CHAPTER Three N
CHAPTER Three N
CHAPTER Three N
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1.3. Capital budgeting processes
The following steps are Capital budgeting processes
1. Identification of various investments proposals: The capital budgeting may have various
investment proposals. The proposal for the investment opportunities may be defined from the top
management or may be even from the lower rank. The heads of various departments analyses the various
investment decisions, and will select proposals submitted to the planning committee of competent
authority.
2. Screening or matching the proposals: The planning committee wills analyses the various proposals
and screenings. The selected proposals are considered with the available resources of the concern. Here
resources referred as the financial part of the proposal. This reduces the gap between the resources and
the investment cost.
3. Evaluation: After screening, the proposals are evaluated with the help of various methods, such as
payback period proposal, net discovered present value method, accounting rate of return and risk analysis.
Each method of evaluation used in detail in the later part of this chapter. The proposals are evaluated by.
(a) Independent proposals
(b) Contingent of dependent proposals
(c) Partially exclusive proposals.
Independent proposals are not compared with another proposal and the same may be accepted or rejected.
Whereas higher proposals acceptance depends upon the other one or more proposals. For example, the
expansion of plant machinery leads to constructing of new building, additional manpower etc. Mutually
exclusive projects are those which competed with other proposals and to implement the proposals after
considering the risk and return, market demand etc.
4. Fixing property: After the evolution, the planning committee will predict which proposals will give
more profit or economic consideration. If the projects or proposals are not suitable for the concern’s
financial condition, the projects are rejected without considering other nature of the proposals.
5. Final approval: The planning committee approves the final proposals, with the help of the following:
(a) Profitability
(b) Economic constituents
(c) Financial violability
(d) Market conditions.
The planning committee prepares the cost estimation and submits to the management.
6. Implementing: The competent authority spends the money and implements the proposals. While
implementing the proposals, assign responsibilities to the proposals, assign responsibilities for completing
it, within the time allotted and reduce the cost for this purpose. The network techniques used such as
PERT and CPM. It helps the management for monitoring and containing the implementation of the
proposals.
7. Performance review of feedback: The final stage of capital budgeting is actual results compared with
the standard results. The adverse or unfavorable results identified and removing the various difficulties of
the project. This is helpful for the future of the proposals.
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1.4. Capital Budgeting Evaluation Techniques
Three steps are involved in the evaluation of an investment
1. Estimation of cash flows.
2. Estimation of the RRR(cost of capital)
3. Application of a decision rule for making the choice.
There are two project evaluation techniques
1. The traditional criteria (technique)
They are called the traditional techniques because they do not consider the time value of money
concepts in ranking investments proposals. Two methods are included under the traditional
technique, namely the payback period & the accounting rate of return.
a) The payback period: the payback period is the number of years that is required for 5the
business firm to recover from the project the amount of the initial investment in total. If
the cash flows from the project are in annuity form, the payback period can easily be
determined by dividing the initial investment by the annual cash flow in the annuity.
Initial investment
That is, payback period (in years) =
Annual cash flow
When the cash flows from the project are not in an annuity, the payback period is computed as
Unrecovered cost
follows: payback period = year before full recovery +
Annual flow during thenext 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 24,000 birr & the annual after-
tax cash flows of 6,000 birr for five years. The payback period is, therefore,
This 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. 6000 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, assume the project requires an initial investment of 60,000 birr. The after-tax
cash flows from the project are 8,000 birr during year 1, 15,000 birr during year 2, 22,000 birr
during year 3, 20,000 birr during year 4, & year 5 each. Here, the cash flows are not uniform. In
this case, we first need to compute the cumulative.
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
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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 whereas the cumulative cash flows at 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:
This is true if the cash flows of 20,000 birr during year four are uniformly distributed over the
entire year. Otherwise, the payback period is different from 3 years & 9 months. For instance, if
the cash flow of 20,000 birr is expected to occur only once at the end of year 4, the payback
period will be 4 years.
