CAPITAL BUDGETING

INVESTMENT ANALYSIS
Any company will invest finance for the sake of deriving a return which is useful for four main
reasons:
1. To reward the shareholders or owners of the business for staking their money and by
foregoing their current purchasing power for the sake of current and future return.
2. To reward creditors by paying them regular return in form of interest and repayment of
their principal as and when it falls due.
3. To be able to retain part of their earnings for plough back purposes which facilitate not
only the company’s growth present and the future but also has the implication of
increasing the size of the company in sales and in assets.
4. For the increase in share prices and thus the credibility of the company and its ability to
raise further finance.
Such a return is necessary to keep the company’s operations moving smoothly and thus
allow the above objective to be achieved.
A financial manager with present investment policies will be concerned with how efficiently the
company’s funds are invested because it is from such investment that the company will survive.
Investments are important because:
a) They influence company’s size
b) Influence growth
c) Influence company’s risks
In addition, this investment decision making process also known as capital budgeting, involves
the decision to invest the company’s current funds in viable ventures whose returns will be
realized for long term periods in future. Capital budgeting as financial planning is characterized
by the following:
1. Decisions of this nature are long term i.e. extending beyond one year in which case they
are also expected to generate returns of long term in nature.
2. Investment is usually heavy (heavy capital injection) and as such has to be properly
planned.
3. These decisions are irreversible and any mistake may cause the company heavy losses.
Importance of Investment Decisions
a) Such decisions are importance because they will influence the company’s size (fixed
assets, sales, and retained earnings).
b) They increase the value of the company’s shares and thus its credibility.
c) The fact that they are irreversible means that they have to be made carefully to avoid any
mistake which can lead to the failure of such investment.
d) Due to heavy capital outlay, more attention is required to avoid loss of huge sums of
money which in the extreme may lead to the closure of such a company. However, these
decisions are influenced by:
i) Political factors – Under conditions of political uncertainty, such decisions cannot be
made as it will entail an element of risk of failure of such investment. Thus political
certainty has to be analyzed before such decisions are made, such factors must be taken
into account such that the company forecasts the inflows and outflows within given
limitations such as the degree of competition, performance of economy, changing tastes
etc. which influence ability to generate sufficient return from a venture which will pay
not only interest but principal on such funds invested.
 ii) Technological factors – These influence the returns of the company because such
technology will affect the company’s ability to utilize its assets to the utmost ability
in particular if such assets become obsolete and cannot generate good returns or the
output of such machines may be low with time and may not meet planned
expectations which in most cases will have an impact on inflows from a venture.
Methods of Analyzing Investment
Capital Budgeting Methods.
There are two methods of analyzing the viability of an investment:
a) Traditional methods
 Pay back period method
 Accounting rate of return method
b) Modern methods (Discounted cash flow techniques)
 NPV – Net present value method
 IRR – Internal rate of return method
 PI – Profitability index method
For the above two (a & b) methods to be used, they have to meet the following:
i) They should rank ventures available in the investment market according to their
viability i.e. they should identify which method is more viable than others.
ii) They should rank a venture first if the venture brings in return earlier and in large
lump sums than if a venture brought in late and less inflows over the same period.
iii) Should rank any other projects as and when it is available in the investment market.
Such methods should take into account that all returns (inflows), must be cash returns
as it is necessary to be able to finance the cost of the venture.

TRADITIONAL METHODS
Payback period method
This method gauges the viability of a venture by taking the inflows and outflows over time to
ascertain how soon a venture can payback and for this reason PBP (or payout period or payoff) is
that period of time or duration it will take an investment venture to generate sufficient cash
inflows to payback the cost of such investment. This is a popular approach among the traditional
financial managers because it helps them ascertain the time it will take to recoup in form of cash
from operations the original cost of the venture. This method is usually an important preliminary
screening stage of the viability of the venture and it may yield clues to profitability although in
principle it will measure how fast a venture may payback rather than how much a venture will
generate in profits and yet the main objectives of an investment is not to recoup the original cost
but also to earn a profit for the owners or investors.

Computation of payback period:

1. Under uniform annual incremental cash inflows – if the venture or an asset generates
uniform cash inflows then the payback period (PBP) will be given by:

PBP = Initial cost of the venture

Annual incremental cost
e.g. If a venture costs 37,910/= and promises returns of 10,000/= per annum indefinitely then the
PBP = 37,910
10,000 = 3.79 years
The shorter the PBP the more viable the investment and thus the better the choice of such
investments
2. Under non-uniform cash inflows:
Under non-uniformity PBP computation will be in cumulative form and this means that the net
cash inflows are accumulated each year until initial investment is recovered.

