Chapter One: Capital Budgeting Decisions

Long-term investments are also called capital budgeting. The term capital refers to the fixed
assets used in production, while a budget is a detailed plan of projected cash flows during some
future period. Thus, the capital budget of the firm outlines the planned expenditures of the fixed
assets, and capital budgeting is the whole process of analyzing projects whose returns are
expected to extend beyond the period of one year and deciding which project should be included
in the capital project. Capital budgeting expenditures include expenditures for land, building,
equipment, and for permanent additions to working capital associated with plant expansion, for
advertising and promotion campaigns, and for research and development programs.
1.1. Process to Capital Budgeting

A systematic approach to capital budgeting requires the following procedures to follow:

1. The formulation of long-term strategy and goals
2. The creative search and identification of new investment opportunities.
3. The estimation and forecasting of current and future cash-flows.
4. A set of decision rules that can differentiate acceptable from unacceptable alternatives.
5. The building of suitable administrative framework that is capable of transferring the
required information to the decision level.
6. The controlling of expenditures and the careful monitoring of project implementation.
If the financial managers under take all the 6-step under the capital budgeting approach, they are
able to make effective capital budgeting decisions.

1.2. Basic Terminologies in Capital Budgeting

1. The initial investment. The initial investment is an outlay of cash that takes place at the
beginning of the life of the project.
2. The operating cash flows. The operating cash inflows from revenue sources and the cash
out flows for different expenditures.
3. The terminal cash flows. These are the cash inflows and out flows that take place at the
end of the project life.
4. Gross investment. The gross investment of a project or asset is its purchase price and
other incidental costs. Gross investment the base for depreciation of the entire project
alternatives.
5. Investment tax Credit. It is an incentive that might be granted by the government in order
to encourage investment. It is a reduction allowed by the government to reduce tax
liabilities by a stated fraction of the new capital investment the company has made in a
given year. For instance, assume that a firm is considering a project that entails the
purchase of new equipment for Br. 500,000 with an expected duration of 10 years. If the
asset acquisition qualifies for tax credit of 10 percent, the investment tax credit is Br.
50,000 (i.e. 500,000 x 10% = 50,000 birr).
6. Net Working Capital Increases: Investment in new long-term asset may increase the
amount of net working capital if the project is the revenue expansion investment. Cost
reduction investment will not affect the amount of net working capital required. Increase in
the amount of net working capital is added to the gross investment while determining the
amount of initial investment.
7. Opportunity Costs: Opportunity cost is the highest return that will not be earned if the
funds are invested in a particular project type. In other words, opportunity cost is the
income generated by the alternative use of an asset that is forgone when a new project is
adopted. The relevant opportunity costs associated with an investment proposal should be
included in the initial investment.
8. Tax Increase or Shield: The tax both ordinary income tax and capital gain tax will be
added to the original costs of long-term assets in order to determine the initial investment.
In the case of replacement projects, if the old assets (i.e. assets to be replaced) are sold at
amounts less than their book values, there will be losses on sales of these assets. The
ordinary income tax rate is applied to these loss amounts to determine the amount of tax
shield which will be deducted from the original cost of new fixed assets to determine the
amount of the initial investment.
9. Salvage Proceed of the Old Asset: If the project is involves the replacement of the old
fixed assets with the new ones, the proceeds from the sale of the old assets should deducted
from the gross investment to be made in the new assets to determined the amount of the
initial investment.
10. Terminal Cash Flows
The terminal cash flows are those cash flows associated with end of the project. These are:
1. The salvage proceeds from the sale of assets, net of the relevant income taxes when the
project is completed.
2. The recovery of net working capital at the end of the projects life. An increase in the net
working capital during the time of investment is expected to be recovered when the project
terminates. The recovery of net working capital is tax-free because this amount is neither an
ordinary gain nor a capital gain. Rather it is the recovery of the funds placed in the project
for the day to day operation of the project when the project comes to an end.

Therefore, the net cash flows from the project during the final year of the project's life comprise
of the operating cash flows, the proceeds from the sale of the used assets, and the recovery of net
working capital.

1.3. Capital Budgeting Techniques

This topic is concerned with the ranking of projects for the decision of whether or not they
should be accepted for inclusion in the capital budget. It is assumed that projects to be covered
in this topic are equally risky. All cash flows are assumed to occurs at the end of the designated
year. Generally, the project evaluation techniques are classified into two categories. These are:

1. Non-Discounted cash flow technique: They are called the traditional techniques because
they do not consider the time value the time value of money concepts in ranking investment
proposals. Two methods are included under the traditional technique, namely the payback
period and the accounting rate of return.

a) The payback period: - The payback period is the number of years that is required for the
business firm to recover from the project the amount of the initial investment in total. If
the cash flows from the project are in an annuity form, the payback period can easily be
determined by dividing the initial investment by the annual cash flow in the annuity. That
is,
Payback period (in years) = Initial investment
Annual Cash flows
When the cash flows from the project are not in an annuity, the payback period is computed as
follows:
Unre cov ered Cost
Payback period = year before full recovery + Annual flow during the next year
To illustrate the computation of the payback period when the cash flows from the project is an
annuity form, suppose the project requires an initial investment of Br. 24,000 and the annual
after-tax cash flows of Br. 6,000 for five years. The payback period is, therefore,
Pay back period = 24,000/6000 = 4 years

This is to mean that the initial investment amount of this particular project will be recovered with
in the first four years of the project life (i.e. 6,000 for four years is 24,000).