As a general rule, the shorter the payback period required, the better the project. Thus, the project
is accepted if it’s payback period is less or equal to the period required by the management of the
business firm. If two projects are mutually exclusive (i.e. if the acceptance of one project
precludes the acceptance of the other), a project with the shorter payback period selected even if
both of them fulfill the acceptance criteria. On the other hand, if two projects are independent
(i.e. the cash flows of one of the project do not influence the cash flows of the other), both the
projects can be accepted as long as their payback periods are less than the planned payback
period.
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original costs+salvage value
Average cost of investment =
2
To illustrate the accounting rate of return consider the project that has the original investment of
70,000birr, the life of 4 years, & the salvage value of 6,000 birr at the end of year 4. The straight
line method of depreciation is used. Income before depreciation & taxes are 40,000 birr for year
1, 42,000 birr for year 2, 36,000 birr for year 3, & 50,000 birr for year 4. Determine the
accounting rate of return if income tax rate on the project is 40%. To compute the accounting
rate of return (ARR) for this project, first we have to determine the average investment & the
annual depreciation amount.
Average investment = (70,000+6,000)/2 = 38,000 birr
Annual depreciation = (70,000-6,000)/4 = 16,000 birr
To compute the new profit for each year during the four years.
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
Average annual net profit 15,600
Hence, ARR ¿ = = 0.41or 41%
Average cost of investment 38,000
This is to mean that an average of 1 birr invested in this project, there is an average return of
41% 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 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 fluctuation of cash flows over the life of the project as it assumes an average cash flows
every during the project’s life.
The Discounting cash flow (DCF) techniques are other methods of evaluating & ranking
investment project proposals. These techniques employ the time value of money concept; unlike
the traditional methods. Four DCF techniques are discussed in the section that follows.
a) The discounting 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. Discounting payback period in computed
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in the same manner as that of the regular payback period except the discounted cash
flows are used in the case of the former one. The expected future cash flows are
discounted by the project’s cost of capital. To illustrate the computation of the
discounted payback period, suppose that a given capital budgeting alternative is
expected to have an initial of 30,000 birr & the life of 5 years. The after-tax cash flows
from the project during years 1,2,3,4 & 5 are 15,000 birr, 18,000 birr, 12,000 birr,
20,000 birr, & 22,000 birr respectively. The cost of capital (the4 required rate of
return) is %. What is the discounted payback period for this project? To this question,
first we have to compute the discounted cash flows & the cumulative cash flows for
each year which help buys to locate the discounted payback period for this project.
Hence, the discounted cash flows & the cumulative cash flows year by year are show
as follows.
It requires the project a period of 2 years & 2 months to recover its initial net investment taking
the time value money into account. This is true only if the cash flows assumed to occur
uniformly throughout the year. But the cash flows are discounted back to their present cash
equivalents by considering that the cash flows are occurring at the end of every year. Hence, the
project needs to wait for one more years after year 2 in order to recover the remaining present
value equivalent amount of 1,497 birr at the end of year 2. Therefore, the discounted payback
period of this project is 3 years instead.
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b) The net present value(NPV) method: is an investment project proposals evaluating &
ranking method using the net present value, w/c is the difference b/n the present values
of future cash inflows & the present values of future cash out flows, 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 values of each cash flow, including both inflows & out flows using the
cost of capital of the project for discounting.
2. Sum the discounted cash outflows & the discounted cash outflows separately.
3. Obtain the difference b/n the sum of the cash inflows & the sum of cash out flows.
In all the cash out flows for the project occur at time zero, i.e. at the beginning 9of year 1, the
present value of the cash outflows is the same as to the net investment amount.
If 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 thee lower
positive NPV. Projects with negative NPV should not be considered for acceptance in the first
place.
The rational for the net present value method is that a NPV of zero signifies that the cash flows
of the project are just sufficient to repay the invested capital & to provide the required rate of
return, no more no less. If the project has a positive NPV, it is generating more cash than needed
to service its debts & to provide the require rate of return to the shareholders, & this excess cash
accrues solely to the firm’s shareholders. Therefore, if the firm takes on a project with a positive
NPV, the wealth of the shareholders will improved as indicated above.
