CHAPTER 4

INTRODUCTION TO
CAPITAL BUDGETING /
INVESTMENT APPRAISAL
CAPITAL BUDGETING DEFINED:
 Capitalbudgeting is the process of planning,
evaluating and selecting the best from a range of
possible capital investment.

 CapitalInvestment Decision involve the outlay of

cash and other resources in the expectation of
receiving larger sums of cash in the future.

 Theselection of a particular capital investment

should be premise on the most efficient use of
funds in anticipation of expected flow of benefit
over a period of time.
 CAPITAL INVESTMENT DECISIONS
The following are examples of some Capital
investment decisions:

The replacement of Equipment;

The expansion of company activity;
 Undertaking Research and Development;
Introducing new product line;
Construction of office complex, etc.
 CAPITAL INVESTMENT DECISIONS
In Capital Investment Decisions, the
financial manager tries to identify
investment opportunity that are worth more
to the firm than they cost to acquire.

A good capital investment decision requires

the following steps be taken in the decision
making process:
 STEPS IN DECISION MAKING PROCESSES
1) Identification/search for investment
opportunity.

2) Collection of data on the opportunity

identified and determining cash flow.

3) Evaluation of the opportunities.

4) Selection of the best project.

5) Implementing and re-evaluation.

 INVESTMENT APPRAISAL TECHNIQUES
 There are several established ways to evaluate
investment projects, and each can potentially
lead to different investment decisions.
 Among the methods are:
 Payback period
 Discounted payback period
 Average Accounting rate of return (ARR)
 Net Present Value (NPV)
 Profitability Index
 Internal rate of return (IRR)
 PROJECT EVALUATION CRITERIA
The following conventions apply to all investments:
 Cash outflows or expenditures are represented by negative
figures.
 Cash inflows or incomes are represented by positive
figures.
 The timing of cash flows is very important in an
investment appraisal; for convenience, an annual time scale
is used where;
 ‘0’ represents the date of making an investment (i.e.
‘present’ time)
 ‘1’ represents the date one year after the initial
investment. It is the end of the first year in the life of the
investment and also it is the beginning of the second year.
 THREE STEPS IN INVESTMENT EVALUATION

 Estimation of cash flows

 Estimation of the required rate of return (the

opportunity cost of capital.ie WACC).
It is also referred to as the discounted rate.

 Application of a decision rule for making the

choice.
 PAYBACK PERIOD
 This method of investment appraisal looks at the
number of years required to recover the initial cost
of the investment.
 It looks at how long it will take the company to
recoup the amount invested in the project.
 That is, the length of time required for a project's
cumulative net cash inflows to equal its net cash
outflows.
 Payback period is the length of time it takes to
recover the amount invested in a project.
 PAYBACK PERIOD CONT’D
 There are two ways of estimating the payback period.
If the net annual cash inflows expected from the
project are equal, then the payback period is calculated
as;

 PBP = Initial Investment

Annual cash Inflow

Decision Rule
 Accept a project with shorter payback, or

 Accept a project which has a payback period which is

less than the cut-off point.
 PAYBACK PERIOD CONT’D
Advantages
1) It is simple and easy to understand.
2) It is important to the industry which has rapid technological development.
3) It is very ideal under capital rationing situation.
4) It uses cash flows from the project which is not easy to manipulate.
5) It helps to select projects with short payback periods this helps to reduce
business and financial risk.
Disadvantages
1) It ignores time value of money
2) It ignores cash flows after the payback period.
3) Does not measure the profitability of the projects.
4) It is not able to distinguish between mutually exclusive projects with the
same payback period.
5) It may lead to excessive investment in short-term projects.
6) The selection of any cut-off period by an organisation is arbitrary which
does not have any theoretical support.
 PAYBACK PERIOD ILLUSTRATION

Example
Assume that a project requires an outlay of
GH¢50,000 and yields annual cash inflow
of GH¢10,000 for 8 years. The payback
period for the project is:
50,000/10000 = 5 years
Thus, it will take the project 5 years to
recover the initial investment.
 WHERE THERE IS UNEVEN CASHFLOWS

 Ministry for Education is considering two projects with capital outlays of

GH¢ 5million and GH¢ 5.5million. Given below are the projected cash
flows:
Projects
A B
Year GH¢ GH¢

1 590,000 600,000
2 600,000 900,000
3 800,000 1,400,000
4 1,000,000 1,500,000
5 2,110,000 600,000
6 850,000 1,400,000

Advise the ministry as to which project should be selected.

