Capital budgeting
Lecturer: Magayi Emmanuel
Capital Budgeting
capital budgeting is defined as the process of identifying,evaluating,selecting and implementing
feasible projects/investments from which future cash inflows are expected into the organization
for a number of years.
Stages of capital budgeting
The stages include generation of investment alternatives, screening of projects, cash flow
determination, financial evaluation, selection and implementation, and monitoring and review as
explained below
Review of a firms strategic investment plan; firms normally conduct a periodic strategic
investment plan review either annually,bi annually or quarterly to assess the level of progress
and the possible adjustments in the plan.
Generation of investment alternatives; capital budgeting begins with generation of capital
investment alternatives a firm can undertake. This may come from market research, strategic
planning process, benchmarking, seeking expert opinion, regulatory requirements to comply with
a given regulations.
Screening; the different alternatives are then subjected to the corporate strategic plan to establish
if these investment alternatives align with the corporate objectives.
Cash flow determination: This involves estimation of how much will be required in terms of cost
of inject in projects that are considered to be in line with the corporate objectives. as well as the
estimation of the expected net cash flows over the project.
Evaluation; after determination of the cost and benefits expected from the project, different
approaches may be applied to determine the viability of the investment alternatives. This can be
done using any of the appraisal techniques such as payback period, accounting rate of return, Net
present value, internal rate of return and present value index.
Selection and implementation: After considering the viability of the project, a decision to
undertake the project is made.
Monitoring and Review; At this stage, the project is monitored to ensure that it stays on truck
and within the estimated. The review is made on periodic basis to ensure that the project
objectives are being achieved and that any deviations in terms of costs are dealt with on a timely
basis.
Non discounting rates
Accounting rate of return.
This technique unlike other capital budgeting approaches uses accounting profits in
determination of the financial viability of investment alternatives. It measures the profitability of
the proposed project by looking at average net income of the project in relation to the average
amount invested in long term assets, total investment or average investments.
ARR = × 100%
Where Average Net Income (ANI) =
Average Investments =
Decision Criteria
Accept – ARR>Target ARR
Reject – ARR<Target ARR.
Example
Let’s assume that company X is planning an investment that requires an initial sum of $500,000
in long term assets expected to last for five years. The company has also estimated that it will be
able to dispose the assets for $100,000 at the end of its useful life.
Below is the forecast from the proposed investment reflecting periodic net earnings.
Years 1 2 3 4 5
EAT 120,000 80,000 95,000 150,000 175,000
Payback
Payback is the minimum length of time a project takes to recover the initial cost of the
[Link] is taken as a liquidity technique that is concerned with how fast an investment can
generate cash flows sufficient to offset the initial cost. The investment is considered to be more
desirable where the payback period is shorter than the target period set by management.
Payback period =( )
Example
Assume an investment has an initial outlay of ugx 100 m and it is projected that it will have a
useful life of 10 years with a uniform annual net cash inflow of ugx [Link] also that the
investors target payback period is 3 years.
Solution
Payback period =
PBP =
PBP = 4 years
This means that it will take 4 years for the firm to recover its initial outlay on the investment
which means the investments is not viable based on the target payback period.
b) Under non uniform cash flows, the payback is determined by cumulative approach to recover
the total investment cost. The payback period is determined at a point where the cumulative
balance is equal to zeros
Step 1 use a cumulative table to determine the PBP at zero cumulative balance
Years Cash flows Cumulative balance
0 (xxx) (xxx)
1 xxx (xxx)
2(payback period) xxx 0
3 xxx
step 2;Where the table doesn’t give a zero cumulative balance in any year as shown below, use
interpolation expression.
Years Cash flows Cumulative balance
0 (xxx) (xxx)
1 xxx (xxx)
2 xxx (xxx)
Payback period 0
3 xxx xxx
4 xxx
PBP = +( )× 12 months
Ly = A year before full recovery (Lower year)
Amount to Recover = the last negative cumulative balance
Next cash flow = cash flow expected after the lower year.
This expression gives us the number of years and months it takes for the project to recover its
initial investment cost.
