CHAPTER Four

CAPITAL BUDGETING
(LONG TERM INVESTMENT DECISIONS)

3.1 Introduction

The financial or capital requirements of a firm are of two types-Fixed capital

requirements and Working Capital requirements. The fixed capital requirements are
relate to firm’s investment in fixed assets like land, buildings, Machinery, furniture,
fixtures, patents, etc., from which the benefits will be received over a period of time. It,
therefore, involves a current cash outlay or huge investment in expectation of a series of
anticipated future benefits. The working capital requirements of a firm refer to the
amount of capital required to meet its day-to-day expenses, like purchases of raw
materials, payments of expenses, such as salaries, wages, rates, rents, etc. An efficient
allocation of capital is one of the most important aspects of financial management in a
firm as it involves investment decisions. The decisions of investing a firm’s funds in
long-term assets are of considerable significance since they tend to have an impact on its
wealth, size, pace and direction of its growth and its business risk.
Capital Budgeting
Capital Budgeting involves decisions on investment of a firm’s funds in long-term
activities in anticipation involves a current cash outlay in the anticipation of benefits to
be realized in the future. Capital budgeting is the decision making process by which a
firm evaluates the purchases of major fixed assets. Viz., Buildings, Machinery and
Equipment, etc.,
Capital budgeting describes a firm’s formal process for the acquisition and investment
of capital, and results in a capital budget, i.e., the firm’s plan for the expenditure of
money to purchase fixed assets. It involves the planned expenditures on fixed assets,
and capital budgeting is the whole process of analyzing projects and deciding whether
they should be included in capital budget.
Nature and significance of Capital Budgeting
Generally, the capital budgeting of a firm includes addition, disposition, modification
and replacement of long-term or fixed assets. Some of the types of such investments
are:
 Commencing the business: While starting the business, the promoters need to
many capital budgeting decisions.
 Mechanization of a process: A company may intend to mechanize its exiting
process by installing a machine.
 Replacing and Modernizing a Process: Where a company intends to replace an
existing machine with a latest model.
 Choosing between alternative machines: Where a company has to choose/decide
between alternative machines available.
 Introducing a new product: A company needs to make a capital budgeting
decision when it wants to introduce a new product into the market.
 Expanding the business: In order to increase the scale of operation a company
may expand its business.
The investment/capital budgeting decisions exclude the decisions regarding current
assets. However, it should be noted that the decisions to invest in fixed assets,
invariably require funds to be invested in current assets like receivables and
inventories. As such, investment in fixed assets and investment in current assets are not
two separate decisions, but parts of one single activity.
Capital investment decisions represent the growing edge of a firm and they are
important for three inter-related reasons:
 They have long-term consequences. They have considerable impact on what the
firm can do in future.
  It is difficult to reverse capital investment decisions because the market for used
capital investment is ill-organized and /or most of the capital equipment bought
by a firm is tailored to meet its specific requirements.
 Capital investment decisions involve substantial outlays’
The problem of capital budgeting is to decide which of the available investment
opportunities a firm should accept and which it should reject. To make this decision
rationally, the firm should have an objective. The capital budgeting decisions influence
the firm’s wealth. The firm’s wealth will increase if the investment proposals are
profitable, otherwise it would decrease. This, intern, affects the value of the firm in the
market. Thus, the investment proposals should be evaluated on the basis of a criterion,
which is compatible with the objective of maximizing the market value of firm.
One of the most important aspects of capital budgeting is estimating the future of a
project in terms of cash flow. The reason why the future benefits are expressed in terms
of cash flow rather in terms of income is that cash is what is central to all decisions of
the firm. The firm invests cash now in the hope of receiving cash returns in a greater
amount in future. Only cash receipts can be reinvested in the firm or paid to stock
holders in the form of dividends. Thus cash, not income, is what is important in capital
budgeting.
Since capital budgeting decisions are among the most crucial and critical business
decisions. They deserve financial manager’s special care and considerable amount of
his time in their treatment.
The Process of Capital Budgeting
The investment must not only pay for itself during its probable life, but must pay the
interest on its cost and rising home enough profit over and above these two items to
make it worth while bothering about . In order to make the investment proposals of a
firm profitable, they should be properly evaluated in order to accept or reject them. In
general, the important steps involved in the capital budgeting process are:
1. Project Generation 2. Project Evaluation
3. Project Selection and 4. Project Execution
Project Generation: At this stage the firm recognizes the need for making a capital
budgeting decision by buying a fixed asset. The investment/capital budgeting
proposals generally originated from different departments, like Production, Marketing
and other departments of a firm, at any level of the organization top/middle/lower
management level and either systematically or haphazardly. The investment proposals
so originated may involve:
a) Proposals to add a new product to the product line;
b) Proposals to expand existing capacity in existing product lines; and
c) Proposals designed to reduce cost of production of existing products without
altering the scale of operation, i.e., Modernization of plant and machinery.
Project Evaluation: Every capital budgeting opportunity will have to pass through
Technical Evaluation and Financial Evaluation. Under the Technical Evaluation,
whether the project is technically sound or not, whether it will be useful to the business
organizational or not will be evaluated. Then under the Financial Analysis the
profitability and risk ness of project will be evaluated with the help of a few techniques.
It involves:
 Estimation of Benefits and Costs: the benefits and costs should be
measured in terms of cash flows: and
 Selection of an appropriate criterion to judge the desirability of the
projects.
The estimation of cash flows is a formidable task because future is uncertain. The risk
associated with the projects should be properly estimated and should be taken into
account in the decision process.
The evaluation of projects should be performed by an impartial group of experts in
order to maintain the objectivity of evaluation process. Care must be taken in selecting
a criterion to judge the desirability of the projects. The selected criterion must be
consistent with the firm’s objective.

