CHAPTER – 4

COST OF CAPITAL
INTRODUCTION
The concept of capital is based on the assumption that the core goal of profit -Seeking business
firms is to maximize the wealth of shareholders. This assumption makes it possible to formulate
several equivalent definitions of cost of capital that pinpoint some important implications in the
concept of cost of capital. The concept of cost of capital has its roots in the items on the right -
hand-side of the balance sheet, which includes various types of debt, preferred stock, common
stock, and retained earnings. These items are called the capital components. An increase in total
asset must be financed by an increase in one or more of these capital components. Capital is one
of the necessary components of production/operation of a business firm, and like any other factor
it has a cost of its own. The cost of each component of capital is called component/specific cost
of particular capital.
Every profit-making/seeking business firm has its own risk-return characteristics. Each group of
investors in the business firm such as bondholders, preferred stockholders, and common
stockholders requires a minimum rate of return that commensurate with the risks the group
accepts as a result of investing in the firm. From the stand point of the firm, these groups
provide the capital (financial resources) needed to finance the firm’s investments in its total
assets. The minimum rate of return that the business firm must earn in order to satisfy the
overall rate of return required by its financers is called the firm’s cost of capital.
Definition of cost of capital and its implications;
The most important implication of the definition of cost-of-capital can be stated as follows:
If the actual rate of return that the business firm earns exceeds its cost-of-capital, and if this rate
of return is earned without increasing the risk characteristics of the firm, than the shareholders’
wealth is increased, which further implies the achievement of the basic goal of the business firm
(i.e. the maximization of shareholders wealth). The reasoning behind this implication is that
when the rate of return of the firm exceeds its cost of-capital, the bondholders and preferred
stock holders will basically receive their fixed rate of return. Then, the remaining portion of the
firm’s rate of return that is available to common stockholders will definitely exceed their
required rate of return. The excess earnings, then, may be treated in several ways of which some
are:

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 1 The business firm may distribute these excess earnings to common stockholders in the
form of increased dividends, or
2 The business firm may retain and reinvest these excess earnings to further increase its
subsequent rate of return, or
3 The business firm may divide the excess earnings between the increased dividends and
retained earnings (i.e. part of the excess earnings may be distributed to common
stockholders in the form of increased dividends, and other portion of the earnings may be
retained for further expansion of firm’s operation.)

As the consequence of the decision made in relation to the excess earnings, the common shares
will become more demanded in the stock market and the increased demand for common share
ownership will increase the resale prices of common shares. In such a way, shareholders; wealth
will be maximized, thus meeting the basic goal of the business firm. An alternative definition of
cost-of-capital considers cost-of-capital as the minimum rate of return that the firm must earn on
its invested capital if the market value of the firm is to remain unchanged. This definition, as you
can understand, assumes cost-of-capital as a “break-even” rate. According to this definition,
cost-of-capital is the rate that maintains the current market value of the firm. If this cost of
capital (rate of return) is not earned, the market value of the firm will decline. A second
implication of cost-of-capital definition links cost-of-capital with the firm’s capital-budgeting
process. The cost-of-capital is the rate that serves as a discount rate used in evaluating capital-
budgeting alternatives. In the same taken, the firm’s market value is decreased when the rate of
return on its investment projects falls below its cost – of – capital. Hence, using cost-of-capital
(discount rate) to evaluate capital budgeting alternatives is consistent with the firm’s goal of
share holders’ wealth maximization.
Measuring specific (component) Cost-of-capital:
As it was indicated at the beginning, the capital structure of the business firm contains debts
(bonds), preferred stocks, common stocks, and retained earnings and has its own minimum
required rate of return, and its own cost-of-capital (the average cost-of capital). The cost-of-
capital has to be computed for each capital source and security issue. The cost -of-each capital
source or component is called the specific cost-of-capital, or the component cost of that
particular type of capital. Since the measurement of specific cost-of-capital is a difficult process,

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the resulting costs must be looked upon as approximations. The difficulty arises primarily
because the market value of the firm changes constantly and a good deal of this fluctuation is
caused by external factors such as inflation, over which the firm has no control. As a result,
some relatively simple approximation equations are used to determine the specific cost of capital.
Specific cost of Debt:
Since most long-term debts of the firm are in the form of bonds, computation of the cost of debt
capital is based on the characteristics of bonds and the interest charges the bonds impose on the
firm. Estimating this specific (component) cost of debts (bonds) requires computing the
effective cost of debt to the firm and stating this effective cost of debt as an annual compounding
rate.
The computation of the specific (component) cost of debts (bonds) involves three steps:
Step 1: Determine the net proceeds per bond to the firm issuing the value of the bond (usually
1000 Birr) after the costs of selling the bond to the firm are deducted. For instance, the bonds in
the particular bond issue may have 1000 Birr par value. If the bonds are sold at par and the
issuing company pays a 20 Birr selling (flouting) costs per bond, the net proceed per bond is 980
Birr.
Step 2: Determine the effective before-tax cost-of-debt (bond) and use the net proceed from the
bond issue as a time zero cash inflows. Use the annuity of interest payments and the repayment
of the bonds principal (par value) at maturity as the cash outflow. The effective before-tax cost
of debt (bond) is the rate at which the sum of the present values of the interest payments annuity
and the present values of the principal (par value) payment at maturity is equal to the proceeds
from the bond issue. If the net proceed is equal to the par value (face value) of the bond, the
effective before-tax cost of debt is exactly equals to the interest rate attached to the bond (coupon
rate of the bond).
Step3: Since the interest payments are deductible for income tax purpose, you need to convert
the computed before-tax cost of capital into the after-tax cost-of-capital. This is done by
deducting the tax-savings rate from the before-tax cost of capital. The resulting value is the
specific cost-of-capital.
Let:
Kd= Effective before-tax cost of debt
T= Company tax rate, then

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After-tax component cost of debt = Kd (1-T)
Assume that the Ethiopian Government (National Bank of Ethiopia) sells bond issues for 20
million Birr that is to mature in 25 years of time. Each bond is expected to have a par value of
1000 Birr and carries a coupon interest rate of 12 percent. The income tax rate is assumed to be
40 percent. The government (NBE) nets for 985 Birr per bond. Compute the specific
(component) cost of debt (bond) capital to the government. The proceeds per bond that the
government (NBE) collects are 985 Birr. Since the proceed from the sale of the bond is less than
its par value (face value), the before-tax cost of capital of debt should be different form the
coupon rate of the bond. The proceeds from sales of the bond are sold at a discount. Hence, the
government is to pay the coupon rate plus the discount amount (which is 15 Birr per bond in this
case). This implies that the effective before tax cost of bond is greater than the coupon rate of 12
percent because of the addition cost paid in the form of discount on issue. In this case we have to
compute the discounting rate that will equate the sum of the present values of interest payments
annuity and the present value of the principal repayment at maturity of the bond. This rate, as it
was stated, the effective before-tax cost of capital of debt (bond). This rate is computed by trial
and error hint, beginning with the coupon rate moving to the next higher rate). The annual
interest payment equals 1000x12% = 120 Birr per bond per year. Thus, the 120 Birr will be paid
as an interest per bond for the coming 25 years. In addition, the principal (face) value of the
bond (i.e. 1000Birr) will be paid at the end of the 25 years (at maturity).

The specific cost of preferred stock

When a business firm sells preferred stock, it expects to pay fixed dividends to investors
(preferred stock holders) in the return for their money capital. The dividend payments are
basically the cost of the firm preferred stock. In order to express these dividends as yearly rated,
the firm uses the net proceeds it receives after deducting whatever costs incurred in selling (
floating) the issue. If, for example the firm sells the preferred stock for 40 Birr per share and
pays a 2 Birr selling (flotation costs) per share, the firm has to use 38 Birr (40-2) net proceeds
per share in computing the specific (component) cost of capital of preferred stock.
The specific cost of capital of preferred stock, Kps, is the preferred dividends, Dps, divided by
the net proceeds from the issuance of the share Pn, or the price of the share that the firm accepts
after deducting the flotation costs.

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 D ps

In general, specific cost of Preferred share = Kps = P.n

For example, suppose that Bontu Share Company has preferred stock that pays a 10 Birr
dividend per share and sells for 100 Birr per share in the market. If Bontu share company issues
new shares of preferred stock, it will incur an underwriting or flotation cost of 2.5 percent of the
selling price, or 2.50 Birr per share, so it will net 9.50 Birr per share. Therefore, the specific cost
of capital of preferred stock for Bontu share company would be: Specific cost of capital of
preferred stock = K ps =D ps /Pn = 10/97.50 = 10.26%
No tax adjustments are made when calculating the specific cost capital of preferred stock (Kps)
because preferred dividend unlike interest expenses on debt, are non-tax deduct able, hence there
are not tax saving associated with use of preferred stock as a source of capital.
Specific cost of common stock
The specific (component) cost of capital of common stock is the minimum rate of return
that the business firm must earn for its common shareholders in order to maintain the
market value of the firm’s equity. When the firm sells its common stock issue and nets
for Pn Birr amount per share, it can set the net proceeds equal to the stocks’ intrinsic
value because investors have been willing to acquire the security at the price that nets the
firm an amount of Pn Birr.

