CAPITAL BUDGETING/INVESTMENT APPRAISAL (CERTAINTY CONDITION)

This topic will help the learner to understand the various types of capital budgeting techniques
which a financial manager has to use in order to choose the most viable investment opportunity.
Learning objectives
After studying this lesson, you should be able to:

 Define capital budgeting.

 Describe the various classification of projects
 Describe and compute Cash flow components.
 Critically evaluate the capital budgeting techniques.
 Discuss the features of a good appraisal method
 Evaluate projects and rank them based on the budgeting techniques. Already learned.
 Discuss the potential difficulties and   conflicts in using alternative discounted capital  
methods.

CAPITAL BUDGETING DECISIONS

Introduction
Capital budgeting decision is also known as the investment decision. The capital budgeting
process involves a firms decision to invest its funds in the most viable and beneficial project. It is
the process of evaluating and selecting long term investments consistent with the firm’s goal of
owner wealth maximization.
The firm expects to produce benefits to the firm over a long period of time and encompasses
tangible and intangible assets. For a manufacturing firm, capital investment are mainly to acquire
fixed assets-property, plant and equipment. Note that typically, we separate the investment
decision from the financing decision: first make the investment decision then the finance
manager chooses the best financing method.
These key motives for making capital expenditures are;
1. Expansion: The most common motive for capital expenditure is to expand the cause of
operations – usually through acquisition of fixed assets. Growing firms need to acquire
new fixed assets rapidly.
2. Replacements – As a firm’s growth slows down and it reaches maturity, most capital
expenditure will be made to replace obsolete or worn out assets. Outlays of repairing an
old machine should be compared with net benefit of replacement.
3. Renewal – An alternative to replacement may involve rebuilding, overhauling or refitting
an existing fixed asset. A physical facility could be renewed by rewiring and adding air
conditioning.
4. Other purposes – Some expenditure may involve long-term commitments of funds in
expectations of future return i.e. advertising, R&D, management consulting and
development of view products. Other expenditures include installation of pollution
control and safety devises mandated by the government.

Features of investment decisions.

 1. The investment requires a high outlay of capital which must be planned.
2. Capital budgeting decisions have an influence on the rate and direction of the growth of
the organization unlike normal operation costs.
3. The investment has long-term implications. I.e. more than 1 year.
4. The decisions are irreversible. This implies that there might be no second hand market for
the assets since it’s usually tailor made for that particular firm.
5. The future expected cash flows from this project are uncertain thus these decisions
involve a high degree of risk.
Steps in Capital Budgeting Process
The capital budgeting process consists of five distinct but interrelated steps. It begins with
proposal generation, followed by review and analysis, decision making, implementation and
follow-up. These six steps are briefly outlined below.
1. Proposal generation: Proposals for capital expenditure are made at all levels within a
business organization. Many items in the capital budget originate as proposals from the
plant and division management.
2. Review and analysis: Capital expenditure proposals are formally reviewed for two
reasons. First, to assess their appropriateness in light of firm’s overall objectives,
strategies and plans and secondly, to evaluate their economic viability. Review of a
proposed project may involve lengthy discussions between senior management and those
members of staff at the division and plant level who will be involved in the project if it is
adopted.
3. Decision making: Generally the board of directors reserves the right to make final
decisions on the capital expenditures requiring outlays beyond a certain amount. Plant
manager may be given the power to make decisions necessary to keep the production line
moving (when the firm is constrained with time it cannot wait for decision of the board).
4. Implementation: Once approval has been received and funding availed implementation
commences. For minor outlays the expenditure is made and payment is rendered: For
major expenditures, payment may be phased, with each phase requiring approval of
senior company officer.
5. Follow-up: involves monitoring results during the operation phase of the asset. Variances
between actual performance and expectation are analyzed to help in future investment
decision. Information on the performance of the firm’s past investments is helpful in
several respects.
N/B This topic will majorly discuss on the second step: Review and analysis.
Estimation of cash flows is one of the most important and challenging step because decisions
made depend on cash flows projected for each proposal. Cash flows must be relevant and
therefore need to have the following criteria,
i. They must be future cash flows because cash flows already received or paid are sunk
costs hence irrelevant in decision making.
ii. Cash flows must be incremental. This enables the firm to analyze cash flows of the firm
with or without the project.
iii. Cash flows must involve an actual inflow or outflow of cash. Thus expenses which do not
involve a movement of cash e.g. Depreciation are not cash flows.
Cash flow components
The cash flows of any project can include three basic components:
i. An initial investment
ii. Operating cash flows
iii. Terminal cash flows.
All projects will have the first two; some however, lack the final components.
i. Initial Investment: The initial investment is the relevant cash outflow for a proposed project
at time zero. It is found by subtracting all cash inflows occurring at time zero from all cash
outflows occurring at time zero.
ii. Operating Cash Flows: These are incremental after tax cash during its lifetime. Three points
should be noted:-
 Benefits should be measured on after tax basis because the firm will not have the use of
any benefits until it has satisfied the government’s tax claims.
 All benefits must be measured on a cash flow basis by adding back any non-cash charges
(depreciation)
 Concern is only with the incremental (relevant) cash flows. Focus should be only on the
change in operating cash flows as a result of proposed project.
iv. Terminal Cash Flows: The cash flows resulting from the termination and liquidation of
a project at end of its economic life are its terminal cash flow. Terminal cash flow is
determined as incremental after tax proceeds from sale or termination of a new asset or
project.
Determination of Cash Flows
Cash flows are most important when evaluating the project instead of the accounting profits
(Earning after Tax).
Format 1:
Sales revenue XX
Less operating costs (XX)
Profit before depreciation and tax XXX
Less depreciation expense (XX)
Profit before tax XXX
Less tax (XX)
Earning after tax (accounting profits) XXX
Add non-cash flows (e.g. depreciation) XX
Operating cash flows XXX
Add terminal cash flow in the last year XX