To illustrate the computation of the payback period when the cash flows from the project are not
in an annuity form assumes the project requires an initial investment of Br. 60,000. The after-tax
cash flows from the project are Br. 8,000 during year 1, Br. 15,000 during year 2, Br. 22,000
during year 3, Br. 20,000 during year 4, and year 5 each. To determine the payback period, we
first need to compute the cumulative cash flows of the project.

Year Annual Cash flow Cumulative cash flow

1 8,000 8,000
2 15,000 23,000
3 22,000 45,000
4 20,000 65,000*
5 20,000 85,000
Looking at the cumulative cash flows, the cumulative cash flows at the end of year 3, which is
45,000, is less than the initial investment where as the cumulative cash flows at the end of year 4
that is 65,000 is slightly greater than the initial investment. This implies that the payback period
for this project is greater than 3 years but less than 4 years. The exact payback period can be
computed as follows:
 Payback period = 3 years + (15,000/20,000) years
= 3 years + 0.75 years = 3.75 years, or
= 3 years + (0.75) (12 months) = 3years and
9months.
As a general rule, the shorter the payback period, the better the project. Thus, the project is
accepted if its payback period is less or equal to the period required by the management of the
business firm. If two projects are mutually exclusive, a project with the shorter payback period
is selected even if both of them fulfill the acceptance criteria. On the other hand, if two project
are independent, both the projects can be accepted as long as their pay back periods are less than
the planned payback period.
Advantages of Payback Period:
The payback period is an easy and an inexpensive method to evaluate and rank project
alternatives

Disadvantage of Payback Period

1. It ignores the cash flows beyond the computed payback period though they are important
for acceptance or rejection decisions.

2. It ignores the time value of money which is an important variable that demands
consideration in evaluating the desirability of a given project.

b) The Accounting Rate of Return (ARR): The accounting rate of return (ARR) is the rate
of return that is calculated by dividing the projects expected annually net profit by the
average investment outlays. The average investment outlays, on the other hand, are
computed by dividing the sum of original cost of the project and the salvage value of return
(ARR) can be expressed with an algebraic equation as follows.

Expect Average Annual Net Pr ofit

ARR = Average Cost of Investment

Original cos ts +Salvage Value

Average cost of Investment = 2
To illustrate consider the project that has the original investment of Br. 70,000, the life of 4
years, and the salvage value of Br. 6,000 at the end of year 4. The straight line method of
depreciation is used. Income before depreciation and taxes are Br. 40,000 for year 1, Br. 42,000
for year 2, Br. 36,000 for year 3, and Br. 50,000 for year 4. Determine the accounting rate of
return if income tax rate on the project is 40 percent.

To compute the accounting rate of return (ARR) for this project, first we have to determine the
average investment and the annual depreciation amount.
Average investment = (70,000 + 6000)/2 = Br. 38,000
Annual depreciation = (70,000 - 6,000)/4 = Br. 16,000

Then compute the new profit for each year during the four years.
Year 1 Year 2 Year 3 Year 4
Income before depr. & taxes 40,000 42,000 36,000 50,000
Less: Annual depreciation 16,000 16,000 16,000 16,000
Income before taxes 24,000 26,000 20,000 34,000
Less: Income taxes (40%) 9,600 10,400 8,000 13,600
Net Income 14,400 15,600 12,000 20,400
Then we compute the average Net Profit during the four years.
That is:
Average net profit = (14,400 + 15,600 + 12,000 + 20,400)/4
= 15,600 Birr
Hence, ARR = Average Annual net profit = 15,600 = 0.41 or 41%.
Average cost of investment 38,000

This is to mean that for an average of 1 Birr invested in this project, there is an average return of
41 cents in the form of net profit per year over the entire four years of the life of the project.

The accounting rate of return method of project evaluation, like the payback period method,
ignores the timing of cash flows or the time value of money. Moreover, the accounting rate of
return ignores the fluctuations of the cash flows over the life of the life of the project as it
assumes an average cash flows every during the project's life.

2. The Discounted Cash flow (DCF) Techniques: The discounted cash flow techniques are
other methods of evaluating and ranking investment project proposals. These techniques
employ the time value of money concept
a) The discounted Payback period
The discounted payback period is defined as the number of years that is required to recover the
amount of money invested in a project at the beginning after discounting the future cash flows to
their present values. Discounted payback period is computed in the same manner as that of the
regular payback period except the discounted cash flows are used in the case of discounted
payback period. The expected future cash flows are discounted by the project's cost of capital.
To illustrate suppose that a given capital budgeting alternative is expected to have an initial
investment of Br. 30,000 and the life of 5 years. The after-tax cash flows from the project during
years 1, 2, 3, 4 and 5 are Br. 15,000, 18,000, 12,000, 20,000, and 22,000 respectively. The cost
of capital (the required rate of return) is 10 percent. What is the discounted payback period for
this project?
To answer this question, first we have to compute the discounted cash flows and the cumulative
cash flows for each year. Hence, the discounted cash flows and the cumulative cash flows year
by year are show as follows.
Year Cash flows Discount Factor Present Value Cumulative CF
1 15,000 0.9091 13,636 13,636
2 18,000 0.8265 14,877 28,513
3 12,000 0.7513 9,016 37,529
4 20,000 0.6830 13,660 51,189
5 22,000 0.6209 13,660 64,849
As you can see from the cumulative discounted cash flows the discounted payback period for
project is between 2 and 3 years. The exact payback period (discounted) can be computed as:
Discounted Payback period = 2 years + (1,487/9,016) years
= 2 years + 0.16 years = 2.16 years
= or 2 years + (0.16) (12 months)
 = 2 years and 2 months.
It requires the project a period of 2 years and 2 months to recover its initial net investment taking
the time value of money into account.
b) The Net Present Value (NPV) Method
The net present value (NPV) method is an investment project proposal evaluating and ranking
method using the net present value, which is the difference between the present values of future
cash inflows and the present value of cash outflows, discounted at the given cost of capital, or
opportunity cost of capital.

