- 1 - UNIVERSITY OF NAIROBI SCHOOL OF BUSINESS (MBA) DFI605: FINANCIAL SEMINAR 1.7 GROUP ASSIGNMENT: CAPITAL BUDGETING COURSE LECTURER: DR. ADUDA/ MR. MIRIE PRESENTED BY: OGOLO AKOTH DORINE D61/62963/2011 RAEL JELAGAT ROTICH D61/62980/2011 PETER KAMAU WAGEREKA D61/60380/2010 ANTHONY MAINA MWAI D61/67629/2011 JOSEPH BORO NJOROGE D61/68186/2011 WARUTERE JOSEPHINE NYAKIO D61/63326/2011 September 2012
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UNIVERSITY OF NAIROBI
SCHOOL OF BUSINESS (MBA)
DFI605: FINANCIAL SEMINAR
1.7 GROUP ASSIGNMENT: CAPITAL BUDGETING
COURSE LECTURER: DR. ADUDA/ MR. MIRIE
PRESENTED BY:
OGOLO AKOTH DORINE D61/62963/2011
RAEL JELAGAT ROTICH D61/62980/2011
PETER KAMAU WAGEREKA D61/60380/2010
ANTHONY MAINA MWAI D61/67629/2011
JOSEPH BORO NJOROGE D61/68186/2011
WARUTERE JOSEPHINE NYAKIO D61/63326/2011
September 2012
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CHAPTER ONE
1.0 INTRODUCTION
Capital budgeting is obviously a vital activity in any business. Vast sums of money can be easily wasted if
the investment turns out to be wrong or uneconomic. In modern times, the efficient allocation of capital
resources is a most crucial function of financial management. This function involves organization‟s decision
to invest its resources in long term assets like land, buildings, equipment, and vehicles. All these assets are
extremely important to the firm because in general, all the organizational profits are derived from the use of
its capital investment in assets which represent a very large commitment of financial resources, and these
funds usually remain invested over a long period of time.
The future development of a firm hinges on the capital investment projects, the replacement of existing
capital assets, and/or the decision to abandon previously accepted undertakings which turn out to be less
attractive to the organization. The business environment calls for the efficient allocation of resources by the
management of any organization. Lately, a lot of emphasis has been placed on the view that a business firm
facing a complex and changing environment will benefit immensely in terms of improved quality of decision
making if investment decisions are taken in the context of its overall corporate strategy. This approach
provides the decision maker with a central theme or a great picture of investment to keep in mind at all times
as a guideline for effectively allocating corporate resources in any investment opportunities.
1.1 Definition of capital budgeting
Capital budgeting, sometimes referred to as investment appraisal, is a management process which involves
evaluation of the investments of the company to determine whether they are viable or not and thus determine
whether to accept a project or reject it all together. Some of the investment decisions that have to be made by
the companies include replacement decisions for the company's fixed assets such as machinery, introduction
of new products to the already existing products produced by the company, engaging in long term
investments such as purchasing shares of other companies among other investment (Ross, Westerfield&
Bradford, 1998). As such, capital budgeting decisions have a major effect on the value of the firm and its
shareholders wealth.
Investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decision.
It is defined as the firm decision to invest its current funds most efficiently in the long-term assets in
anticipation of an expected flow of benefits over a series of years (the long term assets are those that affects
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the firms operations beyond the one-year period) it includes expansion, acquisition, modernization and
replacement of the long-term assets, sale of a division or business(divestment), change in the methods of
sales distribution, an advertisement campaign, research and development programme and employee training,
shares (tangible and intangible assets that create value) (Pandey 2010).
Horne, (2000) define investment decisions as the allocation of capital to investment proposal whose benefits
are to be realized in the future and includes, new product or expansion of existing products, replacement of
equipment or buildings, research and development, exploration and others.
Capital expenditure includes all those expenditures which are expected to produce benefits to the firm for a
period of over one year, and this includes both tangible and intangible assets. Lynch (2001) looked at the
tactics for improving the capital budgeting process to produce results, as a way of maximizing firm‟s
contribution to shareholders‟ value. He argued that shareholders‟ value can be increased by improving the
capital expenditures process for fixed assets with the caveat that an understanding of the process and a
functioning continuous capital budgeting system were prerequisite to improvement activities.
Capital budgeting/investment appraisal is the “process of evaluating and selecting long-term investments
that are consistent with the business‟s goal of maximizing owner‟s wealth” (Gitman, 2002). Financially
successful companies have a continuing need for capital investment. Typically every organization that
embarks on this process must take all necessary steps to ensure that their decision making processes and/or
criteria supports the business‟s strategy and enhances its competitive advantage. However, growth of a
business can be limited by unavailability of capital. When capital is limited, allocating resources
appropriately is a critical skill which involves taking into consideration current and future market conditions,
such as inflation and demand for a certain product.
Essentially it is the requirement of the management to pursue all the investments options that are available to
the company in order to create wealth of the owners of the company or the shareholders but the resources
available to the company are not sufficient and thus the management are required to conduct project
appraisal in order to determine the projects that would bring the maximum return to the investors (Shim &
Siegel, 2008).
According to Pandey, (2010) investment decisions are decisions that influence a firm‟s growth in the long-
term, affect the risk of the firm, involve commitment of large amount of funds, are irreversible or reversible
at substantial loss, and among the most difficult decisions to make.
Investments should be evaluated on the basis of criteria that are compatible with the objectives of the
shareholders wealth maximization. Therefore, all the stakeholders to some extent have an interest in seeing
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sensible financial decisions being taken. Many business decisions do not involve a conflict between
objectives of each of the stakeholders. Nevertheless, there are occasions when someone has to decide which
claimants are to have their objectives maximized and which are merely to be satisfied-that is, given just
enough of a return to make their contributions (Arnold 2005).
