CAPITAL BUDGETING/INVESTMENT DECISIONS.

This involves the commitment of funds to long-term projects which will generate benefit in the future. The future benefits are normally estimated and they may not be realized i.e. the future benefits have some elements of risk.

Characteristics of capital budgeting 1. They involve significance amount of initial cash outlay. Cash outlay refers to the amount to be invested immediately in order to start off the project e.g. if the cost of a Nissan matatu is shs.1.2m then the initial cash outlay for the matatu will be 1.2m. 2. The investment decisions are irreversible. This is because of the specialized nature of the asset which is to be acquired. 3. The investment decision involves a lot of uncertainty and risk. This is because of uncertainty and risk. This is because of uncertainty of the future estimate of the benefits to be realized from the projects which is to be undertaken. 4. The investment decision involves the commitment of funds to long term assets. This is because the useful life of the project to be undertaken is usually more than 1 year. 5. The benefits or cash flow from the projects will normally be received over a series of periods/years. 6. They are normally limited resources for investment in capital budgeting projects this leads to prioritization of the investment projects and this is known as capital rationing in capital budgeting.

Type of investment projects. Investment projects can be classified into; 1. Mutually exclusive projects: these are those projects which are substitutes or alternative of each other. They compete against each other. If one project is accepted then the other project must be rejected, e.g. a decision on whether to buy a Nissan or a mini-bus. 2. Independent projects: these are those projects which serve different purposes. They do not compete against each other, the benefit derived from one project can be

undertaken simultaneously subject to the availability of funds e.g. acquiring a Nissan or investing in real estate. 3. Divisible &indivisible projects: a divisible project is one which starts to generate revenue even before its complete e.g. a storey building where the ground floor can be leased out even before the building is fully complete. On the other hand an indivisible project is one which cannot start to generate revenue unless its complete e.g. farming, or a project offering computer services in which case the computers must be fully installed. 4. Contingent projects/complimentary: these are those projects which depend on each other. If one project is under taken then the other project must be undertaken. They are also called complimentary projects e.g. where an industry is tobe build in a remote area, it will necessitate the building of schools, staff houses and transportation network. 5. Acquisition projects: these involves the purchase of a completely new assets where did not exist before. E.g. the purchase of a new machine vehicle. e.t.c. 6. Replacement projects: this involves replacement of old inefficient assets with a completely new asset which is more efficient. The replacement can either be identical or non identical. Note: a single project can fall into more than one classification or the same time.

Factors to consider in capital budgeting decision y y y y The initial cash outlay of each of the available alternative projects. The estimated economic life of the project. The expected future cash inflows of each of the available alternative projects. Any additional operating cost or working capital requirement due to the acquisition of the new projects. y The effect of the new projects on the continuity the company or the firm.

Problems encountered by managers when carrying out investment decisions These include.

In adequate information for the investment opportunities available in the environment. Inadequate information to be used to estimate future benefits to be realized from the project. Inadequate information of the available project evaluation techniques. Inadequate information on the selection of the project using appropriate method Inadequate information of the qualitative /monetary aspect of the company.

y y y

Project evaluation techniques a good method of investment evaluation must possess the following characteristics: y It should apply to all projects y It should provide an acceptance criteria so as to make a decision on whether to accept or reject the project y It should be consistent with the objective of the firm ie shareholders wealth maximization y y y Provide a means of ranking the projects in order of priority It must consider all cash flows from the project during evaluation It must consider time value of money and environmental risks and uncertainty

The following are the common methods for evaluating capital projects: Non- discounting techniques The pay back period method The accounting rate of return (ARR) Discounting techniques Net present value (NPV) The profitability index (PI) The internal rate of return (IRR) Net Present Value

Illustration As a result of purchasing a new machine for sh. 600,000, ABC ltd estimates that its sales and expenses will follow the following incremental pattern

