3 50
3 70
4 20 4 50
4 25
5 5 5 40
5 10
Capital Budgeting Decisions
Types of Investments
 There are two main types of Investment projects:
8
1. Independent - a proposal
without a competing alternative.
For example, suppose an old
machine is wearing out and
there is only one replacement
product on the market. The
choice is simply to buy the new
machine or not to buy. It is also
referred to as a Stand alone
project.
2. Mutually Exclusive - a
proposal with two or more
competing alternatives. It
occurs either when there is
more than one way to do
something, or two different
projects are proposed but there
is only enough money to
undertake one. In such cases
choosing one projects excludes
the other.
 Types of projects in reference to the case:
9
◈ There are a total of 3 tenders that the Government plans
on reviewing. Two of the organizations tendered for
Double Decker buses, while the third tender came in for
Metro rail. However attractive both tenders for Double
Decker buses might be, it would be redundant for the
Government to invest in both of them. This makes Tender
1 and Tender 2 to be mutually exclusive projects.
Stages of Capital
Budgeting.
Ascertaining Risks Budgeting Techniques
• Systematic Risk • Payback Period Capital Rationing
• Non-systematic Risk • Discounted Payback Period • Accept Proposal
• Net Present Value • Reject Proposal
• Internal Rate of Return
• Profitability Index

11
 “
Risk comes from not knowing what
you’re doing.
- Warren Buffett

12
 Ascertaining Risk
13
◈ There is a need to determine the risks associated with a project
before choosing which one to embark on. Risks are
categorized into either systematic risk or non-systematic risk.
◈ Systematic Risk - This is the kind of risk associated with
economic events like business cycle, inflation shocks, political
risks. They are beyond the control of the organization.
◈ Non Systematic Risk - This is risk associated with random and
unrelated events across different organizations. It can be
reduced or eliminated through diversification of investments
in an organization.
 In reference to the case study:
14
◈ Considering all the factors related to risk and returns, the
financial team came up with the following table:

Type of Risk Return (%) Weights Total

Risk Averse 11 % 0.3 3.3 %

Risk Indifference 10 % 0.4 4%

Risk seeker 9% 0.3 2.7 %

10 %

◈ According to the computations, 10% is the Expected Rate of

Return for all the tenders.
 Budgeting Techniques
There are different techniques used to assess whether a
project is economically viable.
 a. Payback Period
16
It is the period of time required for the cumulative expected
cash flows from an investment project to equal the initial cash
outflow. This is defined as the time taken by the project to
recoup the initial cash outlay.
 Computations
17 ◈ ◈ ◈
MMM Ltd (Tender 1) JNG Ltd (Tender 2) IYS Ltd (Tender 3)
◈ PBP = year before full ◈ PBP = year before full ◈ PBP = year before
recovery + recovery + full recovery +
Unrecovered amount/ Unrecovered amount/ Unrecovered amount/
cashflow in the cashflow in the cashflow in the
subsequent year subsequent year subsequent year
◈ PBP = 2 + 35/40 = ◈ PBP = 2 + 40/50 = 2.8 ◈ PBP = 3 + 20/ 50 =
2.875 3.4
Yrs CFs Yrs CFs Yrs CFs
0 100 0 200
1 30 30 0 120
1 50 50
2 35 65 1 35 35 2 60 110
3 40 105 2 45 80 3 70 180
4 25 4 50 230
3 50 130
4 20 150

5 10 5 5 155 5 40 270
 b. Discounted Payback Period
18
◈ The concept of Discounted Payback period is similar to
that of traditional payback period, the only difference
being – consideration of time value of money. The true
value of money is ascertained before calculating the
cumulative cash flow.
 Computations (formula) PBP = year before full recovery + Unrecovered amount/ cashflow
in the subsequent year

19 ◈ ◈
MMM Ltd JNG Ltd ◈ IYS Ltd
◈ PBP = 3 + 13.7491 / ◈ PBP = 4 years ◈ PBP = 4 +
17.0534 = 3.8052 6.6209/24.83685 =
4.2666