In order to use this method properly, the following procedures are followed.
1. Find the present value of each cash flow, including both inflows and out flows
2. Sum the discounted cash inflows and the discounted cash outflows separately.
3. Obtain the difference between the cash inflows and the sum of the cash outflows.

Decision Rule for the Net Present Value (NPV) Method: f the projects are independent, the
projects with positive net present values are the ones whose implementation maximizes the
wealth of shareholders. Hence, such projects should be accepted for implementation. If the
projects, on the other hand, are mutually exclusive, the one with the higher positive NPV should
be accepted leading to the rejection of the projects with lower positive NPV. Projects with
negative NPV should not be considered for acceptance in the first place.
To illustrate assume that a given project is expect to have an initial investment of Br. 40,000
and project life of 5 years. The annual after-tax cash flow is estimated at Br. 12,000 for each one
of the five years. Using the required rate of return of 10 percent, What is the net present value
(NPV) of the project? How do you judge the acceptability of this project?

In order answer these question, it is wise to identify the cash inflows and outflows. In the case of
this project, there are annuity cash inflows of 12,000 every year for five years and a single cash
out flow of 40,000 at time zero.
The present value of the annuity cash inflows is:
Present value of annuity = (12,000) )(Annuity factor)
The annuity factor given the period of 5 years and discount rate of 10 percent is 3.791
substituting the factor I the equation above
PVA = (12,000) (3.791) = Br. 45,492
Or Present Value of Annuity is:

PVA = Annual Cashinflow X

( i )
1−(1+i )−n
=
12,000 X

( 1−(1 .1)−5
0.1 )
= 12,000 x 3 .791=Br . 45,492

Present Value of Cash out flows = Br. 40,000

Hence,
The Net Present value (NPV) = Present Value of inflows less present value of outflows
= 45,492 - 40,000 = Br. 5,492

Since the project makes the net present value (NPV) of positive Br. 5,492, it should be accepted.

To further illustrate the NPV method, consider the following mutually exclusive project
alternatives, together with their cash flows.

Alternative Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

A (80,000) 20,000 25,000 25,000 30,000 20,000
B (100,000) 25,000 20,000 30,000 35,000 40,000

The required rate of return on both projects is 12 percent. Then, evaluate these projects using the
net present value method.
The evaluation of these two projects requires the computation of the net preset values for both
projects. The net present value (NPV) for project A is:

Year Cash flows Discount Factor (12%) Present Values

1 20,000 0.893 17,860
2 25,000 0.797 19,925
 3 25,000 0.712 17,800
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Present values of cash inflows (sum) 86,005
Present values of cash outflows 80,000
Net Present Value (NPV) Br, 6,005
The net present value (NPV) for project B is:
Year Cash flows Discount Factor (12%) Present Values
1 25,000 0.893 22,325
2 20,000 0.797 15,940
3 30,000 0.712 21,360
4 35,000 0.636 22,260
5 40,000 0.567 22,680
Present values of cash inflows (sum) 104,565
Present values of cash outflows 100,000
Net Present Value (NPV) Br. 4,565

Since the two projects are mutually exclusive, the one with the higher NPV has to be accepted.
Thus, project A is selected as its NPV is higher than that of project B.

c) The Internal Rate of Return (IRR)

The internal rate of return is the discount rate which equates the present value of the expected
cash flows with the initial investment outlays. In other words, IRR is a method of ranking
investment project proposals using the rate of return on an asset (investment). At IRR, the sum
of the present values of all cash inflows is equal to the sum of the present values of all cash
outflows. That is:
PV (cash inflows) = PV (cash outflows). Hence, the net present value of any project at a
discount rate that is equal to the IRR is zero.

Computing the Internal Rate of Return

1. Uniform Cash Inflows over the Life of the Project:
In this case, the present value table of an annuity can be used to calculate the IRR since the cash
inflows are in annuity form. The following steps can be followed to calculate IRR for constant
cash inflows.
Step 1: Find the critical value of discount factor
Discount factor = Initial investment
Annual Cash inflow

Step 2: Find the IRR by looking along the appropriate line (year) of the present value of
annuity table until the column which contains the critical discount factor (i.e. the discount
factor computed under step 1) is located.

To illustrate assume that a project has a net investment of Br. 20,000 and annual net cash
inflows of Br. 5,200 for five years. What is the IRR of this project? In order to answer this
question, we need to follow the two steps discussed above.