It is important for organizations to engage in capital budgeting before they invest in a certain projects
because of the enormous resources required to start the project. Incase the project fails there would be huge
losses that would be incurred by the firms. Another reason is that the investments decisions that managers
make are not easily reversible, the projects that the company invest in have a long term implications on the
operations of the organization and lastly due to the fact that the investments involves risks and uncertainty to
the firm and thus the organization evaluate the suitability of the investment to the firm through carrying out
capital budgeting. There are various methods that are used in capital budgeting which are classified into two;
traditional methods and the discounting methods. Traditional methods of capital budgeting include payback
period and the Average rate of return which the discounted methods of capital budgeting include Net Present
Value (NPV) and Internal Rate of Return (IRR). Every method of capital budgeting has its weaknesses and
strengths and thus no method is superior or inferior to the other (Brigham & Houston, 2008).
A good capital budgeting system does more than just make accept-reject decisions on individual projects. It
must tie into the firm‟s long range planning process-the process that decides what lines of business the firm
concentrates in and sets out plans for financing, production and marketing etc. It must also tie into a
procedure for measurement of performance (Brealey& Myers, 2007)
The term 'Capital Budgeting' is used interchangeably with capital expenditure management, capital
expenditure decision, long term investment decision, management of fixed assets, etc. It may be defined as
"planning, evaluation and selection of capital expenditure proposals." Capital budgeting involves a current
outlay or serves as outlays of cash resources in return for an anticipated flow of future benefits.
In other words, the system of capital budgeting is employed to evaluate expenditure decisions which involve
current outlays, but likely to produce benefits over a period of time longer than one year. These benefits may
be either in the form of increased revenue or reduction in costs. Capital expenditure management therefore
includes addition, disposition, modification and replacement of fixed assets.
The basic features of capital budgeting are:
a) Potentially large anticipated benefits;
b) A relatively high degree of risk;
c) A relatively long time period between initial outlay and anticipated returns
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1.2 Historical Background of Capital Budgeting
The Period up to 1950
Earlier approaches to capital budgeting models were concerned mostly with theeconomic evaluation of
individual projects. For many years, most firms used Payback period to evaluate investment project. In 1899,
Irving Fisher first articulated the concept of NPV as the market value of securities minus cost of resources.
Fisher (1930) advanced the Theory of Interest in which he suggested that NPV is the key part in theory of
optimal resource allocation. Fisher labeled his theory of interest the “impatience and opportunity” theory. He
put forward that Interest rates, were as a result of the interaction of two
forces:the “time preference” people have for capital now and the investmentopportunityprinciple (that
income invested now will yield greater income in the future). The interest rate, or what is called cost of
Capital, forms the basis of the Internal Rate of Return (IRR) defined as the discount rate that will equate the
present value of future cash flows to the resources employed now. Fisher defined capital as any asset that
produces a flow of income over time. A flow of income is distinct from the stock of capital that generated it,
although the two are linked by the interest rate. Specifically, wrote Fisher, the value of capital is the present
value of the flow of (net) income that the asset generates. In the period between 1930s and 1950s non owner
managed firms put in place capital budgeting control systems that identified planned capital investments
going forward. The size of non financial investments and the number of non owner managed firms increased
during the industrial revolution. These simultaneous changes created fertile ground for use of more
sophisticated evaluation techniques and for the capital budgeting processes in use today (Chapman &
Hopwood, 2007)
1951 to date
During the 1950s, practicing financial controllers began to network with each other, with consultants and
with academicians to develop models for capital budgeting (Chapman &Hopwood, 2007). Dean (1951), in
his book Capital Budgeting, advanced the implementation of Discounted Cash flows (DCF) methodology in
its current form. Managers are required to maximize return on investment at a given level of risk. However
capital budgeting models only consider the return on investment. As a result, managers don‟t usually have
all the information to make the right decisions as far as risk is concerned. To address this law, Hertz (1964)
provided a discussion on how computer simulation can be used to provide managers with of Risk on a
Capital Investment Project. Agency theory that developed in the late 1970s and early 1980s gave rise to
analytical models of capital investment process. These models suggest that current capital
budgeting procedures are a means of reducing agency costs that emanate from the conflict of interest
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between owners of firms and management. The internal rate of return (IRR) and the net present value (NPV)
have long been the accepted capital budgeting measures preferred by corporate management and financial
theorists, respectively. While corporate management prefers the relevancy of a yield-based capital budgeting
method, such as the IRR, financial theorists, based on Orthodox economic theory, endorse the NPV method.
The debate between NPV and IRR methods dates from the inception of modern interest theory. The
introduction of the NPV as Amore superior model created the impetus for conflict
between the two methods. However, both methods suffer from inconsistencies when ranking potential
investment projects based on the assumption of wealth maximization. Therefore, a consistent capital
budgeting method must be robust when correctly ranking and selecting superior investments in varying
Investment conflict between the two methods. However, both methods suffer from inconsistencies when
ranking potential investment projects based on the assumption of wealth maximization. Therefore, a
consistent capital budgeting method must be robust when correctly ranking and selecting superior
investments in varying Investment environments, remain theoretically sound by maintaining the assumption
of wealth maximization, and be expressed as a yield based measure as preferred by corporate management
(Chapman & Hopwood, 2007)
1.3 Importance of Capital Budgeting
Capital budgeting is of paramount importance in financial decision making. Special care should be taken in
making these decisions on account of the following reasons (Pandey, 2010):
(a) Growth
The effects of investment decisions extend into the future and have to be endured for a longer period than the
consequences of current operating expenditures. A firm‟s decision to invest in long term assets has a
decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the
continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating
costs for the firm. On the other hand, inadequate investment in assets would make it difficult for a firm to
gain competitive advantage over its competitors.
(b) Risk
A long term commitment of funds may also change the risk complexity of the firm. If an investment in
assets makes the earnings of an organization to fluctuate significantly over time, the firm will become more
risky, hence investment decisions shape the basic character of a firm.
