Chapter 5:

Long-term Investment:
Capital Budgeting
Dakito Alemu (PhD)
 Learning Objectives
1. Explain the meaning of CAPITAL, CAPITAL BUDGET and capital
budgeting decisions,
2. Distinguish between independent and mutually exclusive capital
investment decisions.
3. Describe the components of cash flow for long investment project
4. Compute the payback period and accounting rate of return for a
proposed investment,
5. Use net present value analysis for capital investment decisions
involving independent projects.
6. Use the internal rate of return to assess the acceptability of
independent projects.
7. Explain why net present value is better than internal rate of
return for capital investment decisions involving mutually
exclusive projects.
Prepared by Dakito Alemu (PhD)
Brainstorming Question
►What is
►Capital
►Capital budget
►Capital budgeting
Prepared by Dakito Alemu
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 What
What is
is Capital
Capital Budget?
Budget?
►A budget allocating money for the
acquisition or maintenance of fixed assets
such as land, buildings, etc.
►Is a long-term investment
►Capital expenditure under taken by
any economic entities
►Business firms
►Governments
►Non-governmental organizations, Etc

►It is also called as project

 China's Three George Hydro Electric Dam
► Begun in 1994, the dam is
massive in scale.
► It stretches 1.5 mile and
rise to a height of over 600
feet.
► It is expected to store 51.4
billion cubic yards of water
and
► raise the current level of the Yangtze River above the
dam site over 570 feet.

► The Three Gorges Dam is

the world's largest with
installed capacity of 22,500 
► Construction cost is
US$26 billion. It is the
world's largest
hydroelectric dam.
 Types of Capital budget
►Capital budgeting projects usually are
classified as:
►Replacement projects:
projects a decision concerning
whether an existing asset should be replaced by
a new asset
►Expansion projects:
projects whether the firm should
increase operations by adding new products,
additional machines
►New project
►Independent projects are projects that, if accepted
or rejected, do not affect the cash flows of other
projects.
►Mutually exclusive projects are those projects that, if
accepted, preclude the acceptance of all other competing
projects.
 What is
Capital Budgeting?

Dakito Alemu (PhD)

 Definition of Capital Budgeting
►Capital budgeting, and investment appraisal, is the
planning process used to
► determine whether an organization's long
term investments such as
► new machinery,
► replacement of machinery,
► new plants,
► new products, and research development
projects are worth the funding of cash through
the firm's capitalization structure.

Dakito Alemu (PhD)

 What
What is
is
Capital
Capital Budgeting?
Budgeting?
► The process of
► identifying,
► analyzing, and
► selecting investment projects
whose returns (cash flows) are
expected to extend beyond one
year.
 Importance of Capital Budgeting
►Capital budgeting decisions are of
paramount importance in financial decision
making,
►Since such decision affects the profitability
of a firm because of the fact that they relate
to long-term assets.
►The long-term assets are the true earning
assets of the firm.
►Thus capital budgeting decisions determine
the future destiny/fate of a firm.
 Feasibility Analysis: A Schematic Diagram
P
r
e Generation of ideas
l
i
m Initial Screening
i
n
a
r
y
Is the Idea Prima Facie Promising?