Example
Assume a project costs Sh.80, 000 and will generate the following cash inflows:
Cash inflows Accumulated inflows
Inflows year 1 = 10,000 10,000
Inflows year 2 = 30,000 40,000
Inflows year 3 = 15,000 55,000
Inflows year 4 = 20,000 75,000
Inflows year 5 = 30,000 105,000
The Sh.80, 000 costs is recovered between year 4 and 5. During year 5 (after year 4) Sh.5, 000 is
(80,000 – 75,000) is required out the total year 5 cash flows of 30,000.

5,000
Therefore 𝑃𝐵𝑃 = 4yrs + 30,000 = 4.17 years

Example
Cedes limited has the following details of two of the future production plans. Only one of these
machines will be purchased and the venture would be taken to be virtually exclusive. The
Standard model costs £50,000 and the Deluxe cost £88,000 payable immediately. Both machines
will require the input of the following:
i) Installation costs of £20,000 for Standard and £40,000 for the Deluxe
ii) A £10,000 working capital through their working lives.
Both machines have no expected scrap value at end of their expected working lives of 4 years for
the Standard machine and six years for the Deluxe. The operating pre-tax net cash flows
associated with the two machines are:

Year 1 2 3 4 5 6
Standard 28,500 25,860 24,210 23,410 - -
Deluxe 36,030 30,110 28,380 25,940 38,500 35,100

The deluxe machine has only been introduced in the market and has not been fully tested in the
operating conditions, because of the high risk involved the appropriate discount rate for the
deluxe machine is believed to be 14% per annum, 2% higher than the rate of the standard
machine. The company is proposing the purchase of either machine with a term loan at a fixed
rate of interest of 11% per annum, taxation at 30% is payable on operating cash-flows one year
in arrears and capital allowance are available at 25% per annum on a reducing balance basis.

Required
For both the Standard and the Deluxe machines, calculate the payback period.
Accounting Rate of Return Method (ARR)
This method uses accounting profits from financial status to assess the viability of investment
proposal by diving the average income after tax by average investment. The investment would be
equal to either the original investment plus the salvage value divided by two or the initial
investment divided by two or dividing the total of the investment book value after depreciating
by the life of the project. This method is also known as financial statement method or book value
method. The rate of return on asset method or adjusted rate of return method is given by:

ARR = Average income x 100 or Average income – Average depreciation

Average investment Initial investment

Unlike PBP, this method will ascertain the profitability of an investment and it will give results
which are consistent with those given by return ratios e.g.
Shs.
Project X cost 500,000
Scrap value 100,000
Stream of income before depreciation and taxes are as follows:
Shs.
Year 1 100,000
Year 2 120,000
Year 3 140,000
Year 4 160,000
Year 5 200,000
Let tax = 50% and depreciation straight line.

Required: Calculate the accounting rate of return.

Note
The best method of depreciation to use should be that which will produce larger depreciation
changes in the 1st few years of the assets life and lesser changes in the later years because this
will produce a higher tax shield to the company with higher value of inflows. Thus reducing
balance is preferred as compared to sum of digits and straight line method.

The salvage value should be treated as follows:

If the asset produces a salvage value at the end of the year, this will increase inflows for payback
period. This value is only used to ascertain how much the company will reduce original cost of
investment to obtain average investment.

Acceptance Rule of Payback Period (Pbp)

Using PBP method a company will accept all those ventures whose payback period is less than
that set by the management and will reject all those ventures whose PBP is more than that set by
the management.
Alternatively, PBP may be gauged against the term of the loan in which case the PBP method
will give a high ranking to all those ventures paying back before the term of the loan and the
highest ranking will be given to those projects with shortest PBP. However, in assessing the
viability of a venture it is also important to see which venture brings returns earlier, other things
being equal.

