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FINANCIAL MANAGEMENT:
Chapter 3: CAPITAL BUDGETING DECISIONS
Dr Jonas BARAYANDEMA
Mr Uziel HATEGEKIMANA
Mr Jean Claude NDIBWIRENDE
Mr Ferdinand HABIMANA

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References
1
...
(2015)
...
Vikas Publication House
Pvt Ltd, 11th Edition
2
...
(2010)
...
Vikas Publication House
Pvt Ltd, 10th Edition
...
Chandra, P
...
Financial Management : Theories and Practice
...

4
...
(2013)
...

Cengage Learning
...
Ross, S
...
, Westerfried, R
...
, Jordan, B
...
, Lim, J
...
(2012)
...
McGraw Hill
...
Meggison, W
...
, Smart, S
...
, & Lucery, B
...
(2010)
...
Cengage Learning EMEA
...
Ross, Westerfried, Jaffe, & Jordan
...
Core Principles and
Applications of Corporate Finance
...

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Learning Outcomes
At the completion of this topic, students should be able to:
• Explain why capital budgeting decision is important
• Apply the capital budgeting decision techniques
• Determine the payback period for an investment proposal
• Compute the NPV, IRR, PI and ARR and formulate
recommendations
• Critically analyse advantages and disadvantages of any capital
budgeting decision approach

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...

• Capital budgeting can be defined as the process
of analyzing, evaluating, and deciding whether
resources should be allocated to a project or not
...


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...

• Any firm that does not follow the capital budgeting process
will not be maximizing shareholder wealth and
management will not be acting in the best interests of
shareholders
...
Why Capital Budgeting is so Important? (Cont’d):
•
•
•
•
•
•

Capital budgeting decisions could be grouped into:
Replacement decisions
Decisions on expenditure for increasing the present operating
level or expansion through improved network of distribution
...

Decisions on penetrating into new geographical area
...

Decisions on
investment to build township
for
providing residential accommodation to employees working in a
manufacturing plant
...
Factors to consider while assessing investment projects
1
...


3
...


5
...


7
...

Estimated life of project: Information regarding the estimated life of the project and
the estimated scrap value of the project at the end of its useful life must also be
known
...

Estimated residual value of project at the end of its life if applicable: Appraisers seek
to know the residual value of the project as it affects the current valuation based on
NPV and also the decision of investment
...

Taxation implications on project: Tax forming a major porting of corporate cash
outflows need to be considered in detail
...

Inflation rates and effect on project: Projects with long gestation periods need to be
very carefully analyzed
...


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...
The
relevant information sought in this decision is in the form of
cash outflows and inflows
...

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The initial outlay
corresponds to what is known as capital expenditure
...
Steps involved in evaluation of investment(Cont’d):
It should be noted that sunk costs, which represent costs incurred in
the assessment of the feasibility of the project but have no direct
relationship to the underlying value of the investment should be
ignored
...
Steps involved in evaluation of investment(Cont’d):
Example:
A company is considering modernizing its plant
...

Clearing charges are estimated to $2 million
...
This is
expected to increase to $3
...

The new equipment will be housed in an extension building provided by local
investment council (LIC) at no cost in appreciation of the company’s efforts to
improve the welfare of the area
...
What is the final initial outlay on the proposed equipment?
Answer:
Invoice value of equipment
40
Add: Transport &Carriage :
8
Clearing charges:
2
Increase in WC:
1
...
5
56
...
Steps involved in evaluation of investment(Cont’d):
 Cash inflows: These are the returns expected from the
investment
...

Cash inflows from operations: These are either an increase of
revenue or a decrease of the costs as a results of undertaking the
investment
...
The most notable of these
expenses is depreciation
...
Therefore, it is
regarded as a boost to inflow, which should be added back to the
cash inflows after tax
...
Steps involved in evaluation of investment(Cont’d):
There are two types of cash inflows expected on an investment
project:
a) Intermediate cash inflows
These are cash inflows expected from period 1 up to
period (N-1) of the useful life of the asset
...

To derive the cash flows therefore requires construction
of a projected income statement over the intermediate
period under review
...
Steps involved in evaluation of investments(Cont’d)
PERIOD

1

2

3

4

Revenues

xxx

xxx

xxx

xxx

Cost savings

xxx

xxx

xxx

xxx

Total projected benefits

xxx

xxx

xxx

xxx

Salaries & wages

xxx

xxx

xxx

xxx

Utilities

xxx

xxx

xxx

xxx

Selling expenses

xxx

xxx

xxx

xxx

Depreciation

xxx

xxx

xxx

xxx

Others

xxx

xxx

xxx

xxx

EBT

xxx

xxx

xxx

xxx

Less Tax

xxx

xxx

xxx

xxx

EAT

xxx

xxx

xxx

xxx

Add back depreciation

xxx

xxx

xxx

Xxx

CASH FLOW FOR THE PERIOD

xxx

xxx

xxx

xxx

LESS OPERATING COSTS

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...
The terminal cash flows differ from
intermediate ones with respect to the expected net realizable
value from disposal of the assets in its final year of use
...

