CHAPTER TWO

Long-term
Investment Decision
 Learning objective
2

 Define capital budgeting

 Understand the nature of capital budgeting

 Understand the major process of capital budgeting

 Understand different classification of project

 Understand different techniques used to evaluate

investment proposal:
 Traditional Approach
 Modern Approach
Overview of long term Investment

 The word Capital refers the total investment of a firm in a

company in terms of
 money,
 tangible and
 intangible assets.
 Budgets are a blue print of a plan and action expressed in quantities
and manners.
 Thus, the capital budget is a summary of planned investments in
long term projects, and capital budgeting is the whole process of
analyzing projects and deciding which ones to include in the
capital budget.
Cont…
 The examples of capital expenditure:
 Purchase of fixed assets such as land and building, plant and machinery,
etc.
 The expenditure relating to addition, expansion, improvement and
alteration to the fixed assets.
 The replacement of fixed assets.
 Research and development project.
Cont. …

Definitions by scholar
 According to the definition of Charles T. Hrongreen, “capital

budgeting is a long-term planning for making and financing

proposed capital out lays.
 According to the definition of G.C. Philippatos, “capital budgeting

is concerned with the allocation of the firm’s source financial

resources among the available opportunities.
 According to the definition of Richard and Green law, “capital

budgeting is acquiring inputs with long-term return”.

 According to the definition of Lyrich, “capital budgeting consists

in planning development of available capital for the purpose of

maximizing the long-term profitability of the concern”.
Importance of capital budgeting
 Huge investments: Capital investment requires huge
investments of funds, but the available funds are
limited,
 Therefore the firm before investing any projects, he/she
should have to plan and control its capital expenditure
through capital budgeting.
 Long-term: Capital expenditure is long-term in nature
or permanent in nature.
 Irreversible: The capital investment decisions are

irreversible, are not changed back.

Project classifications

Capital projects usually are classified into the following

types:
(a) Replacement Projects: A decision concerning
whether:
 an existing machine should be replaced by a newer
version of the same machine or
 even a different type of machine that does the same
thing as the existing machine.
Cont…

(b) Expansion Projects: A decision concerning whether

the firm should increase operations by
adding new products,
additional machines, and so forth.
 Such decisions would expand operations beyond the

existing scope.
Cont…

(c) Independent Projects: Independent (sometimes called

stand-alone) projects are any set of projects in which
choosing one has no impact on our decision to choose
another project from that set.
For example, McBurger Inc. may have the following capital budgeting
projects to consider. The first is a new deep frying system for their french
fries. The second is a new order placement system for the drive-thru.
McBurger could choose to take the new deep fryer or the new order
placement, or it could choose both. Taking one project does not influence
the other, so they are independent.
 When we have independent projects, our decision rule does
not need to rank which project is the best, but merely
identify if the project is good or bad.
Cont…

(d) Mutually Exclusive Projects: Mutually exclusive

projects are any set of projects in which choosing one
makes the other projects no longer possible.
For example, assume a company has a budget of $50,000 for
expansion projects. If available Projects A and B each cost $40,000
and Project C costs only $10,000, then Projects A and B are mutually
exclusive. If the company pursues A, it cannot also afford to pursue B
and vice versa.
Capital budgeting processes

1. Identification of various investments proposals: The

capital budgeting may have various investment proposals.
2. Screening or matching the proposals: The planning
committee will analyze the various proposals and
screenings.
3. Evaluation: After screening, the proposals are evaluated
with the help of various methods, such as
 payback period,
 net discovered present value method,
 accounting rate of return and
 risk analysis.
Cont. …

4. Fixing property: After the evaluation, the planning

committee will predict which proposals will give more profit
or economic consideration.
 If the projects or proposals are not suitable for the concern’s

financial condition, the projects are rejected without

considering other nature of the proposals.
Cont. …

5. Final approval: The planning committee approves the final

proposals, with the help of the following:
(a) Profitability
(b) Economic constituents
(c) Financial availability
(d) Market conditions.
Cont. …

6. Implementing: The competent authority spends the

money and implements the proposals.
 While implementing the proposals, you have to:

 assign responsibilities to the proposals,

 assign responsibilities for completing it within the time
allotted and
 reduce the cost for this purpose.
Cont. …

7. Performance review or feedback: The final stage of

capital budgeting is actual results compared with the
standard results.
 The adverse or unfavorable results identified and

removing the various difficulties of the project.