Project Selection: There is no standard and specific administrative procedure laid

down for approving an investment proposal. The procedure to select the investment
proposal differs from firm to firm. Once the investment proposals are evaluated, they
will be ranked. The investment proposal, ranked number one may be rejected when it
is not suitable to the budget of the firm. However, the final approval of the project may
generally be left to the top management. The investment proposals are screened at
different levels. The top management may delegate authority of approving certain type
of investment proposals by limiting the amount of cash outlay, prescribing selection
criteria and holding the lower level management accountable for the results.
Project Execution: After the firm selects the investment proposals the funds are
apportioned for capital expenditure. The formal plan of the apportioning of funds is
called the capital budget, and the funds are spent in accordance with it. The top
management of the firm should make sure that systematic procedures are laid down
and developed for executing, and reviewing the investment project during their life and
after completion. The comparison of actual performances with the original estimates
and the corrective follow-up action not only ensure better forecasting but also help to
sharpen the techniques for improving future forecasts.
While evaluating the investment proposals, the future cash flows are estimated and
different investment criterion or appraisal methods are used in the process of
estimating the future cash flows and selecting the investment proposals. Here, the
financial manager of the firm should strive to strike a balance or trade-off between the
‘risk’ of variability of cash inflows and outflows and ‘return’ or ‘profitability’ of the
Risk adjusted Discounting Rate method
Discounted Pay-back Period
Non-Statistical Methods

return;
Method Average/Accounting Rate of
Traditional Methods Pay Back Period

investment proposals, to achieve the ultimate objective of maximizing the share value
Profitability

of the firm.

Techniques of Evaluating the Capital Budgeting Opportunities

Internal Rate of Return.
Profitability index or Benefi
Present Value;
Discounted Cash Flow (DCF
Variation
Standard D
Probabilit
Statistical
 Techniques Net
cost ration; and
ethods
viation & and Co-efficient of

