INVESTMENT ANALYSIS

OR
CAPITAL BUDGETING

What is Capital Budgeting?

THE PROCESS OF PLANNING

EXPENDITURES ON ASSETS WHOSE
RETURN WILL EXTEND BEYOND ONE
YEAR.

INVESTMENT

THE ADDITION OF DURABLE

ASSETS TO A BUSINESS

INVESTMENT
OPPORTUNITIES
MAINTENANCE AND REPLACEMENT
OF DEPRECIABLE CAPITAL ITEMS
ADOPTION OF COST-REDUCING
INVESTMENTS
ADOPTION OF INCOME-INCREASING
INVESTMENTS
A COMBINATION OF THE
PRECEDING

STEPS IN INVESTMENT ANALYSIS:

1.

IDENTIFY POTENTIALLY
PROFITABLE INVESTMENT
ALTERNATIVES
COLLECT RELEVANT DATA ON:

2.

CAPITAL OUTLAYS
COSTS
RETURNS

3.

USE AN APPROPRIATE METHOD

TO ANALYZE THE DATA.

4.

DECIDE WHETHER TO ACCEPT

OR REJECT THE INVESTMENT
OR SELECT THE TOP RANKING
AMONG MUTUALLY EXCLUSIVE
PROJECTS.

CAPITAL BUDGETING

METHODS OF CAPITAL BUDGETING

PAYBACK METHOD
SIMPLE RATE OF RETURN
NET PRESENT VALUE
INTERNAL RATE OF RETURN

PAYBACK METHOD
THE PAYBACK METHOD GIVES THE
NUMBER OF YEARS NECESSARY TO
RECOVER THE INITIAL
INVESTMENT.
DOES NOT ACCOUNT FOR THE
TIMING OF CASH FLOWS.

P=I/E

WHERE:
P = PAYBACK PERIOD IN YEARS
I= INITIAL INVESTMENT OUTLAY
E = ANNUAL NET CASH FLOWS
(CASH RECEIPTS LESS CASH EXPENSES)

SIMPLE RATE OF RETURN

EXPRESSES THE AVERAGE ANNUAL
NET INCOME AS A PERCENTAGE OF
THE AMOUNT INVESTED.
THIS MAY BE IN TERMS OF THE
INITIAL CAPITAL OUTLAY OR THE
AVERAGE AMOUNT INVESTED OVER
THE USEFUL LIFE OF THE
INVESTMENT.

RETURN AS A PERCENT OF
INITIAL CAPITAL OUTLAY
SRR = Y/I
WHERE:
SRR = SIMPLE RATE OF RETURN
Y
= AVERAGE ANNUAL NET
INCOME (DEPRECIATION
TAKEN INTO ACCOUNT)
I
= INITIAL INVESTMENT
OUTLAY

CALCULATION OF ANNUAL NET

INCOME
Y =(E D)
WHERE:
Y = AVERAGE ANNUAL NET INCOME
E = TOTAL EXPECTED ANNUAL NET
CASH RECEIPTS
D= TOTAL ANNUAL DEPRECIATION

STRAIGHT LINE DEPRECIATION

D =(INITIAL COST SALVAGE VALUE) /

DEPRECIABLE LIFE

RETURN AS A PERCENT OF
AVERAGE AMOUNT INVESTED
SRR/ = Y/ (I + S)/2

WHERE:
I = INITIAL INVESTMENT
S = SALVAGE VALUE

NET PRESENT VALUE (NPV)

WITH THE NPV, THE CASH FLOWS

OF THE INVESTMENT ARE
DISCOUNTED BY A MINIMUM
ACCEPTABLE COMPOUND ANNUAL
RATE OF RETURN.

THE INVESTMENT IS JUDGED TO

BE ACCEPTABLE IF THE PRESENT
VALUE OF THE NET CASH FLOWS
EXCEEDS THE INITIAL
INVESTMENT OUTLAY.

NPV = - INV + P1/(1+i) + P2/(1+i)2

+ . + PN/(1+i)N + VN/(1+i)N
WHERE:
INV = INITIAL INVESTMENT
PN = ANNUAL NET CASH FLOWS
ATTRIBUTED TO THE
INVESTMENT
VN = SALVAGE VALUE OR
TERMINAL INVESTMENT VALUE

N = LENGTH OF PLANNING
HORIZON
I = THE INTEREST RATE OR
REQUIRED RATE-OF-RETURN OR
DISCOUNT RATE

INTERNAL RATE OF RETURN

(IRR)
THE IRR IS THE COMPOUND
INTEREST RATE THAT EQUATES THE
PRESENT VALUE OF THE FUTURE
NET CASH FLOWS WITH THE
INITIAL OUTLAY.
OR IN OTHER WORDS THE
DISCOUNT RATE THAT GIVES A NPV
= ZERO

BOTH THE NPV AND IRR TAKE

INTO ACCOUNT THE TIME VALUE
OF MONEY.

