Financial Management I Chapter- Five

CHAPTER FIVE
LONG-TERM INVESTMENT DECISION (CAPITAL BUDGETING)
5.1. Introduction
An efficient allocation of capital is the most important finance function in the modern times.
It involves decisions to commit the firm’s funds to the long term assets. Investment
decisions can also be called as capital budgeting decision. Capital budgeting decisions may
be defined as the firm’s decisions to invest its current funds most efficiently in the long term
assets in anticipations of an expected flow of benefits over a series of years. The firm’s
decisions investment would include:
 Expanses(life-span)  Modernizations
 Acquisition  Replacements of the long term assets.
A sale of a division or a business (divestment) is also as an investment decisions. Therefore,
if the decisions have long term implications for the firm’s expenditures and benefits, they
should also be evaluated as investment decision.
5.2. Feature of Investment decision
The following are the feature of investment decisions:
 The exchange of current funds for future benefits.
 The funds are invested in long term assets.
 The future benefits will occur to the firm over series of years.
5.3. Types of Investment Decision
There are many ways to classify investments:
 Expansion of existing business.
 Replacement and modernization.
 Expansion of new business.
I. Expansion of existing Business: A company may add capacity to its existing product line to
expand existing operation. Expansion of new business requires investment in new product
and kinds of production activity within the firm. Sometime a company acquires existing firm
to expand its business in either case the firm make investment in expectation of additional
revenue. Investment in existing or new product may also be called a revenue expansion
investment.
II. Replacement and Modernization: The main objective of modernization and replacement is
to improve operating efficiency and reduces costs. Cost saving is reflect in the increased
profit, but the firm’s revenue may remain unchanged. Assets become outdated and absolute
with technological change. The firms must decide to replace those assets with new asset

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that operate more economically. Replacement decision helps to introduce more efficient
and economical asset called cost reduction investment.
III. Expansion of New Business: If a company invests in a new plant and machinery to produce a
product, which the firm has not produced before, it is the expansion of new business or
unrelated diversification.
Another classification of Investment is that:
1. Mutually exclusive investment: Mutually exclusive investment serves the same purpose
and competes with each other. If one investment is undertaken others will have to be
excluded. Example, A co may use either a semi-automatic machine (labor intensive) or
fully automatic machine (capital intensive) cement. Thus, choosing a semi-automatic
machine precludes the acceptance of the full automatic machine because the company
can produce cement by using either of the two.
2. Independent Investment: Independent investment serves different purpose and do not
compute with each others. Example, Dashen brewery factory may be considering
expansion of its plant capacity to produce additional bottles of beer and additional new
product facility to produce soft dirk. Therefore, the decision is depending upon the
profitability and availability of funds. If there are enough funds, the factory can
undertake both investments.
3. Contingent investment
They are dependent projects; the choice of one investment necessitates undertaking one or
more other investments. Example, if a company decides to build a factory in a remote area,
it may have to invest in houses for employees, roads for transportation etc.
5.4. Investment Evaluation criteria
All the investment evaluation criteria are grouped under two broad categories.
1) Discounted cash flow (DCF) criteria:
a) Net Present Value (NPV)
b) Internal Rate of Return (IRR)
c) Profitability Index
2) Non-discounted cash flow criteria:
a) Payback period (PB)
b) Accounting Rate of Return (ARR)

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1. Discounted cash flow (DCF) criteria