Risk ness
In short clear terms, capital budgeting is long term planning for making and financing proposed
capital outlays. It is a complex process which may be divided into five broad phases: planning,
analysis, selection, implementation, and review.
 Major steps in capital budgeting process are:
o Idea generation
o Estimating cash inflows and outflows(planning)
o Evaluating the project proposals(Analysis)
o Selecting a project.
o Implementing and
o Reviewing projects.
a) Planning
The planning phase of a firm’s capital budgeting process is concerned with the
articulation of its broad investment strategy and the generation and
preliminary screening of project proposals. The investment strategy of the firm
delineates the broad areas or types of investments the firm planning to
undertake. This provides the framework which shapes, guides, and
circumscribes the identification of individual project opportunities.
b) Analysis: If the preliminary screening suggests that the project is prima facie worthwhile, a
detailed analysis of the marketing, technical, financial, economic, and ecological aspects is
undertaken. The questions and issues raised in such a detailed analysis are described in the
following section. The focus of this phase of capital budgeting is on gathering, preparing and
summarizing relevant information about various project proposals which are being considered
for inclusion in the capital budget. Based on the information development in these analyses, the
stream of costs and benefits associated with project can be defined.
c) Selection: Selection follows, and often overlaps, analysis. It addresses the question – Is the
project worthwhile? A wide range of appraisal criteria/methods of evaluating techniques have
been suggested to judge the worthwhile of a project.
d) Implementation: The implementation phase for an industrial project, which involves setting
up of manufacturing facilities, consists of several stages: (i) project and engineering designs, (ii)
negotiations and contracting, (ii) construction, (iv) training, and plant commissioning.
e) Review: Once the project is commissioned the review phase has to be set in motion.
Performance review should be done periodically to compare actual performance with projected
performance. As feedback device, it is useful in several ways:
(i) It throws light on how realistic were the assumptions underlying the project;
(ii) It provides a documented experience that is highly valuable in future
decision making;
(iii) It suggests corrective action to be taken in the light of actual performance;
(iv) It helps in uncovering judgmental biases;
(v) It induces a desired caution among project sponsors.
3.2 Capital budgeting and its characteristics
In businesses an efficient allocation of capital is the most important finance
function in the modern times. Capital budgeting involves decisions to commit
the firm’s funds to the long-term assets. Such decisions are of considerable
importance to the firm since they tend to determine its value, size by
influencing its growth, profitability and risk.

The long- term investment decisions of a firm are generally known as the capital
budgeting, or capital expenditure decisions. As capital budgeting decision may
be defined as the firm’s decision to invest its current funds most efficiently in the
long-term assets in anticipation of an expected flow of benefits over a series of
years. The long-term assets are those which affect the firm’s operation beyond
one-year period.
The following are the features of investment decisions:
 The exchange of current funds for future benefits.
 The funds are invested in long-term assets.
 The future benefits will occur to the firm over a series of year.
Investment decisions require special attention because of the following reasons:
 They influence the firm’s growth in the long run
 They involve commitment of large amount of funds
 They are irreversible, or reversible at substantial loss
 They are among the complex decisions to make
Growth: The effects of investment decisions extend into the future and have to
be endured for a longer period than the consequences of the current operating
expenditure. A firm’s decisions to invest in long-term assets have a decisive
influence on the rate and direction of its growth. A wrong decision can prove
disastrous for the continued survival of the firm; unwanted or unprofitable
expansion of assets will result in heavy operating costs of the firm. On the other
hand, inadequate investment in assets would make it difficult for the firm to
compete successfully and maintain its market share.