Ke = Do (1+g) + g
Pn
This is the equation that is used most frequently to measure the specific cost of capital of
common stock. However, it is based on the assumption of the dividend stream that increases
indefinitely at a given compound rate of ‘g’. This compound rate, ‘g’, is the compound rate of
growth of common stock dividend that might be determined from the records in the past related
to dividend growth. Therefore, the use of this equation is limited to those business firms whose
expected future dividend stream at least approximates this assumption. For instance, assume that
Nib international Bank (NIB) sells an issue of common stock to potential investors in the
country. The selling price per the common share of the bank is 20 Birr. The bank incurs a
selling (flotation) cost of 2.50 Birr per share. The current dividend of the bank’s common share
is 2.00 Brr per share. The current dividend of the bank’s common share is 2.00 Birr per year and

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it is expected to grow at 5 percent annual compound rate. Compute the specific cost of capital of
common stock of Nib International Bank.
The net proceeds per share = Pn = Selling price – Flotation cost
= 20-2.50 = 17.50 Birr per share
Annual dividend = Do = 2.00 Birr per share.
Dividend growth rate per year = 9 = 5%, or 0.05
Therefore,
Ke = Do (1+9) + 9 = (2.00)(1+0.05) + 0.05
Pn 17.50
= (2.00)(1.05) + 0.05
17.50
= 2.10 + 0.05
17.50
= 0.12 + 0.05 = 0.17 or 17%
There is no need to make income tax adjustment to the computed specific cost of capital of
common stock of 17 percent because common stock dividends, unlike interest on debts (bonds),
are not tax deductible, hence there is no tax-savings associated with the use of common stock
financing.
Specific Cost of Retained Earnings
There are two difficulties with computing the specific (component) cost of capital of retained
earnings. Both of these difficulties arise from the nature of the retained earnings. Retained
earnings are an internal, as opposed to external source of funds. First, retained earnings are not
securities, like that of stocks and bonds. Thus, they do not have market values/prices that can be
used to compute their specific cost of capital. Second, since retained earnings do not represent
funds provided directly by common stock holders (investors), there may be a tendency to equate
the specific cost of capital of retained earnings with zero. The approach that is used to measure
the specific cost of capital of retained earnings is to realize that retained earnings represent
profits earned during the current year and available to common shareholders that the business
firm decides to reinvest in itself rather than payout as dividends. Thus, the shareholders are
made to reinvest part of their earnings in the firm. In return, the shareholders expect the firm to
earn a rate of return on these retained funds which is at least equal to the rate earned on the
outstanding common stock. Once, the business firm has earned net profit after tax, it is available
for the common shareholders in the form of dividend. If the net profit after-tax is decided to be

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reinvested in the business it is equivalent to the existing common stock capital. Both the
outstanding common stock and the retained earnings belong to the common stockholders’ equity
and the shareholders expect similar returns on both capital sources. Therefore, the specific cost
of capital of retained earnings is estimated on the bases on the specific cost of capital of common
stock. However, since no selling (floating) costs are incurred in relation to the retention of
earnings, the current market price of common stock, instead of net proceed, is used in the
computation of cost of capital.
The other logic behind attaching the specific cost of capital of retained earnings to that of
common stock is that the market price of common stock is the reflection of the performance of
the business firm which is, to the same extent, measured by the amount of net profit after tax that
is retained for further expansion. If the trend of the business firm shows a continuous growth,
the firm would, in most cases, retain larger portion of its earnings after-tax and at the same time
the market price of the firm’s common shares will either increase or be maintained at the current
level. This clearly shows the existence of strong correlation between retained earnings and
common stock. Therefore, it is reasonable to estimate the specific cost of capital of retained
earnings based on the market value of common share (Po), current dividend per common share
(Do), and compound dividend growth rate per year (9) but ignoring the selling (flotation) costs
since retained earnings are not marketable securities.
Hence,
Specific cost of capital of retained earnings = Kr = Do (1+g) +g
Po
Where, Do = Current dividend per common share
G = Compound dividend growth rate
Po = Current market price of the firm’s common share
Kr = Specific cost of capital of retained earnings.
The only difference between the specific costs of capital equations of retained earnings and
common stock is that the specific cost of capital of retained earnings equation uses the current
market price of the firm’s common stock as a denominator, while the specific cost of capital of
common stock equation uses the proceeds from sales of common stock (i.e. the current market
price of common share less any selling (floating) cost involved in the issuing process of the
common shares. Referring back to the example on the specific cost of capital of common stock

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was computed to be 17 percent. The specific cost of capital of retained earnings for the same
data set is:

Kr = Do (1+9) + 9 = 2.00 (1+0.05) + 0.05

Po 20

= 2.00 (1.05) + 0.05 = 2.1 +0.05 = 0.105 + 0.05

20 20 = 0.15 or 15%

Therefore, the specific cost of capital of retained earnings is only is 15 percent. Here, the
specific cost of capital of retained earnings (11percent) is less than the specific cost of capital of
common stocks (17percent) because common stock issuance involves selling (flotation) cost
while retaining earnings after-tax doesn’t involve any costs.
Weighted Average Cost-of-Capital of the Business Firms:
Once the specific (component) costs of capital for each firm’s long term financing source has
been measured, it is possible to measure the firm’s overall cost-of-capital. It has been defined as
a rate of return that must be earned by the firm in order to satisfy the requirements of the
individual specific (component) costs of capital. The overall cost of capital (weighted average
cost of capital) that is computed from the firm’s existing capital structure allows the firm to
obtain a measure of a minimum rate of return that must be earned on its entire investments. The
overall cost of capital (weighted average cost of capital) of the firm can be helpful in identifying
the discount rate to be used in evaluating the capital-budgeting decisions.
The percentage compositions (weights) can be based either on the book values of the sources of
capital or on their market values. The use of both values to determine the percentage
composition of each capital source of the capital structure has both advantages and limitations.
Book Value Weights:
The first approach to measure firm’s weighted average cost of capital is to use the balance sheet
book values of the individual source of long term and permanent capital. These book values
reflect the amount of capital the firm has raised by selling securities as well as the amount of
capital that has been generated by reinvesting earnings that were not paid out as common stock
dividends. Since each source of capital has its own cost of capital, the following three steps are
needed to compute the overall, weighted average, cost of capital on the basis of book value
weights:

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 1. Find the percentage of long-term capital provided by each financing source. The Birr
values for each capital sources are taken from the firm’s balance sheet.
2. Multiply each capital percentage by its specific (component) cost of capital.
3. Add the products you have computed under step 2.

To illustrate the use of book values of sources of capital as the basis of determining the overall
cost of capital (weighted average cost of capital), assume Lemlem company whose capital
structure contains the following book values and specific costs of capital of its capital sources.
Lemlem Company
Book values and specific cost of capital for a Given Capital Structure
Source of capital Book value Specific cost of capital
9% bonds, 1000Birr par 15,000,000 Birr 5.4%, or 0.054
50,000 Shares, 8 Birr preferred Stock 5,000,000 Birr 8.0%, or 0.080
Common stock, 400,000 shares Outstanding 20,000,000 Birr 11.0% or 0.110
Retained earnings 10,000,000 Birr 10.5%, or 0.105

The specific costs of capital given for Lemlem Company are assumed to have been computed
using the equations for each type of specific costs of capital indicated earlier. The book value
weights are obtained by dividing the book value of each financing source by the total book
values of all financing sources (i.e. 50,000,000 Birr in the case of this example). The book
values weights are then multiplied by the corresponding specific cost of capital to give the
weighted costs. The sum of these weighted costs equals 8.92 percent. This sum of the weighted
costs of the company is what we call the weighted average cost of capital (WACC). The
computation of the WACC on the basis of the book value weights is shown below.
Lemlem Company
Computation of weighted Average cost of capital

Book value Specific cost Weighted

Source of capital Weights of capital costs
9% bond, 1000Birr par……. 0.30 ……… 0.054 ……………. 0.0162
50,000 shares, 8 Birr Preferred Stock ------ 0.10 -------- 0.080 ---------------- 0.0080

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Common Stock, 400,000Outstanding shares 0.40 -------- 0.110 ---------------- 0.0440
Retained earnings ----------- 0.20 -------- 0.105 ---------------- 0.0210
Total 0.0892
The total (sum) of weighted costs is equal to 0.0892 which means 8.92 percent. This is to mean
that Lemlem company is required to earn a minimum of 8.92 percent on its total funds obtained
from all long-term sources, if the company is to satisfy the minimum requirements of its
financers (such as bondholders, preferred stockholders, and common stockholders). The
advantages of using book-value weights in computing a company’s weighted average cost of
capital are as follows:
1. The weighted average cost of capital (WACC) computation is so simple as book values
are available in the balance sheet of the company.
2. The computed weighted average cost of capital (WACC) using book value weights is
generally stable overtime because book value weights are not dependent on market value
which is highly volatile.
3. When the market values/prices of firm’s securities are being influenced by external
factors like inflation, book values don’t.
Book value weights may provide the only usable estimates of the firm’s weighted average cost of
capital. There are two principal limitations in using the book value weights for the computation
of weighted average cost of capital (WACC). These are:
1. Book values provide a historical (based on past data) weighted average cost of capital
that may not yield a cost-of-capital value that is useful for evaluating current strategies.
2. Their use is not consistent with the concept contained in the definition of the overall cost
of capital of the business firm. That definition, as we have touched upon, speaks of a
minimum rate of rate of return needed to maintain the firm’s market value, but the book
value weights ignore market values. As a result, the weighted average cost of capit al of
the firm that is determined on the basis of book value weights can be used only to provide
a quick estimate of the rate of return that investors require form their firm. Otherwise,
the weighted average cost of capital calculated by using book value weights can’t reflect
what is going on in the market at present accurately.

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Market value weights:
A second approach of measuring weighted average cost of capital is to use the market values of
the firm’s securities as weights in the computational process. The resulting cost of capital from
this process reflects the rate of return currently required by investors rather than the historical
rate embodied in the firm’s balance sheet. The computation of the weighted average cost of
capital of a firm using the market value weights requires you to go through the following four
steps:
1. Find the market value of each financing sources, using the current market prices of the
securities.
2. Divide each of the market values by the total market values of all capital sources in order
to obtain the market value weight.
3. Multiply the specific costs of capital (already determined) by their corresponding market
value weights (for example, the specific cost of capital of debts (bonds) is multiplied by
the market value weight of debts (bond) ). The resulting products are the weighted costs.
4. Add the products (weighted costs) you have computed under step 3 above. The sum of
the products is what is called the weighted average cost, of capital (overall costs of
capital) (based on market values).
To illustrate, the computation of weighted average cost of capital of the firm using the market
values of the financing sources, assume the same information provided for Lemlem company
with the necessary market values for each sources which are observed to be the following: Bond
prices are 95 percent of their par values, preferred stocks are 100 Birr per share, and common
stocks are sold for 75 Birr per share.
The first step is to determine the market value for each financing sources. The market values for
bonds, preferred stocks, and common stocks are available in the market at any point in time since
these are securities that are exchanged in the stock exchange markets. But in countries, like ours,
the market value for these securities are hardly available because there is no a formally organized
stock exchange market that sets prices for these securities. Even if there is the stock exchange
market for these securities, the market value will not be available for retained earnings which are
not securities but sources of firm’s funds. As you remember from our previous discussions, the
specific cost of capital of retained earnings was estimated on the basis of the specific cost of
capital of common stock. In the same way, the market value of retained earnings is derived from

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the market value of common stock. The Market value of common stock is divided between
common stock and retained earnings in the same proportion of their book values. The market
values of each financing sources are:

(0.95) (15,000,000) = 14,250,000 birr for the bonds

(100) (50,000 shares) = 5,000,000 birr for the preferred stock

(75) (400,000 shares) = 30,000,000 birr for the common stock

49,250,000 birr for the total capital structure.

