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INSTITUTE OF ACCOUNTANCY ARUSHA (IAA)
(BAF II 2024/2025)
CORPORATE FINANCE (CF)
TOPIC: CAPITAL BUDGETING DECISION (INVESTMENT APPRAISAL)
Introduction
Concept of Capital Budgeting Decision
Capital budgeting, also known as investment appraisal, is the process by which companies
evaluate and decide on significant long-term investments or projects. These investments often
involve large expenditures, and they are critical to the company's future growth and profitability.
Typical examples include the purchase of new machinery, expansion of production facilities,
launching new products, and acquisitions.
A capital budgeting decision is a decision related to the allocation of capital for projects that are
expected to generate returns over an extended period of time. The primary goal of capital
budgeting is to select investments that will maximize the company's value while aligning with its
long-term strategic objectives.
Capital budgeting decisions are at the core of a firm’s financial strategy. These decisions not
only determine the direction in which the company will grow but also ensure the company's
long-term financial stability. A well-planned capital budgeting process ensures that companies
invest their resources in the most promising and profitable projects while minimizing risks and
maximizing shareholder value.
The success of capital budgeting decisions largely depends on the accuracy of future cash flow
estimates, the discount rate used for calculating present values, and the alignment of the
project with the company’s broader strategic goals. Moreover, due to the long-term nature of
these investments, careful monitoring and post-implementation reviews are crucial to ensure that
the project delivers the expected benefits.
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Objectives Of Capital Budgeting Decision
Maximizing Shareholder Wealth
The primary objective of capital budgeting is to increase the wealth of the company's
shareholders. By selecting projects that generate returns higher than the cost of capital, the
company enhances its profitability, leading to an increase in share value. Capital budgeting helps
in identifying investments that will maximize the company's net worth over the long term.
Efficient Allocation of Capital Resources
Companies often have limited financial resources, so capital budgeting helps in prioritizing
investments that will provide the most benefit. The objective is to allocate capital efficiently by
investing in projects with the highest potential returns while considering the risk and long-term
strategic goals of the company.
Facilitating Long-Term Growth
Capital budgeting focuses on decisions that impact a company’s growth trajectory over the long
term. By investing in new technology, expanding production capacity, entering new markets, or
launching new products, companies can position themselves for future growth and maintain their
competitive edge.
Risk Management
Capital budgeting decisions aim to manage and mitigate the risks associated with long-term
investments. By thoroughly evaluating the potential risks (e.g., market changes, technological
obsolescence, regulatory changes), companies can avoid projects that may expose them to
excessive risks. The objective is to ensure that the selected investments have manageable risk
profiles while offering adequate returns.
Optimal Capital Structure
An important objective of capital budgeting is to ensure that the company maintains an optimal
mix of debt and equity financing. By selecting projects that generate cash flows sufficient to
cover debt obligations and offer attractive returns to equity holders, companies can maintain a
balanced and cost-effective capital structure.
Maximizing Cash Flow
Another key objective of capital budgeting is to select projects that generate sufficient cash flows
over time. Positive and consistent cash flows from an investment help the company meet its
operational and financial obligations and fund future investments. The goal is to ensure that
investments deliver the expected cash inflows, both in the short and long term.
Ensuring Liquidity
Another objective of capital budgeting is to ensure that the company maintains adequate liquidity
while undertaking long-term investments. The company must balance its need for long-term
assets with the requirement to maintain enough working capital to meet short-term obligations.
Effective capital budgeting ensures that investments do not strain the company’s liquidity
position.
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Nature/Features of Capital Budgeting Decisions
High Capital Outlay
• Large Investment: Capital budgeting decisions involve substantial financial
commitments. Projects such as purchasing new machinery, building facilities, or entering
new markets require significant amounts of money, often more than other routine
expenditures.
Long-Term Impact
• Long Time Horizon: Capital budgeting projects have long-term implications, often
spanning several years or decades. The benefits (or returns) from these investments are
realized over an extended period, making these decisions essential for the company's
future growth and survival.
Risk and Uncertainty
• Uncertain Future: Capital budgeting involves predicting future cash flows, market
conditions, and technological trends. These projections are often subject to risk and
uncertainty because it is challenging to forecast future outcomes accurately.
• High Risk: Due to the large investments involved and long-time frames, capital
budgeting decisions carry a higher level of risk compared to short-term financial
decisions. Changes in market conditions, economic cycles, or regulations can
significantly impact the outcomes.
Evaluation of Potential Returns
• Profitability Assessment: A key feature of capital budgeting is the evaluation of the
potential profitability of projects. Companies use various methods (like NPV, IRR,
Payback Period, etc.) to assess whether a project is expected to generate sufficient returns
to justify the investment. Capital budgeting decisions focus on cash flows and not just
profits.
Involves Long-Term Commitment of Resources
• Locking Capital for Long Periods: Since capital budgeting projects are long-term, they
involve committing financial and physical resources (such as machinery, infrastructure,
etc.) for extended periods. The company's ability to allocate its resources efficiently is
crucial to its long-term success.