Funding: Investment decisions generally involve large amount of funds which

make it imperative for the firm to plan its investment programs very carefully
and make an advance arrangement for procuring finances internally or
externally.
Irreversibility: Most investment decisions are irreversible. It is difficult to find
a market for such capital items once they have been acquired. The firm will
incur heavy losses if such assets are scrapped.
Complexity: Investment decisions are among the firm’s most difficult decisions. They are an
assessment of future events which are difficult to predict. It is really a complex problem to
correctly estimate the future cash flow of an investment. The uncertainty in cash flow is caused
by economic, political, social and technological forces
3.3 Types of Investment Decisions
There are many ways to classify investments. One classification is as follows:
Expansion and Diversification: A company may add capacity to its existing
product lines to expand existing operations. Expansion of a new business
requires investment in new products and a new kind of production activity
within the firm. If a package manufacturing company invests in a new plant
and machinery to produce a product, which the firm has not manufactured
before, this represents expansion of new business or diversification.
Sometimes a company acquires existing firms to expand its business. In either
case, the firm makes investment in the expectation of additional revenue.
Investments in existing or new products may also be called as Revenue –
expansion investments.
Replacement and Modernization: The main objective of modernization and
replacement is to improve operating efficiency and reduce costs. Costs savings
will reflect in the increased profits. The firm must decide to replace those
assets with new assets that operate more economically. If a cement company
changes from semi-automatic drying equipment to fully automatic drying
equipment, it is an example of modernization and replacement. Replacement
decisions help to introduce more efficient and economical assets and therefore,
are also called cost-reduction investments. However, replacement decisions
which involve substantial modernization and technological improvements
expand revenue as well as reduce costs.
3.4 (Technique) Methods of capital budgeting.
At each point of time a business firm has a number of proposals regarding various projects in
which it can invest funds. But the funds available with the firm are always limited and it is not
possible to invest funds in the entire proposal at a time. Since, it is very essential to select from
amongst the various competing proposals, those which give the highest benefits, the core of
capital budgeting is the allocation of available resources to various projects taking the economic
and non-economic considerations which influences it. The crucial factor that influence capital
budgeting is the profitability of the prospective investment and the risk associated with it.
There are many methods/procedures of evaluating profitability of capital investment proposal.
They generally grouped as traditional (non- discount) and Time adjusted (Discounted) Methods.
A. Traditional (non -discounted) methods
1. Payback period method
2. Average rate of return method. (Accounting rate of return)
B. Time adjusted (Discounted) Method
3. Net present value method (NET PRESENT VALUE (NPV))
4. Internal rate of return method (IRR)
5. Profitability Index method. (PI)
1. Pay back period: is the length of time required for a project's cumulative net cash inflows
after tax to return its net investment in a project from operational resource (Measures the time
needed for a project to break even on its net investments).
Accept Reject Rule: Accept the project if the actual or computed Pay Back
period is less than the maximum payback set by the firm. Otherwise the
project is rejected. In ranking two projects having the same maximum
allowable payback, the project with shorter payback period should be chosen
because it pays for itself more quickly
 Projects are ranked according to the length of their pay back period and the shorter
coverage time is preferred. For a single project the pay back period is specified by
the management and if it does not pay back itself within the period specified by the
management it will be rejected.
 Formula.
 If the expected annual net cash inflows are equal (annuity form)
Pay back period = Net investment /cash out lay of the project/ cost of the asset
Net annual cash inflows
=NI/NCF,
Where, NI = Net investment
 NCF = Annual net cash inflows ignoring interest payments.
OR
 If the annual cash inflows are unequal, it can be found by adding up the cash inflows until
the total is equal to the initial outlay of the project /original cost of the asset. In this case
the payback period is calculated by determining the length of time
required for cumulative cash inflows to equal the net investment.
Thus the following formula can be used:

PBP = Year before recovery + Unrecovered cost at start of year

Cash flow during the next year

Example: A project costs Br.100, 000 and yields annual cash inflow of Br. 20,000 for 8 years.
Required: Calculate its pay back period. This is an example which indicates equal cash inflows
in each year.
Solution: Pay back period = Initial outlay Br.100,000 =5Yrs
Annual cash inflow 20,000