Then, as stated above, the market value of common stock of 30,000,000 birr is divided between
common stock and retained earnings on the bases of their book values in the balance sheet.
Their book values are 20,000,000 Birr for common stock and 10,000,000 Birr for retained
earnings and 30,000,000 in total for both.

Thus, 20,000,000 x 30,000,000 = 20,000,000 Birr (the market value of common

30,000,000 stock allocated to common stock, and

10,000,000 x 30,000,000 = 10,000,000 Birr (the market value of

30,000,000 common stock allocated to retained earnings).

The resulting market values and the market value weights computed from the market values
themselves are indicated below for the company.

Lemlem Company
Market values and their weights for the company’s capital structure
Source of capital Market value Market value weight
9% bond, 1000 Birr par ---------- 14,250,000 ---------------- 0.289
50,000 shares, 8 Birr preferred Stock ------------ 5,000,000 ----------------- 0.102
Common stock, 400,000 shares Outstanding ----20,000,000 ---------------- 0.406
Retained earnings ------------ 10,000,000 ---------------- 0.203
Total 49,250,000 1.000

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 The market value weight for bonds of 0.289 is determined by determined by dividing the market
value of bonds (i.e 14,250,000) by the total market values (i.e. 49,250,000). The other market
value weights are determined in the same manner. Next to the determination of market value
weights, these weights are multiplied by the corresponding specific cost of capital of the
financing sources and the resulting products are added. The sum of 0.0898 or 8.98 percent
which represents the company’s weighted average cost of capital, computed by using market
value weights as shown below.
Lemlem company
Weighted Average cost of capital using market value weights
Source of capital Market value weight x specific cost = weighted
Cost

9% bonds, 1000 Birr par 0.289 0.054 0.0156

50,000 shares, 8 Birr Preferred stock 0.102 0.080 0.0082
Common Stock, 400,000
Shares outstanding 0.406 0.110 0.0447
Retained earnings 0.203 0.105 0.0213
Total 0.0898
Therefore, the average cost of capital that reflects the current conditions in the market is 8.98 percent
for Lemlem Company. The advantages of using the market value weights in computing a company’s
weighted average cost of capital are:
1. The use of market value weights is consistent with the concept of maintaining market
values in the cost-of-capital definition.
2. They provide current estimates of financers (investors) required rate of return, which are
more relevant than historical book value weights in evaluating current capital budgeting
alternatives.
3. To the extent that business firm has attained its targeted or desired capital structure, market
value weights will yield good estimate of cost of capital that would be incurred in case the firm
needs additional financing.
The limitations of using market value weights in computing cost-of-capital are:

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 1. Market value weights are more difficult to use in computing the overall cost of capital of
the firm than the book value weights which are readily available. It is difficult not only to
obtain the market value of the financing sources but also to allocate the market value of the
common stock between common stock and retained earnings when the specific cost of capital
of retained earnings is if the selling costs (flotation costs) of common shares are insignificant
and to be ignored, the specific costs-of-capital of common stock and retained earnings are the
same and there is no need to allocate the market values of common stock between the two.
2. Since the market values/ prices of the firm’s securities change daily, the market value of the
firm and its corresponding cost daily, the market value of value weights also change daily of
capital using market value weights also change daily and highly instable to make use of them.
3. Market value weight can seriously distort the overall cost of capital of the business firm
when the prices of its securities are significantly influenced by external factors/forces
such as inflation. Inflation can depress bond prices severely for a period of time. This
has an effect of increasing the specific cost of capital bonds beyond what it would have
been. If market value weights are to relied upon the computed weighted average cost of
capital may have to be adjusted subjectively for what have been thought to be distortions
by external forces.

Marginal Cost of Capital (MCC):

In the previous section, it was tried to analyze cost-of-capital when the firm’s total financing
remained constant. In reality, the desire of the firm to finance new investment proposals using
internal and/or external funds requires that the firm has to increase its total capital base. When
this happens the cost of capital of the additional financing is called Marginal Cost of Capital
(MCC). Thus, the marginal cost of capital, MCC, is d efined as the cost of the last birr of new
capital the firm raises, and this cost (i.e MCC) rises as more and more capital is raised during a
given period. If the additional financing uses more than one type of funds, such as a
combination of retained earnings and debts, the weighted average cost of capital of the new
financing is called the weighted marginal cost of capital.
Calculating the Marginal Cost of Capital (MCC):

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The firm’s marginal cost of capital (MCC) is a function of several variables. Because of this,
calculating the marginal cost of capital is often a difficult task that yields only approximations of
true values. These variables are:
1. Investors may perceive that the firm’s business risk will increase as a result of new
investment decisions that require additional financing.
2. If new financing changes the percentage composition of the financing sources (composition
of capital structure), its financial risk may increase. Increases in financial and business risks
will be reflected in higher MCC.
3. The investment alternatives that are available and desirable to the firm may require a large
amount of financing relative to its existing total capital. In this case, the size of the desired
financing may increase the firm’s MCC and thus may reduce the importance of some of the
investment alternatives.
4. External forces such as inflation may increase the firm’s MCC to the point where it delays
raising long-term external capital and forcing the firm to finance its new investment proposals
with funds from retained earnings source.
The Marginal Cost of Capital (MCC) calculation procedures followed in this material are based
on the following assumptions.
1. The new financing decision has a minimum impact on the existing capital decision and
has a minimum impact on the existing capital structure of the firm. This assumption
implies that the percentage composition of new financing is specified by the financial
managers of the firms.
2. Market value weights are used. The choice of weights is based on the realizations that
new capital is obtained by paying the cost-of –capital which is a good estimate of the
current market price of capital that market value weights based MCC is more relevant
than the MCC that is computed on the basis of book values of the existing capital
structure.

Financing New Investment Proposal With Retained Earnings:

When the business firm is able to finance its new investment alternative completely with retained
earnings the marginal cost of capital (MCC) equals the specific cost of capital of retained

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earnings. To illustrate, suppose that the existing capital structure composition and specific costs
of capital of each financing source of Selam Share Company are as follows:
Source of Capital Percentage Composition Specific-cost-of-Capital
Bonds…………………….. 0.30 ………………………… 0.06
Common Equity (Common
Stock & retained earnings) 0.70 ………………….. …… 0.13

As it was discussed earlier, the weighted average cost of capital (WACC) for this capital
structure of Selam Share Company is:
(0.3) (0.06) + (0.70) (0.13) = 0.018 + 0.091 = 0.109, or 10.90%.

Assume also that Selam Share Company has decided to finance the new investment proposal that
requires a start-up cost of 2.5 million Birr entirely with funds retained earnings source. The
question here, is, “What is the cost of capital to finance new investment proposal (MCC) by
retaining from the earnings of the company during the current year?” Assume also that the given
specific cost of capital are constant, the marginal cost of capital (MCC) of additional financing is
13 percent which is the specific cost of capital of retained earnings. Though the weighted
average cost of capital (WACC) of the existing capital structure of Selam Share Company is 10.9
percent and the marginal cost of capital of the additional capital is 13 percent because the
financing of new investment proposal was not made in the same pattern of the existing capital
structure (i.e 30 percent bonds, and 70 percent common equity including both common stock and
retained earnings). Rather the additional capital requirement to finance the new investment
proposal was raised 100 percent from retained earnings. Hence, the marginal cost of capital
(MCC) of additional financing of 2.5 million Birr is equal to the specific cost of capital retained
earnings, which is 13 percent.
Financing New Invest Proposal with Constant Cost of Capital
If the specific costs of capital in the new financing equal the specific costs of the existing capital
structure of the firm, and if the new financing doesn't change the existing capital structure
proportion, then the marginal cost of capital equals the weighted average cost of the existing
capital structure of the firm. To illustrate this case, assume the existing capital structure

Page | 16
composition and the specific cost of capital of each financing source of Ture Share Company is
as follows:
Percentage Specific Cost
Capital Source Composition of Capital
Bonds……………………………….. 0.10……………………………….. 0.05
Common Stocks …………………… 0.50 ………………………………. 0.10
Retained earnings …………………. 0.40 ……………………………… 0.09
The weighted average cost of capital (WACC) of the existing capital structure of Ture Share
Company is 9.1 percent computed as follows:
WACC = (0.10) (0.05) + (0.5) (0.10) + (0.4) (0.09)
= 0.005 + 0.05 + 0.036
= 0.091 or 9.1%
Ture Share Company proposes to finance a 4 million Birr capital project by using retained
earnings of 1.6 million birr generated during the current accounting period, by raising 400,000
birr through bonds issues, and 2 million birr through common share issues. The company
estimates the specific cost of capital of the new source of funds and found that they are equal to
the specific costs of the existing capital structure for each capital sources. Of the total new
financing each source provides the following:
Retained earnings: 16 million Birr / 4 million Birr = 0.40, or 40%
Bonds : 400,000 Birr/ 4million Birr = 0.10, or 10%
Common Stock : 2 million Birr/ 4 million Birr = 0.50, or 50%
The percentage composition of the new financing is the same as that of the percentage
composition of the existing capital structure (i.e. both of the capital structures, new and existing,
are formed from 10 percent bonds, 50 percent common stock, and 40 percent retained earnings.)
Therefore, the marginal cost of capital (MCC) under such conditions (i.e. when the new
financing decision doesn't entails any change in the composition of the existing capital structure,
and when the specific cost of capital of the new financing sources are the same as that of the
specific costs of capital in the existing capital structure) is equal to the weighted average cost of
capital of the existing capital structure (WACC), or it can be computed as:
The weighted MCC = (0.40) (0.09) + (0.10) (.0.05) + (0.50) (0.10)
= 0.036 + 0.005 + 0.05 = 0.091, or 9.10%