This concept is based on the time value of money. The flow of income is spread over a few
years. The real value of Birr in your hand today is better than value of birr you earn after a
year. The future income, therefore, has to be discounted in order to be associated with the
current out flow of funds in the investment. The ff methods of appraisal of investment
project are based on this concept.
a) Net Present Value Method (NPV)
It is the classic economic method of evaluating the investment proposals. It is discounted
cash flow technique that explicitly recognizes the time value of money. It correctly
postulates that cash flows arising at different time periods differ in value and comparable
only when this equivalents- present value- are found out.
Steps to calculate the net present value of an investment proposal
1. Cash flows of the investment project should be forecasted based on realistic
assumption.
2. Appropriate discount rate should be identified to discount the forecasted cash flows.
The discount rate is the project opportunity cost of capital, which is equal to the
required rate of return expected by investors on the investment of equivalent risk.
3. Present values of cash flow should be calculated.
4. Net present values should be found out by subtracting present value of cash should be
found out by subtracting present value of cash outflows from present value of cash
inflows.
Formula used to calculate the Net Present Value of any project proposal
n
Ci
 (1  k )t  C 0
NPV = i 1
Where: NPV = Net Present Value
Ci = Periodic Cash Inflow
C0 = Cash Outflow/ Initial Investment
 Acceptance rule
 Accept the project when NPV is positive; NPV>0
 Reject the project when NPV is negative; NPV<0
 May accept the project when NPV is zero; NPV=0
Note:

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The NPV method can be used to select between mutually exclusive projects; the one with the
higher NPV should be selected.
Example: suppose project ‘A’&’B’ - both costing Br 50 each. Project ‘A’ returns Br 100 after
one year & Br 25 after two years. On the other hand, project ‘B’ returns Br 30 after one
years and Br 100 after two years. At discount rates of 5% &10% NPV of ‘A’ & ’B’ are as
follows:
Project NPV at 5% Rank NPV at 10% Rank
A 67.92 II 61.57 I
B 69. 27 I 59.91 II
As you can see from the solution, the project raking is reversed when discount rate is
changed from 5% to 10% .The reason lies in the cash flow patterns.
Example: Assume that a machine will cost Br 100,000 and will provide annual net cash
inflows of Br 50,000; Br 40,000; Br 30,000; Br 20,000;Br 20,000; and Br 20,000 for six years.
The cost of capital is 15%. Calculate the Machines net present value. Should the Machine be
purchased?
Solution
Year cash inflow Discounted factor Discounted cash flow
0 -100,000 1.000 -100,000
1 50,000 0.8696 43,480
2 40,000 0.7561 30,244
3 30,000 0.6575 19,725
4 20,000 0.5718 11,436
5. 20,000 0.4972 9,944
6 20,000 0.4323 8,646
Net Present Value……Br.23,475
Total present value = Birr 123,475
The Net Present Value (NPV) = PV of cash inflows - PV of cash out flow
= Birr 123,457- Birr100, 000
= Birr 23,475
Decision:
Since the NPV of the Machine is positive, the machine should be purchased.
b) Internal Rate of Return (IRR)
Other terms used to describe the IRR method are yield on an investment, marginal
efficiency of capital, rate of return over cost, time adjusted rate of internal return etc,. Thus,
internal rate of return is defined as the rate that equates the investment outlay with the
present value of cash inflow received after one period. This implies that the rate of return is
the discounts rate which makes NPV =0

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n
Ct
1 r
At the exact IRR; i 1 - C0 = 0
Where: IRR=Internal Rate of Return
Ct = Periodic cash inflows
r = the internal rate of return
C0 = Cash outflows/ Initial Investments
 Acceptance Rule:
 Accept the project when internal rate of return is greater than the opportunity cost
of capital; r>k
 Reject the project when internal rate of return is less than the opportunity cost of
capital; r<k
 May accept the when internal rate of return is equals to the opportunity cost of
capital; r=k
Example: Assume that a machine will cost Br 100,000 and will provide annual net cash
inflows for the coming six years are as follows:
Year 1Year 2Year 3Year 4Year 5Year 6
50,000 40,000 30,000 20,000 20, 000 20,000
The cost of capital is 15%.
Calculate the machines IRR. Should the machine be purchased?
There is no a readymade formula to compute the internal rate of return of an investment
proposal just like other investment evaluation criteria. It can be calculated through trial and
error.
Assume r=18% Assume r= 25%
PV at 26% PV at 25%
50,000x0.794 = 39,700 50,000x0.800 = 40,000
40,000x0.630 = 25,200 40,000x0.640 = 25,600
30.000x0.500 = 15,000 30,000x0.512 = 15,360
20,000x0.397 = 7,940 20,000x0.410 = 8,192
20,000x0.315 = 6,300 20,000x0.328 = 6,553.60
20,000x0.250 = 5,000 20,000x0.262 = 5,242.88
PV of inflows 99,140 100,948
Solution
Now you have to use the interpolation method to find out the exact internal rate of return.
Interpolation Method
X
Required IRR= A + Y (B - A)
Where:
A= Lower assumed IRR