Step 1 Compute the critical discount factor. That is

Discount factor = 20,000 = 3.8462
5,200
Step 2 After determining the critical discount factor, we look for the value that is equal to this
factor in the present value of annuity table across the line corresponding to 5 years (i.e
n).
The discount factor of 3.8897 appears in the 9 percent column and the discount factor of 3.7908
appears in the 10 percent column on the line/row of 5 years.
Therefore, the IRR is between 9 percent and 10 percent. Thus, compute the NPV for each of
these two closest rates:
(NPV@9%) = Br. 5,200 x (3.8897) - 20,000 = 226
(NPV@10%) = Br. 5,200 x (3.7908) - 20,000 = (288)

Then, compute the sum of the absolute values of the NPV's obtained:
The absolute sum of the NPVs = |226| + |-288| = 226 + 288 = 514
Thus,
 Pr esent Value of Smaller rate
IRR = Smaller rate + Absolute Sum of NPV (larger rate - smaller rate)
226
IRR = 9% +514 (10 - 9) = 9% + 0.44 = 9.44% or
Pr esent Value of l arger rate
IRR = Larger rate - Absolute Sum of NPV (larger rate - smaller rate)
288
IRR = 10% - 514 (10 - 9) = 10% - 0.56 = 9.44%

2. Fluctuating Cash Inflow over the Life of the Project

When the cash inflows from the project are not in an annuity form, IRR is calculated through an
iterative process or through "trial and error". It may be difficult to identify from which discount
rate to start. A good first guess can be made by estimating the discount factor.

In general, the following procedures are used to calculate the IRR of the non-uniform net cash
flows.
Step 1:Find the estimated discount factor. In fact, if the fluctuations I the cash inflows
is very large, the estimated discount factor doesn't not help you much in
locating the IRR in the present value of annuity table.
Estimated discount factor = Net investment
Average cash inflows
Step 2:Look at the present value of annuity table to obtain the nearest discount
rate for the estimated discount factor determined in step 1.

Step 3:Calculate the NPV using the discount rate identified in step 2.

Step 4:If the resulting NPV is positive, choose the higher discount rate and repeat the
procedure. Choose the lower discount rate if the NPV is negative, and repeat
the same procedure until you find the discount rate that equates the NPV to
zero.
To illustrate assume a project that has an initial investment of Br. 40,000 and the following net
cash inflows:

Year 1, Br. 15,000; year 2, 10,000; Year 3, 10,000; year 4, 15,000; and year 5, 15,000. What is
the IRR of this project.

In order to estimate the discount factor, you need to give weight to the cash flows over the life
of the project. Larger weights should be given to the cash flows towards the beginning of the life
of the project than to the cash flows that occur towards the end of the project life.

Hence,
Year Weight Cash flow x weight
1 5 75,000
2 4 40,000
3 3 30,000
4 2 30,000
5 1 15,000
15 190,000

Average net cash flow= 190,000 = 12,667

15

Estimated discount factor = 40,000 = 3.158

12,667

By looking up in the present value table for annuity, the approximate the discount factor of 3.158
online 5 (n=5) is 18 percent. Thus, the starting point of the iterative process is 18 percent. The
NPV of the project using the discount rate of 18 percent is:

NPV = (15,000) (0.847) + (10,000) (0.718) + (10,000) (0.609) + (15,000) (0.516) +

(15,000) (0.437) - 40,000 = 40,270 - 40,000 = 270
Since the NPV computed using a discount rate of 18 percent is positive, are have to take a
discount rate higher than 18 percent in search for the NPV of zero. So the second guess can be
19 percent. The NPV of the project using the discount rate of 19 percent is:
NPV = (15,000) (0.840) + (10,000) (0.706) + (10,000) (0.593) + (15,000) (0.499) +
(15,000) (0.419) - 40,000 = 39,260 - 40,000 = -640

As per the above calculations, NPV is negative when the discount rate of 19 percent is used and
positive when the discount rate of 18 percent is used. Thus, the IRR for this project falls
between 18 percent and 19 percent. If the exact IRR is needed, the interpolation method is can
be used. That is:

Step 1: Compute the sum of the absolute values of the NPV's obtained:
The absolute sum of the NPVs = |270| + |-640| = 270 + 640 = 910
Thus,
Pr esent Value of Smaller rate
IRR = Smaller rate + Absolute Sum of NPV (larger rate - smaller rate)
270
IRR = 18% +910 (19 - 18) = 18% + 0.3 = 18.3% or
Pr esent Value of l arger rate
IRR = Larger rate - Absolute Sum of NPV (larger rate - smaller rate)
640
IRR = 19% - 910 (19 - 18) = 19% - 0.7 = 18.3%

The rational for the IRR method is that the IRR on a project is its expected rate of return. If the
IRR of a given investment project exceeds the cost of the funds used for financing the project
(cost of capital), there is the remaining surplus after paying for the capital, and this surplus adds
up on the wealth of the shareholders of the firm. Therefore, selecting the project whose IRR
exceeds its cost of capital increase the share holders' wealth. On the other hand, the project with
the IRR less than the cost of capital imposes an unnecessary cost on current shareholders. The
return from the project will to cover even the cost of capital.
Decision Rules for IRR
A project whose IRR is greater than its cost of capital, or Required Rate of Return (RRR) is
accepted and whose IRR is less than the RRR of the project is rejected.

Profitability Index (PI):

Profitability index is the ratio of the present value of the expected net cash flow of the project
and its initial investment outlay.

Pr esent Value
PI = Initial Investment
Profitability index provides or measure of profitability in a more readily understandable terms. It
simply converts the NPV criterion into a relative measure.

Decision rule:
When BCR Decision rule
>1 Accept
=1 Indifferent
<1 Reject
Illustration:
The project which has a cost of capital of 12%, initial investment and cash flows are given below
Project Year 0 Year 1 Year 2 Year 3 Year 4
A (100,000) 25,000 40,000 40,000 50,000

Then, evaluate these projects using the profitability index.

The present value (PV) for the project is:

Year Cash flows Discount Factor (12%) Present Values
1 25,000 0.893 22,325
2 40,000 0.797 31,880
 3 40,000 0.712 28,480
5 50,000 0.636 31,800
Present values of cash inflows (sum) 114,485
The benefit cost ratio measures for this project are:
114 , 485
=1. 145
PI = 100 , 000
Since the project have a Profitability index of 1.145 which is > 1, it should be accepted.