Page | 17
Thus, the weighted marginal cost of raising the ad ditional 4 million Birr financing is equal to the
weighted average cost of the existing capital (i.e. before the new financing) which is 9.1 percent.
Here, you can make a general conclusion that:
When the specific costs of capital of each source in the new financing are equal to their
corresponding specific costs of capital in the existing capital structure of the firm, and
When the new financing decision (additional fund raising decision) doesn't change the
composition of the existing capital structure of the firm, you can conclude that the weighted cost
of capital of additional (new) financing MCC, is equal to the weighted average cost of capital of
the existing capital structure (WACC).
These are situations where the specific cost of capital will not be affected by the amount of funds
raised as we assumed in the preceding examples. If the percentage composition of new financing
remain constant, and then the firm's weighted cost of capital will constant. When, on the other
hand, the weighted marginal cost of capital exceeds the weighted average cost of capital of the
existing capital, raising additional funds will increase the weighted average cost of the new
capital structure (i.e. the capital structure of the existing plus new financing). To illustrate the
impact of a new financing with different weighted marginal cost of capital (MCC) on the
weighted average cost of capital (WACC) of the existing capital structure, consider the current
capital structure of Misrak Share Company that contains a total of 50 million Birr and the
following components.
Source of Capital Percentage Composition Specific cost of Capital
Bonds 0.25 0.055
Common Stock 0.50 0.110
Retained earnings 0.25 0.105

The weighted average cost of capital for this capital structure is:
WACC = (0.25) (0.055) + (0.50) (0.110) + (0.25) (0.105)
= 0.01375 + 0.055 +0.02625
= 0.095, or 9.5%
Total expenditures for the proposed capital investment of the company range from 5 million to
10 million. In order to keep its capital structure composition constant, realizing that 2 million

Page | 18
Birr will be provided by retained earnings, the company would have to raise exactly 8 million
Birr in new capital as follows:
Bonds : 2 million Birr which constitute 25 percent
Common Stock : 4 million Birr which constitute 50 percent
Retained earnings : 2 million which constitute 25 percent
The specific cost of capital of raising the 8 million Birr is estimated as follows:
Source of capital Specific cost of capital
Bonds 0.06
Common Stock 0.12
Retained earnings 0.105
As you can observe the specific costs of capital of bonds and common stocks issues for the new
financing are slightly different from the specific costs of capital of bonds and common stock
issues in the existing capital structure (i.e. before the new financing). Though the new financing
doesn't change the company's existing capital structure composition, the differences that exist
between the specific costs of capital of bonds and common stock for the existing and new capital
of the company results in the weighted marginal cost of capital (MCC) that is different from the
weighted average cost of capital of the existing capital structure (WACC).
The weighted marginal cost of capital (MCC) of raising the additional funds of 8 million Birr to
finance the newly proposed investment alternative is:
Weighted MCC = (0.25) (0.06) + (0.50) (0.12) + (0.25) (0.105)
= 0.015 + 0.06 + 0.02625
= 0.1013 or 10.13%
Therefore, Misrak Share Company has to pay an average cost of 10.13 percent, or about 10 cents
on each Birr, on the additional 8 million Birr its needs to raise to finance the new capital
investment proposal, which is greater than the weighted average cost of capital of the existing
capital structure, 9.5 percent. If Misrak share company raises the additional 8 million Birr funds
as per the indicated composition (i.e. 25 percent from selling bonds, 50 percent from issuing
common shares and the remaining 25 percent from retaining earnings), the weighted average cost
of capital of the new 58 million Birr (i.e. 50 million existing capital plus 8 million Birr from
additional financing) capital structure is 9.59 percent as computed below.

Page | 19
Source of Capital Birr Amount Percentage Composition x Specific Cost = Weighted
Bonds (existing)…… 12,500,000 0.2155 0.055 0.0119
Bonds (new)………. 2,000,000 0.0345 0.060 0.0021
Common Stock
(existing)……….. 25,000,000 0.4310 0.110 0.0474
Common Stock(new) 4,000,000 0.0690 0.120 0.0083
Retained earnings
(existing) 12,500,000 0.2155 0.105 0.0226
Relined earnings(new) 2,000,000 0.0345 0.105 0.0036
Total 58,000,000 1,0000 WACC 0.0959
Therefore, the new financing of 8 million Birr with its associated weighted marginal cost of
capital of 10.13 percent has increased the weighted average cost of capital (WACC) from 9.5
percent to 9.59 percent.
Example:
Assume that the research conducted by Misrak Share Company indicates that the additional 2
million Birr need to finance the entire 10 million Birr of the proposed capital investment could
be raised by issuing additional common stock without changing its specific cost from 12 percent.
The weighted marginal cost of capital (MCC) of raising the 10 million is different from the
weighted marginal cost of capital of raising 8 million Birr in the new financing, and it would be:
Source of Capital Birr Amount Percentage Composition
Bonds 2,000,000 0.20
Common Stock 6,000,000 0.60
Retained earnings 2,000,000 0.20
Total 10,000,000 1.00

Hence, the weighted marginal cost (MCC) of raising the 10 million Birr in the new financing is:
= (0.2) (0.06) + (0.6) (0.12) (0.2) (0.105)
= 0.012 + 0.072 + 0.021
= 0.105, or 10.5%

Page | 20
Again the marginal cost of capital is different from the weighted average cost of the existing
capital structure (50 million Birr existing capital structure) which is only 9.5 percentages. If
Misrak Share Company raises the entire 10 million Birr as indicated above, the weighted average
cost of capital of the new 60 million Birr capital structure (i.e. 50 million Birr existing capital
plus 10 million Birr new financing) then becomes:
Percentage Specific cost Weighted
Source of Capital Birr Amount Composition of capital cost
Bonds (existing)…. 12,500,000 0.2083 0.055 0.0115
Bonds (new) ……. 2,000,000 0.0333 0.060 0.0020
Common Stock
(existing)……… 25,000,000 0.4167 0.110 0.0458
Common Stock (new). 6,000,000 0.1000 0.120 0.0120
Retained earnings
(Existing)……….. 12,500,000 0.2083 0.105 0.0219
Retained earnings (new) 2,000,000 0.0333 0.105 0.0035
Total …………. 60,000,000 1.0000 WACC 0.0967

The weighted average cost of capital (WACC) of the company increases from 9.5 percent to 9.67
percent as a result of its 10 million Birr additional financing. The percentage composition of its
capital structure also changes and is now:
Source of Capital Birr Amount Percentage Composition
Bonds ……………………. 14,500,000 0.24
Common Stock…………… 31,000,000 0.52
Retained earnings………… 14,500,000 0.24
Total………………….. 60,000,000 1.00

In this illustrative example, the company’s weighted marginal cost of capital is 10.13 percent for
8 million Birr financing and 10.5 percent for 10 million Birr financing even though the specific
costs of capital remain constant for both amounts of additional financing decisions. This
increase in the weighted MCC occurs because the percentage composition of each financing
package is different. Hence, in evaluating the capital investment proposal of 8 million Birr, the

Page | 21
financial analyst has to use a discount rate (MCC) of 10.13 percent. Similarly, the discount rate
for evaluating the 10 million Birr capital investment proposal is the 10.5 percent, which is again
the corresponding MCC.

Page | 22
 CHAPTER - 5
Capital Budgeting
Long-term investments are also called capital budgeting. The term capital according to Weston
and Brigham, 1985, refers to the fixed assets used in production, while a budget is a detailed plan
of projected cash flows during some future period. Thus, the capital budget of the firm outlines
the planned expenditures of the fixed assets, and capital budgeting is the whole process of
analyzing projects whose returns are expected to extend beyond the period of one year and
deciding which project should be included in the capital project. Capital budgeting expenditures
include expenditures for land, building, equipment, and for permanent additions to working
capital associated with plant expansion, for advertising and promotion campaigns, and for
research and development programs. The optimum capital budget is simultaneously determined
by the interaction of supply and demand forces under conditions of uncertainty. The forces of
supply refer to the supply of capital to the firm, or its cost of capital schedule. The forces of
demand on the other hand, refer to the investment opportunities available for the firm, as
measured by the stream of revenues that will result from an investment decision. Uncertainty of
conditions enters the decisions because it is impossible to know exactly either the cost of capital
or the stream of revenues that will be derived from a project. The following are some of the
importance of capital budgeting:
1. It has a long-term effect. The result of capital budgeting decisions continues over an
extended period. This enables the firm to be competitive in the market by keeping its
existing customers.
2. Effective capital budgeting will improve both the timing of assets acquisitions and the
quality of the acquired assets. Capital assets must be ready at the time they are needed. If
the firm forecasts its demand properly and plans its required capacity increases, it will be
able to maintain its market, (even to obtain a larger share of the market.) A firm which
forecasts its capital assets requirements advance will have the opportunity to purchase and
install the asset before its sales exceeds its capacity.
3. Capital budgeting enables the firm to raise funds early before the sales approach the
maximum capacity levels. Before the firm spends a large amount of money, it must take
the proper plans. Large amounts of funds are not available over night. A firm that

Page | 23
 contemplates a major capital expenditure program may need to arrange its financing
several years in advance to be sure of having the funds required for the program.
Approaches to Capital Budgeting
A systematic approach to capital budgeting requires the following procedures to follow:
1. The formulation of long-term strategy and goals
2. The creative search and identification of new investment opportunities.
3. The estimation and forecasting of current and future cash-flows.
4. A set of decision rules that can differentiate acceptable from unacceptable alternatives.
5. The building of suitable administrative framework that is capable of transferring the
required information to the decision level.
6. The controlling of expenditures and the careful monitoring of project implementation.
If the financial managers under take all the 6-step under the capital budgeting approach, they are
able to make effective capital budgeting decisions.
1. Formulation of Long-term Goals
Long-term goals serve as the guide for managerial decisions. A systematic approach to capital
budgeting decisions, thus, requires the formulation of a set of long-term goals. Management
will be concerned with both the expected returns and the risks assumed on its capital investment.
2. Generating Investment Proposals (Ideas):
A good investment proposal is not just born; someone has to suggest it. In addition, someone
within the firm must be willing to listen to such proposals. In the absence of creative search for
new investment opportunities, even the most sophisticated evaluation techniques may be
worthless. In a firm with well-equipped research and development division, sophisticated new
products, or processes are created by the division. In a small firm, the search for invest ment
possibilities may be less structured. It often takes the form of employee suggestion box, or
informal discussions during a coffee break. The search for opportunities should include the
acquisition of existing production and marketing facilities by means of a merger with another
company, as well as, the expansion of the company's own facilities or the creation of an entirely
new division.
The long-term investment proposals may be classified as follows:

a) Replacement (Maintenance of Business):- This refers to the expenditures necessary to

replace worn out or damaged fixed assets of the business firm.