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(c) Funding
Since investment decisions generally involve an outlay of large amounts of funds, an organization would
need to plan well ahead and very carefully for such investments. It is imperative for the firm to make
advance arrangement for procuring of finances internally or externally.
(d) Irreversibility
Most investment decisions are irreversible because it may be difficult to find market for such capital items
once they have been acquired. The firm will incur heavy losses if such assets are scrapped. The Nation
Media Group has for example invested in a printing press and refurbished it in the recent past. It would be
very difficult for the media house to make an overnight decision to scrap the press since it may not be easy
to find ready market owing to the small number of local media houses that are involved in printing and its
affordability.
(e) Complexity
Investment decisions are among the firm‟s most difficult decisions. They are an assessment of future events
and the future is very difficult to predict. Political, economic, social, technological forces make the business
environment very volatile.
1.4 Objectives
a) To explain the motives for capital expenditures and the steps followed in capital budgeting
b) To describe and compute cash flow components
c) To explain the basic terminologies used to describe projects, funds, availability, decisions approaches
and cash flow patterns therein
d) To determine the payback periods, the net present values, profitability index and the rates of return of
proposed investments
e) Evaluate projects and rank them based on budgeting techniques
f) Determine difficulties and conflicts in using discounted cash flow methods
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1.8 1.5 Capital Expenditure Motives
A capital expenditure is an outlay of funds by the firm that is expected to provide benefits over a period of
time greater than one year. The basic motives for capital expenditures are expansion, replacement or renewal
of non-current assets, or to obtain some other less tangible benefits over a long period of time. These key
motives may be outlined as follows;
a) Expansion: The most common motive is to expand the cause of operations through acquisition of
non-current assets. Growing firms therefore need to acquire new assets more rapidly. A company
may add capacity to its existing product lines to expand existing operations. Nation Media Group, for
example, refurbished its printing press in the year 2010 to expand its printing capacity and colour
quality.
b) Replacement and Modernization: As a firm‟s growth slows down and reaches its maturity, most
capital expenditures will be made in replacing obsolete and worn out assets. Outlays of repairing old
machines should be compared with the net benefit of replacement. The main objective of
modernization and replacement is to improve operating efficiency and reduce costs. Most of the
times, modernization reduces costs only but sometimes also increases revenues resulting in increased
profits. Monitor Publications, a subsidiary of Nation Media Group, for example, replaced its printing
press in 2011 and disposed off the old press.
c) Renewal: An alternative to replacement may involve rebuilding, overhauling or refitting an existing
fixed asset an example being addition of air conditioning as a means of renewing a physical facility.
d) Other purposes: Some expenditure may involve long-term commitments of funds in expectations of
future returns such as advertising, Research and Development, management, consulting and
development of view products. Others include installation of pollution control and safety devises
mandated by the government.
1.9 1.6 Classification of Investment Projects and Terminologies
Investment projects may be classified into three categories on the basis on how they influence investment
decision process: independent projects, mutually exclusive projects and contingent projects.
a) Independent Project: Is one the acceptance or rejection of which does not directly eliminate other
projects from consideration or affect the likelihood of their selection. For example, management may
want to introduce a new product line and at the same time may want to replace a machine which
currently producing a different product. The projects will thenbe considered independently of each
other if sufficient resources are available for both considerations, provided they meet the firm‟s
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investment criteria. The projects therefore, can be evaluated independently and a decision to accept
or reject be made depending on whether the project (s) add value to the firm.
b) Mutually Exclusive Investments: These are proposals, which compete with each other in a way that
the acceptance of one precludes the acceptance of other or others. For example, if a company is
considering use of ether a more labor intensive, semi-autonomous machine or a highly automated
machine for production, it can only choose either of the two and not both. Choosing the semi-
autonomous machine precludes the acceptance of the highly automated machine (Pandey 2010,
p160).
Mutually exclusive projects can be evaluated separately to select one which yields the highest net
present value of the firm. The earlier identification of mutually exclusive alternatives is crucial for a
logical screening of investments.
c) Contingent Project: Is one acceptance or rejection of which is dependent on the decision to accept
or reject one or more other projects. Contingent projects may be complementary or substitutes. For
example, a decision to construct a pharmacy may be contingent upon a decision to establish a
doctors‟ surgery in an adjacent building. In this case the projects are complementary to each other.
The cash flows of the pharmacy will be enhanced by the existence of a nearby surgery and
conversely, the cash flows of the surgery will be enhanced by the existence of a nearby pharmacy.
d) In contrast, substitute projects are those that the degree of success of one project is increased by the
decision to reject the other project. For example, market research indicates demand sufficiency to
justify two restaurants in a shopping complex and the firm is considering one Chinese and one Thai
restaurant. Customers visiting the shopping complex seem to treat Chinese and Thai food as close
substitutes and have a slight preference for Thai food over Chinese. Consequently, if the firm
establishes both restaurants, the Chinese restaurant‟s cash flows are likely to be adversely affected
which may mean negative net present value for the Chinese restaurant. In this situation, the success
of the Chinese restaurant project will depend on the decision to reject the Thai restaurant proposal.
Since they are close substitutes, the rejection of one project will definitely affect boost the cash flows
of the other. Contingent projects should therefore be analyzed by taking into account all the projects.
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1.10 Terminologies
a) Make or Buy decision: Make or buy decision is no longer a short run operating decision and it
becomes a problem of capital expenditure which necessitates consideration of required rate of return. A
company has to take this decision, when it has to face the following choice buy certain part or sub-
assemblies from outside suppliers; or use available capacity to produce the item within the factory. In
this decision, the following are major considerations:
i. Costs that will be incurred under both alternatives are not relevant to the analysis.
ii. Potential uses of available capacity should be considered.
iii. Pertinent quantitative factors must be evaluated in the decision process. These considerations
include price stability from suppliers, reliability of delivery and quality specifications of
materials or components involved.