• Referring to the earlier example, the form would be adjusted as
follows:

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...
Steps involved in evaluation of investments(Cont’d)
Illustration: A company buys a machine for $500,000 and
depreciates it on a straight line basis over a five year period
for tax purposes
...
At the
end of the five years, it was estimated that the machine
would be sold for $75,000
...

Required:
• Is the investment in the machine attractive in economic
terms, given all of the cashflows? Assume that the cashflows
occur at the end of each year, that the tax rate is 40%, and
that the appropriate discount rate is 8%
...

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...
Techniques of Capital Budgeting Analysis:

•
•
•
•
•

Payback Period Approach
Net Present Value Approach
Internal Rate of Return
Profitability Index
Accounting Rate of Return

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...

• A technique is considered consistent with wealth
maximization if
–
–
–
–
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It is based on cash flows
Considers all the cash flows
Considers time value of money
Is unbiased in selecting projects
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...
)

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“Accept all projects with payback of less than 5 years and reject all
others”
(1) Merits of Pay-back method
The following are the important merits of the pay-back method:
 It is easy to calculate and simple to understand
...

 Pay-back method reduces the possibility of loss on account of obsolescence
...

 It ignores all cash inflows after the pay-back period
...


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...


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The PBP decision rule is:

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If PBP < P*

 Accept project

If PBP = P*

 Indifference

If PBP > P*

 Reject project

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...

Their expected cash flow streams are as follows:
Year
0
1
2
3
4
5
6
7
8
9
10
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Proposal X
(in 000)
(500)
145
145
145
145
145
145

Proposal y
(in 000)
(700)
100
110
130
150
160
150
120
120
110
100

The company employs the risk adjusted
discount method to evaluate risky projects
and selects the appropriate required rate of
return as follows:
Pay back
Period
Less than 1
year
1 to 5 years
5 to 10 years
Over 10 years

Required rate
of return (%)
8
10
12
15

Which proposal should be acceptable to
the company?
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• If NPV is negative (if present value of costs exceeds
present value of benefits), then project is rejected
...
2 Net Present Value(Cont’d)
The meaning of NPV:
• Suppose, in an investment problem, we calculate the NPV of certain
cash flows at 12% to be:
-$97, and at 10% to be zero, and yet at 8% the NPV of the same
cash flows is +$108
...
e
...
e
...
e
...

• In other words, a positive NPV is an indication of the surplus funds
available to the investor now as a result of accepting the project
...
2 Net Present Value(Cont’d)
• Between two mutually exclusive projects, choose project with
highest net present value
...
1: Consider Project A and Project B and 12% discount rate
PVBa = ($50,000)(0
...
797) + ($110,000)(0
...
893) + ($5,000)(0
...
712)
PVBb = $96,820
Investment cost: $100,000

NPVa = $162,000 – $100,000 = $62,800
NPVb = $96,820 – $100,000 = ($3,180)

– Project A is superior to Project B because PVBa >
Investment cost and PVBb < Investment cost
– Return on Project B is insufficient to justify investment
given firm’s cost of capital
...
2 Net Present Value(Cont’d):
Selection of a Discount Rate
• To find discounted present value of sum of
money to be received in future, choose rate at
which money in hand may be invested
between now and future period in which
money is to be received
...


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...
2 Net Present Value(Cont’d):
Advantages and disadvantages of using NPV
a) Advantages:
• Considers the time value of money
• Is an absolute measure of return
• Is based on cash flows not profits
• Considers the whole life of the projects
• Should lead to maximization of shareholders wealth
b) Disadvantages:
• It is difficult to explain to managers
• It requires knowledge of the cost of capital
• It is relatively complex

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...
This shifting will require some investments in
alterations and other costs
...

Further, it is assessed that the shifting benefits will no doubt accrue
forrever but benefits accruing during next 2 years only are relevent for the
decision
...
3 Internal rate of return
The IRR represents the discount rate at which the NPV of an investment is
zero
...


Write down the CF stream
cash inflows and cash outflows (investment)

Set NPV = 0 and solve for the cost of capital (r):
CFt
CF1
CF2
CFT
NPV  CF0 


...

0
1
2
t
T
(1  IRR) (1  IRR)
(1  IRR)
(1  IRR)
Note: use a trial-and-error algorithm to find IRR
...
3 Internal rate of return(Cont’d): rule
IRR is a yield – what we earn, on average, per year
...
In such cases, multiple internal rate of returns are
likely to occur
...
Since this is confusing, managers
should rely in the NPV method when ranking capital budgeting
projects with such cash flows
...
3 Internal rate of return (Cont’d)
• We want to find the exact rate at which it would be breaking
even i
...
the rate at which discounted future cash flow will
exactly equal the present cost, giving an NPV of 0
...
The initial cost is RWF2,500 and there will be no
rebate from scrap values at the end the period
...