Format 2:
Sales revenue XX
 Less Variable costs (XX)
Contribution XXX
Less fixed costs (XX)
Profit before depreciation and tax XXX
Less depreciation expense (XX)
Profit before tax XXX
Less tax (XX)
Earning after tax (accounting profits) XXX
Add non-cash flows (e.g. depreciation) XX
Operating cash flows XXX
Add terminal cash flow in the last year XX

Example
A company intends to purchase a machine whose initial investment is sh. 2,200,000. The
machine is expected to have an economic life of 5 years after which it will be sold at sh. 500,000.
During its 5 year economic life, it is expected to generate the following revenue

Year 1 2 3 4 5
Revenue “000” 1,320 1,440 1,560 1,600 1,500

The annual operating expense of the machine is estimated to be sh. 700,000 per annum. The
machine will be depreciated using straight line method and the corporate tax rate is 30% payable
in the year in which the income relate.
Required;
Determine the cash flows to be generated by the machine.
Classification of projects
1. Mutually exclusive projects: these are projects which compete for the same resources, if
one is accepted the other is rejected.
2. Independent project: these are projects which do not compete against one another and
they can be undertaken together subject to availability of funds.
3. Dependent/contingent project: these are projects which depend on one another, if one is
undertaken the other must be undertaken.
4. Divisible projects: these are projects which start to generate revenue even before they
are complete.
5. Indivisible projects: these are projects which cannot start to generate revenue unless
they are complete.
Capital Budgeting Techniques.
There are different methods of analyzing the viability of an investment. The preferred technique
should consider time value procedures, risk and return considerations and valuation concepts to
select capital expenditures that are consistent with the firm’s goals of maximizing owner’s
wealth.
Capital budgeting techniques are grouped in two:
a) Non-discounted cash flow techniques (traditional methods)
i. Payback period method (PBP)
ii. Accounting rate of return method (ARR)
b) Discounted cash flow techniques (modern methods)
i. Net present value method (NPV)
ii. Internal rate of return method (IRR)
iii. Profitability index method (PI)
Features of a good appraisal method
1. It should recognize time value of money
2. It should use cash flows and not accounting profits. This is because use of accounting
profit is affected by accounting policies and conventions.
3. It should have a decision criteria/rule of acceptance or rejection.
4. It should be flexible and applicable to all projects.
a) Non-Discounted Cash Flow Techniques
i. Pay Back Period Method (PBP)
Payback period refers to the number of periods/ years that a project will take to recoup its initial
cash outlay. This technique applies cash flows and not accounting profits.
 If the project generates constant annual cash inflows, the Payback period will be given
by;
Payback Period = Initial Investment
Annual cash flow
 If the project does not generate constant cash inflows, the payback period will be given
by;