Example 1 — Make or Buy Decision
You have the option to manufacture your own parts or purchase them from outside suppliers. If we purchase
the parts, it will cost Kshs 50.00 per part. Our factory is operating at 70% of capacity and our total cost to
manufacture parts is:
Direct Materials Kshs 15.00 / part
Direct Labor Kshs 19.00 / part
Overhead - Variable Kshs 14.00 / part
Overhead - Fixed Kshs 12.00 / part
Total Costs Kshs 60.00 / part
Since we are operating at 70% capacity, we do not expect an increase in fixed overhead; this is a sunk cost.
We would manufacture the parts since it is Kshs 2.00 / part cheaper: Purchase Kshs 50.00 vs. Manufacture
Kshs 48.00 (Kshs 15.00 + Kshs 19.00 + Kshs 14.00)
a) Unlimited funds: Is a financial situation in which an organization is able to accept all independent
projects that provide an acceptable return ( capital budgeting decision are simply a decision of
whether or not the project clears the hurdle rate)
b) Capital rationing: Is the financial situation in which the organization has only a fixed number of
cash (shillings) to allocate among competing capital expenditures. A further decision as to which of
the projects that meet the minimum requirement is to invest in has to be taken.
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c) Conventional cash flows: Consist of an initial outflow (outlay) followed by only a series of inflows
( For example a firm spends KES 6 Million and expects to receive equal annual cash inflows of KES
2 Million in each year for the next 4 years)
d) Non- Conventional cash flows: Is a cash flow pattern in which an initial outlay is not only followed
by a series of inflows, but also cash flows (at least one). For example, the purchase of a machine may
require KES 10 million (as initial outlay) and may thereafter generate cash inflows of KES 2 million
for 5 years after which in the 6th year an overhaul costing of KES 6 million may be required. The
machine would then generate KES 2 million for the following 5 years
Evaluating projects with unconventional patterns poses challenges that require an analyst‟s special
attention.
e) Relevant cash flows: To evaluate capital expenditure alternatives, the organization must determine
the relevant cash flows which are the incremental after-tax initial cash flow and the resulting
subsequent inflows associated with the proposed capital expenditure.
Example 2 — Calculate Relevant Cash Flows for Capital Project
We plan on purchasing a new assembly machine for Kshs 25,000. It will cost Kshs 2,000 to have the
new machine installed and we expect a Kshs 1,000 net increase in working capital. By making the
investment, we will reduce our annual operating costs by Kshs 7,000 and we expect to save Kshs 500
a year in maintenance. The new machine will require Kshs 750 each year for technical support. We
will depreciate the machine over 5 years under the straight-line method of depreciation with an
expected salvage value of Kshs 5,000. The effective tax rate is 35%.
Annual Savings in Operating Costs Kshs 7,000
Annual Savings in Maintenance Kshs500
Annual Costs for Technical Support Kshs(750)
Annual Depreciation Kshs (4,000) *
Revenues Kshs 2,750
Taxes @ 35% Kshs(962)
Net Project Income Kshs1,788
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Add Back Depreciation (noncash item) Kshs4,000
Relevant Project Cash Flow Kshs 5,788
* Kshs 25,000 - Kshs 5,000 / 5 years = Kshs 4,000
We will receive Kshs 5,788 of cash flow each year by investing in this new assembly machine.
Since we have a salvage value, we have a terminal cash flow associated with this project.
f) Incremental cash flows: Represent the additional cash flows (inflows and outflows) expected to
result from a proposed capital expenditure.
g) Sunk Costs: Are cash outlays that have already been made (past outlays) and therefore have no
effect on the cash flows relevant to a current decision. Therefore, sunk costs should not be included
in a project‟s incremented cash flows.
h) Opportunity Costs: Are cash flows that could be realized from the best alternative use of an owned
asset. They represent cash flows that can therefore not be realized, by employing that asset in the
proposed project. Therefore, any opportunity cost should be included as a cash outflow when
determining a project‟s incremental cash outflow
1.8 Capital Budgeting Process
Capital budgeting as a process can be divided into four major stages; identification and development of
investment proposals; financial evaluation of projects; implementation of projects; and project review. The
financial evaluation portion has a number of tools to determine the wealth that a project can create for the
organization; these methods can be split into accounting based concepts and economic based concepts
(Northcott, 1992)
Capital budgeting is a multi-faceted activity with several sequential stages as indicated above. For typical
investment proposals of a large corporation, the distinctive stages in the capital budgeting process are
depicted in the form of a highly simplified flow chart
Strategic Planning
The key components of 'strategic planning' include an understanding of the firm's vision, mission, values and
strategies. It is the grand design of the firm and clearly identifies the business the firm is in and where it
intends to position itself in the future. Strategic planning translates the firm‟s corporate goals in to specific
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policies and directions, sets priorities, specifies the strategic and tactical areas of business development and
guides the planning process in the pursuit of solid objectives. The vision and mission are often captured in a
Vision Statement and Mission Statement.
Vision: outlines what the organization wants to be, or how it wants the world in which it operates to
be (an "idealized" view of the world). It is a long-term view and concentrates on the future. It can be
emotive and is a source of inspiration. For example, a charity working with the poor might have a
vision statement which reads "A World without Poverty."
Mission: Defines the fundamental purpose of an organization or an enterprise, succinctly describing
why it exists and what it does to achieve its vision. For example, the charity above might have a
mission statement as "providing jobs for the homeless and unemployed".
Values: Beliefs that are shared among the stakeholders of an organization. Values drive an
organization's culture and priorities and provide a framework in which decisions are made. For
example, "Knowledge and skills are the keys to success" or "give a man, bread and feed him for a
day, but teach him to farm and feed him for life". These example values may set the priorities of self
-sufficiency over shelter.
Strategy: Strategy, narrowly defined, means "the art of the general." A combination of the ends
(goals) for which the firm is striving and the means (policies) by which it is seeking to get there. A
strategy is sometimes called a roadmap which is the path chosen to plow towards the end vision. The
most important part of implementing the strategy is ensuring the company is going in the right
direction which is towards the end vision.
