Uganda Management Institute DHRM-

MBL

INVESTMENT DECISIONS/PROJECT SELECTION/CAPITAL BUDGETING

The term capital budgeting or investment decision means planning for

capital assets. Capital budgeting decision means the decision as to
whether or not to invest in long-term projects such as setting up of a
factory or installing a machinery or creating additional capacities to
manufacture a part which at present may be purchased from outside and
so on. It includes the financial analysis of the various proposals regarding
capital expenditure to evaluate their impact on the financial condition of
the company for the purpose to choose the best out of the various
alternatives.

According to Milton “Capital budgeting involves planning of expenditure

for assets and return from them which will be realized in future time
period”.
According to I.M Pandey “Capital budgeting refers to the total process of
generating, evaluating, selecting, and follow up of capital expenditure
alternative

SIGNIFICANCE OF CAPITAL BUDGETING:

Capital budgeting is also vital to a business because it creates a
structured step by step process that enables a company to:
 Develop and formulate long-term strategic goals – the ability to set long-term goals
is essential to the growth and prosperity of any business. The ability to
appraise/value investment projects via capital budgeting creates a framework for
businesses to plan out future long-term direction.
 Seek out new investment projects – knowing how to evaluate investment projects
gives a business the model to seek and evaluate new projects, an important function
for all businesses as they seek to compete and profit in their industry.
 Estimate and forecast future cash flows – future cash flows are what create value for
businesses overtime. Capital budgeting enables executives to take a potential
project and estimate its future cash flows, which then helps determine if such a
project should be accepted.
 Facilitate the transfer of information – from the time that a project starts off as an
idea to the time it is accepted or rejected, numerous decisions have to be made at
various levels of authority. The capital budgeting process facilitates the transfer of
information to the appropriate decision makers within a company.
 Monitoring and Control of Expenditures – by definition a budget carefully identifies
the necessary expenditures of R&D required for an investment project.
 Creation of Decision – when a capital budgeting process is in place, a company is
then able to create a set of decision rules that can categorize which projects are
 Uganda Management Institute DHRM-
MBL

acceptable and which projects are unacceptable. The result is a more efficiently run
business that is better equipped to quickly ascertain whether or not to proceed
further with a project or shut it down early in the process, thereby saving a company
both time and money

CAPITAL BUDGETING PROCESS

➢ Project identification and generation: The first step towards capital
budgeting is to generate a proposal for investments. There could be
various reasons for taking up investments in a business. It could be
addition of a new product line or expanding the existing one. It
could be a proposal to either increase the production or reduce the
costs of outputs.
➢ Project Screening and Evaluation: This step mainly involves
selecting all correct criteria to judge the desirability of a proposal.
This has to match the objective of the firm to maximize its market
value. The tool of time value of money comes handy in this step.
➢ Project Selection: There is no such defined method for the selection
of a proposal for investments as different businesses have different
requirements. That is why, the approval of an investment proposal
is done based on the selection criteria and screening process which
is defined for every firm keeping in mind the objectives of the
investment being undertaken.
 Implementation: Money is spent and thus proposal is implemented.
The different responsibilities like implementing the proposals,
completion of the project within the requisite time period and
reduction of cost are allotted. The management then takes up the
task of monitoring and containing the implementation of the
proposals.
➢ Performance review: The final stage of capital budgeting
involves comparison of actual results with the standard ones. The
unfavourable results are identified and removing the various
difficulties of the projects helps for future selection and execution of
the proposals.

CLASSIFICATION OF INVESTMENT PROJECTS

Investment Projects can be any of the following:
(i) Replacement Investment Projects
(ii) Expansion Investment Projects
(iii) New Product Line Investment Projects
(iv) Research and Development Investment Projects;
(v) Regulatory Investment Projects;
 Uganda Management Institute DHRM-
MBL

(vi) Social Responsibility Investment Projects.