To illustrate the NPV as a method of project proposals ranking assume that a given project is
expected to have an initial investment & project life of 40,000 & 5 years respectively. The
annual after-tax cash flow is estimated at 12,000 birr for each one of the five years. Using the
required rate of return of 10%,
What is the NPV of the project? How do you judge the acceptability of this project?
In order to answer this question, it is wise to identify the cash in flows & cash out flows. In the
case of this project, there are annuity cash inflows of 12,000 every year for five years & single
cash outflows of 40,000 at time zero. The present value of the annuity cash outflows is:
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The annuity factor given the period of 5 years& discount rate of 10% is3.791 substituting the
factor I the equation above.
Hence, the net present value (NPV) = PV of inflows less PV of out flows
Since the project makes the net present value (NPV) of positive 5,492 birr, it should be accepted.
Consequently, the wealth of the shareholders would increase by 5,492 birr in total as the result of
accepting & running this project. Thus, the project can be judged as an acceptable one. To
further illustrate the NPV method, consider the following mutually exclusive project alternatives,
together with their cash flows.
Alternativ Year 0 Year 1 Year Year year 4 Year
e 2 3 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%. Then, evaluate these projects using the net
present value method.
The evaluation of these two projects requires the computation of the net present values for both
projects. As you can see the cash flows from both projects are not in annuity forms. The cash
flows are irregular for both projects. Hence, we need to discount each of the cash flows
individually. Then the individual discounted cash flows are added. The cash outflows at time
zero will be deducted from the sum of the discounted cash inflows in order to get the net present
value of the project. 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 25,000 0.567 11,340
PV of cash inflows (sum) 86,005
PV of cash outflows 80,000
Net present value (NPV)6,005 birr
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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
PV of cash inflows (sum) 104,565
PV of cash outflows 100,000
Net present value (NPV)4,565 birr
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. Had the two project been
independent of one another, both of them would be accepted because both projects have positive
net present values (NPVs).
c) The Internal rate of Return(IRR): is the discount rate which equates the present
value the expected cash flows with the initial investment outlays. In other words, IRR
is a method of ranking investment projects 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 out flows. That is:
PV (cash inflows) =PV (cash out flows). Hence, the net present value of any
project at a discount rate that is equal to the IRR is zero.
initial investment
Discount factor =
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 the calculation of IRR when the cash flows are in an annuity form, assume that a
project has a net investment of 26,030 birr & annual net cash inflows of 5000 birr for seven
years. What is the IRR of this project? In order to answer this question, we need to follow the
two steps discussed above.
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Step 1 computes the critical discount factor. That is
26,030
Discount factor = =5.206
5,000
Step 2 after determining the critical discount facto, we look for the value that is equal to this
factor in the present value of annuity table across the line corresponding of 7 years (i.e. n=7).
The discount factor of 5.206 appears in the 8% column on the line/row of 7 years. Therefore, the
IRR IS 8%.
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5 1 15,000
15 190,000
190,000
Average net cash flow = =12,667
15
40,000
Estimated discount factor = = 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%. Thus, the starting point of the iterative process is 18%. The NPV of the
project using the discount rate of 18% is:
NPV =(15,000)(0.847)+(10,000)(0.718)+(10,000)(0.609)+(15,000)(0.516)+(15,000)(0.437)-
40,000 =270
Since the NPV computed using a discount rate of 18% is positive, are have to take a discount
rate higher than 18% in search for the NPV of zero. So the second guess can be 19%. The NPV
of the project using the discount rate of 19% is:
NPV =(15,000)(0.840)+(10,000)(0.706)+(10,000)(0.593)+(15,000)(0.499)+(15,000)(419)-
40,000 =-640
As per the above calculations, NPV is negative when the discount rate of19 % is used & positive
when the discount rate of 18% is used. Thus, the IRR for this project falls b/n 18 & 19%. If the
exact IRR is needed, the interpolation method it can be used. That is:
Step 1: obtain the NPV of the smaller rate by the absolute sum & add the resulting quotient to
the smaller rate, or divide the NPV of the larger rate by the absolute sum & subtract the resulting
quotient from the larger rate.
Step 2: divide the NPV of the smaller rate by the absolute sum & add the resulting quotient to
the smaller rate, or divide the NPV of the larger rate by the absolute sum & subtract the resulting
quotient from the larger rate.
