Chapter 5: Investment and

Capital Budgeting
Decisions
 The concept of capital budgeting
 Investment appraisal techniques
Non-Discounting Cash Flow
Techniques
Discounted Cash Flow Techniques
 Comparison of IRR and NPV
OBJECTIVES
After reading this lesson, you should be able

(a) to understand meaning and significance of

capital budgeting decisions
(b) to explain the process of evaluation of
capital budgeting decisions; and
(c) to apply various methods of evaluating and
ranking capital expenditure projects.
Recall
Recall the
the Flows
Flows of
of funds
funds and
and decisions
decisions
important
important to
to the
the financial
financial manager
manager

Investment Financing
Decision Decision

Reinvestment Refinancing

Real Assets Financial Financial

Manager Markets

Returns from Investment Returns to Security Holders

 The concept of capital
budgeting
 Capital budgeting is the process of planning and
evaluating long-term investments in assets
whose cash flows extend beyond one year.

 Involves comparing expected future earnings

(cash inflows) from a project against the initial
and future costs (cash outflows) of that project.

 It includes the identification, analysis, and

selection of investment opportunities that
contribute to a firm’s long-term value.
Importance of Investment
Decisions

Investment decisions
require special attention
because of the following
reasons:
•They influence the growth &

prospects of the firm in the

long-run.
•They affect the risk of the

firm.
•They involve commitment

of large amount of funds.

Capital budgeting
analysis
►Proper capital budgeting
analysis is critical to a
firm’s successful
performance, because
sound investment
decisions can improve
cash flows and lead to
higher stock value, but
poor decisions leads to
financial distress and
even to bankruptcy.
►Making the right capital
budgeting decision is
 Steps in the Capital
Budgeting Process
7

Capital Budgeting involves the following steps:

[Link] planning (formulating the firm’s
mission & goals)
[Link] viable investment opportunities
[Link] screening of projects
[Link] net cash flow
[Link] financial appraisal
[Link] qualitative appraisal (environmental
pollution, public support/opposition, employee
moral, etc.)
[Link] /Reject decisions
[Link]
[Link] and control
Types of Investment
projects
Mutually Exclusive Projects:
A set of projects where only one can be accepted. i.e.
the acceptance of one excludes the acceptance of
other projects. E.g. Investing in Addis Ababa or
Hawassa

Independent Projects:
Is one whose cash flows are not related to the cash
flows of any other project. i.e. Accepting or rejecting
an independent project does not affect the
acceptance or rejection of other projects. E.g.
investing in an new delivery van and upgrading
accounting software
 Cont….
Contingent projects
It is also known as dependent projects: Projects that necessitate
the implementation of both projects. The functioning of one project
depends on the functioning of the other project as well. i.e. they are
dependent on the acceptance of another project. E.g. investing in
solar power plant and battery storage facility
Complementary projects:


 The investment in one enhances the cash flows of one or more

other projects
 Consider a manufacturer of personal computer equipment and

software. If it develops new software that enhances the abilities

of a computer mouse, the introduction of this new software may
enhance its mouse sales as well.
 E.g. A tech firm develops new graphics software that 9
improves the usefulness of its hardware (e.g., stylus
tablets).
 Investment appraisal
techniques
10

 Capital budgeting techniques are the

investment decision rules applied in evaluating
potential capital investments under
consideration.

 They are sound investment appraisal techniques

that are used to measure the economic worth
of and investment project.

 The most important characteristics of a sound

investment evaluation criterion is its ability to
identify whether the proposed project maximizes
the wealth of stockholders or not.
 cont…

 There are various capital budgeting techniques applied

in different situations. Broadly speaking there are two
main streams of criteria:
1. Non-Discounted techniques
(a) Pay Back Period
(b) Accounting Rate of Return(ARR)
2. Discounted techniques
(c) Discounted Pay Back period
(d ) Net Present Value(NPV)
(e) Internal Rate of Return(IRR) 11
(f) Profitability Index(PI)
Pay back period
 Pay Back Period refers to the period in which
the project will generate the necessary cash to
recover the original investment of the
project

 Payback period is the time period during which

net cash outlays on capital project are equal
to the net cash inflows.

 In other words, it is the number of year 12

required to recover the original cash outlay
invested in a project.
 Pay back period…
Decision Rule:
•Generally, they compare the project pay back with
predetermined standard pay back.