Note that to return its initial investment it takes a period of 3 years and 6 (1100-3000)/3000
Months.
Decision: The decision is to reject the project because its payback period is longer than the
targeted.
Advantages of the payback method: - Easy to understand, calculate and interpreter.
- It provides measure of liquidity and crude measure of
risk because it considers projects with shorter payback period as less risky.
Disadvantage:
 It ignores the time value of money
 It does not measure the profitability of investment because it ignores cash flows beyond
the payback period.
 Provides no objective criterion for decision making that will maximize shareholders
wealth.
  It biases capital budgeting decisions in favor of short-term projects and against long-term
projects.
2. Accounting rate of Return: is a measure of a project's profitability from a conventional
accounting stand point. It is a profit after tax and depreciation expense.
 Formula: ARR = Average annual net profits (net income) x 100%
Average investment (capital employed)
Average annual profit = Total expected after tax profit of the project
Life of the project
Note - Average investment is assumed to be one half of the net investment.
 Average investment = Book value at beginning. + Book value at end or
2
 Average annual net profits=sum total of the profits/# of the years
 Average Investment = (original investment - salvage value)/2 + add. Working Capital +
salvage value.
 Investment costs are averaged because on the average, firm’s will have one half of their
initial purchase price in the records.
 Salvage value is deducted from investment cost because it is only the depreciable cost
that is to be consumed. Salvage value will be recovered at the end of the projects life.
 Salvage value is again added to the formula because it is an amount tied up till the
end of the life of the project
Decision Rule: If the Accounting rate of Return is greater than or equal to the target
Accounting rate of Return set by the firm, accept the project and In ranking projects, the one
with higher figure of Accounting rate of Return is selected.
Example: 1. A project requires an investment of Br. 500,000 and has a scrap value of Br. 20,000
after 5 years. It is expected to yield profits after depreciation and taxes during the five years
amounting to Br.40,000, Br. 60,000, Br. 70,000, Br. 50,000, Br. 20,000 (assume the target
ARR is 12.5 %.) Calculate the ARR and give your comments.
Solution
 Total profit= 40,000 + 60,000 + 70,000 + 50,000 +20,000
= Br. 240,000
Average profit = Br. 240,000/5 = Br. 48,000
  Net investment in the project = (Br. 500,000 - Br. 20,000) + 20,000 = 260,000
2
... ARR = Average annual net profit x 100
Net investment in the project
ARR = 48,000 x 100% = 18.4%
260,000
 Since it is higher than the target figure, the project should be accepted.

Example: 2. The following information pertains to XYZ Company for a new project.
 Investment…………………..Br. 500,000
 Life of the project ……………5 Years
 Projected net income: 1st year Br. 100,000
2nd year 150,000
3rd year 50,000
4th year 0
5th year (50,000) (it is loss)
 Target ARR 15% .
Required: Calculate the ARR and give your comments.
Answer: Average annual income = 250,000/5years = Br. 50,000
Average investment = 500,000/2 = 250,000
:.ARR= 50,000 = 20%
250,000
=> Accept the project because its computed ARR is greater than the targeted.
Example: 3. Determine the average rate of return from the following data for two machines A
and B. Which machine should be selected? (Assume straight line depreciation method)
Machine A Machine B
Original cost Br. 56,125 Br. 56,125
Additional investment in working capital 5,000 6,000
Estimated life in years 5 5
Estimated salvage value. Br. 3000 Br. 3000
Average income tax rate 55% 55%
Annual estimated net profit:
(after depn and tax ) Year 1. Br. 3375 11375
2. 5375 9375
3. 7375 7375
4. 11375 3375
5. 9375 5375
Br.36875 Br.36875

ARR = Average annual earnings  100% Average = Total earnings

Average investment earnings No of years
A = 36, 875 = 7375
5
ARR, A = 7375  100% = 21.19% B = 36,875 = 7375
34,562.50 5
ARR, B = 7375 = 20.74% Average = (or.c – sav) + Wc+sv
35,562.50 Inv’t 2
A = (56,125 – 3000) + 5000 + 3000
2
= Br. 334,562.50
For B = (56,125 –3000) + 6000 +3000
2
= Br. 35,562.5
 Decision: Accept Machine A than B as it has higher ARR value.
Example: 4. Compute the ARR for an asset with cost of Br. 10,000 and 4 years service life
(use straight line method of depreciation).Assume the cash flows is 2000,3000,4000,5000 for
the years 1,2,3,and 4 respectively. Assume further that the targeted ARR set by the firm
is25%.Shuold it be accepted or rejected?
Solution
Depreciation per year=10000/4=2500.Taking the 2500 as depreciation of each year for the
example the computations for the average accounting return (ARR) is summarized as
follows.
Time (1) Cash flows Annual depreciation Accounting profit
 1 Br. 2000 Br. 2500 (500)
2 Br. 3000 2500 500
3 Br. 4000 2500 1500
4 Br. 5000 2500 2500
4000
Average annual net profits=4000/4=1000.
Average Capital Employed=1000/2=500