Year Incr. sales

1 240

2 480 290

3 640 410

4 720 420

5 730 300

6 210 150

Incr. expenses 160

The required rate of return on the firms investments is 8%. If the machine was to be purchased, it will have a useful life of 6yrs at the end of which it will be scrapped at zero with no alternative use. The prevailing tax rate in the country is 40% on corporate profits. Required Estimate the cash flows that will be obtained from the machine during its lifetime Is the purchase of the machine acceptable Solution Estimation of cash flows Incremental sales Incremental expenses Incremental profit Add incremental savings Icremental earnings b4 depr Less incr depreciation Incremental earnings b4 tax Tax Incremental EAT Add back depreciation Cash flows XX (XX) XX XX XX (XX) XX (XX) XX XX XX

Year Incremental sales Incremental expenses Incremental earnings b4 depr. Less incr depreciation Incremental earnings b4 tax Tax

1 240 (160) 80 (100) (20) -

2 480 (290) 190 (100) 90 (36)

3 640 (410) 230 (100) 130 (52)

4 720 (420) 300 (100) 200 (80)

5 730 (300) 430 (100) 330 (132)

6 210 (150) 60 (100) (40) -

Incremental EAT Add back depreciation Cash flows Cumulative cash flows

(20) 100 80 80

54 100 154 234

78 100 178 412

120 100 220 632

198 100 298 930

(40) 100 60 990

The Payback Period This refers to the length of time it will take to recover the initial outlay committed to the project. The shorter the period the better. PBP = 3yrs + initial amount amount recovered recoverable in last yrs = 3yrs + 600-412 220 = 3+0.854 = 3.854 yrs In case of a project promising annuity its payback period is calculated using the formula Payback period=initial cash outlay/annuity.

Advantages of the payback period technique 1. It is easier to compute and understand. 2. It uses the cash flows of the project instead of the accounting profit 3. It emphasizes the liquidity of the company by favoring projects with a shorter payback period. 4. It considers time based risk by ignoring cash flows for away in the future which are uncertain.

Disadvantages of payback period. 1. It ignores the time value of money. Since the present value of the future cash flows is not determined. 2. It does not use all the cash flows generated by the projects. i.e. it ignores the cash flows after the PBP.

3. Incase of a single project it does not give decisions criteria of accepting the projects since the desirable PBP is arbitrary set the management. 4. It penalizes late blooming projects. Late blooming projects are those projects which promise higher cash flows towards the end of their economic.

Decision rule/criteria In order to determine whether to reject or accept the project using the PBP technique the following criteria is used. Incase of mutually exclusive projects the one with a shorter PBP is accepted. Incase of a single project the desirable pay back period is arbitrary set by the management. The accounting rate of return (ARR) The method utilizes the accounting profits instead of the cash flows. The accounting profits they are the earnings after taxes. ARR = average profit *100% average investment Average profit = -20+54+78+120+198-40 6 = 390/6 = 65 Average investment = initial investment + salvage value 2 ARR = (65/300) * 100% = 21.67% Accept the project since it has a higher rate of return compared to the required rate of return by the company. = (600+0) /2 = 300

Advantages of ARR 1. It is easier to compute and understand. 2. It uses all the accounting profits when evaluating the projects 3. The accounting profits used to evaluate the project can readily be obtained from the financial statement unlike the cash flows which require some adjustment.

Disadvantages 1. It ignores the concept of time value of money since the present value of the accounting profits is not computed. 2. It uses accounting profits in evaluating the profits instead of cash flows. 3. It ignores the fluctuations of the projects during the economics life of the projects. 4. Incase of a single project it does not give the decisions criteria as the final decisions is arbitrarily set by management. 5. By ignoring the derivation/ fluctuations in the accounting profits it ignores the risk associated with the profits.