NPV VS Profitability Index

The NPV and the profitability index criteria reach the same acceptance-rejection decisions for
independent projects. The profitability index is greater than 1 if the net present value of the
project is positive. However, in the case of mutually exclusive projects, NPV and profitability
index will result in different acceptance-rejection decision. One advantage of NPV in this case is
that it reflects the absolute size of alternative investment proposals profitability index does not
reflect difference in investment size. Therefore, the NPV is more appropriate for mutually
exclusive projects than profitability index.
Consider the following two mutually exclusive projects.
Present Value Initial Profitability
of cash inflow Investment NPV Index
Project A 200 100 100 2.0
Project B 3000 2000 1000 1.50

From the above example project A is accepted using profitability index because its PI is greater
than that of project B. However, NPV of project B is greater than that of the NPV of project A.
Thus, even though the profitability index of a project is a very useful tool, it should not be used
as a decision rule when mutually exclusive projects for different size are being considered.

Projects With Unequal Lives

There are many situations in which alternative investments have unequal lives. The most
common example of such situation is unequal replacement decision. Since it is not appropriate
to compare projects of unequal lives, adjustment must be made. Even though there are different
 methods (approaches) of dealing with mutually exclusive alternatives with different lives, three
of them are introduced in this chapter.

1. The Replacement Chain Approach:

Replacement chain, which is called common life approach, is the method of comparing projects
of unequal lives which assumes that each project can be repeated as many times as necessary to
reach a common life span. Then, the NPV or the other method is used to evaluate the project. To
illustrate the comparison of projects with unequal lives consider two mutually exclusive projects
whose cash flows are summarized below. The discount rate for both project is 10 percent.

0 1 2 3 4 5 6
Project A (40,000) 10,000 12,000 15,000 11,000 9,000 11,000
Project B (30,000) 12,000 14,000 13,000 - - -

The two projects are incomparable. Thus, according to replacement chain approach, project B
will be repeated in three years. Assuming that annual cash flows and the discount rates will not
change. Thus, if project B is repeated, its year 4, year 5, and year 6 cash flows are Br. 12,000,
Br. 14,000, and Br. 13,000 respectively. In this way, the two projects have the same life. If
project B is repeated, its cash flows will be:
0 1 2 3 4 5 6
(30,000) 12,000 14,000 13,000 12,000 14,000 13,000

The present value computation of the repeated project B requires a two-step process. These are:

Step 1: you compute the present values at t = 0 and at t = 3 for the repeated project B.
Present value at time zero (t = 0) = (12,000)(0.909) + (14,000)(0.826)+(13,000)(0.751)
= Br. 32,235
Present value at time 3 (t = 3) = (12,000)(0.909) + (14,000)(0.826) + (13,000)(0.751)
= Br. 32,235
Step 2: Discount the present value of the repeated project at time 3 (t=3) to the present value at
time zero (t = 0).
That is, present value of repeated project B at time zero = (32,235)(0.751) = Br. 24,208
Then, add the present value of the first three years cash flows to the present value of the repeated
project after three years. That is:
Total present value = 32,235 + 24,208 = Br. 56,443.
Hence, the NPV of the repeated project B = 56,443 – 30,000 = Br. 26,443
The NPV of project A is calculated as follows.
Year Discount factor Cash flow present value
1 0.909 10,000 9,090
2 0.826 12,000 9,912
3 0.751 15,000 11,265
4 0.683 11,000 7,513
5 0.621 9,000 5,589
6 0.564 11,000 10,204
Present value of cash flows 49,573
Less. Present value of initial investment 40,000
NPV of project A 9,573

Therefore, using the NPV method for project comparison of the two projects, project B should be
selected.

Under the replacement chain approach of comparing projects with unequal lives, the least
common factor of the projects lives is used to find the common useful life. For instance, if the
life of project A is 5 years and that of project B is 3 years, project A is repeated 3 times and
project B is repeated 5 times because the least common factor for the two project lives (i.e 3 and
5) is 15 years.

2. Equivalent Annual Annuity (EAA) Method:

This method enables us to calculate the annual payments a project would provide if it were an
annuity. When comparing projects of unequal lives, the one with higher equivalent annual
annuity should be chosen. Three steps are flowed under this method.
Step 1: Find each project’s NPV over its initial life. The NPV for the above projects are as
follows:
Project A = Br. 9,573 birr (as computed before)
Project B = (12,000) (0.909) + (14,000) (0.826) + (13,000) (0.751) – 30,000
= 32,235 – 30,000 = 2,235 birr

Step 2: Find the equivalent annual annuity that has the same present value as the projects’
NPV.
Equivalent annual annuity can be calculated as follows.
For project A:

NPV = PV of cash flows – PV of initial out lays.

9,573 = PV of cash flows – 40,000
9,573 + 40,000 = PV of cash flows

PV of cash flows = 49,573. By looking up in the present value of annuity table at n = 6 and
i=10%, the discount factor is 4.355.
Thus, PV of cash flows = cash flows x Discount factor
49,573 = (4.355) (x) where x is the equivalent annual annuity.
X = 49,573/4.355 = Br. 11,383
For project B:
NPV = PV of cash flows – PV of initial out lays
2,235 = PV of cash flows – 30,000
PV of cash flows = 2,235 + 30,000 = 32,235

By looking up in the present value of annuity table for the discount factor that corresponds to
n=3 and i=10% is 2.487. Hence
(y) = 32,235/2.487 where y represents the equivalent annual annuity amount for the project.
Solving for y we get.