Hence, ARR = Average annual profits = 1000 = 20%

Average capital employed 500
DECISION: the project should be rejected, for its actual ARR (20%)is less than the
targeted(25%).
Advantage: - Easy to understand and calculate
- It considers profitability
Disadvantage: - It uses accounting income rather than cash flows.
- It ignores the time value of money
- It assumes the net investment is written off at a constant time.
3. Net present value.
The net present value (NPV) of an investment is the value obtained by discounting all cash outflows and
inflows attributable to a purchase of capital equipment by a chosen percentage.
The net present value method is the classic economic method of evaluating the investment
proposals. It is one of the discounted cash flow (DCF) techniques explicitly recognizing the time
value of money. It correctly postulates that cash flows arising at different time periods differ in
value and are comparable only when their equivalent present values are found out. The
following steps are involved in the calculation of NPV.
 Cash flows of the investment project should be forecasted based on realistic
assumptions.
 Appropriate discount rate should be identified to discount the forecasted cash flows.
This rate is the firm’s cost of capital which is equal to the required rate of return
expected by investors on investment of equivalent risk.
  Present value of cash flows should be calculated using the cost of capital as the discount
rate.
 NPV should be found by subtracting present value of cash outflows from present value
of cash inflows.
The formula for the NPV can be written as follows:
NPV = C1 + C2 + --------------- Cn - Co
(1 + K) (1 + K) 2 (1 +K) n
n
∑
Ct _ Co

t=1 (1+k) t

NPV = PVB - PVC

Where:
C1, C2 = net cost inflows in years 1,2 ……..
K = the opportunity cost of capital (cost of capital)
PVB = present value of benefits (inflows)
PVC = present value of costs
Co = the initial cost of investment
n = Expected life of the investment

It should be noted that the cost of capital, K, is assumed to be know (given) and is constant.
The excess of worth over cost or net present value (NPV) is simply the present economic value of
the project less its initial cost.
The present economic value is the sum of the net incremental cash flows generated discounted back to
present value at the opportunity cost of capital (the discount rate)
N.B:
It should be noted that the acceptance rule of NPV method is to accept the investment project if
its NPV is positive (NPV>0) and to reject it if the net present value is negative (NPV<0).
Positive NPVs contributed to the net wealth of the shareholders which should result in the
increased price of the firm’s share. The positive NPV will result only if the project generates
cash inflows at a rate higher than the opportunity cost of capital. A project may be accepted if
NPV = 0. A zero NPV implies that projects generate cash flows at a rate just equal to the cost of
capital.
Thus,
 If a projects Net Present Value (NPV) >0, (the projects rate of return exceeds the minimum rate
of return; and higher figure is preferable), the firm will earn a return equal to or greater than its
cost of capital.
 If Net Present Value (NPV) <0, the projects actual rate of return is less than the minimum
required rate of return.
Example: 1. A company is considering two mutually exclusive projects. Both require an initial
investment of Br. 50, 000 each and have a life of 5 years. The cost of the capital of the company is 10%
and tax rate is 50%. The depreciation is charged on straight line method. The estimated net cash inflows.
(before depreciation and tax) of the two projects are as flows.

Projects
Year A B
1 Br. 20,000 Br. 30,000
2 Br. 22,000 Br. 27,000
3 Br. 28,000 Br. 22,000
4 Br. 25,000 Br. 25,000
5 Br. 30,000 Br. 20,000

Required: Which project should be accepted as per the NET PRESENT VALUE (NPV)?
Solution: Initial investment = Br. 50,000
Depreciation/ year = Br.50,000 = Br. 10,000
5
Cash inflows after Tax rate (50% inflows of Cash inflow
Depreciation cash after depreciation after tax
Year A B A B A B
1 Br.10,000 Br. 20,000 Br. 5000 Br.10,000 Br.
5000 Br.10,000
2 12,000 17,000 6000 8500 6000 8500
3 18,000 12,000 9000 6000 9000 6000
 4 15,000 15,000 7500 7500 7500 7500
5 20,000 10,000 10,000 5000 10,000 5000