Net Present Value NPV = PVCFt Io = Year 1 2 3 4 5 6 PVCFt Less Io NPV (1+r)-n CFt Io Cash flows 80,000 154,000 178,000 220,000 298,000 60,000 PVIF8%t 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 PVCFt 74,072 132,024 141,296 161,700 202,819 37,812 749,723 (600,000) 149,723

The decision rule or criteria: If NPV is greater than 0 you accept If NPV is less than 0 you reject. If NPV=0 then you are indifferent. Advantages of NPV 1. It takes account the time value of money by discounting the cash flows of the projects.

2. It gives a decision rule of accepting or rejecting a single project. 3. It uses all the cash flows of the project when evaluating the project unlike the pay back period techniques. 4. It considers the timing and the magnitude of the cash flows by discounting cash flows. 5. It is consistent with the shareholders wealth maximization goal since project which promises negative benefits in the present value terms will be rejected.

Disadvantages of NPV 1. It assumes that the cost of capital or discounting rate will remain consistent during the economic life of the project. This is unrealistic because the risk of the company or project keeps on changing from one period to another hence the cost of capital will also be expected to keep on changing as per the changes in the risk level of the project. 2. The method may not yield good results when comparing projects of unequal size, since it only gives an absolute value instead of a relative value.

The profitability index (PI)

It is more desirable than NPV because it is a ratio as opposed to an absolute figure and therefore can be used for evaluating projects of different sizes. PI = PVCFt Io = 749,723 = 1.25 600,000

The decision criteria for this techniques is If PI is greater than 1 accept If PI is less than 1 reject. PI =1 indifferent. NOTE; the advantages and disadvantages of the profitability index are the same as those of NPV techniques. However the profitability index is able to run projects in relative terms while the NPV run project in absolute terms. For this reason the profitability index is preferred in some

circumstances of Capital Rationing occurs when there is scarcity of investment of funds.

The Internal Rate of Return The IRR is that discounting rate where NPV= 0. Recall NPV= PVCIF-PVCOF. Therefore for NPV=0then PVCIF=PVCOF i.e. present value cash inflows= present cash outflow. The IRR can be calculated using the trial and error methods while following the following steps. Step 1: compute the NPV of the project using the discounting rate or cost of capital given.

Step II: a. if the NPV obtained in Step I is above is positive you rediscount the cash flows again using a higher trial discounting rate which should give you negative NPV or b. if the NPV obtained in Step I above is negative then you re discount the cash flows using a lower trail discounting rate which should give positive NPV>

STEP III you interpolate the results obtained in step I &II above to obtain the IRR. The interpolation can be carried out using 2 methods. formula method where: IRR=LDR+ {(NPV of LDR-NPV of IRR)/(NPV of LDR-NPV of HDR)}{HDR-LDR} Where: IRR internal rate of return. LDR- lower discounting rate HDR- higher discounting rate Decision rule of criteria In order to determine whether to accept or reject the project using the internal rate of return, the following decision criterion is followed. If IRR is greater than the cost capital accepts. If IRR is less than cost of capital reject If IRR = cost of capital indifferent.

Advantages of IRR 1. It takes into account the time value of money by discounting the cashflows of the project. 2. It uses all the cash flows of the projects when evaluating the project unlike the payback techniques 3. It gives a decision criterion of accepting or rejecting a single project. 4. It considers the timing of the magnitude of the cash flows of the project by computing the present value of the cash flows. Disadvantages: 1. In some instances a single project might have more than one internal rate of return. 2. It is tedious and time consuming to compute IRR 3. In some instances, it gives conflicting results with the NPV technique.

Discounted pay back period The method recognizes time value of money such that the pay back period is determined from discounted cash flows from the project.

Year 1 2 3 4 5 6

CFs 80,000 154,000 178,000 220,000 298,000 60,000

PVIF8%t 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302

Disc cash flows Cumulative CFs 74,072 132,024 141,296 161,700 202,819 37,812 74,072 206,096 347,392 509,092 711,911 749,723

Discounted pay back period = 4yrs + initial amount amount recovered recoverable in last yrs

= 4yrs + 600,000 509,092 = 4yrs + 0.45 = 4.45 yrs