w Yes No
o
r Plan Feasibility Analysis
k Terminate
A
n Conduct Conduct
a
Market Analysis Technical Analysis
l
y
s Conduct Financial
i E
Analysis
s v
a
l Conduct Economic and Ecological analysis
u
a
t Is the project Worthwhile?
i No
o Yes
n Terminate
Prepare Funding Proposal
Prepared by Dakito Alemu
 The Capital Budgeting
Budgeting Process
Process
1. Generate investment proposals (micro &
Macroeconomic data/sources) consistent with
the firm’s strategic objectives.
2. Estimate after-tax incremental cash flows for
the investment projects.
3. Evaluate project incremental cash flows.
4. Select projects based on a value-maximizing
acceptance criterion.
5. Reevaluate implemented investment projects
continually and perform post-audits for
completed projects.
 Feasibility Study
- Feasibility study is related to analyzing the
viability of the identified project to support
decision making of investment.
- As its name implies,
- it is a study to decide whether the
identified project is attractive enough to
go for implementation
- The study needs inputs from many
professional disciplines (multidisciplinary) for
various areas of the study
Areas of Analysis in Feasibility study
►Demand/ Need and Market
Analysis
►Technical Analysis
►Management Analysis
►Financial Analysis
►Economic Analysis
►Environmental Analysis
►Social Analysis
Why Feasibility
Study?
Prepared by Dakito Alemu
 Why Feasibility Study?
- To find if there is adequate demand for the
project’s output.
- To find if there is availability of suitable
technology and inputs
- To find the best options
- To answer if the project meets the
environmental regulations and priority of the
nations
- To examine the project’s financial and
economic viability
 Financial Analysis
The scope of financial appraisal varies
considerably with the nature of project and
whether it is revenue producing (e.g. industry,
agriculture) or not (e.g. roads, public schools).
Financial analysis covers:
- Investment Cost Estimation
- Operating Cost Estimation
- Benefits Estimation
- Cost Benefits Comparison
- Project Selection Decision
 Estimating
Estimating Cash
Cash Flows
Flows
Basic characteristics of relevant
project cash flows
• Cash flows (not accounting income)
• Operating flows (not financing)
• After-tax cash flows
• Incremental cash flows
Components of project Cash Flows
• Initial Investment: an outlay of cash that
takes place at the beginning of the life of the
project..
• Operating cash flows: cash inflows from
revenue and the cash out flows for different
expenditures, during the project life after
the initial investment.
• Terminal cash flows: are the cash inflows
and out flows that take place at the end of
the project life
 I) Initial Cash Outflow
a) Cost of “new” assets
b) - Investment tax credit
c) + (–) Increased (decreased) NWC
d) – Net proceeds from sale of
“old” asset(s) if replacement
e) + (–) Taxes (savings) on the sales
of “old” asset(s) if replacement
= Initial cash outflow
 II) Operating net Cash Flows
1) Net operating cash flow (Indirect Method)
► Net income (accounting profit or loss) ±
► - Non cash operating expenses minus
► + Non-cash operating revenues
2) The net Operating cash flow (Direct
Method)
After-tax cash revenues xxx
Less: after-tax cash expenses xxx
plus (less): tax (saving) non cash items XXX
Net operating cash flow xxxx
III) Terminal Cash Flows
►The terminal cash flows are those cash flows
associated with end of the project.
►Terminal cash flow include:
►The salvage proceeds from the sale of assets,
net of the relevant income taxes.
►The recovery of net working capital at the
end of the projects life.
►The increase in the net working capital at the
time of investment is expected to be recovered
when the project terminates.
 Terminal Cash Flows

a) Salvage value (disposal/reclamation

costs) of any sold or disposed assets
b) - (+) Taxes (tax savings) due to asset sale
or disposal of “new” assets
c) + Net working capital recovered
d) = Terminal year incremental net cash flow
 Example
►BMW company is considering the purchase of a new
machine.
►The machine will cost $50,000 plus $10,000 for
shipping and installation and has useful life of 4 years
and will then be sold (scrapped) for $10,000 at the end
of the fourth year.
►If the machine is purchased:
► NWC will increase by $5,000.
►Revenues will increase by $110,000 and
►Operating costs (excluding depreciation) will rise
by $70,000 for each year for the next four years.
►The company is in the 30% tax bracket.
►Assume straight line method for depreciation.
 Required
Compute :
A)The initial cash flow
B)Net Operating cash flow
C)Terminal cash flow
 Solution
► Initial inv= 50 + 10 + 5 = 65
► Depreciation = 50+10-10/4 = 12,500
► The net Operating cash flow will be determined
as follows:
After-tax cash revenues (110*.7) 77,000
Less: after-tax cash expenses (70*.7) 49,000
plus: tax (saving) non cash items (12.5*.3) 3,750
Net operating cash flow 31,750
 Operating Cash Flows
Year 1 Year 2 Year 3 Year 4
a) $110,000 $110,000 $110,000 $110,000
(70,000) (70,000) (70,000) (70,000)
b) ( 12,500) (12,500) (12,500) (12,500)
c) = 27,500 27,500 27,500 27,500
d) 30% (8,250) (8,250) (8,250) (2,850)
d) 19,250 19,250 19,250 19,250
e) 12,500 12,500 12,500 12,500
f) = $31,750 $31,750 $31,750 $31,750
 Terminal-Year Incremental
Cash Flows
a) $31,750 The incremental cash flow
from the previous slide in
Year 4.
b) + 10,000 Salvage Value.
c) – 0 Note, there is no gain/loss on
disposal of the machine at
the end of Year 4.
d) + 5,000 NWC - Project ends.
e) = $46,750 Terminal-year incremental
cash flow.
 Summary of Project
Net Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
–$65,000* $31,750 $31,750 $31,750 $46,750