•Thus, the project would be accepted if its pay back

period is less than the maximum or standard pay
back period set by management.
EXAMPLE
Year cash outlays Annual net cash inflows
Project X Project Y
1 10,000 4,000 5,000
2 - 4,000 4,000
3 - 4,000 3,000 13

Required:- Which Project is preferable ?

Solution

Project X:  Project Y:
Year 1: Br. 4,000 → Remaining:  Year 1: Br. 5,000 →
10,000 - 4,000 = 6,000 Remaining: 10,000 - 5,000 =
Year 2: Br. 4,000 → Remaining: 5,000
6,000 - 4,000 = 2,000  Year 2: Br. 4,000 →
Year 3: Br. 2,000 out of 4,000 → Remaining: 5,000 - 4,000 =
Takes 0.5 years 1,000
Payback period = 2 +
 Year 3: Br. 1,000 out of 3,000
→ Takes 1/3 years
(2,000 / 4,000) = 2.5
years
 Payback period = 2 +
(1,000 / 3,000) ≈ 2.33
Prefer Project Y because it has a shorter payback period (2.33 years <
2.5 years). If management sets a maximumyears
acceptable payback period of,
say, 3 years — both projects would be acceptable, but Project Y is
more preferable.
Advantages and Disadvantages of
Payback Period
Advantages
1. Simple to compute and understand.
2. Provides some information on the risk of the
investment.
3. Provides a rough measure of liquidity.

Disadvantages
1. No concrete decision criteria to indicate
whether an investment increases the
company’s value.
2. Ignores cash flows beyond the payback 15
period, the time value of money, and
3. Not aligned with wealth maximization
 Exercise
Casey Co. is considering an investment of
$130,000 in new equipment. The new
equipment is expected to last 10 years. It will
have zero salvage value at the end of its useful
life. The straight-line method of depreciation is
used for accounting purposes. The expected
annual revenues and costs of the new product
that will be produced from the investment are:
Sales $200,000
Cost of goods sold $145,000
Depreciation expense 13,000
Selling & Admin expense 22,000 180,000
Income before income tax $20,000
Income tax expense 7,000
Net Income $13,000
 Solution
 To assess the cash inflow from this investment, we
need to calculate Annual Cash Flow After Tax (CFAT)
by adding back non-cash expenses (depreciation):
 CFAT= Net Income+ Depreciation =13,000+
$13,000=$26,000 per year

 The payback period is 5 years, which is reasonable for a

10-year project.
 Accounting Rate of Return(ARR)

 Accounting Rate of Return (ARR)—also referred to

as the Average Accounting Return (AAR)—is one
of the most commonly used methods for evaluating
investment proposals and making capital budgeting
decisions.
 This approach expresses the return on an investment
as a percentage, calculated by dividing the average
annual profit after tax by the average investment
over the project's life.
 Decision Rule:
A project is considered acceptable if its ARR
exceeds the minimum required rate of return 18 set
by management. Generally, the higher the ARR (for a
given level of risk), the more desirable the investment.
 ARR…

ARR= Average annual net income

Average investment or average book value

Example

Consider a company that is evaluating whether

to buy a new store in a new mall. The purchase
price is $500,000. We will assume that the store
has an estimated life of 5 years. We assume that
the store will worth nothing at the end of the
lifetime. Use straight line depreciation. 19
 ARR: example (cont…)

Table 1 Year 1 Year 2 Year 3 Year 4 Year 5

Revenue 433,333 450,000 266,667 200,000 133,333

Expense 200,000 150,000 100,000 100,000 100,000
Before tax 233,333 300,000 166,667 100,000 33,333
Cash flow
Depreciation 100,000 100,000 100,000 100,000 100,000
Earning 133,333 200,000 66,667 0 -66,667
before tax
Tax 33,333 50,000 16,667 0 -16,667
Net Income 100,000 150,000 50,000 0 -50,000
ARR: Solution

Average net income:

=(100,000+150,000+50,000+0-50,000)/
5=50,000
Average investment:
= 500,000+0/2 = 250,0000
• IfSo,the
ARR company
= 50,000/250,000
has a =target
20% average
accounting return smaller than 20% (say
15%), the project will be accepted. If the
company had a target ARR greater than
20%, the project will be rejected.
 ARR…
Advantage
 Provides a straightforward percentage-based decision

rule that is easy for non-financial managers to interpret.