 This is helpful for the future of the proposals.
Capital Budgeting Evaluation Techniques

 In order to maximize the return to the shareholders of a company, it

is important that the best or most profitable investment projects are
selected.
 There are a number of techniques available for appraisal of

investment proposals and can be classified as presented below.

 The methods of evaluations are:

(A) Traditional methods (or Non-discount methods)

 Payback Period
 The Accounting Rate of Return
Cont…
(B) Modern methods (or Discount methods)
 Discounted Payback Period
 Net Present Value
 Profitability Index
 Internal Rate of Return
 Modified Internal Rate of Return
 Traditional methods (or Non-discount methods)
1 - 18

A) Pay-back Period: Pay-back period is the time required

to recover the initial investment in a project.
 Pay-back period with uniform cash flow:

= Initial investment
Annual cash inflows
 Payback period with uneven Cash Inflows:

 Normally the projects are not having uniform cash inflows.

 In those cases, the pay-back period is calculated by cumulating cash
inflows up to the initial investment level.

08/09/2023
1 - 19

Exercise 1
 Project cost is br. 30,000 and the cash inflows are br. 10,000 per year,

the life of the project is 5 years. Calculate the pay-back period.

 Solution = 30,000 = 3 Years

10,000
1 - 20

Exercise 2
 Certain project requires an initial cash outflow of br. 25,000. The cash

inflows for 6 years are:

br. 5,000, 8,000, 10,000, 12,000, 7,000 and 3,000.

1 - 21

Year Cash inflows(br) Cumulative cash inflows (br)

1 5,000 5,000
2 8,000 13,000
3 10,000 23,000
4 12,000 35,000
5 7,000 42,000
6 3,000 45,000
1 - 22

 The above calculation shows that in 3 years br. 23,000 has been
recovered; br. 2,000, is balance out of cash outflow.
 In the 4th year the cash inflow is br. 12,000. It means the pay-back
period is three to four years, calculated as follows:

 Pay-back period = 3 years+2000/12000×12 months

= 3 years and 2 months.
1 - 23

 Accept /Reject criteria:

 If the actual pay-back period is less than the predetermined

pay-back period, then the project would be accepted.

 If not, it would be rejected
 Advantage and limitation of payback period
24

Advantages of the Payback Period

 It continues to be in common use today for the following

reasons:
 It is easy to calculate and simple to understand.
 It favors projects that “pay back quickly” and hence
contributes to the firm’s overall liquidity.
 Cont…
25

Limitations of the Payback Period

 The following are the important demerits of the pay-back

method:
 It ignores the time value of money.
 It ignores all cash inflows after the pay-back period.
 It is one of the misleading evaluations of capital budgeting.
 There is no necessary relationship between a given payback and
investor wealth maximization, so we do not know what an
acceptable payback is.
 The firm might use two years, three years, or any other number as
the minimum acceptable payback; but the choice is arbitrary.
1 - 26

B) Accounting Rate of Return(ARR)

 Is also known as return on investment;
 Uses accounting information from financial statements to

measure profitability;
 Is found by dividing the average after –tax return by

average investment.
1 - 27

ARR on investment = (average Net profit of the project) /

(initial investment or average investment) * 100%
 Example: a project will cost br. 40,000. Its stream of

earnings before depreciation, interest and taxes for 5 years

is expected to be br.10,000, 12,000, 14,000, 16,000 and
20,000. Assume a 50% tax rate and depreciation on
straight line basis, compute the ARR for the project.

