Unit 12
Unit 12
Unit 12
UNIT 12 Capital Budgeting- Net Present Value and Other investment criteria
Unit Structure
12.0 Overview
12.1 Learning Outcomes
12.2 Capital Budgeting
12.3 Payback Method
12.4 Net Present Value
12.5 The internal rate of return (IRR)
12.6 Accounting Rate of Return (ARR)
12.7 Profitability Index
12.8 Activities
12.9 Summary
12.10 Suggested Readings
12.0 OVERVIEW
One of the key decisions of the financial manager is to decide on what non-current assets that they
should buy? As such, they need to allocate budget or capital for this purpose. Indeed, these are not
easy decisions as investment in non-current assets are long term and are not easily reversed once they
are made. In this unit, we consider the different investment appraisal methods which firms can
consider to know which projects are worth considering.
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Companies must make many investment decisions in order to grow, including selecting product lines,
disposing of business segments, choosing to lease or buy equipment, and selecting investments. To
make long-term investment decisions in accordance with the company’s goals, one must perform two
tasks when evaluating capital budgeting projects:
Two projects are independent if the cash flows of one are unaffected by acceptance of the other.
Two projects are Dependent if the cash flows of one are affected by acceptance of the other. For
example, the Fanta Orange and Fanta Apple products can be considered two different projects. The
decision to produce Fanta Apple is likely to have impacted on cash flows of Fanta Orange product.
Mutually exclusive, if accepting one project makes it impossible to accept the other. For example,
there are two different expansion options for the same plot of land.
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· Profitability Index
The main advantages of using the payback period method of evaluating an investment project are that:
1. It is simple to compute and easy to understand.
2. It is a convenient method to use when capital is in short supply as it could be argued that the best
projects to accept would be those which returned the expenditure rapidly.
Payback period= number of year prior to full recovery+ [Uncovered Cost at the start of the year/ Cash
flow during full recovery year]
Illustration:
Sonia plc is a manufacturer of garments. The firm is considering whether to invest in one of two
automated machine processes, A and B, both of which give rise to operational cost savings. The
relevant data relating to each are given below:
A B
$ $
Investment outlay (payable immediately) 10,000 10,000
Annual cost saving:
Year 1 5,000 1,000
Year 2 4,000 3,000
Year 3 3,000 4,000
Year 4 1,000 6,000
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Should the company invest in either of the two proposals and if so, which is preferable?
For Project A
1,000
Payback period for A project: 2 + years = 2.33 years
3,000
2,000
Similarly, Payback period for B project: 3 + years = 3.33 years
6,000
To calculate the discounted payback period, we need to determine the cost of capital (discount rate) for
project. Essentially, the cost of capital or discount rate is cost of a company's funds (both Debt &
Equity). It is used to assess new projects of a company as it is the lowest return that investors expect
for providing capital to the company, thus setting a target that a new project has to meet.
Considering the above example and assuming a discount rate of 10%, the discounted payback period
for project A is as follows;
Taking into account the initial cost of the project $10,000 and deducting discounted cash flows, the
discounted payback period is computed as follows;
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2418.7
Discounted Payback period for A project: 2 + years = 2.953 years
2253.9
3606.31
Discounted Payback period for B project: 3 + years = 3.88 years
4098.08
Based on the above, project A has the lowest payback and discounted payback period and should as
such be preferred.
The discount rate that must be used to discount all the future cash flows back to the present is the rate
of return that is earned on similar projects of equivalent risk. This rate is given at 10% from the
previous example.
Based on the previous example, the NPV for both projects are calculated as follows;
NPV of the project A
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Based on the NPV rule, projects which have positive NPVs should normally be accepted and projects
with negative NPV should be rejected. However, the following scenarios can happen;
· If Projects A and B are mutually exclusive, accept A because NPV A (788.2) > NPV B (491.8).
The IRR is that discount rate which produces an NPV of zero. The IRR is thus the rate of return which
the project actually earns. In this sense it is a rate pertinent or internal to that particular project alone.
The Internal Rate of Return (IRR) Rule states that you should take any investment opportunity where
IRR exceeds the opportunity cost of capital.
Based on the above example, the IRR of project A is calculated by solving the following equation:
The above equation can be solved by a computer package. But a fairly good estimate of the IRR can be
found through the mathematical technique called linear interpolation. This involves selecting two
discount rates so that one of them, when applied to the project's cash flows, produces a positive NPV
and the other produces a negative NPV.
For project A, a discount of 10% produces a +NPV of $788.2 and a discount rate of 15% produces a
negative NPV of $83.3. Using linear interpolation, we estimate the IRR by applying the following
formula:
HDR - LDR 15 - 10
IRR = LDR + ´ NPVLDR = 10% + ´ 788.2 = 14.52%
NPVLDR - NPVHDR 788.2 - -83.3
Where:
HDR = Higher discount rate
LDR = Lower discount rate
NPVLDR = NPV corresponding to the LDR
NPVHDR = NPV corresponding to the HDR
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Actually, the above is an approximation. The exact value where the equation is zero is 14.49%.
You are required to use the above formula and verify calculate the approximate IRR value. (Use the
discount rate of 10% and 15%).
If IRR > cost of capital, then the project’s rate of return is greater than its cost i.e some return is left
over to enhance stockholders’ wealth. Assuming a cost of capital of 10%, both projects should be
accepted given that their IRR is greater than 10%.
The ARR seeks to provide a measure of project profitability over the entire asset life. It compares the
average accounting profit of the project with the book value of the asset acquired. The ARR can be
calculated on the original capital invested or on the average amount invested over the life of the
project.