Page | 24
 b) Replacement (cost reduction):- It refers to expenditures that are made to replace
serviceable but obsolete (outdated) equipments in order to lower the cost of labor,
materials, or other items such as electricity.

c) Expansion of Existing Products or Markets: - These are expenditures necessary to

produce new product or to expand into a geographic area not currently being surveyed.

d) Safety and/or Environmental Projects: - These are expenditures necessary for

complying with government orders, labor agreements, and insurance policy terms. These
expenditures are often called mandatory investments, non-revenue producing investment.

In general, capital budgeting projects can be classified into three categories:

a) Cost Reduction Projects

These projects are intended to reduce the firm's operating costs such as cost of labor, materials
electricity and so on. Cost reduction is achieved through the replacement of plants or fixed
assets. The benefit from cost reduction projects is cost savings.
b) Revenue Expansion Projects
The main purpose of these projects is to increase the volume of sales (revenue) through the
increased level of output of the existing product, expanding product distribution outlets the
markets current served, introducing new products (product development, expanding (searching)
the market into new geographical areas (market development), and/or introducing new products
for new markets (diversification). The benefits are realized in the form of increased net cash
inflows.
c) Non-Revenue Producing (Mandatory) Investments:
These projects are safety and/or environmental protection projects are safety and/or
environmental protection projects that are necessary for complying with government orders,
labor agreements, or insurance policy terms.
3. Forecasting Cash Flows:
Once the investment proposals are identified, the next step is to forecast the cash flows (for
revenue expansion or cost saving projects.) This is accomplished by determining expected
revenues and costs for each project. Even though the timing and size of future cash flows
usually remain uncertain throughout the budgeting process, the proper estimation of the cash
flows is vital. In the analysis of capital budgeting decisions, annual cash flows are used instead

Page | 25
of the accounting profits, cash flows and accounting profits can be very different because
accounting profits include non-cash revenues and non-cash expenses. In fact, accounting profits
are important, but cash flows are often more important for the purpose of setting a value of a
firm. In the entire capital budgeting procedures, probably nothing is of greater importance than a
reliable estimate of the cost savings and revenue increase that will be achieved from the
prospective outlays of capital funds. All the subsequent analyses that will be discussed in this
chapter are based on the cash flow figures not the accounting profit figures. All the capital
budgeting analyses are as successful as the data inputs that are used. The old saying of "the
garbage in the garbage out, GIGo" is certainly applicable to the capital budgeting analysis.
4. Ranking Investment Proposals
This activity involves the setting of decision rule(s) that help us to differentiate projects that are
acceptable and unacceptable. Then we choose (make decision) the project alternative that is
ranked first as it will maximize the value of the firm. The main objective of the financial
manager while undertaking capital budgeting is to answer the following questions.
a) Which of the several mutually exclusive investment alternatives have to be chosen for
implementation? and
b) How many projects (independent and not mutually exclusive) in total, have to be
accepted?
Different techniques are used to rank and choose among many project alternatives. Some of
these techniques are the payback period, the accounting rate of return, the net present value
method, the internal rate of return, and the profitability index. Each one of these techniques will
be discussed in greater details later in this chapter
5. The Administrative Framework
Capital budgeting is a multidimensional activity that demands a high degree of cooperation
among various departments. The final approval of major capital expenditures, however, rests on
the shoulder of the board of directors of the company.
6. The Post-Completion Audit (Monitoring)
This step refers to the implemented project alternative(s). The post-completion audit involves
the careful monitoring of project implantation. The post-implementation audit is a necessary
managerial tool. A careful analysis of the deviation of actual performance from planned
performance may prevent history from repeating itself. The post-completion audit can be

Page | 26
sobering and rewarding experience for the decision-maker. The post-completion audit has two
principal objectives. These are to improve the accuracy of forecasts and to improve the firms
operation.
Assumptions that underlie Capital Budgeting
A number of assumptions must be introduced in order to concentrate on the managerial aspect of
capital budgeting. The effect of these assumptions is to exclude non-financial considerations and
to remove some complications that obscure the major points under capital budgeting. These
assumptions constitute a general set of conditions within which the financial aspects of long-term
alternatives can be evaluated. You can use any one of the capital budgeting criteria and
techniques presented in this chapter when the following assumptions are fulfilled.
1. Shareholders' Wealth Maximization is the Basic Motive of Capital Budgeting Decision.
All capital budgeting alternatives considered here are accepted or rejected on the basis of
their effect on shareholders' wealth. No other company's goals influence the investment
selection decisions.
2. Costs and Revenues are Known With Certainty.
The costs and revenues associated with each investment alternative are known with
certainty, or there exists a fore casting technique that can generate the values with a very
small error. It may be very difficult to estimate revenues and costs more than two or three
years into the future. However, if a proposed investment has a ten year economic life,
accurate fore costs must be available for all ten years.
3. Inflows and Outflows of Cash Occur once a Year: This assumption was also made in
the previous chapter when we were computing the present and future values of cash flows.
The assumption is also important here because capital budgeting criteria use discounting
techniques. Cash inflows or out flows are assumed to occur only once a year (i.e. at the
end of a given year of at discrete yearly intervals. Hence, compounding or/ and
discounting occur only once a year.
4. Inflows and Out flows are Based on Cash:
The data required for evaluating investment proposals must be stated in cash as opposed to
the accounting income. This is because of the fact that the company uses cash to pay its
bills and to pay cash dividends on common and preferred stock. If the business firm does
not generate cash returns from its investments, it will sooner or later become insolvent.

Page | 27
5. Cash Flows Exhibit a Conventional Pattern:
If we represent the cash outflows with minus"-" sign and the cash inflows with plus "+"
sign, then the conversion cash flows under capital budgeting is defined as the time series of
cash flows that contains only one change in sign. For example, if an investment alternative
has one cash flow followed by three cash inflows can be represented as: -, +, +, +. This is
considered to have a conventional cash flow pattern. Investment alternatives are assumed
to exhibit conventional cash flows. Evaluating an investment alternative that violates this
assumption can become very difficult.
6. The Required Rate of Return is known and Constant. The required rate of return is
generally looked at as minimum rate return that the company must earn if shareholders'
wealth is not to decrease. Here, the minimum required rate of return on investment
alternatives is assumed to be known and constant over the life of the proposed investment.
Arriving at the required rate of return is important for two reasons:
1) If the rate is too high, the company will end up in rejecting quite profitable project
s, and
2) If the rate is too small or low, the company will end up in accepting projects that are
not profitable and decrease shareholders wealth.
7. Capital Rationing doesn't exist. Whenever a company is not able to finance its entire
capital budgeting (investment), capital rationing is said to exist. In such a situation some
investments will have to be given up. The capital budgeting techniques assumed in this
context considers that there is no any capital problem or limitation. However, capital
rationing or capital shortage does contain important implications for financial managers.
Part of Investment
There are three parts of long-term investments. These are.
1. The initial investment. The initial investment is an outlay of cash that takes place at
the beginning of the life of the project.
2. The operating cash flows. The operating cash inflows from revenue sources and the
cash out flows for different expenditures.
3. The terminal cash flows. These are the cash inflows and out flows that take place at
the end of the project life.

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 Initial Investment
The components of the initial investment are:
a) Gross investment. The gross investment of a project or asset is its purchase price
and other incidental costs. Gross investment is the base for depreciation of the entire
project alternatives.
b) Investment tax Credit. It is the specified percentage of the Birr amount of new
investments in each of certain categories of assets which business firms deduct as a
credit against their income taxes. This percentage is applied to the gross investment
amount. The purpose of such tax credit is to provide an incentive for new investment
projects. For instance, assume that a firm is considering a project that entails the
purchase of new equipment for 500,000 Birr with an expected duration of 10 years.
If the asset acquisition qualifies for tax credit of 10- percent, the investment tax credit
is 50,000 Birr (i.e. 500,000 x 10% = 50,000 birr). Although the practice varies from
country to country, it is assumed that the tax authorities force the firm to reduce t he
value of the asset by the amount of investment tax credit for depreciation purpose.
This is to avoid double benefits. The investment tax credit is the direct reduction of
taxes. Suppose that a firm estimates that its taxable income next year will be 80,000
birr and that its profit tax is 40 percent. The company expects to acquire an
equipment costing 60,000 birr. If the investment tax credit is 10 percent, the amount
of income tax to be paid to the taxing authority is only 26,000 birr i.e. (80,000) (0.40)
- (60,000) (0.10) = 26,000.
c) Net Working Capital Increases
Net working capital is the difference between the total current assets and total current liabilities.
Investment in new long-term asset may increase the amount of net working capital if the project
is the revenue expansion investment. Cost reduction investment will not affect the amount of net
working capital required. Increase in the amount of net working capital is added to the gross
investment while determining the amount of initial investment.
d) Opportunity Costs:
Opportunity cost is the highest return that will not be earned if the funds are invested in a
particular project type. In other words, opportunity cost is the income generated by the
alternative use of an asset that is forgone when a new project is adopted. The relevant

Page | 29
opportunity costs associated with an investment proposal should be included in the initial
investment.
e) Tax Increase or Shield
Both ordinary income tax and capital gain tax will be added to the original costs of long-term
assets in order to determine the initial investment. In the case of replacement projects, if the old
assets (i.e. assets to be replaced) are sold at amounts less than their book values, there will be
losses on sales of these assets. The ordinary income tax rate is applied to these loss amounts to
determine the amount of tax shield which will be deducted from the original cost of new fixed
assets to determine the amount of the initial investment.
Suppose that Brehan Share Company is considering replacing old equipment with the new one.
The new equipment has an original cost of 900,000birr. The original cost and accumulated
depreciation of the old equipment are 400,000birr and 280,000 birr respectively. The investment
tax credit on the new equipment is assumed to be 5 percent. Determine the amount of the initial
investment of the new equipment under each one of the following assumptions.
i) The selling price of the old equipment is 120,000 birr
ii) The selling price of the old equipment is 150,000 birr
iii) The selling price of the old equipment is 460,000 birr
iv) The selling price of the old equipment is 80,000 birr

Assume also that the ordinary income tax rate is 40 percent and the income tax rate on the capital
gain is 20 percent. We say there is a capital gain when the old asset is sold at a selling price
greater than its original cost. Hence, capital gain is equal to the excess of the selling price of the
old fixed asset over its original cost at the time of replacement.