08/09/2023
1 - 28

 Thus, ARR = 3,200*100 %= 16%

20,000
 Accept/reject criteria: if the project’s ARR is greater than

the ARR set by mgt., then accept the project, otherwise,

reject it. Project having greater ARR will be ranked 1st.
 Advantage and limitation of ARR
29

Advantage of ARR
It is easy to calculate and simple to understand.

It is based on the accounting information therefore; other

special reports are not required for determining ARR.

It considers the total benefits associated with the project.

Limitation of ARR
It ignores the time value of money.

It ignores the reinvestment potential of a project.

Different methods are used for accounting profit.

 So, it leads to some difficulties in the calculation of the project.

 (B) Modern methods (Discount methods)
1 - 30

A) Discounted payback method:

 One of the serious shortcomings of payback period

was its inability to discount the cash flows.

 The number of periods taken in recovering the

investment outlay on the basis of present value is
called discounted payback period.
1 - 31

 Example: Certain project requires an initial cash outflow of br. 25,000.

The firm cost of capital is 10 %. The cash inflows for 6 years are:
br. 5,000, 8,000, 10,000, 12,000, 7,000 and 3,000.
Year Cash Discounted cash Cumulative discounted
inflows(br) inflows cash inflows
1 5,000 4,545.46 4,545.46
2 8,000 6,611.57 11,157.03
3 10,000 7,513.15 18,670.18
4 12,000 8196.16 26,866.34
5 7,000 4346.45 31,212.79
6 3,000 1,693.42 32,906.21
08/09/2023
1 - 32

3 years + 1866.34/8196.16 = 3.23 years

Decision of discount of payback period or Accept/Reject criteria
If the payback period is less than the maximum acceptable discount
payback period, accept the project; if the discount payback period is
greater than the maximum acceptable payback period, reject the project.
 Advantages and Disadvantages of
Discounted Payback Period
33

Advantages Disadvantages
(i) Considers the time value (i) No concrete decision
of money. criteria that tells us
(ii)Considers the riskiness of whether the investment
the cash flows involved in increases the firm’s value.
the payback (ii)Calls for a cost of capital
(iii) Ignores cash flows
beyond the payback
period
1 - 34

B) Net Present Value (NPV)

 The method is one of the modern methods for evaluating

capital projects.
 In this method, cash flows are considered with the time

value of money.
 NPV describes as the difference b/n the present value of

cash inflow and present value of cash outflow.

1 - 35

The formula for computation of NPV is given below:

Where, CFt is the expected net cash flow at period t,

K is the project’s RRR or the firm’s cost of capital,
Io is initial outlay cost, and
n is the project’s life.
Since NPV can be positive, zero, or negative, attention must be paid to its
algebraic sign.
Decision criteria: if NPV is positive, accept the project; if NPV is
negative reject the project.
1 - 36

Example 1
 From the following information, calculate the net present value of the

two projects and suggest which of the two projects should be

accepted. Cost of capital is 10%. The profits before depreciation and
after taxation (cash inflows) are as follows:

Initial Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Scrap
investment value

Project 20,000 5,000 10,000 10,000 3,000 2,000 1,000

X 30,000 20,000 10,000 5,000 3,000 2,000 2,000
Project
Y
37

 Solution:
year Cash inflows PV of br. 1 PV of cash inflows
@10%

Project X Project Pro. X Pro. Y

1 (br.) Y(br.) 0.909 4,545 18,180
2 5,000 20,000 0.826 8,260 8,260
3 10,000 10,000 0.751 7,510 3,755
4 10,000 5,000 0.683 2,049 2,049
5 3,000 3,000 0.621 1,242 1,242
Scrap 2,000 2,000 0.621 621 1,242
1,000 2,000
Total PV 24,227 34,728
Initial investment 20,000 30,000

NPV 4,227
08/09/2023 4,728
38

 Project Y should be selected as its NPV is greater than

that of project X if the projects are mutually exclusive. If
the projects are independent, both are acceptable as NPV
of both projects are positive.