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B= Higher assumed IRR

X= the difference between the PV of cash inflow at lower assumed IRR
and PV of cash inflow at the required/exact IRR.
Y= The difference between the PV of cash inflow at lower assumed IRR
and PV of cash inflow at the higher assumed IRR.
860
Required IRR = 25% + 1808 (26% - 25%)
Required IRR = 25% + 0.48%
Required IRR = 25.48%
Decision:
Since the required internal rate of return of the machine (25.48%) is greater than the cost of
capital (15%), the machine should be purchased.
c) Profitability index
It is the ratio of the present value of cash inflows at the required rate of return, to the initial
cash out flows of the investment.
n
Ci
 (1  i)n
i 1

PI = C0

Where: PI = Profitability Index

Ci = Periodic cash inflow
C0 = Cash outflows/Initial cash outlays
i = required rate of return
n = Number of periods
 Acceptance Rule:
 Accept the project when profitability index is greater than one; PI>1
 Reject the project when profitability index is less than one; PI<1
 May accept/reject the project when profitability index is one; PI=1
Example: Assume that a machine will cost Br 100,000 and will provide annual net cash
inflows for the coming six years are as follows:
Year 1Year 2Year 3Year 4Year 5Year 6
50,000 40,000 30,000 20,000 20, 000 20,000
The cost of capital is 15%.Calculate the machines PI. Should the machine be purchased?
Solutions
Year cash inflows Discount factor of 15% Discounted cash inflow
1 50,000 0.8696 43,480

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2 40,000 0.7561 30,244

3 30,000 0.6575 19,725
4 20,000 0.5718 11,436
5 20,000 0.4972 9,944
6 20,000 0.4323 8,646
PV of cash inflows = 123,475
n
Ci

i 1 (1  i ) n
Br123,475
PI = C0 = Br100,000 = 1.235
Decision
Since, the projects PI is greater than one (i.e. 1.235), the machine should be purchased.
2. Non-Discounted cash flow Techniques(traditional method)
1. Pay Back Period (PBP)
Pay Back Period is the number of year required to recover the original cash outlay invested
in a project.
 Acceptance rule
There is no any common standard which is used by all firms commonly. It is depending up
on the decision of a firm. They compare the project pay back with predetermined standard
pay back. The project would be accepted if it’s payback period is less than the maximum or
standard payback period set by management. During raking, the first rank will be given for a
project having the shortest payback period.
Example:
Cash Flows
Project Year 0 Year 1 Year 2 Year 3 PBP NPV@10%
A -5,000 3,000 2,000 2,000 2years +881
B -5,000 2,000 3,000 2,000 2years +798
As you can see from the solution both projects ‘A’ & ‘B’ have equal pay back period, but
different NPV. It happens because of the failure to consider all the cash inflows as well as
the time value of money.
1) Administrative difficulties: Firms may face difficulties in determining the maximum
acceptable PBP. There is no rational basis for setting a maximum PBP. It is subjective.
2) Inconsistent with shareholder value: PBP is not consistent with the objective of
maximizing the market value of the firm’s share.
A. PBP (for constant cash flows)
If the project generates constant annual cash inflows, the PBP can be computed by
dividing total cash outlay by the annual cash inflow.
PBP = Initial Cash Outlay
Annual Cash Inflow
Example: Assume that a project requires an outlay of Birr 50,000and yields annual cash
inflow of Birr 12,500 for seven years. What would be the payback period of the project?
PBP = Initial Cash Outlay
Annual Cash Inflow