 SOLUTION:
Project A Project B
Yr Annual Inflow Accum. Yr Annual Inflow Accum
GH¢ GH¢ GH¢ GH¢
1 590,000 590,000 1 600,000 600,000
2 600,000 1,190,000 2 900,000 1,500,000
3 800,000 1,990,000 3 1,400,000 2,900,000
4 1,000,000 2,990,000 4 1,500,000 4,400,000
5 2,110,000 5,100,000 5 600,000 5,000,000
6 850,000 5,950,000 6 1,400,000 6,400,000

= 2,010,000 = 500,000
2,110,000 = 0.95 1,400,000 = 0.36
= 4.95years = 5.36years

Hence, the management of the company should select

project A.
 ACCOUNTING RATE OF RETURN (ARR)
 It is the ratio of average annual accounting profit over the
average investment.
 The ARR, like the payback period is a method of estimating the
rate of return for an investment without discounting or
compounding.
 The investment inflows are totalled and the investment costs
subtracted to derive the profit.
 The profit is divided by the number of years invested (to
establish the average annual profit), then by the investment cost
(or average investment cost), to establish an annual rate of
return.
 ARR = Average Accounting Profit × 100

Average Investment
 ACCOUNTING RATE OF RETURN (ARR)
 Note that, the average annual accounting profit here is the net profit before
interest and tax.

 The decision is the higher the rate of returns the better.

Average Accounting Profit = Total Profit after depreciation

No. of years
Average Investment = Initial Investment + Scrap Value
2
Advantages
 It is simple and easy to understand.

 It uses accounting profit which is easy to get them.

Disadvantages
 It ignores the time value of money.

 It does not use cash flows but accounting profit but this is different from
cash flow.
 ILLUSTRATION
 DanielLtd is planning to buy plan at a cost of GH¢
200,000 for 5years with no residual value. The
following are the projected net profit for the 5 years:
Year Net profit
GH¢
1 65,000
2 45,000
3 (15,000)
4 45,000
5 75,000
Required:
Determine the Accounting Rate of Returns.
SOLUTION

Average profit = Total profit

No. of years

Average profit = 65,000 + 45,000 + (15,000) + 45,000 + 75,000

5
= 215,000/5 = GH¢ 43,000

Average Investment = Initial Investment + Residual Value

2
= 200,000 + 0 = GH¢ 100,000
2
 ARR = Average profit × 100 = 43,000× 100
Average Investment 100,000
= 43%
 NET PRESENT VALUE
 The technique involve in evaluating project with NPV is that,
all the project’s cash flows are discounted to a present value,
(i.e. year 0 basis), and then summing these and subtracting
from the initial cost of the investment.

 Appropriate discount rate should be identified to discount the

forecasted cash flows. The appropriate discount rate is the
project’s opportunity cost of capital.

 The decision rule is that accept a project with positive NPV

and reject a project with negative NPV.
 NET PRESENT VALUE CONT’D

 Positive NPV means that the inflows (revenue) from the project
is greater than the outflow (cost) of the project. This implies that,
by accepting such project, the firm will recover the initial cost of
the investment and make extra income.

 Negative NPV means that the inflows (revenue) from the project
is lesser than the outflow (cost) of the project. It implies that, the
inflows from the project will not cover the cost and therefore the
firm will make loss if accept such projects.
 ADVANTAGES OF NET PRESENT VALUE
 This method considers the time value of money.

 This method takes into account all the cash flows from the
project.

 It measures the profitability of projects.

 It can be used to select a mutually exclusive projects if all of

them have positive NPV.

 It considers cash flows from the project which is not easy to

manipulate.

 It is ideal for unconversional cash flows.