Note: if cash out flows occur at any time over the course of
the project implementation period, it should also be
discounted and added to initial investment to calculate
NPV.
 Advantage and Disadvantage of NPV
39

Advantage of NPV
 It recognizes the time value of money.

 It considers the total benefits arising out of the proposal.

 It is the best method for the selection of mutually exclusive

projects.
 It helps to achieve the maximization of shareholders’ wealth.

Limitation NPV
 It is difficult to understand and calculate.

 It needs the discount factors for calculation of present values.

 It is not suitable for the projects having different effective

lives.
40

C) Profitability Index(PI)
 Another method that involves time value of money;

 It is the ratio of benefits to costs or

 the ratio of present value of cash inflows to the

initial investment.
 Thus, PI = Present value of cash inflow

Initial cash outflows

41

Example: The initial cash outlay of a project is 100,000 br and it can generate
cash inflow of 40,000 br, 30,000 br, 50,000 br, and 20,000 br in year 1 through
4. Assume a 10% discount rate. Determine the profitability index of the project.
 PV = 40,000 + 30,000+ 50,000 + 20,000
(1+.1) (1+.1)2 (1+.1)3 (1+.1)4
=
112,350br
 Hence, PI = 112,350 =1.1235

100,000
Acceptance criteria:
 Accept the project if PI>1

 Reject the project if PI<1

 PI>1 means NPV is positive; and PI<1 means NPV is negative.

42

D) Internal Rate of Return (IRR)

 Is another discounted cash flow method;
 It provides a single number summarizing the merits of a project;
 It does not depend on the rate prevailing on the capital market; It is based
on the cash flows of a project;
 Is the rate that equates the NPV of a project to zero.
 Is the breakeven rate where there is no creation and destruction of value to
the firm.
43

Decision criteria:
 Accept the project if the IRR is greater than cost of capital (market
rate); reject the project if IRR is less than cost of capital.

Example: a project costs 16,000 br. and is expected to generate cash

inflows of 8,000 br, 7,000 br, and 6,000 br at the end of each of the next
three yrs. Calculate the internal rate of return for the project.
44

 Solution: it is obtained through trail and error.

 Let us begin with16%:

 Initial investment………………….…………16,000br

 PV = 8000 + 7,000 + 6,000 = 15,943br

(1 + 0.16) (1+0.16)2 (1+0.16)3
NPV ……………….……………………...….. -57br
 At 16% NPV is not zero, it is –ve (-57).

 Let us look at 15% as PV and discounting rate are inversely related.

45

 Initial investment……………………………….16,000
 PV = 8000 + 7,000 + 6,000 = 16,195
(1+0.15) (1+0.15)2 (1+0.15)3
NPV......................................................... = 195br
Therefore, the true rate lies b/n 16% and 15%.
Hence, the true rate can be found by linear interpolation as follows:

LR +(HR – LR) × PV at LR –PV required

PV at LR- PV HR
46

LR + (HR – LR)×PV at LR – PV required

PV at LR- PV HR
 LR – lower rate; HR – higher rate; PV present value

 Thus, IRR = 15%+(16%-15%) ×16,195- 16,000

16,195 – 15,943
= 15%+1%(195/252) = 15.77%.
Alternatively:
 Let us find range between -57 and 195 = 254:

 Thus, IRR = 16%- 57/254 or 15% + 195/254 = 15.77%

47

 Therefore, IRR for this project is 15.77%. Using this rate as a

discounting rate, you will arrive at zero NPV.

 If the cost of capital is 15%, this project is acceptable as it adds value

to owners by the amount of IRR minus cost of capital
 Advantage and Disadvantage of IRR
48

Merits of IRR
 It considers the time value of money.

 It takes into account the total cash inflow and outflow.

 It does not use the concept of the required rate of return.

 It gives the approximate/nearest rate of return.

Demerits of IRR
 It involves complicated computational method.

 It produces multiple rates which may be confusing for taking

decisions.
 It is assume that all intermediate cash flows are reinvested at the

internal rate of return

49

End of the
Chapter!