Proposal Generation
Identification of investment opportunities and generation of investment project proposals is an important
step in capital budgeting process. The investment opportunities have to fit in with the organization‟s
corporate goals, vision, mission and long-term strategic plan. Moreover, if an excellent investment
opportunity presents itself, it is prudent to change the corporate vision and strategy to accommodate the
change(s). Thus, there is a two-way traffic between strategic planning and investment opportunities.
Some investments are however mandatory for instance, those required to satisfy particular regulatory, health
or safety requirements- and they are essential for an organization to remain in business. Other investments
are discretionary and are generated by growth opportunities. , competition, cost reduction opportunities and
so on. These discretionary investments form the basis of the business of the organization.
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A profitable investment proposal is not just born; someone has to suggest it. The organization should ensure
that it has searched and identified potentially lucrative investment opportunities and proposals. There should
be a mechanism such that investment suggestion coming from inside the organization, such as from its
employees, or outside the organization, such as from advisors to the organization. Some organizations have
research and development (R&D) divisions constantly searching for and researching into new products,
services and processes and identifying attractive investment opportunities. Sometimes, excellent investment
suggestions come through informal processes.
Preliminary Screening of Projects
Generally, in an organization, there will be many potential investment proposal generated. Obviously, they
cannot all go through rigorous project analysis process. Therefore, the identified investment opportunities
have to be subjected to a preliminary screening process by the management to isolate the marginal sound
proposals. This may involve some preliminary quantitative analysis and judgments based on intuitive feeling
and experience.
Review and Analysis
Projects that pass through the preliminary screening process become candidates for rigorous financial
appraisal to ascertain if they would add value to the firm. This stage is also the quantitative analysis,
economic and financial appraisal, project evaluation or simply project analysis.
Capital Expenditure proposals are formally reviewed for two reasons; First, to assess their appropriateness in
light of the organization‟s overall objectives, strategies and plans and secondly, to evaluate their economic
viability.
Review of proposed project(s) may involve lengthy discussions between senior management and those
members of staff at the division and plant level who will be involved in the implementation if adopted.
Benefits and costs are estimated and converted into a series of cash flows and various capital budgeting
techniques applied to assess economic viability. The risks associated with the projects are also evaluated
Qualitative Factors in Project Evaluation
When a projects passes through the quantitative analysis test; it has to be further evaluated taking into
account qualitative factors. Qualitative factors are those which will have an impact on the project, but which
are virtually impossible to evaluate accurately in monetary terms. These are:
a) Societal impact of an increase or decrease in employee numbers
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b) Environmental impact of the project
c) Possible positive or negative governmental political attitudes towards the project
d) Strategic consequences of consumption of scarce raw materials
e) Positive or negative relationships with labour unions about the project
f) Possible legal difficulties with respect to the use of patents, copyrights and trade or brand names
g) Impact on the organization‟s image if the project is socially questionable
Some of the mentioned items may or may not affect the value of the organization. The organization can
address these issues during project analysis by means of discussion and consultation with various parties, but
these process is considerably lengthy and outcomes often unpredictable. It requires considerable
management experience and judgmental skills to incorporate the outcomes of these processes into the project
analysis.
Making Decision (Accept/ Reject)
NPV results from the quantitative analysis combined with qualitative factors from the basis of the decision
support information. The analysis relays this information to management with appropriate recommendations.
Management considers this information and other relevant prior knowledge using their routine information
sources, experience, expertise, “gut feeling‟ and of course, judgment to make a major decision – to accept or
reject the proposed investment project
Implementation and Monitoring
Once investment projects have vetted, then they have to be implemented. During this phase of
implementation, various divisions of an organization are likely to be involved. An integral part of project
implementation being the monitoring of project‟s progress with a view to identifying potential bottlenecks
thus allowing early intervention. Deviations from the estimated cash flows need to be monitored on a regular
basis with a view to taking corrective action(s) when need be.
Post- Implementation Audit
Post-implementation audit does not relate to the current decision support process of the project; it deals with
a post-mortem of the performance of already implemented projects. An evaluation of the performance of
past decisions, however, can attribute greatly to the improvement of current investment decision making by
analyzing the past “rights‟ and „wrongs‟.
The post-implementation audit can also provide useful feedback to project appraisal or strategy formulation.
It therefore helps pin-point sectors in the organization‟s activities that may warrant further financial
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commitment; or may call for retreat if a particular project becomes unprofitable. The outcome of an
investment also reflects on the performance of those members of the management involved with it. Finally,
past errors and successes provide clues on the strengths and weaknesses of the capital budgeting process
itself.
1.9 Capital budgeting techniques
Capital budgeting process involves investment decisions in long term assets. Capital budgeting techniques
are used to evaluate the acceptability of each project in order to make accept or reject decisions and ranking
decisions.
The success of any business can be determined through its capacity to generate positive cash flows.
Therefore, cash inflow or outflow is considered one of the most essential elements which give us an idea
about the continued existence of a business in the future. The shareholders focus on two things while
investing in business: first, how does business generate funds and second, where does the business invest
those funds for generating more. The process involves three basic steps: -
a) Identifying potential investments
b) Analyzing investment opportunities, isolating those that will create shareholders‟ value and
prioritizing them, and;
c) Implementing and monitoring the investment project selected in step 2 (Megginson, Smart &Gitman,
2007).
Bringham and Besley (2000) identified several basic methods used by businesses to evaluate projects and to
decide whether they should be accepted for inclusion in the capital budget. These methods are; Payback
period, net present value and internal rate of return. The payback period method is a non-discounting
technique since it does not consider the time value of money. NPV and IRR are referred to as discounting
techniques since they take into account time value of money.
Relevant cash flows
The relevant cash flows include;
a) An initial investment – relevant cash outflow for a proposed project at time zero.
Example3 — Calculate Initial Investment
Referring back to Example 2on calculation of relevant cash flows, we can calculate our Net Investment.