• Opportunity Cost: By committing resources to one project, the company forgoes other
potential investment opportunities, making it important to choose projects that align with
its strategic goals.
Time Value of Money Consideration
• Discounting Cash Flows: Since capital budgeting involves long-term investments, the
time value of money is a crucial factor. Cash flows are discounted to their present value
to account for the fact that money received in the future is worth less than money
received today.
Irreversibility
• Difficult to Reverse: Once a capital investment is made, reversing the decision is often
impossible or very expensive. This is because assets purchased, such as machinery or
buildings, may have limited resale value, or stopping a project mid-way can lead to sunk
costs.
• High Sunk Costs: Investments in long-term projects often include significant sunk costs,
which cannot be recovered even if the project is discontinued. Therefore, companies need
to carefully evaluate projects before making decisions.
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Factors Affecting Capital Budgeting Decisions (CBD)
Cash Flow Projections
The most critical factor in capital budgeting is the projection of future cash flows from
the investment. Accurate and realistic cash flow estimates help determine the project’s
potential profitability. If cash flow estimates are incorrect or overly optimistic, it can lead
to poor decision-making.
Cost of Capital
The cost of capital (or required rate of return) is the rate at which future cash flows are
discounted to their present value. It reflects the company’s cost of financing (debt, equity,
or a mix). Projects must generate returns that exceed the cost of capital to be considered
viable.
Risk and Uncertainty
The inherent risk of the project due to market conditions, competition, and the economic
environment significantly influences the capital budgeting decision. Projects with high
uncertainty or volatility in returns may require a higher rate of return or may be rejected
altogether.
Some projects carry higher risk due to technological changes, regulatory issues, or market
demand uncertainty. Companies must evaluate project-specific risks and assess whether
they can be managed effectively.
Availability of Funds
Companies often face capital constraints, meaning they have limited funds to invest in
multiple projects. This leads to capital rationing, where the company must choose among
competing projects. Only the most financially viable and strategically important projects
are selected.
Time Horizon of the Project
The time horizon of a project influences the capital budgeting decision. Projects with
longer durations involve greater uncertainty due to changes in market conditions,
technology, or the economy.
Short-term projects might be less risky but offer limited growth potential. Some
companies may prioritize projects that offer quicker returns or shorter payback periods,
especially if liquidity is a concern or there is uncertainty about long-term conditions.
Strategic Alignment
Capital budgeting decisions must align with the company’s long-term strategy. Projects
that support the company’s growth objectives, competitive position, or market expansion
may be prioritized over others.
Technological Changes
In industries with rapid technological advancement, companies must consider the risk of
technological obsolescence. Investing in outdated technology or infrastructure can lead to
losses if new innovations emerge quickly. Companies need to assess the likelihood of
future technological changes that could affect the viability of an investment.
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Tax Considerations
The availability of tax benefits (such as tax shields from depreciation or interest
payments on debt) can make capital investments more attractive. Tax incentives or
favorable tax rates can improve a project's net present value (NPV) and increase its
chances of being selected.
Changes in tax laws or regulations can impact the cost and profitability of a capital
investment. Companies must consider current and potential future tax policies when
making capital budgeting decisions.
Stakeholder Preferences
Management and Board Preferences: Sometimes, decisions are influenced by the
preferences of senior management or the board of directors, especially when considering
projects with high visibility or strategic importance.
Shareholder Expectations: Shareholders may influence capital budgeting decisions,
particularly when they expect higher returns or prefer investments in certain types of
projects (e.g., dividends vs. growth investments).
Techniques/Methods of Capital Budgeting Evaluation
Capital budgeting evaluation refers to the process of analyzing and selecting long-term
investments or projects that will generate returns over time. This is crucial for organizations, as it
involves determining the most efficient allocation of resources to maximize profitability and
growth. Several techniques or methods are employed to evaluate these investment decisions,
helping firms to assess the viability and potential returns of projects.
The techniques/methods of capital budgeting evaluations are classified as follows:
Traditional Methods
✓ Pay-Back Period (PBP)
✓ Accounting/Average Rate of Return (ARR)
Modern Methods
✓ Net Present Value (NPV)
✓ Internal Rate of Return Method (IRR)
✓ Profitability Index Method (PI)
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Pay-Back Period (PBP)
Pay-back period is the time required to recover the initial investment in a project.
Decision Criteria
If the actual pay-back period is less than the predetermined pay-back period, the project would
be accepted. If not, it would be rejected.
Payback period for projects with even or equal Cash Inflows
Pay-Back Period = Initial investment
Annual cash inflows
Payback period for projects with uneven Cash Inflows
Normally the projects are not having uniform cash inflows. In those cases, the pay-back period is
calculated by using cumulative cash inflows.
Example one
The information below presents the information of both project A and B.