Advantages of Payback Period

1. Simple to use and understand and this has made it popular among executives especially
traditional financial managers in ascertaining the viability of a venture.
2. Ideal under high-risk investments because it will identify which venture will payback earlier
thus minimizing the risks with a venture.
3. Advantageous when choosing between mutually exclusive projects because it will give a
clue as to which venture is viable if one considers the shortest PBP and the highest inflow of
a venture.
Disadvantages of Payback Period
1. Does not take into account time value of money and assumes that a shilling received in
the 1st year and in the Nth year have the same value so as to rank them together to
ascertain the PBP which is unrealistic given that a shilling now is valuable than a shilling
N years from now.
2. PBP method does not measure the profitability of a venture but rather measures the
period of time a venture takes to pay back the cost. The method is outside looking (lender
oriented rather than owner oriented).
3. PBP method ignores inflows after PBP and as such, it does not accommodate the element
of return to an investment.
4. This method will not have any impact on the company’s share prices because profitability
which is one of the most important factors in gauging the company’s value of shares is
not a function of PBP and as such the method fall short of meeting the criteria of
investment appraisal.

Acceptance Rule of Accounting Rate of Return (Arr)

ARR method will accept those projects whose ARR is higher than that set by management or
bank rate and it will give highest ranking to ventures with highest ARR and vice versa.

Advantages
1. Simple to understand and use.
2. Readily computed from accounting data thus much easier to ascertain.
3. It is consistent with profitability objectives as it analyses the return from entire inflows
and as such it will give a clue or a hint to the profitability of venture.
Disadvantages
1. It ignores time value of money.
2. It does not consider how soon the investment should recover the cost (it is owner looking
than creditor oriented approach).
3. It uses accounting profits instead of cash inflows some of which may not be realizable.
MODERN METHODS OR DCF i.e. Discounted Cash Flow Techniques
1. Present Value Concept
This concept acknowledges the fact that a shilling losses value with time and as such if it is to be
compared with a shilling to be received in Nth year then the two must be at the same values. This
means that an investor’s analytical power is increased by his/her ability to compare cash inflows
and outflows separated from each other by time. He/she should be able to work in the reverse
direction i.e. from future cash flows to their present values.

2. Present Value of a Lump sum

Usually an investor would wish to know how much he/she would give up now to get a given
amount in year 1, 2 … n. In this situation he would have to decide at what rate of discount also
known as time preference rate, he/she will use to discount the anticipated lump sum using this
rate by applying the following formula:

L
PV = 𝑛
1+𝐾

Where: PV = Present value

L = Lump sum
K = Cost of finance or time preference rate
n = given year.
This implies that if the time preference rate is 10%, the present value of 1/= to e received at the
end of year 1 is:

PV = 1
1.1 = 0.909

The present value of inflows to be received in the 2nd year to Nth year, will be equal to:

A
PV = 𝑁
1+𝐾

Where: A = annual cash flows

N = Number of years
Also, the present value of a shilling to be received at a given point in time can in addition to
using the above formula is found using the present value tables.

Suppose that an investor can expect to receive:

40,000 at the end of year 2
70,000 at the end of year 6
100,000 at the end of year 8
Compute his present (value) if his time preference is 12%.
Net Present Value Method
The method discounts inflows and outflows and ascertains the net present value by deducting
discounted outflows from discounted inflows to obtain net present cash inflows i.e the present
value method will involve selection of rate acceptable to the management or equal to the cost of
finance and this will be used to discount inflows and outflows and net present value will be equal
to the present value of inflow minus present value of outflow. If net present value is positive you
invest, If NPV is negative you do not invest.

Pv(inflow) – Pv(outflows) = NPV

Note
Initial outflow is at period zero and their value is their actual present value. With this method, an
investor can ascertain the viability of an investment by discounting outflows. In this case, a
venture will be viable if it has the lowest outflows.

A1 𝐴2 𝐴3 𝐴𝑁
NPV = + + +⋯+ -C
1+𝐾 1 1+𝐾 2 1+𝐾 3 1+𝐾 𝑁

Where: A = annual inflow

K = Cost of finance
C = Cost of investment
N = Number of years
Example 1
Cost of investment = 100,000/=, interest rate = 10%, inflows year 1 = 80,000/= year 2 =
50,000/=

Example 2
Jeremy limited wishes to expand its output by purchasing a new machine worth 170,000 and
installation costs are estimated at 40,000/=. In the 4th year, this machine will call for an overhaul
to cost 80,000/=. Its expected inflows are:
Shs.
Year 1 60,000
Year 2 72,650
Year 3 35,720
Year 4 48,510
Year 5 91,630
Year 6 83,715
This company can raise finance to purchase machine at 12% interest rate. Compute NPV and
advise management accordingly.