Payback Period = Year before full recovery + cash balance to pay back
Cash flow received in the full year

Illustration
AQMW systems, a medium sized software engineering company that is currently contemplating
two projects: project A requires an initial investment of Sh.42 million and project B requires an
initial investment of Sh.45 million. The projected relevant cash flows for the two projects are
shown below.
Project A Project B
Initial Investment (year 0) Sh.42 million Sh.45 million
Operating cash flows
 Year 1 Sh.14 million Sh.28 million
Year 2 Sh.14 million Sh.12 million
Year3 Sh.14 million Sh.10 million
Year 4 Sh.14 million Sh.10 million
Year 5 Sh.14 million Sh.10 million
Average Sh.14 million Sh.14 million
Discounted payback period method
One of the main drawbacks of the simple payback period is that it does not recognize time value
of money because cash flows are not discounted. To solve this limitation, the discounted payback
period is used where cash are discounted and then the payback period determined using the
discounted cash flows.
Example
A project whose initial outlay is 38.5 million promises the following cash flows.
Year 1 2 3 4 5 6
Cash flows 25M -11M 20M 15M 6M 5M

If the cost of capital is 15%, calculate the discounted payback period of the project.
Advantages of Payback Period Method
1. It’s simple to understand and use.
2. It uses cash flows and not the accounting profits.
3. It’s ideal under high risk investment as it identifies which project will payback as soon as
possible
4. It is cost effective as it does not require use of computers and a lot of analysis
5. It emphasizes on liquidity hence funds which are released as early as possible can be
reinvested elsewhere
Weaknesses of Payback Period
1. It does not consider all the cash flows in the entire life of the project.
2. Payback period does not take into account the time value of money
3. It does not measure the profitability of a project but rather the time it will take to payback
the initial outlay
4. It does not have clear decision criteria as a firm may face difficulty in determining the
minimum acceptable payback period
5. It is inconsistent with the shareholders wealth maximization objective. Share values do
not depend on the payback period but on the total cash flows.
ii. Accounting Rate Of Return Method (ARR)
This is the only method that does not use cash flows but instead uses accounting profits as shown
in the financial statements of a company. It is also known as return on investment (ROI).
The ARR is given by:
ARR = Average annual profit after tax ×100
Average investment
Average Investment = Initial Outlay + Salvage Value
2
Illustration
Aqua ltd has a proposal for a project whose cost is Sh.50 million and has an economic useful life
of 5 years. It has a nil residual value. The earnings before depreciation and tax expected from the
project are as follows:
Year Earnings before depreciation and tax
Sh.’000’
1 12000
2 15000
3 18000
4 20000
5 22000
The corporate tax rate is 30% and depreciation is on straight line basis.
Advantages of ARR.
1. Simple to understand and use.
2. The accounting information used is readily available from the financial statements.
3. All the returns in the entire life of the project are used in determining the project’s
profitability.
Weaknesses of ARR.
1. Ignores time value of money.
2. Uses accounting profits instead of cash flows which could have been arbitrarily
determined.
3. It does not give decision rule in respect of single project
4. Growth companies earning very high rates of return on the existing assets may reject
profitable projects as they have set a higher minimum acceptable ARR, the less profitable
companies may set a very low acceptable ARR and may end up accepting bad projects.
5. Does not allow for the fact that profits can be reinvested.
b) Discounted cash flow techniques
i. Net Present Value (NPV)
This is the difference between the present value of cash inflows and the present value of cash
outflows of a project (initial outlay). To get the present values a discount rate is used which is the
rate of return or the opportunity cost of capital. The opportunity cost of capital is the expected
rate of return that an investor could earn if the money would have been invested in financial
assets of equivalent risk. Hence it’s the return that an investor would expect to earn.
When calculating the NPV the cash flows are used and this implies that any non-cash item such
as depreciation if included in the cash flows should be adjusted for. In computing NPV the
following steps should be followed:
1. Cash flows of the investment should be forecasted based on realistic assumptions. If
sufficient information is given one should make the appropriate adjustments for non-cash
items
2. Identify the appropriate discount rate. (It is usually provided)
3. Compute the present value of cash flows identified in step 1 using the discount rate in
step 2
4. The NPV is found by subtracting the present value of cash out flows from present value
of cash inflows.