Decision Criteria
If payback period >Target payback period – Reject
If payback period </= target Payback period – Accept.
Example
Assuming Wyatt international plans to invest in two different projects with a total sum of $500M
all expected to last for five Years. The Company plans to invest $250m in each project while the
expected cash flows are indicated as follows.
Years 1 2 3 4 5
Project A 80M 70M 100M 105M 95M
Project B 100M 80M 120M 150M 175M
Required
Determine the payback period for the two projects if the company’s target payback period is
normally at 3 years.
Techniques that incorporate time value of money (Discounted Cash flows)
There are three commonly used techniques that incorporate time value of money in project
appraisal and these include ;the Net Present Value, Internal Rate of Return and Profitability
Index.
a) Net Present Value (NPV)
The Net Present Value technique is used to determine the net contribution from a project by
looking at the difference between the summation of the present values of future net cash flows
and the present value of initial outlay.
NPV = + + + + …….+ -
Summarized as;
NPV = ∑ -
Where: = Cash flow in time t,
r = cost of capital (discount rate)
= Initial Cash Outlay
n = the number of years
WP group of companies have been operating as health services providers across Africa with
reputation in service quality. The group has decided to venture into the Ugandan market to offer
the same services and expects to invest a total sum of $500,000 in fixed capacity with working
capital expected to be $75,000 specifically for Ugandan operation. Capital allowance on medical
facilities for tax purposes is usually at 25% on reducing balance method in Uganda. The group
has also decided that it will operate the facility for a balance method in Uganda. The group has
also decided that it will operate the facility for a period of five years after which it intends to
dispose it at a giveaway price of $45,000 to any local investor. The group expects to recover
75% of net working capital at the end of the fifth year of operation.
For all the investments that WP group undertakes, it expects a rate of return of not less than 15%
per annum while its target payback period is normally three years. The group will be expected to
pay a corporation tax at a rate of 25% each year and the expected earnings to be generated over
the five years are estimated as shown in the table below.
Years 1 2 3 4 5
EBDT $150,000 $175,000 $195,000 $225,000 $200,000
Required:
Appraise the project using the DCF technique and payback period(Round off the discount factors
to three decimal places).
b) Internal rate of return
internal rate refers to actual rate of return expected from an investment over its economic life
given the anticipated net [Link] is also known as the discount rate that equates the present
value of the expected future net cash flows to the initial [Link] is therefore that discount rate
that equates the projects Net present Value to zero. The IRR can be determined by the expression
indicated below;
NPV = + + + + …….+ -
Summarized as;
NPV = ∑ -
The internal rate of return is also the discount rate above which a project generates a negative net
present value. There is no direct formula that is used to determine the internal rate of return and
therefore it is determined using a trial and error method and interpolated in the expression below.
IRR= +( )× (%[Link] the LR and HR)
Summarized as;
IRR = +( )× (
Please note; a rate with a positive NPV is considered a lower rate ( ) in the expression and
that with a negative NPV is considered a higher rate ( ).
Decision criteria
Where IRR > RRR (Cost of capital) – Accept
IRR< RRR (Cost of capital) – Reject
IRR = RRR (Cost of capital) – Accept/Reject
Example
Using WP group of companies above, the following cash flows were generated.
Years 0 1 2 3 4 5
Initial $575,000
Outlay
Periodic CFs $143,750 $154,687 $163,828 $181,933 $279,550
Without changing any variable, appraise the viability of the project using the internal rate of
return.
Profitability index
Profitability index as the name suggest measures relative profitability of a given project by
determining how much in terms of present value of future cash flows are generated by a unit of
currency invested
P.I =
Alternatively
P.I = +1
Decision criteria
Where PI > 1.0 – Accept
PI < 1.0 – Reject
PI = 1.0 – Accept/Reject
Note: Profitability index above 1.0 means the investment has a positive Net Present Value and
therefore adds to the wealth of the shareholders.
Example.
According to the case of WP group of companies, the company injected a total sum of $575,000
as initial outlay and the present value of future cash inflow amounted to $592,807 using 15%
cost of [Link] on the above information, determine the profitability index of WP group of
companies.