Example
Resilou limited intends to purchase a machine worth Shs.1, 500,000 which will have a residue
value Shs.200, 000 after 5 years useful life. The saving in costs resulting from the use of this
machine are:
Shs.
Year 1 800,000
 Year 2 350,000
Year 3 -
Year 4 680,000
Year 5 775,000
Using NPV method, advice the company whether this machine should be purchased if the cut off
rate is 14% and acceptable saving in cost is 12% of the cost of the investment.
.
Example
A section of a roadway pavement costs £400 per year to maintain. What new expenditure of a
new pavement is justified if no maintenance will be required for the 1st five years then £100 for
the next 10 years and £400 a year thereafter? Assume cost of finance to be 5%.

ACCEPT OR REJECT RULE OF NPV

Under this method, a company should accept an investment venture if N.P.V. is positive i.e. if
present value of cash outflows exceeds that of cash inflows or at least is equal to zero. (NPV ≥0).
This will rank ventures giving the highest rank to that venture with highest NPV because this
will give the highest cash inflow or capital gain to the company.

Advantages of NPV
1. It recognizes time value of money and such appreciates that a shilling now is more
valuable than a shilling tomorrow and the two can only be compared if they are at their
present value.
2. It takes into account the entire inflows or returns and as such it is a realistic gauge of the
profitability of a venture.
3. It is consistent with the value of a share in so far as a positive NPV will have the
implication of increasing the value of a share.
4. It is consistent with the objective of maximizing the welfare of an owner because a
positive NPV will increase the net worth of owners.
Disadvantages of NPV
1. It is difficult to use.
2. Its calculation uses cost of finance which is a difficult concept because it considers both
implicit and explicit whereas NPV ignores implicit costs.
3. It is ideal for assessing the viability of an investment under certainty because it ignores
the element of risk.
4. It may not give good assessment of alternative projects if the projects are unequal lives,
returns or costs.
5. It ignores the PBP.
Irr (Internal Rate of Return)
This method is a discounted cash flow technique which uses the principle of NPV. It is defined
as the rate which equates the present value of cash outflows of an investment to the initial
capital.
IRR = Pv (cash inflows) = Pv(cash outflows) or IRR is the cost of capital when NPV = 0.

It is also called internal rate of return because it depends wholly on the outlay of investment and
proceeds associated with the project and not a rate determined outside the venture.

At IRR, cost equals discounted inflows. Ie

A1 𝐴2 𝐴3 𝐴𝑁
C= 1
+ 2
+ 3
+ ⋯+
1+𝑟 1+𝑟 1+𝑟 1+𝑟 𝑁

A = inflow for each period

C = Cost of investment

The value r can be found by:

i) Trial and error
ii) By interpolation
iii) By extrapolation
1) Trial and error method
a) Select any rate of interest at random and use it to compute NPV of cash inflows.
b) If rate chosen produces NPV lower than the cost, choose a lower rate.
c) If the rate chosen in (a) above gives NPV greater than the cost, choose a higher rate.
Continue the process until the NPV is equal to zero and that will be the IRR.

Example
A project costs 16,200/= and is expected to generate the following inflows:
Shs.
Year 1 8,000
Year 2 7,000
Year 3 6,000
Compute the IRR of this venture.

Acceptance Rule of IRR

IRR will accept a venture if its IRR is higher than or equal to the minimum required rate of
return which is usually the cost of finance also known as the cut off rate or hurdle rate, and in
this case IRR will be the highest rate of interest a firm would be ready to pay to finance a project
using borrowed funds and without being financially worse off by paying back the loan (the
principal and accrued interest) out of the cash flows generated by that project. Thus, IRR is the
break-even rate of borrowing from commercial banks.

Advantages of IRR
i) It considers time value of money
ii) It considers cash flows over the entire life of the project.
 iii) It is compatible with the maximization of owner’s wealth because, if it is higher than
the cost of finance, owners’ wealth will be maximized.
iv) Unlike the NPV method, it does not use the cost of finance to discount inflows and
for this reason it will indicate a rate of return of interval to the project against which
various ventures can be assessed as to their viability.
Disadvantages of IRR
i) Difficult to use.
ii) Expensive to use because it calls for trained manpower and may use computers
especially where inflows are of large magnitude and extending beyond the normal
limits.
iii) It may give multiple results some involving positive IRR in which case it may be
difficult to use in choosing which venture is more viable.