Y = 32,235/2.487 = Br. 12,961

Thus, PV of cash flows = cash flows x Discount factor
 32,235 = (2.487) (y) where y is the equivalent annual annuity.
Y = 32,235/2.487 = Br. 12,961

Step 3: The project with the higher equivalent annual annuity will always have the higher NPV
when extended out to any common life. Therefore, project B’S equivalent annual
annuity (EAA) is larger than project A’S, project B would be chosen.

3. Abandonment Value Approach

This approach presumes that the larger-lived investment alternative is prematurely terminated at
the end of the life of the shorter project alternative. This presumption requires us to estimate an
abandonment value for long-lived investment at the end of the life of the shorter project
alternative. Assume the above example and the estimated abandonment value of Br. 15,000 for
project A at the end of year 3, which is the end of the life of project B. Then, compute the NPV
for both projects at the required rate of return of 10 percent. Hence,

The NPV for project A if it abandoned at the end of year 3 is:

NPV = (10,000) (0.909) + (12,000) (0.826) + (30,000) (0.751) - (40,000). Here the cash
flow of 30,000 birr considered for year 3 is the sum of the cash flow during the year from project
A (i.e 15,000) and the abandonment value of the project of Br. 15,000.

The NPV for project A = 41,532 – 40,000 = 1,532 birr.

The NPV for project B = (12,000) (0.909) + 914,000) (0.826) + (13,000)
(0.751) – 30,000 = 32,235 – 30,000
= 2,235 birr
According to the above analysis, therefore, project B is better than project A.

Capital Rationing
Capital rational is a situation in which a constraint is placed on the total size of the firm’s capital
budget. Capital ration is said to exist when we have profitable (positive NPV) investments
available but we can’t get the needed fund to undertake all of them. Two main reasons can be
mentioned. One is what is called soft rationing which is the situation that occurs when units are
allocated a certain amount of financing for capital budgeting. Such allocation is primarily a
means of controlling and keeping track of overall spending. Soft rationing doesn’t mean that the
business firm as a whole is not short of capital. The other reason is hard rationing. Hard
rationing is the situation that occurs when a business cannot raising finance or funds for a project
under any circumstances. A business firm with a sound financial status does not face hard
rationing.
1. The timing and magnitude of the cash flows of all projects (all project alternatives) are
known.
2. The cost of capital is known
3. All projects are strictly independent
4. The total investment outlay of all those projects that have a positive NPV exceeds the firm’s
budget constraints.

Taking these assumptions into account, the problem under capital rationing is how to choose a
subset of desirable projects in such a way that total investment does not exceed the budget. In
order to solve this problem, the sound procedures are as follows.

1. Rank all projects with positive NPVS in accordance with their profitability indeed.
2. Select projects from the top of the list (with the highest profitability index) until the fixed
budget is exhausted.

To illustrate suppose that a firm has a fixed capital budget of Br. 600,000 and has the following
investment alternatives.

Project Initial Investment NPV Profitability Index

A 150,000 40,000 1.50
B 190,000 40,000 1.40
C 120,000 70,000 1.80
D 180,000 50,000 1.30
E 330,000 60,000 2.00
The question is that which of these projects should the firm select and implement give the fixed
amount of capital budget indicated above.

To answer this question, first we have to rank these project based on the value of their
profitability index. Hence, their arrangement according to their profitability index is E-C-A-B-
D. Therefore, given the capital budge constraint of Br. 600,000, projects E, C and A are selected.
The initial capital requirements for these projects (i.e. 330,000 + 120,000 + 150,000 = 600,000).
So the total initial investment cost of the three projects is exactly equal to the total capital budget
of the firm. This implies that the rest of the project alternatives cannot be implemented because
of the lack of capital though they are all acceptable ones. The total net present value (NPV) of
the projects that were selected is 60,000 + 70,000 + 40,000 = Br. 170,000.

4.5. Capital Budgeting Under Uncertainty

Up to this point, we have ignored risk in capital budgeting; that is we have discounted expected
cash flows back to their present values and ignored any uncertainty that might surround the
expected cash flows. In reality, the future cash flows associated with the introduction of a new
sales outlet or a new product are estimates of what is expected to happen in the future, not
necessarily what will happen in the future. But, these cash flows discounted to their present
values have only been our best estimate of the expected cash flows.

In this section, we will assume that under conditions of risk we do not know beforehand what
cash flows will actually result from the new project. However, we do have expectations
concerning the outcomes and are able to assign probabilities to these outcomes. Staled in another
way, although we do not know the exact cash flows resulting from the acceptance of a new
project, we can formulate the probability distributions from which the flows will be drawn. Risk,
here, is defined as the potential variability in the future cash flows.

Relevant Risks in Capital Budgeting

In capital budgeting, a project’s risk can be looked at in three levels. First, there is a total project
risk, which is a project’s risk ignoring the fact that much of this risk will be diversified away as
the project is combined with the firm’s other projects and risks. Second, we have the project’s
contribution to firm’s risk, which is the amount of risk that the project contributes to the firm as a
whole; this measure considers the fact that some of the project’s risks will be diversified away as
the project is combined with the firm’s other projects and assets, but ignores the effects of
diversification of the firm’s shareholders. Finally, there is what is known as a systematic risk,
which the risk of the project from the viewpoint of a well diversified shareholder; this measure
considers the fact that some of the project’s risk will be diversified away as the project is
combined with the firm’s other projects, and in addition some of the remaining risk will be
diversified away by shareholders as they combine this stock with other stocks in the portfolio.