• We must begin by choosing a possible rate, and testing to see
how near this is
...


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...
0000
0
...
8734
0
...
00
747
...
40
979
...
64

A positive NPV, as we have seen, means that we have taken too low a rate for our
attempt
...
0000
0
...
8264
0
...
00
727
...
40
901
...
76

This time, we have obtained a negative NPV so 10% is too high
...

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...
0000
0
...
8417
0
...
00
733
...
70
926
...
26

Clearly, since we are working to the nearest 1% we are not going to get any
closer than this
...

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...
3 Internal rate of return (Cont’d)
Example 2:
• A company is considering a project which is expected to last 4 years, and
requires an immediate investment of RWF20,000 on plant
...
The company’s cost of capital is 10% and the
plant would have zero scrap value at the end of the 4 years
...

Year
0
1
2
3
4

Cash flows
(20,000)
7,000
7,000
6,000
6,000

Disc
...
909
0
...
751
0
...
In an attempt to find a negative NPV try a higher rate of 15%
...
3 Internal rate of return (Cont’d)
Year
0
1
2
3
4

Cash flows Disc
...
869
6,083
7,000
0
...
658
3,948
6,000
0
...
The
IRR is calculated by “Linear Interpolation”
...
The NPV, in fact, falls in a curved line but
nevertheless the interpolation method is accurate enough
...
3 Internal rate of return (Cont’d)
a) Advantages:
The IRR has a number of benefits:
• Considers the time value of money
• Is a percentage and therefore easily understood
• Uses cash flows not profits
• Considers the whole life of the project
• Means a firm selecting projects where the IRR exceeds the cost of capital
should increase shareholders’ wealth
b) Disadvantages:
• It is not a measure of absolute profitability
• Interpolation only provides an estimate and an accurate estimate requires
the use of a spreadsheet programme
• It is fairly complicated to calculate
• Non-conventional cash flows may give rise to multiple IRRs which means
the interpolation method can’t be used
...
3 Internal rate of return (Cont’d)
A project requires an initial investment of $24,000 and
will generate annual cash flows as follows:
Year

1

Cash flows (in $) 7,800

2

3

4

5

6,000

4,200

7,400

9,200

Required:
The cost of capital is 10%
...
4 Profitability index
Write down the CF stream
cash inflows
cash outflows (investment)
Use the risk adjusted cost of capital to calculate:
NPV = PV (cash inflows) - PV (cash outflows)
PV (cash inflows)
PI =
PV (cash outflows)

Note that PI is a ratio while NPV is a difference
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5 Accounting Rate of Return
– The accounting rate of return method calculates the
estimated overall profit or loss on an investment
project and relates that profit to the amount of capital
invested and to the period for which it is required
...
This is related to the cost of
capital of the business
...

– The accounting rate of return is an average rate of
return calculated by expressing average annual profit
as a percentage of the average value of the
investment
...
5 Accounting Rate of Return
ARR = Average annual profit
Average investment

Average annual profit

Average investment

Total
project
profit
after
depreciation and before interest,
tax and dividends, divided by the
estimated life of the project
...


Example: A company is considering investing $135,000 in a new project
...
The
following cash flows and profits (in $) have been estimated as follows
Year
1
2
3
4
5
6
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Total

Net operating cash flow Depreciation Operating profit
14,000
25,000
35,000
36,000
30,000
25,000
165,000

20,833
-6,833
20,833
4,167
20,833
14,167
20,833
15,167
20,833
9,167
20,833
4,167
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124,998
40,002

Use the ARR and advise the
company on whether or not they
should make this investment
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...
2%

Accept the project

Reject the project

Project ARR greater
than the minimum
required return
...


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– It is simple to understand and easy to use
...

Disadvantages:
– It is based on accounting profits rather than cash flows
...

– The ARR does not take into account the time value of money
...

– The ARR takes no account of the size of the initial investment
...
a
Periods
Cash flows in USD (A)

Y0
(130,000)

Y1
44,000

Y2
42,000

Y3
40,000

Y4
38,000

Cash Flows in USD (B)

(130,000)

38,000

40,000

42,000

44,000

Required:
a) Compute NPV for each project and suggest which one should be
undertaken
...

c) Give two circumstances under which the decision taken under
NPV would differ from the one taken under IRR
...

The property consists of 12 apartments, each of which
fetches a rent of $600 per month
...

The effective monthly discount rate is 1%
...

1
...
What if the owner is selling for $500,000?

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