• Notice again that this value is a negative

cash flow as we calculated it as the initial
cash OUTFLOW.
• Year 4= 31,750 + 5000+10,000
 Basic Capital Investment
Decision Models
►The basic capital investment
decision models can be classified into
two major categories:
►Non-discounting models ignore
the time value of money.
►Discounting models explicitly
consider the time value of money.
 Non-discounting Models:
Payback Period
►The payback period is a non-discounting model that
presents the time required for a firm to recover its
original investment.
► If the cash flows of a project are an equal amount each
period, payback period is computed as follows:

► If the cash flows are unequal, the payback period is computed by

adding the annual cash flows until such time as the original
investment is recovered.
► If a fraction of a year is needed, it is assumed that cash flows occur
evenly within each year.
 Using the Payback Period
to Choose Among Alternatives
►Under this approach, the investment
with the shortest payback period is
preferred over investments with longer
payback periods.
►The payback period can be used to choose
among competing alternatives.
►Used for projects under taken in a country/place political
unrest is high.
►Risk measurement
Example
 Accounting Rate of Return
►The accounting rate of return (ARR)
measures the return on a project in terms of
income, as opposed to using a project’s cash
flow.
►Measure profitability of the project
►The accounting rate of return is computed by
the following formula:
Example
 Discounting Models:
The Net Present Value Method
► Discounting models use discounted cash flows which are future cash
flows expressed in terms of their present value.
► One discounting model is the net present value (NPV), which is the
difference between the present value of the cash inflows and
outflows associated with a project.
 Decision Rule for NPV
►Once the NPV for a project is computed, it can
be used to determine whether or not to accept
an investment.
►A positive NPV, the project shall be accepted.
►If the NPV equals zero, the decision maker will
find acceptance or rejection of the investment
indifferent.
►If the NPV is less than zero/negative, the
investment should be rejected.
►In this case, it is earning less than the required rate of
return.
 Example
•A detailed market study revealed expected annual
revenues of $300,000 for new earphones.
Equipment to produce the earphones will cost $320,000.
After five years, the equipment can be sold for $40,000.
In addition to equipment, working capital is expected
to increase by $40,000 because of increases in
inventories and receivables.
The firm expects to recover the investment in working
capital at the end of the project’s life.
Annual cash operating expenses are estimated at
$180,000.
The required rate of return is 12 percent.
Required:
Estimate initial and annual cash flows, and calculate
Example: Solution
Example: solution …
 Internal Rate of Return
►The internal rate of return (IRR): the interest rate that sets
the present value of a project’s cash inflows equal to the
present value of the project’s cost.
►It is the interest rate that sets the project’s NPV at zero.
►The following equation can be used to determine a
project’s IRR, where t = 1, …, n :