 Uses information readily available from financial
statements, requiring no complex cash flow projections
or discounting.
Disadvantages
 ARR uses accounting number. Since the decision to

depreciate or expense a certain item depends on

accountant judgment, the computed ARR is influenced
by accountant judgment.
 Minimum acceptance criteria is set arbitrarily by
management.
 ARR does not take into account the time value of money.
 (C) Discounted Payback Period

 Discounted Payback Period is a variation of the

traditional payback period method, with one key
improvement—it accounts for the time value of
money.
 It measures the amount of time required to recover
the initial investment using the present value of
expected cash inflows, rather than nominal
amounts.
 While this method improves accuracy by
incorporating discounting, it still retains the major
limitations of the regular payback period—most
notably, it ignores cash flows beyond the payback
period and does not measure overall
profitability.
Example: Discounted Payback Period

 Initial Investment: Br. 20,000, Discount Rate: 10%

Estimated Cash Inflows: 6000 every year

Year 1: PV = 6,000 × 0.909 = 5,454 → Remaining = 20,000 – 5,454 =

14,546
Year 2: PV = 6,000 × 0.826 = 4,956 → Remaining = 14,546 – 4,956 =
9,590
Year 3: PV = 6,000 × 0.751 = 4,506 → Remaining = 9,590 – 4,506 = 5,084
Year 4: PV = 6,000 × 0.683 = 4,098 → Remaining = 5,084 – 4,098 = 986

Year 5 needed fraction = 986 ÷ (6,000 × 0.621) = 986 ÷ 3,726 ≈

0.26
 Discounted Payback Period ≈ 4.26 years (It takes about 4.26
years to recover the initial investment of Br. 20,000
Advantages and Disadvantages of
Discounted Payback Period

Advantages
1. Considers the time value of money.
2. Considers the project’s cash flows’ risk through the
cost of capital.

Disadvantages
1. No concrete decision criteria that indicate
whether the investment increases the company’s
value.
2. Requires an estimate of the cost of capital in
order to calculate the payback.
3. Ignores cash flows beyond the discounted
payback period
 (D) Net Present Value (NPV) method

 The Net Present Value (NPV) method, also known

as the discounted benefit-cost method, is a
capital budgeting technique that evaluates
investment decisions
 It compares the present value of cash inflows with
the present value of investment outlays.
 As a discounted cash flow approach, NPV
explicitly accounts for the time value of money,
recognizing that cash flows occurring at different
times are not equal in value.
 It emphasizes that such cash flows can only be 26
meaningfully compared after they are converted to
their present value equivalents.
 NPV…

Acceptance rule
 Accept the project when NPV is positive; NPV>0
 Reject the project when NPV is negative; NPV<0
 May accept the project when NPV is zero; NPV=0
n Where:
CFt
NPV   CF0 . NPV = Net Present Value
t 1 1  K 
t CF = Periodic Cash Inflow
CF0 = Cash Outflow/ Initial
cost
K = the discount rate
Note: The higher the positive NPV, the more
attractive the investment
NPV: Example

 Assume that a machine will cost Br

100,000 and will provide annual net cash
inflows of Br 50,000; Br 40,000; Br 30,000;
Br 20,000; Br 20,000; and Br 20,000 for six
years. The cost of capital is 15%. Calculate
the machines net present value. Should
the machine be purchased? 28
NPV: Solution

Year cash in flow Discounted factor Discounted cash flow

0 -100,000 1.000 -100,000
1 50,000 0.8696 43,480
2 40,000 0.7561 30,244

3 30,000 0.6575 19,725

4 20,000 0.5718 11,436

5. 20,000 0.4972 9,944

6 20,000 0.4323 8,646

Present Value………..Br. 123,475

 Total present value = Birr 123,475

 The Net Present Value (NPV) = PV of cash inflows - PV of cash out flow

= Birr 123,457- Birr100, 000

= Birr 23,475
Decision: Since the NPV of the Machine is positive, the machine should be
purchased.
 Advantages and disadvantages of NPV

Advantages Disadvantages
 Considers all cash  Requires accurate
flows estimation of discount rate
May not be comparable
Useful for comparing

mutually exclusive for projects of unequal

projects size or duration
Assumes cash flows are
Accounts for the time
reinvested at the discount
value of money
rate
Easy to interpret in
Forecasting future cash
monetary terms flows can be uncertain
(E) The Internal Rate of Return(IRR)
Method