PV factor Net cash flows Net Present Value (NPV) of cash inflows before
Year At 10% (before depn & after tax) deprecation & after tax
A B A B
1 0.909 Br.15,000 Br. 20,000 Br. 13,635 Br. 18,180
2 0.827 16,000 18,500 13,216 15,299.5
3 0.751 19,000 16,000 14,269 12,016
4 0.683 17,500 17,500 11,952.5 11,952.5
5 0.621 20,000 5,000 12,240 9,315
Total cash inflow Br. 65,508 Br. 66,763
Cash out flow 50, 000 50, 000
Net Present Value (NPV) 15,508 Br. 16, 763

Decision Rule: Hence, for project B has higher Net Present Value (NPV) amount it should be accepted
Example 2: Cash outlay of machine A and B is Br. 56125 each. Both machines are estimated to
have a salvage value of Br. 3000 and useful life of 5 years. The net cash flows for the two
projects are estimated below.

Net Cash Inflows

Year Machine A Machine B
1 Br. 14000 Br. 22000
2 16000 20000
3 18000 18000
4 20000 16000
5 25000 17000
Total Br. 93000 Br. 93000
Required:
1. Compute NPV of the two machines assuming K = 10%
2. Which machine should be accepted if the two machines are:
a. Mutually exclusive.
 b. Independent and the firm, has sufficient cash
Solution:

Machine A Machine B
Net cash PV Present Net Cash PV Machine
Year Inflows Factor Value Inflows Factor Value
1 14000 0.9091 12727 22000 0.9091 20000
2 16000 0.8264 13222 20000 0.8264 16528
3 18000 0.7513 13523 18000 0.7513 13523
4 20000 0.6830 13660 16000 0.6830 10928
5 25000* 0.6208 15523 17000* 0.6209 10555
Total present value of inflows Br.68655 Br.71534
Cash outlay (Project cost) 56125 56125
Net present value (NPV) Br.12530 Br. 15409
* Includes salvage value
Solution 2. A) If project A and B are mutually excusive, machine B would be preferred because
it has higher NPV and we must select only one in case of such projects (mutually
exclusive).
B) If projects A and B are independent, we would accept both machines because the
firm has no shortage of fund. This is because both have positive NPV.
Advantages: - It considers the magnitude and timing of cash flows
- It provides an objective criterion for decision making which maximizes shareholders
wealth
- It is the most conceptually correct capital budgeting approach for selection of
mutually exclusive project.
- It considers the total cash flows arising from the proposed project over its life time.
Disadvantages: - Net Present Value (NPV) is more difficult to compute & interpret.
4. Internal rate of return.
The internal rate of return (IRR), although considerably more difficult to calculate by hand than
NPV, is probably the most used sophisticated capital budgeting technique for evaluation
investment alternatives.
The internal rate of return (IRR) is defined as the discount rate that equals the present value of
cash inflows with the investment a project. The (IRR), in other words, is the discount rate that
equates the NPV of an investment opportunity with zero (because the present value of cash
inflows equals the initial investment).
NPV = Present value of Initial
Cash inflows Investment
NPV =
n C
CF t
∑(1+k) t
t=1
Where C = initial investment
CFt = Cash inflows
K = firms discount rate
- Now the above NPV formula can be solved for the value of K that causes
NPV to equal zero, I.e. It is the discount rate that will course the Net Present
Value (NPV) of an investment to be zero. i.e. NET PRESENT VALUE(NPV)
=0

 Formula:
O= n
CF II
t
∑(1+k) t
t=1

The Decision Criterion

The decision criterion when IRR is used to make accept-reject decision is as follows:
 If IRR greater than the cost of capital, accept the project
 If IRR is less than the cost of capital, reject the project
This criterion guarantees that the firm earns at least its required return.
Alternatively, the IRR can be described as the maximum cost of capital that can be applied to
finance a project without causing harm to the shareholders.

Formula: Net Present Value (NPV) = FV1 + FV2 + F+… .FVn- In

(1+k) 1 (1+k) 2 (1+k) 3 (1+k) n.
Linear interpolation method
 IRR = A + C (B – A), A = the discount rate of the low trial
C-D B = the discount rate of the high trial
C = The Net Present Value (NPV) of cash inflows of the low trial.
D = The Net Present Value (NPV) of cash inflows of the high trail.
Note: If IRR > the discount rate accepts the proposal.
If IRR < the discount rate reject the proposal.