Solutions
i) The book value of the old equipment is 120,000 birr (i.e. 400,000 - 280,000 =
120,000 birr).
1 Loss/gain on sale of the old equipment is zero (i.e. 120,000-120,000 = 0).
2 Ordinary income tax is also zero, that is (0.40) (0) = 0.
3 Investment tax credit is 45,000 birr, that (900,000) (0.05) = 45,000birr.
Therefore, initial investment is:

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 Investment tax credit (45,000)
Ordinary income tax 0____
Initial investment 735,000
ii) → Gain on sale of old equipment is 30,000 birr that is 150,000 birr selling
price minus 120,000 birr, its original cost.
→ Ordinary income tax is 12,000 birr that is the ordinary income tax rate of
40 percent multiplied by the amount of recapitulated depreciation of 30,000
birr.
Hence, initial investment is:
Original cost of the new equipment 900,000
Proceed from sale of old equipment (150,000)
Investment tax credit (45,000)
Ordinary income tax 12,000
Initial investment 717,000 birr
iii) When the old asset is sold above its original cost, two types of taxes are paid
on the proceed. The first type of tax is the ordinary income tax which is based
on the difference between the original cost and the book value of the old asset,
or on the balance of the accumulated depreciation as on the date of
replacement. This amount is also known as the recapitulated total
depreciation. The second type of tax is based on the difference between the
selling price of the old asset and its original cost. Note that, in most of the
cases the ordinary income tax rate and the income tax rate of capital gain are
not the same. Thus, these income taxes and the initial investment under this
investment are computed as follows.

→ Ordinary gain on sale of old equipment is 280,000 birr, that is 400,000, the
original cost minus 120,000 birr, the book value of the old equipment.
→ Ordinary income tax is 112,000 birr, that is 40 percent ordinary income tax
rate multiplied by 280,000 birr the ordinary gain on sale of the old equipment.
→ Capital gain is 60,000 birr, that is 460,000 birr, the selling price of the old

Page | 31
 equipment on the date of replacement minus 400,000birr, the original cost of
the old equipment.
→ Capital gain income tax is 12,000 birr, that is the capital gain tax rate of 20
percent multiplied by 60,000 birr, the total amount of capital gain on the sale of
the old equipment.
Thus the amount of initial investment is:
Original cost of the new equipment 900,000
Proceeds from sale of old equipment (460,000)
Investment tax credit ( 45,000)
Ordinary income tax 112,000
Income tax on capital gain 12,000
Initial investment 519,000
iv) → Loss on sale of the old equipment is 40,000 birr, that is the selling price of
80,000 birr minus the book value of 120,000 birr both corresponding to the old
equipment.
→ The loss on sale of the old equipment has an effect of tax saving. Therefore,
the tax shield is 16,000 birr which is computed by multiplying the ordinary
income rate of 40 percent by the total amount of initial investment is:

Hence, the amount of initial investment is:

Original cost of the new equipment……………… 900,000
Proceed from sale of old equipment (80,000)
Income tax saving (shield) (16,000)
Income tax credit (45,000)
Initial investment 759,000

f) Salvage Proceed of the Old Asset

If the project involves the replacement of the old fixed assets with the new ones, the
proceeds from the sale of the old assets should be deducted from the gross investment
to be made in the new assets to determine the amount of the initial investment

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 Add: Tax savings on non-cash expenses xxx
After-tax Cash flow xxx

The after-tax cash revenue is cash revenue minus the income tax on cash revenue (i.e
tax rat e multiplied by cash revenue)
The after tax cash expense is cash expense minus the income tax on cash expense (i.e
income tax rate multiplied by the amount of cash expense).
Tax savings on non-cash expense is computed by multiplying the income tax rate by
the total amount of non-cash expense.
To illustrate suppose that Wanza Share Company is considering a project that requires an
investment on fixed assets of 200,000 birr. The project is expected to generate annual cash
revenue of 72,000 birr for the coming five years. Annual cash expenses are estimated at 27,000
birr over the five years. The project is also expected to have the salvage value of 45,000birr at
the end of year 5. In addition to the investment in fixed assets mentioned above, the project
requires a net working capital of 25,000 birr at the beginning of year 1. This amount of working
capital will be recovered at the end of the life of the project (i.e. end of year 5). The income tax
rate and the investment tax credit are 40 percent and 10 percent respectively. Use the straight-
line method of depreciation to depreciate the project's fixed assets and compute the initial
investment and the annual cash flows for each one of the five years for the project.

Solution:
The initial investment of this project is:
Investment in fixed assets 200,000
Investment tax credit (20,000)
Net working capital required 25,000
Initial investment 205,000
To determine the after-tax cash flows during each one year of the coming five year, we have to
compute the annual depreciation. The depreciable amount is not the initial investment; rather it
is the 200,00 as illustrated with the help of the previous cases for Brehan Share Company.

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Terminal Cash Flows:
The terminal cash flows are those cash flows associated with end of the project. These are:
1. The salvage proceeds from the sale of assets, net of the relevant income taxes when the
project is completed.
2. The recovery of net working capital at the end of the projects life. An increase in the
net working capital during the time of investment is expected to be recovered when the
project terminates. The recovery of net working capital is tax-free because this amount
is neither an ordinary gain nor a capital gain. Rather it is the recovery of the funds
placed in the project for the day to day operation of the project when the project comes
to an end.
Therefore, the net cash flows from the project during the final year of the project's life comprise
of the operating cash flows, the proceeds from the sale the used assets, and the recovery of net
working capital.
Capital Budgeting Project Evaluation Techniques:

This topic is concerned with the ranking of projects for the decision of whether or not they
should be accepted for inclusion in the capital budget. It is assumed that projects to be covered
in this topic are equally risky. All cash flows are assumed to occur at the end of the designated
year. Generally, the project evaluation techniques are classified into two categories. These are:
1. The Traditional Criteria (technique)
They are called the traditional techniques because they do not consider the time value of
money concepts in ranking investment proposals. Two methods are included under the
traditional technique, namely the payback period and the accounting rate of return.
a) The payback period: - The payback period is the number of years that is required for
the business firm to recover from the project the amount of the initial investment in
total. If the cash flows from the project are in an annuity form, the payback period
can easily be determined by dividing the initial investment by the annual cash flow in
the annuity. That is,

Payback period (in years) = Initial investment

Annual Cash flows

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When the cash flows from the project are not in an annuity, the payback period is computed as
follows:
Payback period = year before full recovery Unrecovered cost
Annual flow during the next 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 24,000Birr and the annual
after-tax cash flows of 6,000 Birr for five years. The payback period is, therefore,
Pay back period = 24,000/6000 = 4 years
This is 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. 6,000 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 assumes the project requires an initial investment of 60,000 Birr. The after-
tax cash flows from the project are 8,000Birr during year 1, 15,000Birr during year 2 22,000Birr
during year 3, 20,000Birr during year 4, and year 5 each. Here, the cash flows are not uniform.
In this case, we first need to compute the cumulative cash flows of the project.
Year Annual Cash flow Cumulative cash flow
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

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 the 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:
Payback period = 3 years + (15,000/20,000) years
= 3 years + 0.75 years = 3.75 years, or

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 = 3 years + (0.75) (12 months) = 3years and
9months.
This is true if the cash flows of 20,000Birr during year four are uniformly distributed over the
entire year. Otherwise, the payback period is different from 3 years and 9 months. For instance,
if the cash flows of 20,000Birr 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, the better will be the
project. Thus, the project is accepted if it’s payback period is less than 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 is 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 pay back periods are less
than the planned payback period.
Advantages of Payback Period:
The payback period is an easy and an inexpensive method to evaluate and rank project
alternatives
Disadvantage of Payback Period
The disadvantages of the payback period are:
1. It ignores the cash flows beyond the computed payback period though they are important
for acceptance or rejection decisions.
2. It ignores the time value of money which is an important variable that demands
consideration in evaluating the desirability of a given project.
b) The Accounting Rate of Return (ARR)
The Accounting Rate of Return (ARR) is the rate of return that is calculated by dividing the
projects expected annually net profit by the average investment outlays. The average
investment outlays, on the other hand, are computed by dividing the sum of original cost of the
project and the salvage value of return (ARR) can be expressed with an algebraic equation as
follows.
Expect ed Average AnnualNet Pr ofit
ARR =
Average Cost of Investment

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 Average cost of Investment = Original costs + salvage value
2
To illustrate the accounting rate of return consider the project that has the original investment of
70,000Birr, the life of 4 years, and the salvage value of 6,000 Birr at the end of year 4. The
straight line method of depreciation is used. Income before depreciation and taxes are
40,000Birr for year 1, 42,000Birr for year 2, 36,000 Birr for 3 year 3, and 50,000 Birr for year 4.
Determine the accounting rate of return if income tax rate on the project is 40 percent. To
compute the accounting rate of return (ARR) for this project, first we have to determine the
average investment and the annual depreciation amount.
Average investment = (70,000 + 6000)/2 = 38,000Birr
Annual depreciation = (70,000 - 6,000)/4 = 16,000Bir
Then compute the new profit for each year during the four years.