Yr Y CF Yr
s CFs Disc DCF CDCF rs s Disc DCF CDCF s CFs Disc DCF CDCF
0 100 100 0 120 120 0 200 200
27.2727
1 30 0.909091 27.27273 3 1 35 0.909091 31.81818 31.818182
56.1983 1 50 0.909091 45.45455 45.45455
2 35 0.826446 28.92562 5 2 45 0.826446 37.19008 69.008264
86.2509 2 60 0.826446 49.58678 95.04132
3 40 0.751315 30.05259 4 3 50 0.751315 37.56574 106.574
103.326 3 70 0.751315 52.59204 147.6334
4 25 0.683013 17.07534 3 4 20 0.683013 13.66027 120.23427 4 50 0.683013 34.15067 181.784
5 10 0.620921 6.209213
5 5 0.620921 3.104607 123.33888 5 40 0.620921 24.83685 206.6209
 c. Net Present Value
20
◈ Net Present Value is the net value of the project computed by
converting all the cashflows to the present. Once the discounted
cashflows are computed, all the positive cashflows are added less
the initial outlay. It shows the amount of surplus gained or loss
sustained by the end of the project after considering the amount
invested.
◈ In general, a positive Net Present Value is considered viable and a
negative Net Present Value is considered not viable. According to
this rule, all the three tenders are viable. However, they differ in
thei quantitative profits they yield. This could be the differentiating
factor that helps in taking a decision.
 Computations (formula) Sum of present value of future cashflows – Initial outlay
21 ◈ ◈ ◈
MMM Ltd JNG Ltd IYS Ltd
◈ NPV = 209.5355 – ◈ NPV= 243.3389 – 120 ◈ NPV = 406.6209 –
100 = 109.5355 = 123.3389 200 = 206.6209

Discount Cashf Cashfl

Cashflo Discounti ed lows ows (in Discounti
Yea ws (in ng factor Cashflo (in Discounti Ye million ng factor Discounted
rs millions) @ 10% ws Yea millio ng factor Discounted ars s) @ 10% Cashflows
0 100 100 rs ns) @ 10% Cashflows 0 200 200
1 30 0.909091 27.27273 0 120 120
1 50 0.909091 45.45455
2 35 0.826446 28.92562 1 35 0.909091 31.81818
3 40 0.751315 30.05259 2 45 0.826446 37.19008 2 60 0.826446 49.58678
4 25 0.683013 17.07534 3 50 0.751315 37.56574 3 70 0.751315 52.59204
5 10 0.620921 6.209213 4 20 0.683013 13.66027
4 50 0.683013 34.15067
209.5355 5 5 0.620921 3.104607
243.3389 5 40 0.620921 24.83685
406.6209
 d. Internal Rate of Return
22
◈ Internal Rate of Return is the discount rate that equates the present
value of the project’s expected cash inflows to the present value of
the project’s cost. It is the rate of return that results in NPV of 0. In
other words, it is the minimum rate that is required for the project
to neither gain profits, not suffer losses.
◈ Basic interpretation of IRR is that if it is more than the expected
rate of return, it means that the project yields returns and not suffer
losses. The three tenders have IRR more than 10%, hence are
profitable. However, the higher the IRR the better the yields of the
project
 MMM Ltd Computations
23
◈ Lower rate – ◈ Higher rate – ◈ Extrapolation
12% 15%

Cashflo Cas
ws (in Discounting hflo Lower Rate 0.12
Yea million factor @ Discounted ws Discoun
rs s) 12% Cashflows (in Discounting ted Higher Rate 0.15
0 100 100 milli factor @ Cashflo
Years ons) 15% ws Absolute Sum of
1 30 0.892857 26.78571
0 100 100 Present Values of
2 35 0.797194 27.90179
Future Cashflows 202.8392
3 40 0.71178 28.47121 1 30 0.869565 26.08696
4 25 0.635518 15.88795 2 35 0.756144 26.46503 Difference between
5 10 0.567427 5.674269 3 40 0.657516 26.30065 Lower rate and
104.7209 4 25 0.571753 14.29383 Higher Rate 0.03
5 10 0.497177 4.971767
Internal Rate of
98.11823 Return 0.135488
 JNG Ltd Computation
24
◈ Lower Rate - ◈ Higher Rate - ◈ Extrapolation
11% 13%