PROFITABILITY INDEX (P.I.)

P.I. (benefit-cost ratio) = Present value of inflows
Present value of cash outlay

If P.I. is greater than 1.0, invest. If less than 1.0, reject.

Example
The following information was from XYZ feasibility studies. It has studied two ventures:
a) Cost 100,000/= and 160,000/= at the beginning of the 4th year and it will generate
inflows 1-3rd year 80,000/= and from 4-6th year 50,000/= per annum.
b) Initial cost 200,000/= and 80,000/= at the beginning of the 4th year and it will generate
the following inflows:
1st – 2nd year -> Shs.100,000 per annum
3rd – 6th year -> Shs.70,000 per annum
Using the cost of finance of 12% compute the P.I. of these two ventures, advise the company
accordingly.

Example
A company is faced with the following 5 investment opportunities:
Cost NPV P.I = Total P.v P.I Ranking
Initial capital
1. 500,000 150,000 1.3 4
2. 100,000 40,000 1.4 3
3. 400,000 40,000 1.1 5
4. 200,000 100,000 1.5 2
5. 160,000 90,000 1.6 1

This company has 750,000/= available for investment projects, 3 and 4 are mutually exclusive.
All of the projects are divisible. Which group should be selected in order to maximise the NPV.
Indicate this NPV figure.

Advantages of profitability index

a) Simple to use and understand.
 b) The element of NPV in the venture will indicate which venture is more powerful as the
most profitable venture will have the highest P.I. as the difference or net P.I. will
continue to the company’s profitability.
c) It acknowledges time value for money and at the same time the NPV of a venture at its
present value which is consistent with investment appraisal requirements.
Disadvantages of profitability index
a) It may be useful under conditions of uncertain cost of finance used to discount inflows
and yet this cost is a complex item due to the implicit and explicit element.
b) It may be difficult to ascertain if the economic life of a venture is long and it yields large
inflows because their discounting may call for use of computers that are expensive.

COMPARISON OF METHODS
Both traditional and modern methods will show or indicate strong weaknesses such that a
company cannot use either to select a viable venture and for this reason the selection of the
investment will depend on which method the company has identified it can meet its investment
needs. The choice should not be limited to one method but at least 2 modern methods. In all,
when ranking projects, a conflict will rise between IRR and NPV especially under the following
conditions:
a) If the lives of the projects are different.
b) Where the cash outlay is larger than the other.
c) When the cash flow pattern differs i.e the cash flows of one project may overtime
increase while those of the other decrease. In this case NPV may give consistently correct
solution especially so because it does not yield multiple rates.

PBP RECIPROCAL
PBP expresses the profitability of a project in terms of years. It does not show any return as
measure of investment. The PBP reciprocal has been utilized to rectify the situation, but it is only
of value where the pattern of cash flow is relatively consistent and where the life of the asset is at
least double the payback period of the asset. The payback period is expressed as:

Investment
Annual cash flows

This PBP reciprocal is often used as a guide to ascertain the discount factor in discounted cash
flow calculations i.e. to approximate IRR.
1
Payback period reciprocal = X 100
PBP

REPLACEMENT OF ASSETS
Example
Estate Developers purchased a machine five years ago at a cost of £7,500. The machine had an
expected economic life of 15 years at the time of purchase and a zero estimated salvage value at
the end of 15 years. It is being depreciated on a straight line basis and currently has a book value
of £5,000. The Financial Manager has conducted a feasibility study aimed at acquiring a new
machine for £12,000 and is depreciated over its 10 years useful life. The new machine will
expand sales from £10,000 to £11,000 per annum and will reduce labour and materials usage
sufficiently to cut operating cost from £7,000 to £5,000. The salvage value of the new machine is
£2,000 at the end of useful life. The current market value of the old machine is £1,000 and tax is
40%. The firms cost of capital is 10%. The financial manager wishes to make a decision on
whether to replace the old machine with a new one and he seeks your held.
N.B. The decision to replace takes into account the following:
a) Estimate the actual cash outlay attributable to the new machine
b) Determine the incremental cash flows.
c) Compute the NPV of incremental cash flows.
d) Add up the present value of the expected salvage value to the P.V. of the
incremental cash flow.
e) Ascertain whether the NPV (net present value) is positive or whether the IRR
(internal rate of return) exceed the cost in which case invest if it’s positive.