►The right side of this equation is the present value of

future cash flows
►The left side is the investment.
►Thus, the IRR (the interest rate, i, in the equation) can
be found using trial and error.
 Decision Rule for IRR
►Once the IRR for a project is computed, it is
compared with the firm’s required rate of return:
►If the IRR is greater than the required rate, the
project is deemed acceptable.
►If the IRR is less than the required rate of return,
the project is rejected.
►If the IRR is equal to the required rate of return,
the firm is indifferent between accepting or
rejecting the investment proposal.
►The IRR is the most widely used of the capital
investment techniques.
Example
 Profitability Index
►Profitability index (Benefit – cost ratio) is the
ratio of the present value of the expected net
cash flow of the project to its initial
investment outlay.
 Converts the NPV criterion into a relative
measure
Decision Rule:
When PI or NPV Rule
>1 >0 = Accepted
<1 <0 = Rejected
 Example
Let us consider a project which is being
evaluated by a firm that has a cost of
capital of 12%
Project A Project B
Initial Investment Br 100,000 Br 250,000
net cash flows Year 1 25,000 40,000
Year 2 40,000 80,000
Year 3 40,000 100,000
Year 4 50,000 120,000
[1] Calculate the Profitability Index
[2] which project should be accepted
PI, NPV and IRR
►If PI ≥ 1.0 then
►NPV ≥ 0, and
►IRR ≥ RRR
 6 Mutually Exclusive Projects
►Up to this point, we have focused on independent
projects.
►NPV and IRR both yield the same decision for
independent projects.
►However, many capital investment decisions deal with
mutually exclusive projects.
►For competing projects, the two methods can
produce different results.
►Choosing the project with the largest NPV is
consistent with maximizing the wealth of
shareholders. PREPARED BY Dakito Alemu
 6 Net Present Value Compared with
Internal Rate of Return (continued)

► When choosing between projects, what counts are the total

dollars earned—the absolute profits—not the relative profits.
► Accordingly, NPV, not IRR, should be used for choosing among
competing, mutually exclusive projects or competing projects
when capital funds are limited.
PREPARED BY Dakito Alemu
 Post-audit of Capital Projects
►A key element in the capital investment process
is a follow-up analysis of a capital project once
it is implemented.
►A post-audit compares the actual benefits with the
estimated benefits and actual operating costs with
estimated operating costs.
►It evaluates the overall outcome of the
investment and proposes corrective action if
needed.
 Post-audit Benefits
►Firms that perform post-audits of capital projects
experience a number of benefits, including the
following:
►Resource Allocation: By evaluating profitability,
post-audits ensure that resources are used wisely.
►Positive Impact on Managers’ Behavior : If
managers are held accountable for the results of a
capital investment decision, they are more likely to
make such decisions in the best interests of the
firm.
►Independent Perspective: Post-audit by an
independent party ensures more objective results.
 Initiating the Feasibility Study
►Appointment of an experienced manager
and Selection of study team members
►Scope of the study
►External Advisers to support study team
►Plan and Schedule the Study
►Starting study as per plan and schedule
►Controlling study to complete as per per
plan and schedule
 Completing the Feasibility study
►The feasibility study should act as a
springboard for the next phase in the
project life cycle.
►– design and appraisal –ensuring that it is able to
commence in a focused way.
►The end product of Feasibility Study
should therefore comprise a clear,
concise report, called Feasibility Study
Report
The end!
Questions and Discussion
 Initial Investment
a) Gross investment (price + installation
+ shipment)
b) + (-) Increased (decreased) NWC
c) - Net proceeds from sale of
“old” asset(s)
d) + (-) Taxes (savings) due to the sale
of “old” asset(s)
Gross investment - Investment tax Credit, + Net Working Capital
Increases, + Opportunity Costs, + Tax Increase - Tax Shield, - Salvage
Proceed of the Old Asset
Example, Suppose that Brehan Share Company is considering replacing an old
equipment with the new one. The new equipment has an original cost of
900,000birr. The original cost and accumulated depreciation of the old equipment are
400,000birr and 280,000 birr respectively. The investment tax credit on the new
equipment is assumed to be 5 percent. Determine the amount of the initial
investment of the new equipment under each one of the following assumptions.
•The selling price of the old equipment is 120,000 birr
•The selling price of the old equipment is 150,000 birr
•The selling price of the old equipment is 460,000 birr
•The selling price of the old equipment is 80,000 birr
 Assume also that the ordinary income tax rate is 40 percent and the income tax rate
on the capital gain is 20 percent. We say there is a capital gain when the old asset is
sold at a selling price greater than its original cost. Hence, capital gain is equal to the
excess of the selling price of the old fixed asset over its original cost at the time of
replacement. What is the initial investment cost under each scenarios????
 Operating Cash Flows
(CFAT)
a) Cash Revenue – Cash Expenses
b) - Depreciation
c) = Net income before taxes
d) - Taxes
e) = Net income after taxes
f) + Depreciation
g) = Operating cash flow for period
 The operating cash-flow…
►Thus, to find the annual operating cash flow
is:
►CFAT= CFBT(1-T) + Deprn (T)
►CFBT = Cash rev – Cash Exp
►T = the tax rate
 Terminal Cash Flows