Year 1 Year 2 Year 3 Year 4

Income before depr. & taxes 40,000 42,000 36,000 50,000
Less: Annual depreciation 16,000 16,000 16,000 16,000
Income before taxes 24,000 26,000 20,000 34,000
Less: Income taxes (40%) 9,600 10,400 8,000 13,600

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

Hence, ARR = Average Annual net profit = 15,600 = 0.41 or 41%.

Average cost of investment 38,000

This is to mean that for an average of 1 Birr invested in this project, there is an average return of
41 cents in the form of net profit per year over the entire four years of the life of the project.

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The accounting rate of return method of 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 fluctuations of the cash flows over the life of the life of the project as it
assumes average cash flows during the project's life.

2. The Discounted Cash flow (DCF) Criteria (Techniques):

The discounted cash flow techniques are other methods of evaluating and ranking investment
project proposals. These techniques employ the time value of money concept, unlike the
traditional methods. Four DCF techniques are discussed in the sections that follow.
a) The discounted Payback period
The discounted 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. Discounted payback period is computed 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 investment of 30,000Birr and the life of 5
years. The after-tax cash flows from the project during years 1,2,3,4 and 5 are 15,000Birr,
18,000Birr, 12,000Birr, 20,000Birr, and 22,000Birr respectively. The cost of capital (the
required rate of return) is 10 percent. What is the discounted payback period for this project? To
answer this question, first we have to compute the discounted cash flows and the cumulative cash
flows for each year which helps to locate the discounted payback period of this project. Hence,
the discounted cash flows and the cumulative cash flows year by year are show as follows.

Year Cash flows Discount Factor Present Value Cumulative

CF
1 15,000 0.909 13,635 13,635
2 18,000 0.826 14,868 28,503
3 12,000 0.751 9,012

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4 20,000 0.683 13,660
5 22,000 0.621 13,662

As you can see from the cumulative discounted cash flows the discounted payback period for
project is between 2 and 3 years. This is because the cumulative discounted cash flow at the end
of year 2 is less than the initial investment of 30,000Birr and the cumulated discounted cash
flows at the end of year 3 is greater than the same initial net investment. The exact payback
period (discounted) can be computed as:
Discounted Pay back period = 2 years + (1,497/9,0120) years
= 2 years + 0.17 years = 2.17 years
= or 2 years + (0.17) (12 months)
= 2 years and 2 months.

It requires the project a period of 2 years and 2 months to recover its initial net investment taking
the time value of 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 1,497Birr at the end of year 2. Therefore, the discounted pay back
period of this project is 3 years instead.

b) The Net Present Value (NPV) Method

The net present value (NPV) method is an investment project proposals evaluating and ranking
method using the net present value, which is the difference between the present values of future
cash inflows and the present value of cash outflows, 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 value of each cash flow, including both inflows and out flows using
the cost of capital of the project for discounting.

Page | 39
 2. Sum the discounted cash inflows and the discounted cash outflows separately.

3. Obtain the difference between the sum of the cash inflows and the sum of the cash
flows.
If all the cash outflows for the project occur at time zero, i.e. at the beginning of year 1, the
present value of the cash our flows is the same as to the net investment amount.
Decision Rule for the Net Present Value (NPV) Method:
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 lower
positive NPV. Projects with negative NPV should not be considered for acceptance in the first
place. The rationale for the NPV method is that an NPV of zero signifies that the cash flows of
the project are just sufficient to repay the invested capital and 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 and to provide the require rate of return to the shareholders, and 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 be improved as indicated above.

To illustrate the NPV as a method of project proposals ranking assume that a given project is
expect to have an initial investment and project life of 40,000Birr and 5 years respectively. The
annual after-tax cash flow is estimated at 12,000Birr for each one of the five years. Using the
required rate of return of 10 percent, what is the net present value (NPV) of the project? How do
you judge the acceptability of this project?
In order to answer these questions, it is wise to identify the cash inflows and outflows. In the
case of this project, there are annuity cash inflows of 12,000 birr every year for five years and
single cash out flow of 40,000 at time zero.

The present value of the annuity cash outflows is:

Present value of annuity = (12,000) (Annuity factor)

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The annuity factor given the period of 5 years and discount rate of 10 percent is 3.791
substituting the factor I the equation above
PVA = (12,000) (3.791) = 45,492Birr
Present Value of Cash out flows = 40,000Birr
Hence,
The Net Present value (NPV) = Present Value of inflows less present
value of out flows
= 45,492 - 40,000 = 5,492Birr
Since the project makes the net present value (NPV) of positive 5,492Birr, it should be accepted.
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.

Alternative Year 0 Year 1 Year 2 Year 3 Year 4 Year 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 percent. Then, evaluate these projects using the
net present value method. The evaluation of these two projects requires the computation of the
net preset 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
out flows 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 20,000 0.567 11,340

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Present values of cash inflows (sum) 86,005
Present values of cash outflows 80,000
Net Present Value (NPV) 6,005 Birr
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
Present values of cash inflows (sum) 104,565
Present values 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)
The NPV Profile
As indicated above, the net present value of the project depends solely on the size and timing of
the cash flows, the investment out lays, and the discount rate. A simple graphic device that
visualizes this dependence is called the NPV profile.
To illustrate the NPV profile supposes that a project is expected to have an initial investment of
200Birr and the first year cash flow of 230Birr. The net present value of this simplified project
using four alternative discount rates of 0, 10, 15, and 20 percent is shown as follows.
Present value Net Present
Discount Rate Discount Factor of 230Birr Less net Investment Value
0 1.000 230.00 200 30.00
10% 0.909 209.07 200 9.07
15% 0.870 200.01 200 0.00
20% 0.833 191.59 200 -8.41

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The NPV profile can e shown with the help of the X-y coordinate plane where the Y-axis is to
represent the NPVs and the X-axis is to represent the discount rates.

30*
20
10 *
*
-10 10 15 20 25
*
The discount factor is 1 when the discount rate is zero. This reflects the fact that 0 Birr received
tomorrow is equal to a birr received today in a world where there is no other profitable
alternative of using money. At the discount rate of 15 percent the NPV is zero, which means that
this project is earning exactly 15 percent returns. The above graph indicates that the NPV of the
project under consideration is positive when the discount rates are less than 15 percent , and
negative when the discount rates are greater than 15 percent. Therefore, this project should be
accepted if and only if the opportunity cost of is below 15 percent.
C) The Internal Rate of Return (IRR)
The internal rate of return 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
project 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 outflows.
That is:
Pv )cash inflows) = PV (cash outflows). Hence, the net present value of any project at a
discount rate that is equal to the IRR is zero.

Computing the Internal Rate of Return

1. Uniform Cash Inflows over the Life of the Project:

In this case, the present value table of an annuity can be used to calculate the IRR since the
cash inflows are in annuity form. The following steps can be followed to calculate IRR f or
constant cash inflows.

Page | 43
 Step 1: Find the critical value of discount factor
Discount factor = Initial investment
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 and annual net cash inflows of 5000Birr 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.
Step 1 Compute the critical discount factor. That is
Discount factor = 26,030 = 5.206
5,000
Step 2 After determining the critical discount factor, we look for the value that is equal
to this factor in the present value of annuity table across the line corresponding
to 7 years (i.e n=). The discount factor of 5.206 appears in the 8 percent
column on the line/row of 7 years. Therefore, the IRR is 8 percent.
2. Fluctuating Cash Inflow over the Life of the Project
When the cash inflows from the project are not in an annuity form, IRR is calculated through an
iterative process or through "trial and error". It may be difficult to identify from which discount
rate to start. A good first guess can be made by estimating the discount factor.

In general, the following procedures are used to calculate the IRR of the non-uniform net cash
flows.
Step 1: Find the estimated discount factor. In fact, if the fluctuations I the cash inflows
is very large, the estimated discount factor doesn't not help you much in
locating the IRR in the present value of annuity table.
Estimated discount factor = Net investment
Average cash inflows
Step 2: Look at the present value of annuity table to obtain the nearest discount

Page | 44
 rate for the estimated discount factor determined in step 1.
Step 3: Calculate the NPV using the discount rate identified in step 2.
Step 4: If the resulting NPV is positive, choose the higher discount rate and repeat the
procedure. Choose the lower discount rate if the NPV is negative, and repeat the same
procedure until you find the discount rate that equates the NPV to zero.
To illustrate the IRR computation under fluctuating cash inflows from the project assume a
project that has an initial investment of 40,000 Birr and the following net cash inflows:
Year 1, 15,000Birr; year 2, 10,000Birr; Year 3,, 10,oooBirr; year 3, 15,000 Birr; and year
5, 15,000Birr. What is the IRR of this project.
In order to estimate the discount factor, you need to give weight to the cash flows over the life
of the project. Larger weights should be given to the cash flows towards the beginning of the life
of the project than to the cash flows that occur to wards the end of the project life. Hence,
Year Weight Cash flow x weight
1 5 75,000
2 4 40,000
3 3 30,000
4 2 30,000
5 1 15,000
15 190,000
Average net cash flow= 190,000 = 12,667
15
Estimated discount factor = 40,000 = 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 percent. Thus, the starting point of the iterative process is 18 percent. The
NPV of the project using the discount rate of 18 percent is:
NPV = (15,000) (0.847) + (10,000) (0.718) + (10,000) (0.609) + (15,000) (0.516) +
(15,000) (0.437) - 40,000 = 40,270 - 40,000 = 270
Since the NPV computed using a discount rate of 18 percent is positive, are have to take a
discount rate higher than 18 percent in search for the NPV of zero. So the second guess can be
19 percent. The NPV of the project using the discount rate of 19 percent is:

Page | 45
NPV = (15,000) (0.840) + (10,000) (0.706) + (10,000) (0.593) + (15,000) (0.499) +
(15,000) (0.419) - 40,000 = 39,260 - 40,000 = -640