We will also assume that an existing machine can be sold for Kshs 6,000.
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Acquisition Costs Kshs 25,000
Installation Costs Kshs2,000
Increase in Working Capital Kshs1,000
Proceeds from Sale Kshs 6,000
Less Taxes @ 35% Kshs(2,100)
Net Proceeds from Sale Kshs(3,900)
Net Initial Investment Kshs24,100
b) Operating cash inflows –the incremental after-tax cash inflows resulting from execution of a project
during its life.
c) Terminal cash flow- the after-tax non-operating cash flow occurring in the final year of the project.
It is usually attributable to liquidation of the project.
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CHAPTER TWO
2.0 CAPITAL BUDGETING TECHNIQUES
Capital budgeting techniques are categorized into two;
Non Discounted Cash Flow Techniques
a) Payback period (PBP)
b) Accounting Rate of Return (AROR)
Discounted Cash Flow Techniques
a) Net Present Value (NPV)
b) Internal Rate of Return (IRR)
c) Profitability Index (PI)
Most large companies according to Ryan (2002) utilize all, one or more of these methods when evaluating
capital projects. Cadbury Schweppes, as previously mentioned, utilizes three of these, namely: Payback
period, internal rate of return and profitability index when evaluating capital projects.
2.1 Pay Back Period (PBP)
Brigham and Besley (2000) define payback period as the number of years required to recover the original
investment. It‟s the simplest and the oldest formal method used to evaluate capital budgeting method. Using
the pay back to make capital budgeting decisions is based on the concept that it‟s better to recover the cost of
a project sooner rather than later. As a general rule a project is considered acceptable if its payback period is
less than the maximum cost recovery time established by the firm. The major limitations of this method are
the failure to recognize the time value of money and cash flows beyond the payback period.
To compute the payback period for a project using this technique, compute the present value of all future
cash flows expected to be generated and then subtract its initial investment to find the net benefit the firm
will realize from investing in the project. If the net benefit computed on a present value basis is positive,
then the project is considered an acceptable investment, (Brigham & Besley, 2000). The shorter the payback
period, the sooner the company recovers its investment.
Payback (Even Cash Flows)= Initial Investment
Annual Cash Inflow
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For uneven cash flows, sum cash flows and get a moving balance. The PBP is then computed using the
formulae below;
PB = Year before full recovery + Cash flows remaining to full recovery
Cash flow the following year
Example 6- Payback Period (Even Cash Flows)
A project requires an outlay of Kshs 50,000 and yields annual cash inflows of Kshs 12,500 for 7 years. The
payback period for the project is:
PB= Kshs 50,000
Kshs 12,500
= 4 years
Example 7- Payback Period (Uneven Cash Flows)
If the Turtles Co. has a project with a cost of $150,000, and net annual cash inflows for the first seven years
of the project are: $30,000 in year one, $50,000 in year two, $55,000 in year three, $60,000 in year four,
$60,000 in year five, $60,000 in year six, and $40,000 in year seven, then its cash payback period would be
3.25 years. See the example that follows.
The Payback period has the following merits:
a) Easy to calculate
b) It is the simplest capital budgeting tool used for decision making
c) It provides a crude way of dealing with risk. The risk of a project can be tackled by having a shorter
standard payback period as it may ensure guarantee against loss.
d) It emphasizes liquidity
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In spite of its simplicity and widespread use, the Payback Period technique suffers the following limitations:
a) It ignores cash flows that are received after the cut-off period. This leads to discrimination against
projects which generate substantial cash inflows in later years.
b) It is the measure of a project‟s capital recovery, not its profitability. Though it measures a project‟s
liquidity, it does not indicate the liquidity position of the firm as a whole, which is more important.
c) It ignores the time value of money. In the payback calculation, cash inflows are simply added
without suitable discounting. This violates the most basic principle of financial analysis, which
stipulates that cash flows occurring at different points of time can be added or subtracted only after
suitable compounding or discounting.
2.2 Accounting Rate of Return (ARR)
The Accounting Rate of Return (ARR) is defined as an investment‟s average net income divided by its
average book value. Simply put, it can be defined using the below equation:
ARR = Profit after tax
Book value of the investment
The numerator of this ratio is the average annual post-tax profit over the life of the investment; the
denominator is the average book value of investment committed to the project.Traditionally, a popular
investment appraisal criterion, the Accounting Rate of Return has the following advantages:
a) It is simple to calculate.
b) It is based on accounting information which is readily available and familiar to the businessman.
c) It considers benefits over the life of the project.
Despite these merits the ARR also has the following disadvantages:
a) It is based on accounting profits not cash flows, and
b) It does not take into account the time value of money.
The acceptance rule using the Accounting Rate of Return technique in capital budgeting is that a project is
acceptable if its accounting rate of return exceeds a target average accounting return. However, this rule has
some limitations:
a) ARR ignores the time value of money. In using average figures that occur at different times, the near
future and the distant future are treated in the same way.
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b) ARR uses net income and book value instead of looking at the cash flows and market values. As a
result, the ARR does not provide information on what the effect on share price will be for
undertaking an investment.
c) ARR lacks an objective cut-off period. That is, a calculated ARR is really not comparable to a market
return, the target ARR must somehow be specified. There is no generally agreed way to do this.
2.3 Net Present Value (NPV)
(Bringham & Besley, 2000), defines NPV as a method of evaluating capital investment proposals by finding
the present value of future net cash flows discounted at a rate of return required by the firm. To implement
this approach, we find the present value of all future cash flows a project is expected to generate and then
subtract its initial investment to find the net benefit the firm will realize from investing in the project. If the
net benefit computed on a present value basis is positive, then the project is considered acceptable
investment.