Cashflo Discountin
Discount Lower Rate 0.11
Year ws (in g factor @ Discounted
Cashflo Discounti ed
s millions) 11% Cashflows Higher Rate 0.13
ws (in ng factor Cashflow
0 120 120 Years millions) @ 13% s Absolute Sum of
1 35 0.900901 31.53153 0 120 120 Present Values of
2 45 0.811622 36.52301 1 35 0.884956 30.97345 Future Cashflows 236.6037
3 50 0.731191 36.55957 2 45 0.783147 35.2416 Difference
4 20 0.658731 13.17462 3 50 0.69305 34.65251 between Lower
5 5 0.593451 2.967257 rate and Higher
4 20 0.613319 12.26637 Rate 0.02
120.756 5 5 0.54276 2.7138 Internal Rate of
115.8477 Return 0.120207
 IYS Ltd Computation
25
◈ Lower Rate – ◈ Higher Rate – ◈ Extrapolation
11% 12%
Cash Cash
flows Discoun flow Discount Lower Rate 0.11
(in ting Discounte Ye s (in ing
Ye millio factor @ d ar milli factor @ Discounted Higher Rate 0.12
ars ns) 11% Cashflows s ons) 12% Cashflows
0 200 200
0 200 200
1 50 0.892857 44.64286 Absolute Sum of
1 50 0.900901 45.04505 Present Values of
2 60 0.797194 47.83163 Future Cashflows 398.3725
2 60 0.811622 48.69735
3 70 0.71178 49.82462
3 70 0.731191 51.1834
4 50 0.658731 32.93655 4 50 0.635518 31.7759 Difference between
Lower rate and
5 40 0.593451 23.73805 5 40 0.567427 22.69707 Higher Rate 0.01
196.7721 Internal Rate of
201.6004 Return 0.115061
 e. Profitability Index
26
◈ The profitability index is the ratio between present value of the
future cashflows and the initial outlay. In other words, it shows the
ratio between input and outcome of the money invested. One huge
advantage of this method is that it overcomes the distortion of
results that occur between projects of different levels of
investments.
◈ Th biggest advantage of Profitability Index is that eliminates the
scale of the project and just compares the investment and returns.
The higher the ratio, the better the returns. The three tenders differ
with small margins.
 Computation
27
◈ MMM Ltd ◈ JNG Ltd ◈ IYS Ltd

Present Value of Present Value of Future Present Value of Future

Future Cashflows 209.5355 Cashflows 243.3389 Cashflows 406.6209

Initial Outlay 100 Initial Outlay 120 Initial Outlay 200

Profitability Index 2.095355 Profitability Index 2.027824 Profitability Index 2.033104

 Summary on Budgeting Techniques
28
Tenders Payback Period Payback Period Net Present Internal Rate of Profitability
(Traditional) (Discounted) Value Return Index

Tender 1 – MMM 2.875 3.8052 109.5355 0.135488 2.095355

Ltd

Tender 2 - JNG 2.8 4 123.3389 0.120207 2.027824

Ltd

Tender 3 - IYS 3.4 4.2666 206.6209 0.115061 2.033104

Ltd
Capital Rationing
Project Selection Criteria
 Capital Rationing
30 ◈ Many times, a firm may come across a situation where it has various profitable
investment proposals. In our case study, all three projects are profitable with
each one having a positive NPV. The Ministry of Transport has allocated a total
amount of 500 Million for these projects. Since there are two mutually exclusive
projects and one independent project, only two of the projects can be accepted.
◈ Using the NPV, decide which project should be accepted and which one should
be rejected:
- MMM Ltd - NPV is 109.53548 with initial investment being 100
- JNG Ltd - NPV is 123.3388 with initial investment being 120
- IYS Ltd - NPV is 206. 6208 with initial investment being 200
 Decision
31
◈ Between the two mutually exclusive projects by MMM and
JNG Ltd, JNG Ltd has a higher NPV. However, all the other
indicators point that MMM ltd is a better investment
opportunity.
◈ Therefore the Ministry of Transport should accept the two
tenders by IYS Ltd and MMM Ltd as they are within the
budget planned by The Ministry of Transport.
CONCLUSION
Budget Tender Tender Budget

KES 500 Million Tender 1 – MMM Ltd KES 100 Million

KES 400 Million Tender 3 – IYS Ltd KES 200 Million

KES 200 Million Find a better investment opportunity

33
THANK YOU!

34