CHAPTER FOUR

CAPITAL BUDGETING/INVESTMENT DECISION

4.1. Introduction
The success of a business unit depends upon the investment of resource in such a way that
brings in benefits or best possible returns from any investment. The investment in general means
an expenditure in cash or its equivalent during one or more time periods in anticipation of
enjoying a net cash inflows or its equivalent in some future time period or periods.

The investment in any project will bring in desired profits or benefits in future. If the financial
resources were in abundance, it would be possible to accept several investment proposals which
satisfy the norms of approval or acceptability. Since, we are sure that resources are limited; a
choice has to be made among the various investment proposals by evaluating their comparative
merit. This would help us to select the relatively superior proposals keeping in view the limited
available resources. For this purpose, we have to develop some evaluating techniques for the
appraisal of investment proposals.

4.2. Importance of investment decisions

The terms in financial management like investment decisions, investment projects, and
investment proposals are generally associated with application of long-term resources. What is
long-term? There is no hard and fast rule to define it, but by common practice and accordance
with the financing policies, practices and regulations of the financial institutions and banks a
period of ten years and above may be treated as long period. The decisions related to long-term
investment is also known as capital budgeting techniques. It is important because of the
following reasons:
1) The investment decisions are the vehicles of a company to reach the desired destiny of the
company. An appropriate decision would yield spectacular results whereas a wrong
decision may upset the whole financial plan and endanger the very survival of the firm.
Even firm may be forced into bankruptcy.
2) Capital budgeting techniques involve huge amounts of funds and imply permanent
commitment. Once you invest in the form of fixed assets it is not easy to reverse the
decision unless you incur heavy loss.

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 3) A capital expenditure decision has its effect over a long period of time span and inevitably
affects the company’s future cost.
4) Investment decisions are among the firm’s most difficult decisions. They are the predictors
of future events which are difficult to predict. It is a complex problem investment. The cash
flow uncertainty is caused by economic, political, social and technological forces.
4.3. Project Classification

The long-term funds are required for the following purposes:

Expansion: A company adds capacity to its existing product lines to expand existing operations.
For example, a manufacturing unit producing one hundred thousand units per year. If it intends
to double the output by two hundred thousands, this will obviously increase the need for funds
for acquiring fixed and current assets.

Diversification: Sometimes the management of a company may decide to add new product line
to the existing product lines. Philips, a famous company for radio and electric bulbs etc.
diversified into production of other electrical appliances and television sets.

Replacements: Machines used in production may either wear out or may be rendered obsolete
on account of new technology. The productive capacity of the enterprise and its competitive
ability may be adversely affected. Extra funds are required for modernization or renovation of
the entire plant. The investment obviously is going to be long terms.

Research and Development: There has been an increased realization that the efficiency of
production and the total operations can be improved by application of new and more
sophisticated techniques of production and management. To acquire the technology huge funds
are needed.

The useful way of classifying investments is as under

1. Accept - Reject Decisions

2. Mutually Exclusive Decisions
3. Capital Rationing

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Accept-Reject Decisions
Under this, if a project is accepted, the firm is going to invest; otherwise it is not going to invest
its funds. In general, the project proposals that yield a rate of return greater than the certain
required rate of return or cost of capital are accepted and others are rejected. By applying this
criteria more than one independent project are accepted subject to availability of funds. Various
appraisal techniques are used to evaluate each project.
Mutually Exclusive Decisions
These are the projects which compete with each other in such a way that the acceptance of one
will exclude the acceptance of the other one. The alternatives are mutually exclusive one may be
chosen.

Capital Rationing
We are aware that the financial resources are limited. But, a large number of investment
proposals compete for those limited funds. The firm, therefore ration them. The firm allocates
funds to projects in a manner that it maximizes long-run returns. Thus, capital rationing refers to
the situation in which the firm has more acceptable investments, requiring a greater amount of
finance than is available with the firm. It is concerned with the selection of a group of investment
proposals out of making investment proposals acceptable under the accept reject decision. The
projects are ranked as per their merits of acceptance basing on certain predetermined criteria.

4.4. Data required for investment decisions

Initial Investment: The total amount of cash required buying various assets like land, buildings,
plant, machinery, equipment, etc and there installation expenses have to be estimated. In addition
to fixed cost, the cost of maintaining stocks, contingency reserves to cover the cost of supporting
the additional receivables. Benefit of credit from suppliers will have the effect of reducing the
quantum of additional working capital required.
Subsequent Investment: The cost of maintenance, replacement and updating are to be treated as
outflows during the period in which they are expected to be incurred.

Economic Life of the project:

The economic life of a project is to be distinguished from the life of an individual asset. The
building may have life of fifty years, plant may have ten years, and some equipment may have

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five years only. The economic life of the project is determined by the duration of the “earnings
flow” generated by the project.

4.5. Capital Budgeting Evaluation Techniques

There are two important methods of evaluating the investment proposals
Traditional methods
 Payback period
 Accounting rate of return
Discounted cash flow method

 Net present value

 Profitability Index method / Benefit cost Ratio
 Internal Rate of Return
Pay Back Period:

This is one of the widely used methods for evaluating the investment proposals. Under this
method the focus is on the recovery of original investment at the earliest possible. It determines
the number of years to recoup the original cash out flow, disregarding the salvage value and
interest. These methods do not take into account the cash inflows that are received after the
payback period. There are two methods in use to calculate the payback period

1) Where annual cash flows are not consistent vary from year to year 2) Where the annual cash
flow is uniform
B
1. Unequal cash flows P=E+
C
Where, P stands for payback period.
E stands for number of years immediately preceding 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.