Risk, Return and Net Present Value

When a financial manger is considering a set of risky alternatives, one important consideration
involves the choice of the required rate of return. Given the risk aversion nature of mangers, the
required rate of return of each project is the function of its risk. The riskier the project, the
higher the required rate of return.

Selecting the appropriate required rate of return involves subjective judgments. Given the
general patterns of managerial risk aversion, which shows the direct relationship between risk
and return, the following guidelines can be established.

1. The coefficient of variation can be used as the measure of risk per birr of return. As such,
it can be used to rank the riskiness of probability distributions of cash values.
2. The required rate of return can be set to the sum of the risk-free rate plus some additional
return to compensate for risk.

The Risk Adjusted Net Present Value (RANPV)

The risk adjusted net present value (RANPV) service as a capital budgeting decision criterion
under conditions of risk and is defined as the sum of the present values of the expected cash
values discounted at the required rate of return.
The RANPV coefficient that is positive or zero indicates that the project earns at least the risk
adjusted required rate of return and that adopting such a project can increase the value of the firm
and thus the shareholders’ wealth.

When a risky investment is to be evaluated on an accept or reject basis, the RANPV criterion
provides the following decision rule: Accept the risky project if its RANPV is positive or zero;
reject it if the project’s RANPV is negative.

To illustrate how to evaluate a project under a condition of risk (i.e. when the cash flows are not
certainly know rather given probability distributions under different state of the economy)
suppose a risky project that has a life of four years. The estimated risk adjusted rate of return is
10 percent. The initial investment of the project is Br. 29,000.

Year State of Economy Cash flows Probability

1 Boom 12,000 0.20
Average 10,000 0.50
Recession 7,000 0.30
2 Boom 18,000 0.10
Average 15,000 0.50
Recession 13,000 0.40
3 Boom 15,000 0.30
Average 14,000 0.40
Recession 12,000 0.30
4 Boom 19,000 0.30
Average 16,000 0.50
Recession 14,000 0.20

Compute the payback period for this risky project. What is the RANPV of the project? Compute
the IRR of the project. Calculate the profitability index of the project. Before we answer each
one of the questions, let us computed the expected cash flows for each year of the project life as
follows:
Year 1: (12,000) (0.20) + (10,000) (0.50) + (7,000) (0.30) = 9,500 birr
Year 2: (18,000) (0.10) + (15,000) (0.50) + (13,000) (0.40) = 14,500 birr
Year 3: (15,000) (0.30) + (14,000) (0.40) + (12,000) (0.30) = 13,700 birr
Year 4: (19,000) (0.30) + (16,000) (0.50) + (14,000) (0.20) = 16,500 birr

Using these expected cash flows for the project, the payback period can be computed as follows:
Year Expected Cash flows Cumulative cash flows
1 9,500 9,500
2 14,500 24,000
3 13,700 37,700
4 16,500 54,200

The payback period for this project is longer than 2 years and shorter than 3 years because the
initial investment of Br. 29,000 is greater than the cumulative cash flows at the end of year 2 of
Br. 24,000 and less than the cumulative cash flows at the end of year 3. If the expected cash
flows occur uniformly throughout the year, the payback period will be between 2 year and 3
years. The exact payback period is computed as follows.

Payback period = 2 years + Amount of initial investment not paid back

Expected cash flow during year 3
= 2 years + 5,000
13,700
= 2 years + 0.36 = 2.36 years, or
= 2 years + (0.36) (12 months) = 2 years and 4 months

The Risk adjusted Net present value (RANPV) of the project can be computed by using the
expected cash flows determined above. These expected cash flows are discounted at the risk
adjusted discounting rate of 10 percent. The initial investment amount is subtracted from the sum
of the discounted expected cash flows and difference is what is known as the risk adjusted net
present value (RANPV).
RANPV = (9500) (0.909) + (14,500) (0.826) + (13,700) (0.751) + (16,500) (0.683) – 29,000
= 8,635.50 + 11,977 + 10,288.70 + 11,269.50 – 29,000 = 42,170.70 – 29,000
= 13,170.70

The IRR of this project is determined through an iterative process because the expect cash flows
are not in an annuity form. To identify the starting point, we assign a weight, the highest weight
to the cash flows of the first year and the lowest weight to the cash flows of the last year in the
project life.

Year Expected cash flows Weight Expected cash flow X weight

1 9,500 4 38,000
2 14,500 3 43,500
3 13,700 2 27,400
4 16,500 1 16,500
10 125,000
The weighted average cash flows = 125,400/10 =12,540
The estimated discount actor = 29,000
12,540

The estimated discount factor of 2.313 is near to the present value of annuity table value of
2.320, which is found in the 26 percent column in year 4 row. Hence, the first guess is 26
percent.

The RANPV using 26 percent as the risk adjusted discounting factor:

RANPV = (9,500) (0.794) + (14,500) (0.630) + (13,700) (0.500) + (16,500) (0.397) – 29,000
= 7,543 + 9,135 + 6,850 + 6,550.50 – 29,000
= 30,078.50 – 29,000 = Br. 1,078.50
Since the RANPV using a discount rate of 26 percent is a large positive, we have to try larger
discount rates. Second guess. Let us try 29 percent because the NPV corresponding to 26
percent is far from zero.