By following the above two steps, the exact IRR for this project is thus:
The absolute sum of the NPVs =|270|+|-640| = 270+640 =910
Then, dividing the NPV of the smaller rate by the absolute sum, you get 270/910 = 0.30 to the
nearest two digits after the decimal point, & add this figure to the smaller rate.
IRR = 18%+0.30% = 18.30%
Or you can divide the NPV of the larger rate by the absolute sum, & you get:
-640/910-0.70 t0 the nearest two digits after the decimal point, & subtract this figure
from the larger rate to obtain the exact IRR.
IRR = 19%-0.70% = 18%
In both cases, you arrive at the same IRR value of 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, & this surplus
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adds up on the wealth of the shareholders of the firm. Therefore, selecting 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.
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1. Difference in the size of investment
All investments do not usually require the same amount of initial outlay. One investment may
have larger initial investment than its alternatives. In this case, NPV leads to better investment
decision b/c it ensures that the firm will reach the optimal scale of investment. NPV
automatically examines & compares the incremental cash flows against the cost of capital. The
IRR criteria ignore this important aspect of an investment decision b/c the return is expressed in
a percentage.
To illustrate, the difference b/n the NPV & IRR as project ranking techniques consider the
following mutually exclusive projects, project A & project B.
012 345
Project A (50,000) 17,000 17,000 17,000 17,000 17,000
Project B (32,000) 12,000 12,000 12,000 12,000 12,000
The required rate of return for this project is 8%. Which one of these two projects should be
selected? From the above illustrative example, we can see that the lives of both projects are the
same. However, the initial investment of project A is greater than that of project B. Thus; one
can learn that there is a difference in the size or scale of investment. In order to identify the
project to be selected, the NPV & IRR for both projects have to be calculated. Since the cash
flows for both projects arte in an annuity form, the IRR can be easily determined from the
present value table of annuity after determining the discount factors. Therefore, the discount
50,000
factor for project A = = 2.941
17,000
Looking in the present value table of annuity in the raw of 5 years, the discount factor of 2.941
corresponds to 20.8%.
32,000
The discount factor for project A = = 2.667
12,000
Looking in the present value of annuity table across the 5 year (n=5) row, the discount factor of
2.667 corresponds to 25.5% &
The NPV of project A = (17,000) (the discount factors of annuity at the required rate of 8%)-
50,000
= (17,000) (3.993)-50,000
= 17,881 birr
The NPV of project B = (12,000) (the discount factors of annuity at the required rate of 8%)-
50,000
= (12,000) (3.993)-50,000
=15,916 birr
The above calculations indicate that both projects are acceptable if they are independent
projects. However, those projects are mutually exclusive. As a result, IRR ranks project B first,
but NPV ranks project A first. Thus, there is a paradox b/n the two methods. in order to clarify
such paradoxical result, it is advisable involved. Then the internal rate of return (cross over rate)
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is determined on the incremental cash flows & additional investment. Additional investment is
the difference b/n the investment outlays of the two projects. Cross over rate is the discount rate
at which the NPV profiles of the two projects cross,& thus, at which the projects’ NPVs are
equal. Thus, the internal rate of return on incremental cash flows is the same as the cross over
rate. The cross over rate for the illustration under consideration is calculated in the same,
procedures as IRR for the project, i.e.
Discount factor = 18,000/5,000 = 3.600
From the present value of annuity table, the discount factor of 3.600 corresponds to the 12%
column. Thus, the cross over rate is 12%. The cross over rate indicates that indicates that the
NPV gives priority to projects A at discount rates below cross over rate of 12%, but IRR
supports project B for a discount rate above the cross over rate.
Since the cost of capital is 8%, the incremental cash flow represents a profitable opportunity.
Therefore, the larger project which incorporates these additional cash flows should be accepted.
If the cross over rate is less than the cost of capital (IRR), the project with the smaller investment
should be selected b/c the additional commitment of resources will not be compensated.
Therefore, by examining & comparing the incremental cash flows against the cost of capital, the
NPV method ensures that the firm will reach the optimal scale or size of investment.