a) Salvage value (disposal/reclamation

costs) of any sold or disposed assets
b) - (+) Taxes (tax savings) due to asset sale
or disposal of “new” assets
c) + Net working capital recovered
d) = Terminal year incremental net cash flow
 Illustration
► To illustrate suppose that Wanza Share Company is considering or project that
requires an investment I fixed assets of 200,000 birr.
► The project is expected to generate annual cash revenue of 72,000 birr for the
coming five years.
► Annual cash expenses are estimated at 27,000 birr over the five years. The project
is also expected to have the salvage value of 45,000birr at the end of year 5.
► In addition to the investment in fixed assets mentioned above, the project requires
a net working capital of 25,000 birr at the beginning of year 1. This amount of
working capital will be recovered at the end of the life of the project (i.e end of
year 5).
► The income tax rate and the investment tax credit are 40 percent and 10 percent
respectively. Use the straight-line method of depreciation to depreciate the
project's fixed assets compute the initial investment and the annual cash flows for
each one of the five years for the project.
 Solution

►The initial investment of this project is:

►Investment in fixed assets 200,000
►Investment tax credit (20,000)
►Net working capital required 25,000
►Initial investment 205,000
For revenue expansion long-term investment projects, operation
cash flows represent the net cash flows after tax. The after-tax
operating cash flows can be determined by using one of the
following approaches.
1.the accounting net income approach- Here, the after tax cash
flows is equal to the accounting net income plus the sum of non-
cash operating expenses, if any.
2.The decomposition approach.
Here, the operating cash flows will be:
After-tax cash revenues xxx
Less: after-tax cash expenses xxx
Sub total: xxx
Add: tax savings on non-cash expresses xxx
After-tax cash flow xxxxx
 Annual depreciation is 39,000 birr (i.e
200,000 birr minus 5000 birr divided by 5
years). Then, the annual after-tax cash
flows for the five years computed year by
year as follows.
Year 1 Year 2 Year 3 Year 4 Year 5
Cash revenue 72,000 72,000 72,000 72,000 72,000
Less: Cash expenses 27,000 27,000 27,000 27,000 27,000
Cash flows before dep. & taxes 45,000 45,000 45,000 45,000 45,000
Less Depreciation 39,000 39,000 39,000 39,000 39,000
Income before Income tax 6,000 6,000 6,000 6,000 6,000
Less: Income tax (40%) 2,400 2,400 2,400 2,400 2,400
Net Income 3,600 3,600 3,600 3,600 3,600
Add: Depreciation 39,000 39,000 39,000 39,000 39,000
Salvage proceeds - - - - 5,000
Recovery of Net W.C. ____­­-__ ___-_ __-__ ___-___ 25,000

After-tax cash flows 42,600 42,600 42,600 42,600 72,600

•Using the decomposition approach, the after-tax cash flow is
computed to be the same as the one computed above using the
accounting income approach. That is 42,000Birr as show below.
After-tax cash revenue 72,000 (1-0.4) = 43,200
Less: after tax cash expenses 27,000(1-0.4) = 16,200
Subtotal 27,000
Add: tax savings on non-cash expresses (0.4) (39,000) =15,600
After-tax cash flow = 42,600
 Example: Expansion Project

BMW is considering the purchase of a new basket weaving

machine. The machine will cost $50,000 plus $20,000 for
shipping and installation. Depreciation is 40%, 30%, 20%
and 10% of the gross investment in years 1, 2, 3, and 4,
respectively. NWC will rise by $5,000. BMW forecasts that
revenues will increase by $110,000 for each of the next 4
years and will then be sold (scrapped) for $10,000 at the
end of the fourth year, when the project ends. Operating
costs will rise by $70,000 for each of the next four years.
BMW is in the 40% tax bracket.
 Initial investment
a) $50,000
b) + 20,000
c) + 5,000
d) - 0 (not a replacement)
e) + (-) 0 (not a replacement)
f) = $75,000*