THE PURPOSE OF THESE

INVESTMENT ANALYSIS
TECHNIQUES IS TO EVALUATE
THE ACCEPTABILITY OF
INVESTMENTS RELATIVE TO AN
ACCEPTABLE RATE OF RETURN.

COMPARING NPV AND IRR

AS THE DISCOUNT RATE USED TO

CALCULATE NET PRESENT VALUE IS
INCREASED THE NPV WILL
DECREASE

THE IRR IS THE DISCOUNT RATE

THAT GIVES A NPV OF ZERO

REINVESTMENT
ASSUMPTION

THE IRR METHOD IMPLICITLY ASSUMES

THAT NET CASH INFLOWS FROM AN
INVESTMENT ARE REINVESTED TO EARN
THE SAME RATE AS THE INTERNAL RATE
OF RETURN.
THE NPV METHOD ASSUMES THAT NET
CASH INFLOWS CAN BE REINVESTED AT
THE DISCOUNT RATE USED.

WHICH REINVESTMENT RATE IS

MORE REALISTIC?

THE DISCOUNT RATE USED TO

CALCULATE THE NPV HAS THE
ADVANTAGE OF BEING
CONSISTENTLY APPLIED TO ALL
INVESTMENTS BEING EVALUATED.

CASH FLOWS FOR THREE

INVESTMENTS
YEAR

INV A

INV B

INV C

-20,000

- 20,000

- 20,000

2,000

5,800

10,000

4,000

5,800

8,000

6,000

5,800

6,000

8,000

5,800

3,000

10,000

5,800

1,000

AVG

6,000

5,800

5,600

PAYBACK PERIOD

20000/6000 = 3.33 YEARS

20000/5800 = 3.45 YEARS

20000/5600 = 3.57 YEARS

SIMPLE RATE OF RETURN

A (30000-20000)/5 = 2000
2000/20000 = 0.10 10%

B (29000-20000)/5 = 1800
1800/20000 = 0.09 9%

C (28000-20000)/5 = 1600
1600/20000 = 0.08 8%

* Assume that the investment is fully depreciated in 5 years

NET PRESENT VALUE

A NPV = -20000 + 2000/(1.08)

+ 4000/(1.08)2 + 6000/(1.08)3
+ 8000/(1.08)4 + 10000/(1.08)5
+ 0/(1.08)5

NPV = -20000 + 1852 + 3429

+ 4763 + 5880 + 6806 + 0

NPV = 2730

NET PRESENT VALUE AND

INTERNAL RATE OF RETURN

A NPV = 2730

IRR = 12.01

B NPV = 3158

IRR = 13.82

C NPV = 3766

IRR = 17.57

WHAT GOES INTO THE DISCOUNT

RATE?
THE DISCOUNT RATE SHOULD
REFLECT THE COST OF CAPITAL OR
THE COST OF FUNDS USED TO
FINANCE THE BUSINESS.
AN INVESTMENT IS NOT
ACCEPTABLE UNLESS IT
GENERATES A RETURN SUFFICIENT
TO COVER THE COST OF FUNDS.

THE DISCOUNT RATE CONTAINS

THREE COMPONENTS:
REAL RISK-FREE RATE
RISK PREMIUM
INFLATION EXPECTATIONS

WEIGHTED AVERAGE COST

OF CAPITAL
THERE ARE TWO TYPES OF CAPITAL
INVESTED IN A BUSINESS:
DEBT CAPITAL
EQUITY CAPITAL
COST OF DEBT
COST OF EQUITY

WEIGHTED AVERAGE COST

OF CAPITAL

Kc = wd Kd + we Ke
Where:

Kc is the weighted average cost of capital

wd is the proportion of assets financed with
debt
Kd is the cost of debt capital
we is the proportion of assets financed with
equity
Ke is the cost of equity capital

PROFITABILITY INDEX
USED TO ALLOCATE LIMITED
CAPITAL AMONG SEVERAL
INDEPENDENT PROJECTS
PRESENT VALUE OF THE CASH
INFLOWS DIVIDED BY THE INITIAL
CASH OUTLAY

ANNUITY EQUIVALENT

USED TO COMPARE NPVs WITH UNEQUAL

LIVES.

DETERMINES THE SIZE OF ANNUAL

ANNUITY FOR THE ECONOMIC LIFE OF
THE INVESTMENT THAT COULD BE
PROVIDED BY A SUM EQUAL TO THE
PRESENT VALUE OF ITS PROJECTED
CASH FLOW STREAM, GIVEN THE COST
OF CAPITAL.

ANNUITY EQUIVALENT IS
CALCULATED BY SETTING THE NPV
OF THE INVESTMENT AS THE PV
AND THEN SOLVING FOR THE PMT
USING THE SAME PLANNING
HORIZON AND DISCOUNT RATE TO
DETERMINE NPV.

FINANCIAL FEASIBILITY
ONCE YOU HAVE EVALUATED AN
INVESTMENT, THE FINANCING OF
THE PROJECT SHOULD BE
DETERMINED.
AFTER-TAX CASH FLOWS MAY NOT
BE SUFFICIENT TO MEET DEBT
REPAYMENT REQUIREMENTS.