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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
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
Uniform cash flows:
Where the annual cash flows are uniform

Original Investment
PB =
Annual cash flows

Shorter is the payback period better is the product

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EX: A project requires an investment of $ 100,000; it will generate annual cash flow of $25,000
per year. Calculate the payback period.
Original Investment
PB =
Annual cash flows

100,000
=
25,000
= 4 years
Accounting Rate of Return
This method is based on the financial accounting practices of the company working out the
annual profits. Here, instead of taking the annual cash flows, we take the annual profits into
account. The net annual profits are calculated after deducting depreciation and taxes. The
average of annual profits thus derived is worked out on the basis of the period

Consider following investment:

Initial investment $6,500
Estimated life 20 years
Cash inflows per year $1,000
Depreciation per year (using straight) $325
The accounting rate of return is:
ARR = net income = $1,000 - $325 = 10.4%
Investment $6,500
If average investment (usually assumed to be one-half of the original investment) is used, then:
ARR = $l, 000 - $325 = 20.8%
$3,250
The advantages of this method are that it is easily understandable, simple to compute,
and recognizes the profitability factor.
The shortcomings of this method are that it fails to recognize the time value of money, and it
accounting data instead of cash flow data. The ARR is compared to the predetermined rate. The
project will be accepted if the actual ARR is higher than the desired ARR. Otherwise it will be
rejected.

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Discounted cash flow techniques:

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. Two methods of appraisal of investment project are based on
this concept. These are net present value and internal rate of return method.

Net Present Value

Net present value may be defined as the total of present value of the cash proceeds in each year
minus the total of present values of cash outflows in the beginning
n
CFt
NPV =  (1  K ) t
 Co

Where; NPV = Net present value

CFt = Cash inflows at different periods
Co = Cash outflow in the beginning
K = Cost of capital
The decision rule here is to accept a project if the NPV is positive and reject if it is negative
I) NPV > Zero accept
II) NPV = Zero accept
III) NPV < Zero reject
EX: ABC PLC is considering investing in a cement project. It has on hand $180,000. It is
expected that the project may work for seven years and likely to generate the following annual
cash flows. Calculate the Net present value.

Year ACF
1 30,000
2 50,000
3 60,000
4 65,000
5 40,000
6 30,000
7 16,000
The cost of capital is 8%

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Solution: Year ACF PV factor Present value
1 30, 000 .926 27, 780
2 50, 000 .857 42, 850
3 60, 000 .794 47, 640
4 65, 000 .735 47, 775
5 40, 000 .681 27, 240
6 30, 000 .630 18, 900
7 16, 000 .583 9, 328
221, 513
- Original investment 180, 000
Net present value 41, 513
I. The above problem the NPV is greater than zero hence, it may be accepted.

1 1
Present value of birr 1 = 
(1  r ) n
(1  .10)1
The present value of 1 Birr @ 10 costs after one year .909
Two year .826
Three .751

Profitability Index Method / Benefit Cost Ratio B/C Ratio

Profitability index method is the relationship between the present values of net cash inflows and
the present value of cash outflows. It can be worked out either in unitary or in percentage terms.
The formula is

Present value of cash inflows

Profitability Index =
Pr esent value of cash outflows

PI > 1 Accept
PI = 1 indifference
PI < 1 reject
Higher the profitability index more is the project preferred.
From the above example we can calculate the profitability index as below
Present value of cash out flows $ 180, 000
Present value of cash inflows $ 221, 513

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 221,513
: - PI =
180,000

= 1.23 so accept the project.

Internal Rate of Return (IRR)

The internal rate of return is also known as yield on investment, marginal efficiency of capital,
marginal productivity of capital, rate of return time adjusted rate of return and so on. Internal rate
of return is nothing but the rate of interest which equates the present value of future earnings
with the present value of present investment. Therefore, IR depends entirely on the initial outlay
and the cash proceeds of the project which is being evaluated for acceptance or rejection. The
computation of IRR is difficult one; you have to start equating the two values i.e., present value
of future earnings and present value of investment. It is possible through trial and error method.
IRR can be calculated basing on the payback period where annual cash flows are uniform, in
case the annual cash inflows are different for the periods, the fake payback period is calculate
then adopt trial and error procedure.

NPVL
IRR = LRD + R
PV
where; IRR = Internal Rate of Return
LRD = Lower Rate of Discount
NPVL = Net present value at lower rate of discount
(i.e., difference between present values of cash)
PV = The difference in present values at lower and higher discount values at
lower.
R = The difference between two rates of discount.
Ex: Nissan Plc. has $100, 000 on hand. This amount is invested in a project, where the annual
benefits after taxes are as below. It would like to know the rate of return earned by the company
at the end of the life of the project.

Year ACFS
1 $ 40, 000
2 35, 000
3 30, 000
4 25, 000
5 20, 000

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Solution
At Discount Factor 20% At Discount Factor 10%
Year ACFS PV Factor PV in $ PV Factor PV in $
1 40, 000 .833 33, 300 .909 36, 400
2 35, 000 .694 24, 300 .826 28, 900
3 30, 000 .579 17, 400 .751 22, 500
4 25, 000 .482 12, 100 .683 17, 100
5 20, 000 .402 8, 000 .621 12, 400
95, 100 117, 300
NPVL
IRR = LRD + R
PV
17 ,300
= 10 +  10
22,200
= 17.8

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