TECHNIQUES OF PROJECT SELECTION

These are tools for analysing project data with the aim of reaching a
decision as to which investment project should be undertaken or not
undertaken. Investment Appraisal involves analysis of the risks,
cash flows and cost of capital associated with a project to enable
making a decision as to whether the project can be undertaken or
not.
Investment Appraisal is done with the help of a number of
techniques. The following techniques are normally used in
investment appraisal:
(i) The Pay Back Period;
(ii) The Accounting Rate of Return;
(iii) Net Present Value;
(iv) Profitability Index;
(v) Internal Rate of Return; and
(vi) Modified Internal Rate of Return.
The first two techniques are known as Non-discounted Cash Flow
Techniques and the last two are known as Discounted Cash Flow
Techniques.
The Pay Back period
Any rational investor before sinking large sums of money in a
project would want to know how long it will take to recover the
money from such a project. The period within which the cash
inflows from a project equal to the cash outflows of the
project is what is known as the Pay Back period.
The decision rule
When using this technique:
 The shorter the pay-back period the better the project;
 When evaluating more than one project, the project with the
shortest pay-back period is preferred over the one with a
longer one.
Disadvantages of the technique
This technique suffers from the following limitations:
 It does not take into account the time value of money. In other
words it assumes that a shilling now is the same as a shilling
tomorrow which is not true in an inflationary economy that we
live in.
 The technique also does not take into account all the cash
flows associated with the project. The technique only
considers the cash flows up-to the pay back point.
 Uganda Management Institute DHRM-
MBL

 Discourages projects which take long but which are very

profitable.
Advantages of the Technique
Despite these limitations, this technique is widely used because:
 It is easy to understand and to compute; and
 It is useful for an investor who has cash limitations and would
want a project that generates cash quickly.
Computation of Pay Back Period – Illustration
Kwani District council is considering the construction of a well
standard and modernized Road to ease the traffic jam in the district.
When the road is completed, it will be a commercial road for heavy
vehicles where the user pays a service fee for using the facility.
Kwani has approached the African Development Bank to fund this
project with a five year loan with a cost of 15% per annum. This
project is expected to cost US $ 100,000,000. When completed, the
road will generate net cash inflows from the user fees as follows:

Year Net cash

inflows in US $
Year 1 20,000,000
Year 2 25,000,000
Year 3 30,000,000
Year 4 50,000,000
Year 5 60,000,000

What is the Pay Back Period of the project?

Computation of the Pay Back Period
Cum
ulati
Y Cas ve
e h Cash
a Inflo inflo
r w w
20,0 20,0
00,0 00,0
1 00 00
25,0 45,0
00,0 00,0
2 00 00
3 30,0 75,0
00,0 00,0
 Uganda Management Institute DHRM-
MBL

00 00
50,0 125,
00,0 000,
4 00 000
60,0 185,
00,0 000,
5 00 000

PBP = 3 years + (25,000,000 X 12)months

50,000,000

= 3 years and 6 months

THE ACCOUNTING RATE OF RETURN

The accounting rate of return (also known as simple rate of
return) is the ratio of estimated accounting profit of a project
to the average investment made in the project.

Formula

Accounting Rate of Return is calculated using the following

formula:
ARR = Average Accounting Profit
Average Investment
Average accounting profit is the arithmetic mean of
accounting income expected to be earned during each year of
the project's life time. Average investment may be calculated
as the sum of the beginning and ending book value of the
project divided by 2. Another variation of ARR formula uses
initial investment instead of average investment.
Decision Rule
Accept the project only if it’s ARR is equal to or greater than
the required accounting rate of return. In case of mutually
exclusive projects, accept the one with highest ARR.
Illustration
 Uganda Management Institute DHRM-
MBL

DPPM International is considering undertaking an investment

that will cost $130,000 as an initial cash outlay. The
investment is expected to generate annual cash inflow of
$32,000 for 6 years. Depreciation is allowed on the straight
line basis. It is estimated that the project will generate scrap
value of $10,000 at end of the 6th year. Calculate its
accounting rate of return assuming that there are no other
expenses on the project

If the company’s Required Rate of \return is 25%, should they

take up the project?

Solution

Computation of ARR:
Annual Depreciation = Cost of the Investment – Scrap
Value
Number of Years the asset will be used
= 130,000 – 10,000
6
= 20,000

Annual Profit = Annual Revenues – Annual

Depreciation
= 32,000 – 20,000
= 12,000.

Average Investment = Invest at the beginning – Invest

at the end
2
= 130,000 – 10,000
2

= 60,000.
ARR = Average Annual Profits X100
Average Investment

= 12,000 X 100
60,000

= 20%
 Uganda Management Institute DHRM-
MBL

Since the ARR of the project is less than the Required Rate of
Return, the project should not be accepted.