Project A
Cash outflow shs100,000
Annual cash inflow (After tax before depreciation) shs25,000
Estimated Life 6 years
Project B
Cash outflow shs100,000
Annual cash inflow (After tax but before depreciation) year 1-5 shs20,000
Annual cash inflows (After tax but before depreciation) year 6-10 shs8,000
Estimated life 10 Years
Required
From the above information compute the Pay-Back Period. On the basis of Pay-Back Period
comment which project should be accepted.
Example two
Project Machozi Dot Com require an initial cash outflow of shs.25,000,000. The cash inflows for
6 years are shs.5,000,000, shs.8,000,000, shs.10,000,000, shs.12,000,000, shs.7,000,000 and
shs.3,000,000, respectively.
Required: Calculate the Pay-Back Period and Comment on the viability of the project
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Accounting Rate of Return/Average Rate of Return (ARR)
Accounting Rate of Return (ARR), also known as the Average Rate of Return (ARR), is a
financial metric used to assess the profitability of an investment by comparing the average
annual accounting profit generated by the investment to the initial or average investment. It is
typically expressed as a percentage.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
ARR = × 100%
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑟 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Decision Criteria
If the actual accounting rate of return is more than the predetermined required rate of return, the
project would be accepted. If not, it would be rejected.
Example three
A company has two alternative proposals. The details are as follows: (Amount are in millions)
Automatic Machine Manual Machine
Cost of the machine 500,000 300,000
Estimated life 10 years 15 years
Estimated sales p.a. 150,000 150,000
Costs: Material 50,000 50,000
Labor 12,000 60,000
Variable Overheads 24,000 20,000
Required: Compute the accounting rate of return on the two projects and recommend which
machine should be purchased.
Net Present Value (NPV)
Net present value method is one of the modern methods for evaluating the project proposals. In
this method cash inflows are considered with the time value of the money. Net present value
describes as the summation of the present value of cash inflow and present value of cash
outflow. Net present value is the difference between the total present value of future cash inflows
and the total present value of future cash outflows.
𝑛
𝑁𝑃𝑉 = ∑ 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒(𝑃𝑉) − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡(𝐼𝑜)
𝑡=1
Decision Criteria
✓ Independent projects: If NPV is positive (+ve) accept the project. If NPV is negative (-
ve) reject the project.
✓ Mutually exclusive projects: If the NPV of one project is greater than the NPV of the
other project, accept the project with the higher NPV. If both projects have a negative
NPV, reject both projects.
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Example four
Assume you are an expert in finance department of PHILLIPS Ltd the company in Arusha which
manufacture and supply electrical equipment within and outside Tanzania. Your boss, the chief
financial officer (CFO), has just handed you with the estimated cash flows for two proposed
projects.
Project 1: Involves making electrical transformer.
Project 2: Involves making electrical cables.
Both projects have 6-years lives, because PHILLIPS Ltd is planning to introduce entirely new
models after 6 years.
Cash flows
Projects Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
P1 24,000,000 5,000,000 10,000,000 10,000,000 5,000,000 3,000,000 3,000,000
P2 36,000,000 10,000,000 5,000,000 3,000,000 3,000,000 2,000,000 4,000,000
If the above two projects are independent
Required
i. Calculate the net present value of the two projects.
ii. Recommend which of the two projects should be accepted if a discount rate of the two
projects is 14%
Internal Rate of Return (IRR)
Internal Rate of Return (IRR) is a financial metric used to evaluate the profitability of an
investment. It is the discount rate at which the net present value (NPV) of all cash flows (both
incoming and outgoing) from a project or investment equals zero. In other words, the IRR is the
rate at which an investment breaks even in terms of NPV.
Formula
IRR = LR + NPVLR x (HR – LR) x 100%
NPVLR - NPVHR
Whereby;
NPVHR = Net Present Value with higher rate
NPVLR = Net Present Value with lower rate
HR = Higher rate
LR = Lower rate
Decision Criteria
If the internal rate of return is greater than the required rate of return, the proposed project is
accepted. If not, it would be rejected.
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Note: Internal Rate of Return will be calculated by the trial-and-error method. The cash flow is
not uniform. To have an approximate idea about such rate, we can calculate the “Factor”. It
represents the same relationship of investment and cash inflows in case of payback calculation:
F = I/C
Where F = Factor
I = Original investment
C = Average Cash inflow per annum
Example five
Project Cost TZS. 110,000,000
Years Cash Inflows:
(Amounts in “Millions”)
Year 1 60M
Year 2 20M
Year 3 10M
Year 4 50M
Required
Calculate the Internal Rate of Return.
Profitability Index (PI)
Profitability Index = P.V. of cash inflow
P.V. of cash outflow
Decision Criteria
If PI > 1, project is accepted
PI < 1, project is rejected
The PI signifies present value of inflow per shilling of outflow. It helps to compare projects
involving different amounts of initial investments.
Example six
Initial investment TZS20,000,000. Expected annual cash flows TZS6,000,000 for 10 years. Cost
of Capital @ 15%.
Required: Calculate Profitability Index if Cumulative discounting factor @ 15% for 10 years is
5.019
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