* Note that we have calculated this value as a “positive”

because it is a cash OUTFLOW (negative).
 Operating Cash Flows
Year 1 Year 2 Year 3 Year 4
a) $40,000 $40,000 $40,000 $40,000
b) - 28,000 21,000 14,000 7,000
c) = $12,000 $19,000 $26,000 $33,000
d) - 4,800 7,600 10,400 13,200
e) = $7,200 $ 11,400 $15,600 $19,800
f) + 28,000 21,000 14,000 7,000
g) = $35,200 $32,400 $29,600 $26,800
 Terminal cash flow
a) 10,000 Salvage Value.
b) - 4,000 .40*($10,000 - 0) Note, the
asset is fully depreciated at
the end of Year 4.
c) + 5,000 NWC - Project ends.
d) = $11,000 Terminal-cash flow.
 Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-$75,000* $35,200 $32,400 $29,600 $37,800

* Notice again that this value is a negative cash

flow as we calculated it as the initial cash
OUTFLOW in slide 12-18.
 Example of an Asset
Replacement Project
Let us assume that previous asset expansion project is
actually an asset replacement project. The original cost of
the old machine was $30,000 and depreciated using
straight-line over five years ($6,000 per year). The old
machine has served for three years and has two years of
useful life remain-ing. BW can sell the current machine for
$6,000. The new machine will not increase revenues
(remain at $110,000) but it decreases operating expenses by
$10,000 per year (old = $80,000). NWC will rise to $10,000
from $5,000 (old).
 Initial Cash Outflow
a) $50,000
b) + 20,000
c) + 5,000
d) - 6,000 (sale of “old” asset)
e) - 2,400 <----
f) = $66,600 (tax savings from
loss on sale of
“old” asset)
 Calculation of the Change
in Depreciation
Year 1 Year 2 Year 3 Year 4
a) $28,000 $21,000 $14,000 $ 7,000
b) - 6,000 6,000 0 0
c) = $22,000 $15,000 $14,000 $ 7,000
a) Represent the depreciation on the “new”
project.
b) Represent the remaining depreciation on the
“old” project.
c) Net change in tax depreciation charges.
 Incremental Cash Flows
Year 1 Year 2 Year 3 Year 4
a) $10,000 $10,000 $10,000 $10,000
b) - 22,000 15,000 14,000 7,000
c) = $ -12,000 -$5,000 $ -4,000 $ 3,000
d) - -4,800 -2,000 -1,600 1,200
e) = $ -7,200 $ -3,000 $ -2,400 $ 1,800
f) + 22,000 15,000 14,000 7,000
g) = $14,800 $12,000 $11,600 $ 8,800
 Terminal Cash Flows

a) + 10,000 Salvage Value.

b) - 4,000 (.40)*($10,000 - 0). Note, the
asset is fully depreciated at
the end of Year 4.
c) + 5,000 Return of “added” NWC.
d) = $11,000 Terminal cash flow.
 Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-$75,000 $35,200 $32,400 $29,600 $37,800

Asset Replacement
Year 0 Year 1 Year 2 Year 3 Year 4
-$66,600 $14,800 $12,000 $10,600 $20,000
 Capital Budgeting
Techniques
1. Non-Discounted methods: do not consider time
value of money.
2. Discounted Methods: Consider time value of
money
 1. Non discounted Methods

a) Payback Period (PBP)

b) The accounting rate of return
 Proposed Project Data

Julie Miller is evaluating a new project for

her firm, Basket Wonders (BW). She has
determined that the after-tax cash flows
for the project will be $10,000; $12,000;
$15,000; $10,000; and $7,000,
respectively, for each of the Years 1
through 5. The initial cash outlay will be
$40,000.
 Independent Project
 For this project, assume that it is independent of any other potential
projects that Basket Wonders may undertake.