RANPV (29%) = (9,500) (0.775) + (14,500) (0.601) + (13700) (0.446) + (16,500) (0361) –
29,000
= 7,362.50 + 8,714.50 + (6384.20 + 5956.50 – 29,000 = 28,417.70 – 29,000
= Br. (582.30)

Since the Net present value at a discount rate of 29 percent is negative, the IRR for this project
must be less than 29 percent and greater than 26 percent. Hence, the IRR of this project can be
computed as follows.

Step 1: Compute the sum of the absolute values of the NPV's obtained:
The absolute sum of the NPVs = |1078.5| + |-528.3| = 1,669.8
Thus,
Pr esent Value of Smaller rate
IRR = Smaller rate + Absolute Sum of NPV (larger rate - smaller rate)
1,078.5
IRR = 26% + 1,669.8 (29 - 26) = 26% + 1.93 = 27.93% or
Pr esent Value of l arger rate
IRR = Larger rate - Absolute Sum of NPV (larger rate - smaller rate)
582.3
IRR = 29% - 1,669.8 (29 - 26) = 29% - 1.07 = 27.93%
Certainty Equivalent

1. While appraising projects, future cash flows are estimated using probability measures like
forecasting techniques. These measures do not give a true picture of future events. To
avoid uncertainty, convert expected future cash flows into certain cash flows. Certain
cash flows are cash flows obtained by multiplying uncertain cash flows with a
predetermined base known as certainty-equivalent coefficient. A certainty-equivalent
 coefficient is factor that determines the risk associated with future cash flows. Risky
investments have a low certainty equivalent rating, hence they are avoided. This is
because the probability of netting the estimated cash flows is unlikely.

Advantages of Certainty Equivalent Method

1. The certainty equivalent method is simple and easy to understand and apply.
2. It can easily be calculated for different risk levels applicable to different cash flows.
For example, if in a particular year, a higher risk is associated with the cash flow, it can
be easily adjusted and the NPV can be recalculated accordingly.
Disadvantages of Certainty Equivalent Method
1. There is no objective or mathematical method to estimate certainty equivalents.
Certainty Equivalents are subjective and vary as per each individual’s estimate.
2. Certainty equivalents are decided by the management based on their perception of risk.
However, the risk perception of the shareholders who are the money lenders for the
project is ignored. Hence it is not used often in corporate decision making

Sensitivity Analysis

Sensitivity analysis put in simple terms is a modeling technique which is used in Capital
Budgeting decisions which is used to study the impact of changes in the variables on the
outcome of the project. A project's return on investment is affected by factors such as sales,
investments, tax rate and cost of sales. Sensitivity analysis measures the extent to which the
project's cash flows change in response to changes in one of these factors. The sensitivity
analysis process involves identifying the factors that influence the project's cash flows,
establishing a mathematical relationship between these factors and analyzing how a change in
each of these factors affect the project's cash flows. If a project's cash flows are sensitive to
changes in any of the above-listed factors, it is considered risky and hence avoided.

Steps involved in Sensitivity Analysis

Sensitivity Analysis is conducted by following the steps as below:
1. Finding variables, which have an influence on the NPV (or IRR) of the project
2. Establishing mathematical relationship between the variables.
3. Analysis the effect of the change in each of the variables on the NPV (or IRR) of the project.
Advantages of Sensitivity Analysis:
Following are main advantages of Sensitivity Analysis
1) Critical Issues: This analysis identifies critical factors that impinge on a project’s success or failure.
2) Simplicity: It is a simple technique.
Disadvantage of Sensitivity Analysis:
Following are main disadvantages of Sensitivity Analysis
(1) Assumption of Independence: This analysis assumes that all variables are independent i.e. they are not
related to each other, which is unlikely in real life.
(2) Ignore probability: This analysis does not look to the probability of changes in the variables.
Scenario Analysis
Although sensitivity analysis is probably the most widely used risk analysis technique, it does have
limitations. Therefore, we need to extend sensitivity analysis to deal with the probability distributions of
the inputs. In addition, it would be useful to vary more than one variable at a time so we could see the
combined effects of changes in the variables.
Scenario analysis provides answer to these situations of extensions. This analysis brings in the
probabilities of changes in key variables and also allows us to change more than one variable at a time.
his analysis begins with base case or most likely set of values for the input variables. Then, go for worst
case scenario (low unit sales, low sale price, high variable cost and so on) and best-case scenario.
Alternatively scenarios analysis is possible where some factors are changed positively and some factors
are changed negatively.
So, in a nutshell Scenario analysis examine the risk of investment, to analyse the impact of alternative
combinations of variables, on the project’s NPV (or IRR).

Sensitivity analysis and Scenario analysis both help to understand the impact of the change in input
variable on the outcome of the project. However, there are certain basic differences between the two.
Sensitivity analysis calculates the impact of the change of a single input variable on the outcome of the
project viz., NPV or IRR. The sensitivity analysis thus enables to identify that single critical variable that
can impact the outcome in a huge way and the range of outcomes of the project given the change in the
input variable.
Scenario analysis, on the other hand, is based on a scenario. The scenario may be recession or a boom
wherein depending on the scenario, all input variables change. Scenario Analysis calculates the outcome
of the project considering this scenario where the variables have changed simultaneously. Similarly, the
outcome of the project would also be considered for the normal and recessionary situation.
The variability in the outcome under the three different scenarios would help the management to assess
the risk a project carries. Higher deviation in the outcome can be assessed as higher risk and lower to
medium deviation can be assessed accordingly.
Scenario analysis is far more complex than sensitivity analysis because in scenario analysis all inputs are
changed simultaneously considering the situation in hand while in sensitivity analysis only one input is
changed and others are kept constant.
//
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