 C C2 C3 Cn 
NPV   1  2
 3
 L  n 
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
n
Ct
NPV   t
 C0
t 1 (1  k )

CO = Initial investment.
NPV= PV (inflows) –PV (outflows)
Decision Criteria
When NPV is used to make accept – reject decisions, the decision criteria are as follows:
 If the NPV is greater than 0, accept the project
 If the NPV is less than 0, reject the project.
 If NPV > 0, the firm will earn a return greater than its cost of capital, thereby enhancing
the market value of the firm and shareholders wealth.
Recall the previous illustration (AQMW systems)
Additional information; the firms required rate of return is 10%. Compute the NPV of AQMW
systems and advise the management of the company
Advantages of NPV
 1. It uses cash flows to appraise projects
2. It considers all cash flows of the project when appraising it
3. It recognizes the time value of money
4. It is consistent with wealth maximization goal because only projects with positive NPV
shall be undertaken
Disadvantages of NPV
1. It requires estimation of cash flows which is tedious
2. It requires estimation of the required rate of return which presents practical difficulties
3. It is sensitive to discount rates
ii. Profitability Index.
It is defined as the ratio of the present value of the cash flows at the required rate of return to the
initial cash out flow on the investment.

PI = Present value of cash inflow

Initial cash outflow.
It is also called the benefit –cost ratio because it shows the present value of benefits per shilling
of the cost. It is therefore a relative means of measuring a project’s return. It thus can be used to
compare projects of different sizes.
Decision criteria:
 PI > 1 Accept project.
 PI < 1 Reject project.
 PI = 0 It is a point of indifferent i.e. the project may be accepted or rejected
For example from previous example,
Advantages of PI.
1. It considers time value of money.
2. It considers all cash flows yielded by the project.
3. It ranks projects in order of the economic desirer ability.
4. It gives a unique decision criterion.
5. It is a relative measure of profitability and therefore can be used to compare projects of
different sizes.
Weaknesses of PI.
It is not consistent with maximizing shareholders wealth and It assumes the discount rate is
known and consistency which might not be the case.
iii. Internal Rate Of Return (IRR)
This is the discounting rate that equates present value of expected future cash flows to the cost of
the investment .It is therefore the discounting rate that equates NPV to zero.
It is time adjusted technique and covers the disadvantages of the traditional techniques. In other
words it is a rate at which discounts cash flows to zero because the present value of cash inflows
equals the initial investment

The IRR can be found by using the following formula;

IRR = Lower rate + NPV at lower rate X Difference between HR and LR

Absolute sum of NPV

Steps to be followed

1. Calculate the NPV of the project using the cost of capital given.
2. If NPV above is positive, recalculate another NPV using higher discounting rate in order
to obtain a negative NPV.
3. If NPV above is negative, recalculate another NPV using a lower discounting rate in
order to obtain a positive NPV.

Decision criteria
 If IRR is greater than the cost of capital accept the project
 If IRR is less than the cost of capital reject the project
 When comparing two projects accept one with a higher IRR.

This criteria guarantees that the firm at least earns the required return. This outcome enhances
the market value of the firm and therefore the wealth of its owners

Merits
i. It takes into account the total cash inflow and outflow.
ii. It considers the time value of money
iii. It does not use the concept of required rate of return.

Demerits
i. It involves complicated computational method
 ii. It produces multiple rates which may be confusing for taking decisions.

Example
Consider a project with an initial outflow of sh. 170,000 promising the following cash flows.
Year 1 2 3 4
Cash flows 60,000 60,000 60,000 60,000
The cost of capital is 12%.
Required;
Evaluate whether the project is worth pursuing using IRR.
Conflict between NPV and IRR
Sometimes there is a conflict between NPV and IRR. This occurs mostly in the following
circumstances;
1. In case of non-conventional cash flows where cash flows change signs more than once.
2. In case of disparity in sizes of mutually exclusive projects.
3. In case of disparity in economic life of mutually exclusive projects.
4. In case of disparity in timing of cash flows of mutually exclusive projects.