►Independent -- A project whose acceptance

(or rejection) does not prevent the
acceptance of other projects under
consideration.
 a) Payback Period (PBP)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

PBP is the period of time required for

the cumulative expected cash flows
from an investment project to equal
the initial cash outflow.
 Payback Solution (#1)

0 1 2 3 (a) 4 5

-40 K (-b) 10 K 12 K 15 K 10 K (d) 7K

10 K 22 K 37 K (c) 47 K 54 K

Cumulative
Inflows PBP =a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
 Payback Solution (#2)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows Note: Take absolute value of last negative
cumulative cash flow value.
 PBP Acceptance Criterion
The management of Basket Wonders has
set a maximum PBP of 3.5 years for
projects of this type.
Should this project be accepted?

Yes! The firm will receive back the initial cash

outlay in less than 3.5 years. [3.3 Years <
3.5 Year Max.]
 PBP Strengths
and Weaknesses
Strengths: Weaknesses:
► Easy to use and ► Does not account
understand for TVM
► Can be used as a ► Does not consider
measure of cash flows beyond the
liquidity & risk PBP
► Cutoff period is
subjective
 b) Accounting Rate of Return
ARR = Average NIAT / Average Investment
Eg. A project earns net incomes of Br 10,000, Br 15,000, Br
20,000 and Br 15,000 in years 1, 2, 3, & 4, respectively.
The initial investment in the project is Br 90,000 and it is
expected to have a salvage value of Br 10,000. What is the
ARR of the project?
Average NIAT = 60,000/4 = 15,000
Average Investment = (90000 + 10,000)/2 = 50,000
ARR = 15,000/50,000 = 30%
 2. Discounted Methods

►A) Net Present Value

►B) Internal Rate of Return
►C) Profitability Index
 a) Net Present Value (NPV)
NPV is the present value of an
investment project’s net cash flows
minus the project’s initial investment.
The discount rate is the opportunity cost
of capital

CF1 CF2 CFn

NPV = + +...+ - IInvt
(1+k)1 (1+k)2 (1+k)n
 NPV Solution
Basket Wonders has determined that the
opportunity cost of capital appropriate (Kr) for
this project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)
 NPV Solution

NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +

$15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $
7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) + $
7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 - $40,000
= - $1,428
 NPV Acceptance Criterion
The management of Basket Wonders has
determined that the required rate is 13%
for projects of this type.
Should this project be accepted?

No! The NPV is negative. This means that the

project is reducing shareholder wealth. [Reject
as NPV < 0 ]
 NPV Strengths
and Weaknesses
Strengths: Weaknesses:
► Cash flows ► May not include
assumed to be managerial
reinvested at the options embedded
hurdle rate. in the project.
► Accounts for TVM.
► Considers all
cash flows.
 b) Internal Rate of Return
(IRR)
IRR is the discount rate that equates the present
value of the future net cash flows from an
investment project with the project’s initial
investment. I.e. NPV at IRR = 0

CF1 CF2 CFn

IINVt = + +...+
(1+IRR) (1+IRR)2
1
(1+IRR)n
 IRR Solution

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000.
 IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +

$15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $
7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
 IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +

$15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $
7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
 IRR Solution (Interpolate)

.10 $1,444
X
.05 IRR $0.00 $4,603
.15 $3,159

X $1,444
.05 $4,603
=
 IRR Solution (Interpolate)

.10 $1,444
X $1,444
.05 IRR $0.00 $4,603
.15 -$3,159

($1,444)(0.05)
X= $4,603 X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

 IRR Strengths
and Weaknesses
Strengths: Weaknesses:
► Accounts for ► Assumes all cash
TVM flows reinvested at
► Considers all the IRR
cash flows ► Difficulties with
► Less project rankings and
subjectivity Multiple IRRs
 Profitability Index (PI)

PI is the ratio of the present value of a

project’s future net cash flows to the
project’s initial investment.
Method #1:
CF1 CF2 CFn
PI = + +...+ IInVT
(1+k)1 (1+k)2 (1+k)n
<< OR >>
Method #2:
PI = 1 + [ NPV / IINVT ]
 PI Strengths
and Weaknesses

Strengths: Weaknesses:
► Same as NPV ► Same as NPV
► Allows ► Provides only
comparison of relative profitability
different scale ► Potential Ranking
projects Problems
 Evaluation Summary