As per the above calculations, NPV is negative when the discount rate of 19 percent is used and
positive when the discount rate of 18 percent is used. Thus, the IRR for this project falls
between 18 percent and 19 percent. If the exact IRR is needed, the interpolat ion method is can
be used. That is:
Step 1: Obtain the NPV of the smaller rate by the absolute sum and add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute sum
and subtract the resulting quotient from the larger rate.
Step 2: Divide the NPV of the smaller rate by the absolute sum and add the resulting
quotient to the smaller rate, or divide the NPV of the larger rate by the absolute
sum and 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, and 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, and you get:
-640/910 = - 0.70 to the nearest two digits after the decimal point, and subtract this
figure from the larger rate to obtain the exact IRR.
IRR = 19% - 0.70% = 18.3%
In both cases, you arrive at the same IRR value of 18.3 percent.
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, and this surplus adds
up on the wealth of the shareholders of the firm. Therefore, selecting the project whose IRR
exceeds its cost of capital increase the share holders' wealth. On the other hand, 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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Decision Rules for IRR
A project whose IRR is greater than its cost of capital, or Required Rate of Return (RRR) is
accepted and whose IRR is less than the RRR of the project is rejected.
d. Profitability Index (PI):
Profitability index is the ratio of the present value of the expected net cash flow of the project
and its initial investment outlay.
PI = PV/IO where =
PV = Present value of expected net flows
IO = Initial investment outlay
PI = Profitability Index
Profitability index provides or measure of profitability in a more readily understandable terms. It
simply converts the NPV criterion into a relative measure.
NPV VS Profitability Index
The NPV and the profitability index criteria reach the same acceptance-rejection decisions for
independent projects. The profitability index is greater than 1 if the net present value of the
project is positive. However, in the case of mutually exclusive projects, NPV and profitability
index will result in different acceptance-rejection decision. One advantage of NPV in this case is
that it reflects the absolute size of alternative investment proposals profitability index does not
reflect difference in investment size. Therefore, the NPV is more appropriate for mutually
exclusive projects than profitability index.

Consider the following two mutually exclusive projects.

Present Value Initial Profitability
of cash Flow Investment NPV Index
Project A 200 100 100 2.0
Project B 3000 2000 1000 1.50

From the above example project A is accepted using profitability index because its PI is greater
than that of project B. However, NPV of project B is greater than that of the NPV of project A.
Thus, even though the profitability index of a project is a very useful tool, it should not be used
as a decision rule when mutually exclusive projects fo different size are being considered.

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NPV Vs IRR
The NPV and the IRR project ranking techniques lead to the same acceptance-rejection decisions
for independent projects. However, these methods may lead to different decisions when it is
impossible to undertake all investment opportunities. In other word s, when investment
opportunities are mutually exclusive, NPV and IRR may result in contradicting decisions. If this
is the case, which one of the two methods should be used to select between/among the mutually
exclusive projects? What are the reasons for the difference between the two methods? Let us
first discuss the reasons for the difference. These reasons can be classified into two. These are:
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 because it ensures that the firm will reach the optimal scale of investment. NPV
automatically examines and compares the incremental cash flows against the cost of capital. The
IRR criteria ignores this important aspect of an investment decision because the return is
expressed in a percentage. To illustrate, the difference between the NPV and IRR as project
ranking techniques consider the following mutually exclusive projects, project A and project B.

0 1 2 3 4 5
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 rat e of return for this project is B percent. 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 larger than that of project B. Thus, one
can learn that there is a difference I the size or scale of investment. In order to identify the
project to be selected, the NPV and IRR for both projects have to be calculated. Since the cash
flows for both projects are 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 factor for
project A = 50,000 = 2.941
17,000

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looking in the present value table of annuity in the raw of 5 years, the discount factor of 2.941
corresponds to 20.8 percent.
The discount factor for project B = 32,000 = 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 percent and

The NPV of project A = (17,000) (the discount factors of annuity at the required
rate of 8 percent) - 50,000.
= (17,000) (3.993) - 50,000
= 17,881Birr.
The NPV of project B = (12,000) (the discount factor of annuity at the required rate of return of
8 percent) - 32,000
= (12,000) (3.993) - 32,000 = 15,916
The above calculations indicate that both projects are acceptable if they are independent projects.
However, those project are mutually exclusive. As a result, IRR ranks project B first, but NPV
ranks project A first. Thus, there is a paradox between the two methods. In order to clarify such
paradoxical result, it is advisable involved. Then the internal rate of return (cross over rate) is
determined on the incremental cash flows and additional investment. Additional investment is
the difference between the investment outlays of the two projects. Cross over rate is the discount
rate at which the NPV profiles of the two projects cross, and 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 = 3.600
5,000
From the present value of an annuity table, the discount factor of 3.600 corresponds to the 12
percent column. Thus, the cross over rate is 12 percent. The cross over rate indicates that the
NPV gives priority to project A at discount rates below cross over rate of 12 percent, but IRR
supports project B for a discount rate above the cross over rate. Since the cost of capital is 8
percent, the incremental cash flow represents a profitable opportunity. Therefore, the larger

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project which incorporates these additional cash flows should be accepted. If the cross over rate
is less than the cost of capital (RRR), the project with the smaller investment should be selected
because the additional commitment of resources will not be compensated. Therefore, by
examining and 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 and the IRR can still give contradictory rankings even when initial investment outlays
are the same because of the difference in the timing of the cash flows. Most of the cash flows
from one project may occur in the early years and 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 because
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 to 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 and 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) because 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 and project B have the same initial
investments, 10,000 birr. The RRR is for the firm 10 percent.

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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 1501 1401
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 between 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 = 13,924Birr
Project B = 7,200 Birr + (6000) (1.1) Birr = 13,800Birr
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.
Capital Rationing
Capital rational is a situation in which a constraint is placed on the total size of the firm’s capital
budget. Capital ratio is said to exist when we have profitable (positive NPV) investments
available but we can’t get the needed find to undertake all of them. Two main reasons can be
mentioned. One is what is called soft rationing which is the situation that occurs when units are
allocated a certain amount of financing for capital budgeting. Such allocation is primarily a
means of controlling and keeping track of overall spending. Soft rationing doesn’t mean that the
business firm as a whole is not short of capital. The other reason is hard rationing. Hard
rationing is the situation that occurs when a business cannot raising finance or funds for a project
under any circumstances. A business firm with a sound financial status does not face hard
rationing.
1. The timing and magnitude of the cash flows of all projects (all project alternatives) are
known.
2. The cost of capital is known
3. All projects are strictly independent

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 4. The total investment outlay of all those projects that have a positive NPV exceeds the
firm’s budget constraints. Taking these assumptions into account, the problem under
capital rationing is how to choose a subset of desirable projects in such a way that total
investment does not exceed the budget. In order to solve this problem, the sound
procedures are as follows.
1. Rank all projects with positive NPVS in accordance with their profitability indeed.
2. Select projects from the top of the list (with the highest profitability index) until the fixed
budget is exhausted
To illustrate how to select project alternatives when the company has a limited capital amount
(i.e. when there is capital rationing) suppose that a firm has a fixed capital budget of 600,000 birr
and has the following investment alternatives.
Project Initial Investment NPV Profitability Index
A 150,000 40,000 1.50
B 190,000 40,000 1.40
C 120,000 70,000 1.80
D 180,000 50,000 1.30
E 330,000 60,000 2.00
The question is that which of these projects should the firm select and implement give the f ixed
amount of capital budget indicated above? To answer this question, first we have to rank these
project based on the value of their profitability index. Hence, their arrangement according to
their profitability index is F-C-A-B-D. This is to mean that project F is with the highest
profitability index and project D is with the lowest profitability index. Therefore, given the
capital budge constraint of 600,000 birr, projects F,C and A are selected. The initial capital
requirements for these projects are the sum of the initial investment costs of these projects F,C
and A are selected. So the total initial investment cost of the three projects is exactly equal to the
total capital budget of the firm. This implies that the rest of the project alternatives cannot be
implemented because of the lack of capital though they are all acceptable ones. The total net
present value (NPV) of the projects that were selected is 60,000 birr + 70,000 birr + 40,000 birr
= 170,000 birr.

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Capital Budgeting Under Risk
Up to this point, we have ignored risk in capital budgeting; that is we have discounted expected
cash flows back to their present values and ignored any uncertainty that might surround the
expected cash flows. In reality, the future cash flows associated with the introduction of a new
sales outlet or a new product are estimates of what is expected to happen in the future, not
necessarily what will happen in the future. But, these cash flows discounted to their present
values have only been our best estimate of the expected cash flows. In this section, we will
assume that under conditions of risk we do not know beforehand what cash flows will actually
result from the new project. However, we do have expectations concerning the outcomes and are
able to assign probabilities to these outcomes. Staled in another way, although we do not know
the exact cash flows resulting from the acceptance of a new project, we can formulate the
probability distributions from which the flows will be drawn. Risk, here, is defined as the
potential variability in the future cash flows.
Relevant Risks in Capital Budgeting
In capital budgeting, a project’s risk can be looked at in three levels. First, there is a total project
risk, which is a project’s risk ignoring the fact that much of this risk will be diversified away as
the project is combined with the firm’s other projects and risks. Second, we have the project’s
contribution to firm’s risk, which is the amount of risk that the project contributes to the firm as a
whole; this measure considers the fact that some of the project’s risks will be diversified away as
the project is combined with the firm’s other projects and assets, but ignores the effects of
diversification of the firm’s shareholders. Finally, there is what is known as a systematic risk,
which the risk of the project from the viewpoint of a well-diversified shareholder; this measure
considers the fact that some of the project’s risk will be diversified away as the project is
combined with the firm’s other projects, and in addition some of the remaining risk will be
diversified away by shareholders as they combine this stock with other stocks in the portfolio.
Risk, Return and Net Present Value
When a financial manager is considering a set of risky alternatives, one important consideration
involves the choice of the required rate of return. Given the risk aversion nature of mangers, the
required rate of return of each project is the function of its risk. The riskier the project, the
higher will be the required rate of return. Selecting the appropriate required rate of return
involves subjective judgments. Given the general patterns of managerial risk aversion, which

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shows the direct relationship between risk and return, the following guidelines can be
established.
1. The coefficient of variation can be used as the measure of risk per birr of return. As such,
it can be used to rank the riskiness of probability distributions of cash values.
2. The required rate of return can be set to the sum of the risk-free rate plus some additional
return to compensate for risk.

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