Example.:1. A firm has invested Br. 1000 in capital equipment with a life of 3 years. The estimated cash
inflows are Br. 300, Br. 1000, and Br. 400 in the 1st, 2nd and 3rd years respectively.

Required: Determine the IRR and comment on it (given the minimum desired discount rate 10%).
Solution:
Cash Low trial Discount another low trial
Year Inflow Rate (25%) (NPV) at 30% (factor) NP V at 30% rate
0 (1000) 1.00 (1000) 1.00 (1000)
1 300 0.800 240 0.769 231
2 1000 0.640 640 0.592 592
3 400 0.5120 204.80 0.455 182
85 5

Cash high trial Discount

Year Inflow Rate (35%) (NPV)
0 (1000) 1.00 (1000)
1 300 0.7407 222.21
2 1000 0.5487 548.70
3 400 0.4060 162.58
(66.51)
(NPV) = (67)
Applying the formula, A + C (B – A) =
C–D

IRR = 0.3 + 5 (0.35 – 0.3)

5-(-67)
= 0.3 + 5 (0.05)
72
= 30.3%
Accept the project.
  N.B both Net Present Value (NPV) method & IRR method should reach the same accept reject
conclusion.
Advantages:
 It has advantages of NP?V
 It is a relative measure of return per Br. of net investment and therefore, it is better then the Net
Present Value (NPV) method when projects have the same Net Present Value(NPV) but different
PV of cash out flows.
Disadvantages: May conflict with the Net Present Value (NPV) method when dealing with mutually
exclusive investments.
5. Profitability Index: is the sum of the present values of a project’s net cash flows divided by its
Net investment. It indicates the increase in value of the firm created by each Br. invested in the project. It
is also called benefit /cost ratio.

 Formula PI = PV of NCFt , Where, PI = Profitability index

NI NCFt = Net cash flows.

NI = Net investment.
Note that if PI =1, it is at break-even (may accept the project)
PI >1, is should be accepted and increases the value of the firm.
PI <1, it should be rejected and decreases the value of the firm.
A project with higher PI rate is preferable; and it gives the same results regarding investment proposal, as
that of Net Present Value (NPV).
Example 1: As company has to select one of the following two projects. Using the cost of capital cut-off
rate of 8% calculate PI for both projects and suggest which project is preferable

Cash flows.
Year A B
0 Br. (12,000) Br. (10,000) is the initial investment!
1 6000 1000
2 2000 1000
3 1000 2000
4 5000 10,000

Solution Cash inflows PV. Factorat 8% PV of cash inflows

Years A B A B
 1 6000 1000 0.296 5556 926
2 2000 1000 0.857 1714 857
3 1000 2000 0.794 794 1588
4 5000 10,000 0.735 3675 7350
Br. 11, 739 10,721
PI of project A = 11, 739 = 97.8% - reject the asset
12,000
PI or project B = 10,721 = 107% => accept the asset.
10,000
Example 2 :The initial cash out lay of a project is Br. 100,000 and it can generate before depreciation
cash inflows of Br. 40,000;Br 30,000, Br. 50,000 and Br. 20,000 in year one through 4. Assume a 10%
rate of discount.

Calculate the PI.

PV = Br. 40,000 (PVF1 , 0.1) + 30,000 ( PVF2, 0.1) + 50,000 (PVF3,0.1) + 20,000(PVF4 ,0.1)
= 40,000 (0.909) + 30,000 (0.826) + 50,000 (0.751) + 20,000 (0.680)
= 112,350
PI = 112,350 = 1.123
100,000
Accept the project.
Advantages of PI
1. It has all advantages of NPV.
2. It is a relative measure of return per Br. of net investment and, therefore, it is better than
the NPV method when projects have the same NPV but different PV of cash outflows.
Disadvantages
 PI may conflict with the NPV method when dealing with mutually exclusive Investments.