Basket Wonders Independent Project

Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
 Project Relationships

Independent -- A project whose acceptance

(or rejection) does not prevent the
acceptance of other projects under
consideration.
Mutually Exclusive -- A project whose acceptance
precludes the acceptance of one or more
alternative projects.
 Example: Expansion Project

BW is considering the purchase of a new basket weaving

machine. The machine will cost $50,000 plus $20,000 for
shipping and installation. Depreciation is 40%, 30%, 20%
and 10% of the gross investment in years 1, 2, 3, and 4,
respectively. NWC will rise by $5,000. Lisa Miller
forecasts that revenues will increase by $110,000 for each
of the next 4 years and will then be sold (scrapped) for
$10,000 at the end of the fourth year, when the project
ends. Operating costs will rise by $70,000 for each of the
next four years. BW is in the 40% tax bracket.
 Initial investment
a) $50,000
b) + 20,000
c) + 5,000
d) - 0 (not a replacement)
e) + (-) 0 (not a replacement)
f) = $75,000*

* Note that we have calculated this value as a “positive”

because it is a cash OUTFLOW (negative).
 Operating Cash Flows
Year 1 Year 2 Year 3 Year 4
a) $40,000 $40,000 $40,000 $40,000
b) - 28,000 21,000 14,000 7,000
c) = $12,000 $19,000 $26,000 $33,000
d) - 4,800 7,600 10,400 13,200
e) = $7,200 $ 11,400 $15,600 $19,800
f) + 28,000 21,000 14,000 7,000
g) = $35,200 $32,400 $29,600 $26,800
 Terminal cash flow
a) 10,000 Salvage Value.
b) - 4,000 .40*($10,000 - 0) Note, the
asset is fully depreciated at
the end of Year 4.
c) + 5,000 NWC - Project ends.
d) = $11,000 Terminal-cash flow.
 Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-$75,000* $35,200 $32,400 $29,600 $37,800

* Notice again that this value is a negative cash

flow as we calculated it as the initial cash
OUTFLOW in slide 12-18.
 Example of an Asset
Replacement Project
Let us assume that previous asset expansion project is
actually an asset replacement project. The original cost of
the old machine was $30,000 and depreciated using
straight-line over five years ($6,000 per year). The old
machine has served for three years and has two years of
useful life remain-ing. BW can sell the current machine for
$6,000. The new machine will not increase revenues
(remain at $110,000) but it decreases operating expenses by
$10,000 per year (old = $80,000). NWC will rise to $10,000
from $5,000 (old).
 Initial Cash Outflow
a) $50,000
b) + 20,000
c) + 5,000
d) - 6,000 (sale of “old” asset)
e) - 2,400 <----
f) = $66,600 (tax savings from
loss on sale of
“old” asset)
 Calculation of the Change
in Depreciation
Year 1 Year 2 Year 3 Year 4
a) $28,000 $21,000 $14,000 $ 7,000
b) - 6,000 6,000 0 0
c) = $22,000 $15,000 $14,000 $ 7,000
a) Represent the depreciation on the “new”
project.
b) Represent the remaining depreciation on the
“old” project.
c) Net change in tax depreciation charges.
 Incremental Cash Flows
Year 1 Year 2 Year 3 Year 4
a) $10,000 $10,000 $10,000 $10,000
b) - 22,000 15,000 14,000 7,000
c) = $ -12,000 -$5,000 $ -4,000 $ 3,000
d) - -4,800 -2,000 -1,600 1,200
e) = $ -7,200 $ -3,000 $ -2,400 $ 1,800
f) + 22,000 15,000 14,000 7,000
g) = $14,800 $12,000 $11,600 $ 8,800
 Terminal Cash Flows

a) + 10,000 Salvage Value.

b) - 4,000 (.40)*($10,000 - 0). Note, the
asset is fully depreciated at
the end of Year 4.
c) + 5,000 Return of “added” NWC.
d) = $11,000 Terminal cash flow.
 Summary of Project Net
Cash Flows
Asset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
-$75,000 $35,200 $32,400 $29,600 $37,800

Asset Replacement
Year 0 Year 1 Year 2 Year 3 Year 4
-$66,600 $14,800 $12,000 $10,600 $20,000