2. Difference in timing of cash flows
The NPV & the IRR can still give contradictory ranking even when initial investment outlays are
the same b/c of the difference in the timing of the cash flows. Most of the cash flows one project
may occur in the early years & most of the cash flows from the other project may occur during
the later years. The critical issue is that “how useful is the project if it generates cash flows
sooner than later?” so, which method should be sued?
Basically, the cash flows that occur sooner are better than the cash flows that occur later b/c early
cash flows can be reinvested. In fact, we cannot use the scale of investment project argument
discussed earlier to justify the preference of NPV & IRR. However, we can still use the same
incremental cash flow technique. So, how can we justify the use of NPV as a project ranking &
evaluating method when differences in the scale of investment do not exist?
In order to justify the superiority of NPV rule over that of the IRR, we need to consider the
reinvestment rate assumption of early cash flows. According to the reinvestment rate assumption,
NPV method implicitly assumes that the cost of capital (RRR) is the rate of which cash flows
can be reinvested, whereas the IRR method assumes that the business firm has the opportunity to
reinvest at the IRR. Which assumption do you think is better?
The best assumption is the one that considers the reinvestment of cash flows at the cost of
capital, i.e. NPV method, the IRR method incorrectly penalizes the receipts of more distant years
by using high discount rate (IRR) B/C IRR is greater than required rate of return (RRR). Thus,
the best reinvestment rate assumption is the cost of capital which is consistent with NPV method.
To illustrate, let us assume that project A & project B have the same initial investments, 10,000
birr. The RRR is for the firm 10%.
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Year project A project B
0 (10,000) (10,000)
1 - 6,000
2 13,924 7,200
IRR 18% 20%
NPV 1,501 1,401
Which project should be selected?
IRR singles that project B is better than project A; whereas NPV signals that project A is better
than project B. Since NPV method is the superior top the IRR method in selecting b/n two
mutually exclusive projects, project A is selected. Project A will provide the most wealth to the
shareholders. To prove the soundness of this decision, we can calculate the terminal value of
each project using future value technique. Thus, terminal value of:
Project A = 13,924 birr
Project B = 7,200 birr + (6,000) (1.1) birr =13,200 birr
Since the terminal value of project A is greater than the terminal value of project B, the former
project is selected which is in line with the NPV decision rules.
Projects with unequal lives
Earlier in this chapter, we assumed that mutually exclusive projects have equal lives. But there
are many situations in which alternative investment 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, there 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 off projects with unequal lives consider two mutually exclusive
projects whose cash flows are summarized below. The discount rate for both projects is 10%.
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 - - -
Two projects are incomparable. Thus, according to replacement chain approach, project B will
be repeated in the three years. Assuming that cash flow & the discount rates will not change.
Thus, if project B is repeated, its year 4, years 5, & year 6 cash flows are 12,000 birr, 14,000 birr,
& 13,000 birr respectively. In this way, the two projects have the same life. If project B is
repeated, its cash flows will be:
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0 1 2 3 4 5 6
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Step 1: find each project’s NPV over its initial life. The NPV for the above projects are as
follows:
Project A = 9,573 birr (as computed before)
Project B = (12,000) (0.909) + (14,000) (0.826) + (13,000) (0.751)-(30,000) =2,235 birr
Step 2: find the equivalent annual annuity that has the same present value as the project’s N
Equivalent annual annuity can be calculated as follows.
Project A NPV = PV of cash flows – PV of initial outlays.
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 & I=10%,
the discount factor is 4,355. As you know PV of cash flows = cash flow x discount factor.49,
573= (4.355) (x)
Where, x is the equivalent annual annuity.
X= 49,573/4.355 = 11,383 birr
For project B NPV = PV of cash flows – PV of initial outlays
2,235 = PV of cash flows – 30,000
2,235 + 30,000 = PV of cash flows
PV of cash flows=32,235. By looking up in the present value of annuity table for the discount
that corresponds to n=3 & I=10% is 2.487. Hence
2.487(y)= 32,235 where, y is represents the equivalent annual annuity amount for the
project. Solving for y we get. Y = 32,235/2.487 = 12,961 birr
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.
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