Assuming straight line depreciation in each case, the average accounting profit and the ARR (based on
initial capital invested) for both projects are as follows:
7.50%
Year
Project 1 2 3 4 Average ARR
Profit
B $ $ $ $
Cash flow 1,000 3,000 4,000 6,000
Depreciation -2,500 -2,500 -2,500 -2,500
Profit -1,500 500 1,500 3,500 1,000 1000/10,000
10.00%
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A project is acceptable if the ARR exceeds the target average accounting return. From the above, if the
target accounting returns for the firm is 6%, both projects should be accepted.
The advantages of this method are that it is easily understandable and simple to compute and it
recognises the importance of profitability. Its main weaknesses are that it ignores the time value of
money and that it focuses on accounting data instead of cash flow data. Finally, there is no agreed way
on how to calculate the target ARR.
The profitability index (PI) is the present value of future cash flows divided by the initial cost.
n t
å CFt /(1+ r )
PI = t =1 = Present value all future cash flows/ initial cost
Initial capital invested
For a positive NPV investment, the PI index will be greater than one while for a negative NPV
investment, it shall be less than one. It measures the value created per cash unit invested. As such, for
project A, a PI of 1.079 tells us that, per $ invested, $1.079 in value or $0.079 in NPV results. With
limited capital, it makes sense to choose projects with the highest PI.
However, the PI method does not work well when there mutually exclusive investment decisions.
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12.8 ACTIVITIES
Activity 1
Consider the following cash flows for 2 investments:
0 -$400 -$4,00
1 $208 $164
2 $252 $176
3 $390.8 $760
Activity 2
A firm is considering two capital projects with cash flows as follows:
Project X Project Y
Rs Rs
Investment outlay (payable immediately) 40,000 50,000
Annual cost saving:
Year 1 16,000 17,000
Year 2 16,000 17,000
Year 3 16,000 17,000
Year 4 12,000 17,000
The rate of return on projects of equivalent risk to the one above is 14%.
(ii) Calculate the Net Present value and IRR for both projects.
(iii) Calculate the Accounting Rate of return for both projects assuming a straight line
method of depreciation.
(iv) If the projects were mutually exclusive, which one would you prefer?
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Activity 3
Calculate the following cash flows, which of the two investments is better if we require a 6%
return?
Year Investment X Investment Y
0 -Rs20000 -Rs20000
1 Rs14000 Rs8200
2 Rs12600 Rs8800
3 Rs19540 Rs37000
Activity 4
You have been asked by Sun Ltd to consider the following cash flows for 2 mutually exclusive
investments:
0 -Rs100000 -Rs100000
1 Rs40000 Rs60000
2 Rs60000 Rs60000
3 Rs90000 Rs60000
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Solution
Activity 1
Activity 2
(I)
8,000
Payback period for X project: 2 + years = 2.5 years
16,000
16,000
Payback period for Y project: 2 + years = 2.9 years
17,000
(II)
NPV of the Xproject
HDR - LDR 20 - 18
IRR Project X = LDR + ´ NPVLDR = 18% + ´ 976 = 19.31%
NPVLDR - NPVHDR 976 + 510
(III)
Assuming straight line depreciation in each case, the average accounting profit and the ARR (based on
initial capital invested) for the projects are as follows:
Year Average ARR
1 2 3 4
Rs Rs Rs Rs Rs %
Project
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x
Cash flow 16,000 16,000 16,000 12,000
Depreciation (10,000) (10,000) (10,000) (10,000)
Profit 6,000 6,000 6,000 2,000 5,000 5,000/40,000
= 12.5%
Project Y
Cash flow 17,000 17,000 17,000 17,000
Depreciation (12,500) (12,500) (12,500) (12,500)
Profit 4,500 4,500 4,500 4,500 4,500 4.500/50,000
= 9%
Iv)
Project X is preferred. Lowest payback, higher NPV, IRR, ARR
Activity 3
Investment x: NPV = –20000 + 14000/1.06 + 12600/(1.06)2 + 19540/(1.06)3 = Rs20830
Investment y: NPV = –20000 + 8200/1.06 + 8800/(1.06)2 + 37000/(1.06)3 = Rs26630
Investment y is the better investment.
Activity 4
a. X: Payback period = 2 years
Y: Payback period = 1.67 years
Project Y has the shorter payback period.
b. X: IRR= 34.4%
Y: IRR= 36.3%
12.9 SUMMARY
· The firm must consider that each investment is an option and it must determine which options are
valuable and which one are not.
· One must perform two tasks when evaluating capital budgeting projects: estimate the project's relevant
cash flows and apply a decision rule to determine whether or not a project should be undertaken.
· The payback period is the period of time taken for the future net cash inflows to match the initial cash
outlay.
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· One of the flaws of the payback period is that it ignores time value of money.
· The NPV method is a discounted cash flow method. Money which occurs at different points in time
cannot be compared directly but must first be converted to a common point of time, which is the present
time.
· The ARR seeks to provide a measure of project profitability over the entire asset life.
· The profitability index (PI) is the present value of future cash flows divided by the initial cost.
· Fundamentals of Corporate Finance- David Hiller, Ian Clacher, Stephen Ross, Randolph
Westerfield, Bradford Jordan- Second European Edition- MC Graw Hill
· Berk, Jonathan, Peter DeMarzo and Jarrad Harford. 2012. Fundamentals of Corporate Finance
Global Edition 2nd Edition or latest. England: Pearson.
· Brigham, Eugene F. and Joel F. Houston. 2013. Fundamentals of Financial Management 13th
Edition or latest. Mason: South-Western Cengage Learning.
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