 IRR, also called, ‘yield of investment’, ‘marginal

efficiency of capital’ and ‘discounted cash flow rate
of return’ is a method of project evaluation technique
 IRR addresses the limitations of the NPV method by
showing the rate of return expected from an
investment.
 Defined as the discount rate that equates the Present
Value of Cash Inflows with the Initial Investment
Outlay
 Represents the true rate of return or yield on the
project
 IRR is usually determined using a trial-and-error
method or financial tools/software.
 (E) The Internal Rate of Return Method

 IRR is an alternative to the Net Present Value

(NPV) method.
 IRR is the discount rate at which the NPV of

a project is zero
 It is the rate where:

Present Value of Cash Inflows = Initial

Investment
 IRR takes into account the time value of
At the exact IRR;
money
n
 RepresentsCFt the trate of return earned by the

project over
i 1 (1  r ) -
its life
CF 0
= 0
 IRR…
33

Acceptance Rule:
 Accept the project when internal rate of return is
greater than the opportunity cost of capital; r>k
 Reject the project when internal rate of return is
less than the opportunity cost of capital; r<k
 May accept the project when internal rate of
return is equals to the opportunity cost of capital;
r=k
 IRR: Example…

Assume that a machine will cost Br 100,000 and will provide

annual net cash inflows for the coming six years are as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
Year 6
50,000 40,000 30,000 20,000 20, 000
20,000

The cost of capital is 15%.

 Calculate the machines IRR. Should the machine be
purchased?
Note: There is no a ready made formula to compute the internal rate of


return of an investment proposal just like other investment evaluation

criteria. It can be calculated through trial and error.
 IRR: Solution

So, at 20%, NPV is positive → IRR > 20%

Still positive → IRR > 25%

 IRR: Solution…

Now NPV is negative → IRR is between 25% and 26%

Use linear interpolation between 25% and 26%:

Decision:
Since IRR ≈ 25.5% > Cost of Capital (15%), the machine should be purchased.
 Net Present Value Method Vs.
Internal Rate of Return—
Which is Better ?
 These two methods can sometimes yield
conflicting results when used to select the
most profitable project among mutually
exclusive investment options.
 The discrepancy arises from the differing
assumptions each method makes regarding the
reinvestment of cash flows.
 The IRR method assumes that all future cash
inflows are reinvested at the project's internal
rate of return throughout its life.
 In contrast, the NPV method assumes that cash
inflows generated during the project’s
operational period are reinvested at the
 NPV vs IRR…
 Since the management’s objective is to maximize
the shareholder’s wealth, and, therefore, the
value of the firm, the NPV method provides the
correct criterion of investment decisions.

 A company should select the project which has the

maximum NPV out of the mutually exclusive
projects under its consideration.

 The project with the maximum NPV makes maximum

contribution to the present value of the firm.
 (F) Profitability Index(PI)
 The NPV method helps assess whether a project
creates value.
 However, NPV alone does not indicate the rate
of return or how one project compares to another in
relative terms.
 NPV only shows if a project's return is above or
below the required rate — not by how much.

• PI provides a comparative measure across

projects.
• It is useful for ranking and selecting projects,
especially when capital is limited.
• While PI shows which project is more profitable, it
 Profitability Index …
n
Ci

PI =  (1  i )n = PV of Cash inflows/ PV of Cash outflows
i1

C0
 Where: PI = Profitability Index
Ci = Periodic cash inflow
C0 = Cash outflows/Initial cash outlays
i = Required rate of return
n = Number of periods
Acceptance Rule:
 Accept the project when profitability index is grater than one; PI>1
 Reject the project when profitability index is less than one; PI<1
 May accept/reject the project when profitability index is one; PI=1
 Choose the project with the higher Profitability Index (PI)
 A higher PI indicates a more efficient use of capital
 Profitability Index: Example

Assume that a machine will cost Br 100,000 and will

provide annual net cash inflows for the coming six
years are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

Year 6
50,000 40,000 30,000 20,000 20, 000
20,000

 The cost of capital is 15%.

 Calculate the machine’s PI. Should the machine be
purchased?
41
 Profitability Index: Solution
Year Cash inflows Discount factor of 15% Discounted cash
inflow
1 50,000 0.8696 43,480
2 40,000 0.7561 30,244
3 30,000 0.6575 19,725
4 20,000 0.5718 11,436
5 20,000 0.4972 9,944
6 20,000 0.4323 8,646
PV of cash inflows =
123,475
Br123,475
Br100,000
PI = = 1.235

Decision:

Since, the projects PI is greater than one (i.e. 1.235), the

machine should be purchased.
43