Advantages

 Like payback period, this method of investment

appraisal is easy to calculate.
 It recognizes the profitability factor of investment.

Disadvantages
 It ignores time value of money. Suppose, if we use ARR
to compare two projects having equal initial
investments. The project which has higher annual
income in the latter years of its useful life may rank
higher than the one having higher annual income in the
beginning years, even if the present value of the income
generated by the latter project is higher.
 It can be calculated in different ways. Thus there is
problem of consistency.
 It uses accounting income rather than cash flow
information. Thus it is not suitable for projects which
have high maintenance costs because their viability also
depends upon timely cash inflows.

THE NET PRESENT VALUE

A good technique for investment appraisal should have two
very important qualities:
(i) It should recognize that the value of money changes with
time. That is a shilling now is not the same as a shilling
tomorrow; and
(ii) It should take into account all the cash flows associated
with an investment.
The Net Present value Technique satisfies these conditions.
This technique discounts all future cash flows of a project to
their current present values.
Present Value of future cash flow is dependent on two factors:
 The prevailing interest rate(cost of capital) or inflation rate;
and
 The period into the future when the cash flow will be realized.
The present value of a shilling at a given rate of interest and
for a given period in years is given at the end of this Unit.
 Uganda Management Institute DHRM-
MBL

Readers are advised to learn how to use this Table for

evaluating projects.
Net Present Value is the difference between the value of the
initial cash outlay on a project and the present value of the
future cash flows associated with the project.
When using this technique, the decision rule is as follows:
 For a project to be undertaken, the NPV must be greater
than zero. If the NPV of a project is less than zero, the
project is not viable.
 When we have more than one investment project, the
one with a higher positive NPV is preferred to the one
with a lower positive NPV.
Illustration
Kampala Capital City Authority (KCCA) is considering the
construction of Southern Bypass to ease the traffic jam in the
city. When the Bypass is completed it will be a commercial
express highway where the user pays a service fee for using
the facility.
KCCA has approached the African Development Bank to fund
this project with a five year loan with a cost of 15% per
annum. This project is expected to cost US $ 100,000,000.
When completed, the Bypass will generate net cash inflows
from the user fees as follows:

Net cash
Yea
inflows in US
r
$
Year
1 20,000,000
Year
2 25,000,000
Year
3 30,000,000
Year
4 50,000,000
Year
5 60,000,000

Compute the Net Present Value of the Project and advise the
Authority wheter to take up the project or not.
Y Cashflo DF(1 PV
e
 Uganda Management Institute DHRM-
MBL

ar w 5%)
- -
100,000 1.00 100,000
0 ,000 0 ,000
20,000, 0.87 17,400,
1 000 0 000
25,000, 0.75 18,900,
2 000 6 000
30,000, 0.65 19,740,
3 000 8 000
50,000, 0.57 28,600,
4 000 2 000
60,000, 0.49 29,820,
5 000 7 000
14,460
NPV = ,000
COMPUTATION OF NPV
Since the NPV is positive, the project is viable and therefore
the Authority can go ahead and implement it.
Advantages of NPV Technique
 It takes into account the time value of money;
 It considers all cash-flows associated with a project
Disadvantages of NPV Technique
 Difficult to use;
 Does not take into account the size of the project

Profitability Index
NPV Technique is a good method of investment appraisal as it
addresses the major weaknesses of the non-discounted cash flow
techniques. This technique, however, does not take into account the
amount of resources invested in a project. A project can give a high
NPV simply because large resources have been put in it. The
profitability per unit of money put in a project is also important in
determining the overall profitability of a project.
Suppose we have two projects with the following details:
Bbbbbbbb PROJECT PROJECT
l A B
Initial Investment Cost in
US $ 100,000 300,000
Net Present Value in US $ 10,000 15,000
 Uganda Management Institute DHRM-
MBL

According to the NPV technique, the higher the NPV the better the
project. For that matter Project B would be taken because it has a
higher NPV. However if we computed the profitability of every unit
of money put in each of these projects, the decision may change.
This analysis of profitability is done with the help of Profitability
Index.
Profitability Index = NPV X 100
Cost of the Investment

Evaluating the Projects A and B above using this technique, we find

that Project A has a Profitability Index of 10% whereas Project B has
a Profitability Index of only 5%.

