CAPITAL BUDGETING/INVESTMENT ANALYSIS

Definition:-
 Capital budgeting is the process of making investment decisions in long
term assets. It is the process of deciding whether or not to invest in a
particular project as all the investment possibilities may not be
rewarding.
 Thus, the manager has to choose a project that gives a rate of return more
than the cost financing such a project. That is why he has to value a
project in terms of cost and benefit.
Cont…
Following are the categories of projects that can be examined using capital
budgeting process:
 The decision to buy new machinery
 Expansion of business in other geographical areas
 Replacement of an obsolete equipment
 New product or market development etc
Cont…
Capital Budgeting:-
This involves commitment of funds to long-term project which will generate benefits in the
future.
Capital budgeting projects normally have the following characteristics:-
a) Initial Outlay- They involve significant commitment of funds during the initial
period
b) Future benefits:- ie benefits of an amount invested today will be realized in the future
c) Irreversibility- Once undertaken it will be difficult to abandon the project
d) Time- This projects normally takes along period of time
e) Risk/Uncertainty- Since the projects involve significant commitments in the initial
period there is uncertainty concerning the realization of the future
benefits
Cont…
Types/Classification of Capital Budgeting Projects
Capital budgeting projects can be classified into various categories among them
a) Mutually Exclusive projects:-
They are projects which are substitutes to one another ie they compete against each
other and if one project is accepted ,the other one is rejected.
b) Independent projects:- These are those projects which serve different purposes
they can be undertaken simultaneously subject to the availability of funds
c) Divisible projects and Indivisible projects:- Divisible projects are those
projects which starts to generate returns even before they are complete which while
indivisible projects are those projects which cannot start generate returns unless
they are fully undertaken
Cont…
d) Contingent/Dependent/Complementary:-
These are those projects which depends on each other, if one project is undertaken
the other project must also be undertaken ie if an industry is to be set up in a remote
area it will necessitate the setting up of new schools, road network, estate etc. These
projects depend on each other
Cont…
Determination of the cash flows of a Project
Cash flows are more important when evaluating the project instead of the
accounting profit ( Earnings after tax) due to the following reasons:-
1. Because accounting profits includes non cash flow items deducted such as
depreciation, provision for doubtful debts, loss on disposal of fixed assets, losses
carried forward etc.
2. Because earnings after tax is subject to manipulations by the accountants
3. Because accounting profit (EAT) is normally influenced by IAS, IFRS, IAG and
the stock exchange regulations
4. Because accounting profits differs from one company to another because of the
accounting policies adopted by each company.
Cont…
5. Because accounting profit are normally determined at the end of the financial
period while cash flows can be determined at any point any time.
6. There are normally two formats of determining cash flows of a project:-
Format 1,
Operating cash flows = EBD&T( 1- T) + Depreciation expense * tax shield benefit
Where, depreciation tax shield benefit = depreciation expense * tax rate
Cont…
Format 2
Sales revenue xxx
Less operating cost excluding depreciation xxx
Profits before depreciation and tax xxx
Less depreciation expense (xxx)
Profit before tax xxx
Less tax (xxx)
EAT (Accounting profit) xxx
Add Non cash flows eg depreciation xxx
Operating cash flow xxx
Cont…
Example. A company intends to purchase a machine whose initial cost is KES 2.2
Million with no salvage value. The machine is estimated to have a five year economic
life. During its five year economic life, it is expected to generate the following
revenues.
YEAR 1 2 3 4 5

Revenue 1320 1440 1560 1600 1500

“000”

The annual operating expenses of the machine is estimated to be KES 700,000 p.a The
Machine will be depreciated using straight-line method. The corporate tax rate is 35%
payable in the year in which the income relates.
Required. Determine the cash flow to be generated by the machine.
Cont…
Cash flow statement
1 2 3 4 5
Sh 000 Sh 000 Sh 000 Sh 000 Sh 000
Revenue 1320 1440 1560 1600 1500
Less operating cost 700 700 700 700 700
EBD&T 620 740 860 900 800
Less dep. 2200- 0 = 440 440 440 440 440 440
5
Profit b4 tax 180 300 420 460 360
Less Tax @ 35% 63 105 147 161 126
EAT 117 195 273 299 234
Add depreciation 440 440 440 440 440
Annual cash inflows 557 635 713 739 674
Cont…
Project Evaluation Techniques
This involves a cost benefit analysis. In order to determine which project to accept
or reject, these techniques are classified into two broad categories:-
a) Non discounting techniques
b) Discounting techniques
1. Non Discounting techniques:-
These are those methods which ignores the concept of time value of money. They
include;
i) The payback period (PBP) technique
ii) Accounting rate of return (ARR)
Cont…
i) Payback Period (PBP) technique
Pay back period is the length of time it will take the company to recover the initial
amount invested in the project by the cash flows generated by the project.
Ex 1. Consider a 5 year project expected to generate the following cash inflows
YEAR 1 2 3 4 5

Cash flows 45 30 25 20 20

The initial cost of the project is KES 100,000

Required. Determine the payback period and the percentage payback period
reciprocal for the project.
Cont…
Answer,
Period Cash flows Accumulated Cash flows
Sh 000 Sh 000
1 45 45
2 30 75
3 25 100
4 20 120
5 10 130
PBP = 3 Years
% PBP reciprocal = 1/ PBP * 100
= 1/3 * 100
= 33.333%
The percentage payback period reciprocal indicates the rate at which the initial cash outlay is recovered on average
each year.
Cont…
Ex 2 . Consider a four year project whose initial cash outlay is KES 400,000, the
project is expected to generate the following cash flows

YEAR 1 2 3 4

Cash flows 200 150 120 80

000

Required.
Determine the payback period for this project.
Cont…
Period Cash flows Accumulated Cash flows
1 200 200
2 150 350
3 120
4 80
PBP = 2
2 years + 400- 350
120
= 2.42 years
Cont…
Ex. 3
Consider a four year project whose initial outlay is KES 1.5Million. The project is
expected to generate annual cash inflows of Sh 600,000 p.a. Determine the payback
period of this project.
Cont…
Period Cash flows Accumulated Cashflows
1 600 600
2 600 1200
3 600
4 600
PBP = 2 years + 1500 - 1200
600
= 2.5 years
or,
PBP = Initial Outlay
Annuity
= 1500
600
= 2.5 years.
Cont…
 Decision Rule/criteria
In order to determine whether to accept or reject a project using the payback period
technique the following criteria is used:-
1. Incase of mutually exclusive projects the project with the shortest payback period
is accepted
2. Incase of a single project the desirable payback period is arbitrarily set by the
management.
Cont…
Advantages of Payback period
1. It is easier to compute and understand
2. It uses cash flows in evaluating the project and not the accounting profits (EAT)
3. 3. It is normally concerned with the liquidity of the company by accepting
projects with the shortest payback period.
4. 4. It gives a decision rule or criteria of accepting or rejecting a project
5. 5. It is normally used by managers who do not admire risk ( risk averse)
Cont…
Disadvantages of Payback Period
1. It ignores the concept of time value of the money since the present value of the
cash flows generated by the project is not calculated
2. It ignores the cash flows of the project after the pay back period
3. By ignoring the cash flows after the pay back period it assumes that the project
is abruptly abandoned which in practice is not the case
4. It normally penalizes the late blooming projects. There are those projects which
promises higher cash flows towards the end of their economic life.
5. It does not give a decision rule or criteria of accepting or rejecting a single
project since in these case the desirable payback period is arbitrarily set by the
management