 NET PRESENT VALUE CONT’D

NPV decision rule

• Accept the project when NPV is positive NPV > 0

• Reject the project when NPV is negative NPV < 0
• May accept the project when NPV is zero NPV = 0
The NPV method can be used to select between mutually exclusive projects; the one
with the higher NPV should be selected over the project with the lower NPV
ILLUSTRATION
 Example 1
 The estimated cash flow from project A are shown below. Assuming a cost of capital of 10%,
calculate the NPV
YEAR 0 1 2 3 4
CASHFLOW (5000) 1000 2000 3000 2000
ILLUSTRATION 2

 Addo Ltd. is planning to buy a machine with an initial

cost of GH¢ 120,000. The life of the project is 5 years
with nil residual value. The following are the
projected inflows from the project;
Yr Inflow (GH¢)
1 30,000
2 45,000
3 20,000
4 60,000
5 40,000
 The cost of capital of the company is 10%. Advise the
management of the firm.
ILLUSTRATION 3
Osei Ltd. wants to buy a plant to expand its production line.
Experts were consulted at the cost of GH¢25,000 and the following
data was made available:
Initial cost of the plant is GH¢ 150,000 which will be paid for

immediately.
Life of the plant is 4years

Residual value GH¢ 12,000

Projected cash inflows from the project:

Year 1 GH¢ 45,000
Year 2: GH¢ 50,000
Year 3: GH¢ 30,000
Year 4 GH¢ 40,000
The cost of capital of the company is 5%. Advise management.
 SOLUTION 3

Yr. Initial Cost Inflows DF DCF (PV)

GH¢ GH¢ GH¢
0 (150,000) 1.000 (150,000)
1 45,000 0.952 42,840
2 50,000 0.907 45,350
3 30,000 0.864 25,920
4 52,000 0.823 42,796
NPV 6,906
Advise: The project is viable and therefore the management should carry it on.The company will
cover its initial capital and get extra cash of GH¢6,906.
 PROFITABILITY INDEX
 It is a criteria for selecting a project, when
two or more projects are mutually exclusive
and each of them has a positive NPV.
 Profitability index is used to select a project
with higher profitability ratio. Profitability
index is also known as Benefit/Cost ratio.
 It is the present value of cash inflows divided
by the investment. It can also be defined as
the ratio of present value of the project cash
inflows to the cost of the investment.
 PROFITABILITY INDEX CONT’D

Profitability Index = Present Value of future cash flows

Value of initial capital invested
The decision rule is to accept a project with
profitability index (PI) greater than 1 (i.e PI >
1);
and reject Project with PI less than 1

(i.e PI < 1)

Noticethat if the PI is more than 1.0, the NPV

must be greater than zero.
 DISCOUNTED PAYBACK PERIOD
 The discounted payback period is the number
of periods taken in recovering the investment
outlay on the present value basis.
 It is a version of payback method but this time,
it takes into account time value of money.
 However, the discounted payback period still
fails to consider the cash flows occurring after
the payback period.
 EXAMPLE ON DISCOUNTED PAYBACK PERIOD
 Da-Costa Ltd is planning to invest in any one of the following two
projects. Advise the management of the company using Discounted
Payback Period.

Project A B
Initial Cost (GH¢) 85,000 96,000
Annual inflows:
Year 1 20,000 30,000
2 30,000 35,000
3 40,000 40,000
4 60,000 80,000

5 20,000 45,000

 The company's cost of capital is 20%

 INTERNAL RATE OF RETURN (IRR)
 A project’s
IRR is equal to the discount rate that
produces a zero NPV.

 Tocalculate a project’s Internal Rate of Return

(IRR) we simply find at what discount rate the
project’s NPV becomes zero.

 That discount rate is said to be the project’s IRR.

 INTERNAL RATE OF RETURN (IRR) CONT’D

 Having calculated the two NPVs, the IRR can

be estimated as follows:

IRR = R1 + NPV1 x (R2 - R1)

NPV1 - NPV2

Where; R1 is the initial cost of capital

R2 is the subsequent cost of capital
 END OF
CHAPTER