Formula for calculating the NPV is as follows:
NPV=CFo+CF1/ (1+r) 1
} + {CF2/ (1+r) 2
} + …………. + {CF/ (1+r) n
}
Where:
CFOxis the initial cost of investment
CFi is the expected net cash inflow at time t, (t>0)
ris the project‟s opportunity cost of capital
nis the expected life of the project
It is assumed that the cost of capital is constant
The NPV decision rules for selecting or rejecting a project are as follows:
Independent projects:
If NPV>0: Accept the project
If NPV<0: Reject the project
If NPV=0: The project may be accepted
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Example4— Calculate Net Present Value
The Cottage Gang is considering the purchase of $150,000 of equipment for its boat rentals. The equipment
is expected to last seven years and has a $5,000 salvage value at the end of its life. The annual cash inflows
are expected to be $250,000 and the annual cash outflows are estimated to be $200,000. Assuming a
required rate of return of 12%, the net present value is $80,452. It is calculated by discounting the annual net
cash flows and salvage value using the 12% discount factors. The Cottage Gang has equal net cash flows of
$50,000 ($250,000 cash receipt minus $200,000 operating costs) so the present value of the net cash flows is
computed by using the present value of an annuity for seven periods. Using a 12% discount rate, the factor is
4.5638 and the present value of the net cash flows is $228,190. The salvage value is received only once, at
the end of the seven years (the asset's life), so its present value of $2,262 is computed using the Present
Value of the table factor for seven periods and 12% discount rate factor of .4523 times the $5,000 salvage
value. The investment of $150,000 does not need to be discounted because it is already in today's dollars (a
factor value of 1.0000). To calculate the net present value (NPV), the investment is subtracted from the
present value of the total cash inflows of $230,452. See the examples that follow. Because the net present
value (NPV) is positive, the required rate of return has been met.
Mutually exclusive projects
Accept the project with the highest NPV.
If no project has positive NPV, then reject all projects
Brigham and Earnhardt (2011) referred to the NPV generally as the best screening criterion which has the
following merits:
a) It is the true measure of an investment profitability in that it provides the most acceptable investment
rules;
b) It recognizes the time value of money;
c) It uses all cash flows occurring over the life of the project in calculating its worth;
d) It is consistent with value additivity principle; NPV of different projects can be summed up to arrive
at the overall increase/ decrease in firm value as a result of investing in different projects;
e) It relies on the discount rates rather any arbitrary assumptions, and
f) It is consistent with the objectives of shareholders value maximization.
Limitations of NPV Method
a) It is difficult to obtain the estimates of cash flows due to uncertainty;
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b) It is difficult to precisely measure the discount rate;
c) It does not incorporate managerial flexibility in calculating the NPV;
d) Caution needs to be taken when using NPV method to evaluate mutually exclusive projects with
unequal lives, or when there are fund constraints.
e) The ranking of projects is not independent of discount rates under NPV.
2.4 Profitability Index (PI)
The profitability index (PI) shows the relative profitability of any project or the present value per dollar of
initial cost. Pike & Neale (2009) defined the PI as the ratio of the present value of project cash flows to the
present value of its initial cost. The PI is the ratio of investment to payoff of a suggested project. It is a
useful capital budgeting technique for grading projects because it measures the value created by per unit of
investment made by the investor.
This technique is also known as profit investment ratio (PIR), benefit-cost ratio, and value investment ratio
(VIR). The PI can be calculated as follows:
PI = Present Value of Cash Inflows
Initial Cash Outlay
Example5- Profitability Index
The initial outlay of a project is Kshs 100,000 and it can generate cash inflow of Kshs 40,000, Kshs 30,000,
Kshs 50,000 and Kshs 20,000 in year 1 through to 4. Assume a 10% rate of discount. The PV of cash
inflows at 10% discount rate is:
NPV= Kshs 112,350-Kshs 100,000= Kshs 12,350
PI= Kshs 112,350
Kshs 100,000
= 1.1235
Decision Rule for PI Technique
If the PI for a project is greater than one, then accept the project; if the PI of a project is less than one, then
reject the project; if the PI of the project is equal to 1 the project may be accepted.
The PI and the NPV techniques are closely related. If a project has a positive NPV, the present value of the
future cash flows must be bigger than the initial investment and the PI for such project would therefore be
bigger than one. On the other hand, a project with a negative NPV will have a PI less than one.
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The PI technique enjoys some advantages which include:
a) It recognizes the time value of money
b) It is consistent with value maximization. A project with a PI greater than 1 when accepted will
increase shareholders‟ wealth. The PI measures the value created per dollar.
c) It gives a relative measure of project profitability.
2.5 Internal Rate of Return (IRR)
IRR is the discount rate that forces the present value of a project‟s expected cash flows to equal its initial
cost. As long as the project‟s IRR, which is its expected return, is greater than the rate of return required by
the firm for such an investment, the project is accepted.
If the return is greater than the cash outlay for the project, then the difference is a bonus to shareholders
which causes share price to rise. If the return is less than the cash invested for the project, then shareholders
will have to make up for the shortfall, a situation that hurts the stock price (Brigham &Earnhardt, 2010).
IRR is computed as follows:
( ) + + + ………. + = 0
NPV = = 0
The decision rules for accepting or rejecting project based on the IRR technique are as follows:
Independent Project
a) If IRR is greater than the opportunity cost of capital (IRR>k), then accept the project
b) If IRR is less than the opportunity cost of capital (IRR<k), then reject the project
c) If IRR is equal to the opportunity cost of capital (IRR=k), then decision makers may accept.