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Br 50,000
PBP = Br12,500 = 4 Years
The company can recover the initial cash outlay within four years.
B. PBP (For uneven cash flows)
P=E+E/C
Where, P stands for payback period.
E stands for number of years immediately proceeding the year of final recovery.
B stands for the balance amount still to be recovered.
C stand for cash flow during the year of final recovery
Example: Ex: The following is the information related to a company
Project A Project B
Year Cash flow $ Year Cash flow $
0 -700 0 -700
1 100 1 400
2 200 2 300
3 300 3 200
4 400 4 100
5 500 5 0

Required: Calculate payback period

Project A Cumulative Project B Cumulative
Year Cash flow cash flow Year Cash flow Cash flow
0 -700 -700 0 -700 -700
1 100 -600 1 400 -300
2 200 -400 2 300 0
3 300 -100 3 200 200
4 400 300 4 100 300
5 500 800 5 0 -
B
P=E+ C
100
= 3 + 400
= 3.25 year
B
P=E+ C
=2+0
= 2 years
Accounting Rate of Return (ARR)
It also known as return on investment (ROI) uses accounting information, as revealed by
financial statements to measure the profitability of investment. ARR is the ratio of the
average after tax profit divided by the average investment. The average investment would
be equal to half of the original investment if it were depreciated constantly. Alternatively, it
can be found out by dividing the total of the investments book values after depreciation by
the life of the project.
ARR= Average Income
Average Investment
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 EBITt (1  T ) n
i 1
( Io  In )
ARR = 2
Where:
EBITt = Earnings before Tax and Interest for ‘t’ time periods.
T = Income Tax Rate.
n = Number of periods.
Io = Beginning Balance of Investment
In = Ending Balance of Investment.
 Acceptance Rule
As an acceptance or reject criterion, this method will accept all those projects whose ARR is
higher than the minimum rate established by the management and reject those projects
which have ARR less than the minimum rate.
A project will cost Br 40,000. Its stream of earnings before depreciation, interest and taxes
(EBDIT) during first year through five years is expected to be Br.10,000; 12,000 ; 14,000;
16,000 and 20,000 respectively. Assume a 50% tax rate and depreciation on straight line.
Salvage value is zero. What would be the Accounting Rate of Return?
Solutions
Years Cash inflows Depreciation EBIT Tax (50%) EAT
1 10,000 8,000 2,000 1,000 1,000
2 12,000 8,000 4,000 2,000 2,000
3 14,000 8,000 6,000 3,000 3,000
4 16,000 8,000 8,000 4,000 4,000
5 20,000 8,000 12,000 6,000 6,000
16,000
Solutions
n
EBITt (1  T )

i 1
n
( Io  In )
ARR = 2
Br16,000
5 years
Br 40,000
ARR = 2 100% = 16%

Exercise: Solve the following problems

1. A project costs Birr 2,000,000 and yields annually a profit of Birr 300,000 after
depreciation at 12.5% but before tax at 50%. Calculate the payback period.
2. Dashen trading company is considering two projects. Each requires an investment of Birr
20,000. The net cash flows from investment in the two projects X and y are as follows:
Year Project Project
X Y
1 10,00 4 , 0 0

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0 0
2 8,00 5,00
0 0
3 6,00 6,00
0 0
4 4,00 7,00
0 0
5 2,00 8,00
0 0
6 1,00 10,00
0 0
The required rate of return is 10 per cent.
Compute
a) Net Present Value of each project and give decision.
b) Internal Rate of Return of each project give decision
c) Profitability Index of each project give decision
d) Pay Back Period of each project give decision

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