The technique that addresses the profitability per unit of funds put
in a project is the Profitability Index.
Profitability Index is given by:
PI = NPV/Initial Investment.
Decision Rule:
The higher the Profitability Index the better the project.

The Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is the interest rate at which the net
present value of all the cash flows (both positive and negative)
from a project or investment equal zero. It is the rate of interest or
the discount rate that equates the present values of the cash
outflows of a project to the present values of the cash inflows of
the project.

Decision rule:
If the IRR of a new project exceeds a company’s required rate of
return or the cost of capital, that project is desirable. If IRR falls
below the required rate of return (cost of capital) the project should
be rejected.

Computation of IRR
 Uganda Management Institute DHRM-
MBL

IRR can be determined by mathematical trial-and-error method and

either using graphical method or application of a mathematical
formula

Using trial and error method and a mathematical formula, IRR is

given by:

IRR = A + C (B-A)
C-D

Where, A is the discount rate that gives a lower NPV;

B is the discount rate that gives a higher NPV;
C is the lower NPV; and
D is the higher NPV
To use this formula, assume any discount rate (interest rate)
and compute the NPV of the Project. Assume another discount
rate (interest rate and compute another NPV of the same
project. These are called trials.
If the first trial gives you a positive NPV, ensure that the
second trial gives you a negative NPV and vice versa. This is
because we are looking for a discount rate that will give us
zero NPV. This discount rate should lie in between the the two
discount rates assume above. When this is done substitute the
values in the above formula and get the IRR.
We demonstrate this with the example below:
Kampala Capital City Authority (KCCA) is considering the
construction of Southern Bypass to ease the traffic jam in the
city. When the Bypass is completed it will be a commercial
express highway where the user pays a service fee for using
the facility.
KCCA has approached the African Development Bank to fund
this project with a five year loan with a cost of 15% per
annum. This project is expected to cost US $ 100,000,000.
When completed, the Bypass will generate net cash inflows
from the user fees as follows:
 Uganda Management Institute DHRM-
MBL

Net cash inflows in

Year
US $

Year 1 20,000,000
Year 2 25,000,000
Year 3 30,000,000
Year 4 50,000,000
Year 5 60,000,000

Compute the IRR of the Project and advise the Authority

whether to take up the project or not.

Y
e
a Cashflo DF(1
r w 5%) PV
- -
100,000, 100,000,
0 000 1.000 000
20,000,0 17,400,0
1 00 0.870 00
25,000,0 18,900,0
2 00 0.756 00
30,000,0 19,740,0
3 00 0.658 00
50,000,0 28,600,0
4 00 0.572 00
60,000,0 29,820,0
5 00 0.497 00
14,460,
NPV = 000
TRIAL 1
 Uganda Management Institute DHRM-
MBL

TRIAL 2
DF(20
Year Cashflow %) PV
- -
100,000,00 100,000,00
0 0 1.000 0
1 20,000,000 0.833 16,660,000
2 25,000,000 0.694 17,350,000
3 30,000,000 0.579 17,370,000
4 50,000,000 0.482 24,100,000
5 60,000,000 0.402 24,120,000
NPV = -400,000

Here we have:

A = 20% or 0.2
B = 15% or 0.15
C = -400,000; and
D = 14,460,000.

Substituting this in the formula:

IRR = A + C (B-A)
C-D

= 0.2 + -400,000 (0.15 - 0.2)

-400,000 – 14,460,000

= 0.2 + 400,000 (-0.05)

14,860,000

= 0.2 - 0.0013

= 19.87%
 Uganda Management Institute DHRM-
MBL

They should invest in the project since the IRR (19.87%) is greater
than the cost of capital (15%)

PRACTICE QUESTIONS
Question
(a) Briefly discuss the process of capital investment projects

(b) Nagongera Millers Limited is considering the purchase of a

modern maize milling machine from China that will cost them
US 150,000 inclusive of insurance, transport and installation.

When the machine is purchased, it will generate net cash

inflows as follows:
US $ US $
Year 1 25,000 Year 5 25,000
Year 2 30,000 Year 6 20,000
Year 3 30,000 Year 7 20,000
Year 4 25,000

The funds to be used to purchase the machine will be

accessed from the Uganda Development Bank at annual
interest of 10%.

Required:
(i) Using the Net Present Value technique advise the
company management accordingly.
(ii) Using the Internal Rate of Return and advise the company
management accordingly.