Mutually Exclusive Projects
a) Accept project with the highest IRR provided that its IRR is greater than the opportunity cost of
capital (IRR>k).
b) Reject if IRR is less than the opportunity cost of capital (IRR<k)
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Example 8- Calculate Internal Rate of Return
Referring back Example2 on calculation of relevant cash flow for projects, we would solve for IRR as
follows:
Kshs 5,788 x discount factor = Kshs 24,100 or Kshs 24,100 / Kshs 5,788 = 4.164.If we look in the Present
Value Tables for n = 5 years, we want to find apresent value factor nearest to 4.164. By referring to
published presentvalue tables, we find the following:
At 6%, n = 5 4.2124 4.2124
As Calculated 4.1640
At 7%, n = 5 4.1002
Difference .0484 .1122
.06 + (.0484 / .1122) x (.07 - .06) = .0643
Internal Rate of Return = 6.43%
The IRR faces the following setbacks:
a) Problems with the IRR may arise when cash flows are not conventional or when two or more
mutually exclusive projects are under consideration for investment.
b) It gives unrealistic rate of return. In the case of a mutually exclusive project in which firms are faced
with take-it-or-leave-it projects, the decision rule is that the firm should choose the one that add most
to shareholders‟ wealth. That is choosing the project with the highest NPV. It would also be
misleading to choose the one with the highest rate of return, according to the return rule.
c) In comparing projects with the same life but different outlays, the IRR may mistakenly favour small
projects with high rates of return but low NPVs (Brealey, Myers & Marcus, 2009).
The IRR method also poses a multiple rates of return problem. This occur when there are two discount rates
or two IRRs that equate the present value equal to the initial investment or a rate that makes the NPV equal
to zero. Hence the question that arises is which of these rates is correct. The answer is both or neither. More
precisely, there is no unambiguously correct answer. Purpose of this question is not to resolve the cases
where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in
the business world, entails more problems than a practitioner may think. This multiple rates problem
indicates that despite the widely used IRR technique amongst firms in the business world it still contains
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some little problems than we think. Unless the calculated IRR is a reasonable rate for reinvestment of future
cash flows, it should not be used as a yardstick to accept or reject a project.
2.6 Modified Internal Rate of Return (MIRR)
Bringham & Besley (2000) define MIRR as the discount rate at which the present value of a project‟s cost is
equal to the present value of its terminal value, in which the terminal value is found as the sum of the future
values of the cash flows, compounded at the firm‟s required rate of return. The use of the technique helps
overcome the IRRs limitation resulting from the reinvestment rate assumption.
The MIRR has two advantages over the IRR which makes it theoretically superior to the IRR. The MIRR
assumes that cash flows from each project are reinvested at the firm‟s cost of capital or some explicit rate. It
is an indicator of a project true profitability. Secondly, it eliminates the multiple IRRs problem: there is only
one MIRR for a project; it can be compared to the cost of capital when deciding to accept or reject (Brigham
&Ehrhardt, 2010). Despite these advantages over the IRR, it is not as widely used as the IRR. The MIRR can
be computed as follows:
PV (Costs) = PV (Terminal value)
=
Here, COF refers to cash outflows, or the cost of the project, and CIF refers to cash inflows. The left term is
the PV of the investment outlays when discounted at the cost of capital, and the numerator of the right term
is the compounded value of the inflows, assuming that the cash inflows are reinvested at the cost of capital.
The compounded value of the cash inflows is also called the terminal value. The MIRR is the discount rate
that forces the PV of the terminal value to equal the PV of the costs.
2.7 Discounted Payback Period
One of the limitations in using the payback period is that it does not take into account the time value of
money. Thus, the future cash inflows are not discounted or adjusted for debt/equity used to undertake the
project, inflation, etc. However, the discounted payback period solves this problem. It considers the time
value of money; it shows the breakeven after covering such costs. This technique is similar to payback
period except that the expected future cash flows are discounted for computing payback period. Discounted
payback period is how long an investment‟s cash flows, discounted at the project‟s cost of capital, will take
to cover the initial cost of the project. In the approach, the present values of the future cash inflows are
cumulated up to the time they cover the initial cost of the project. Discounted payback period is generally
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higher than payback period because it is money you will get in the future and will be less valuable than
money today.
Example 9— Calculate Discounted Payback Period
Referring back to Example 2, we can calculate the discounted paybackperiod as follows:
Year Cash Flow x P.V. Factor = P.V. Cash Flow Total to Date
1 Kshs 5,788 .893 Kshs 5,169 Kshs 5,169
2 5,788 .797 4,613 9,782
3 5,788 .712 4,121 13,903
4 5,788 .636 3,681 17,584
5 5,788 .567 3,282 20,866
6 3,250 .567 1,843 22,709
Under the Discounted Payback Period, we would never receive a payback on our project; i.e. the total to date
present cash flows never reached Kshs 24,100 (net investment). If we had relied on the regular payback
calculation, we would falsely assume that this project does payback inthe fourth year.
2.1 Methods of calculating the overall cost of capital
a) Weighted Average Cost of Capital (WACC.),
b) Capital Asset Pricing Model (CAPM)
c) Arbitrage Pricing Theory (APT)
a. Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) according to Bierman and Smidt (1980:258) represents the
average cost of funds to an organization and as such represents the sources of capital and their uses. WACC
for a given capital structure reflects the characteristics of organization‟s assets and in particular, their
average risk as well as the timing of expected cash proceeds. WACC represents an averaging of all the
financial risks of an organization.
The calculation of the weighted average cost of capital (WACC) according to Northcott (1992:77) has
several steps:
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a) The identification of the ranges of the sources of long-term capital.
b) The determination of the cost of the capital sources.
c) The determination of the market value of the capital sources.
d) The calculation of the WACC.
Four sources of long-term capital exist; (a) long-term debt, (b) preferred shares, (c) common shares, and (d)
retained earnings (Gitman, 2003: 472; Lovemore, 1996: 87). The cost of each of the above mentioned sources
of capital can be calculated; this is not being explored in this text but is extensively covered in management
accounting texts.
It is sufficient to note for the purpose of this text that the cost of long-term debt is a function of the interest
payable, the tax rate, any issuing expenses and the market value of the debt. The cost of equity capital sources
(ordinary or preference shares) for listed organizations depends on dividend payable, the cost of issuing equity
and the market price of shares. Retained earnings are usually a less expensive source of capital than issuing
new shares, due to the fact that they do not incur the transaction costs associated with the public offering of