DFA1035 Y Fundamentals of Finance and Practice

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.

12.1 LEARNING OUTCOMES

By the end of this Unit, you should be able to do the following:
1. Understand the importance of capital budgeting decisions.
2. Understand the payback rule and some of its weaknesses.
3. Calculate the discounted payback period.
4. Understand the net present value criterion when evaluating investment projects.
5. Calculate the internal rate of return for investment projects.
6. Calculate the accounting rate of return for investment projects.
7. Calculate the profitability index.

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12.2 Capital Budgeting

Read: Chapter 8, Page 191, Introduction - Book FCF, 2nd Ed.
The firm must consider that each investment is an option and it must determine which options are
valuable and which one are not. To this end, Capital budgeting is the process of making long-term
investment decisions that further a company’s goals. The shareholders have entrusted the company
with their money, and they expect the company to invest their money wisely. Investments in fixed
assets should be consistent with the goal of maximising the market value of the firm.

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:

1. estimate the project's relevant cash flows

2. apply a decision rule to determine whether or not a project should be undertaken.

12.2.1 Dependent, Independent and Mutually Exclusive Projects

Projects can be independent, dependent or mutually exclusive.

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.

12.2.2 Capital Budgeting Techniques

We consider a number of methods to analyse and identify whether or not investments are worth
undertaking. These are as follows;
· Payback & discounted payback

· Net Present Value (NPV)

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· Internal Rate of Return (IRR)

· Accounting Rate of Return

· Profitability Index

12.3 Payback Method

Read: Chapter 8, Page 196, the payback rule - Book FCF, 2nd Ed.
The payback period is the period of time taken for the future net cash inflows to match the initial cash
outlay. As a rule, it is wiser to choose the project with the shorter payback period. Such projects are
deemed to be less risky since they recoup the initial capital outlay faster.

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.

The main shortcomings of this method are:

1. It does not recognise the time value of money.
2. It ignores the impact of cash inflows received after the payback period, which could determine the
project’s profitability.

The pay back rule is as follows;

· Calculate the amount of time it takes to pay back the initial investment, called the payback
period

· Accept if the payback period is less than required

· Reject if the payback period is greater than required.

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

12.3.1 Discounted Payback

One of the flaws of the payback period is that it ignores time value of money. As such, a variation of
the payback method is to consider the length of time required for an investment’s discounted cash
flows rather than the cash flows over time.

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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Discounted Cash Cumulative

Year Flow at 10% Balance
0 -10000
1 4545.5 -5454.5
2 3305.8 -2148.7
3 2253.9 105.2

2418.7
Discounted Payback period for A project: 2 + years = 2.953 years
2253.9

Similarly, for project B, the discounted payback period is as follows;

Discounted Cash Cumulative
Year Cash flows Flow at 10% Balance
0.00 -10000.00 -10000.00
1.00 1000.00 909.09 -9090.91
2.00 3000.00 2479.34 -6611.57
3.00 4000.00 3005.26 -3606.31
4.00 6000.00 4098.08 491.77

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.

12.4 Net Present Value

Read: Chapter 8, Page 192, Net Present Value - Book FCF, 2nd Ed.
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 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

5,000 4,000 3,000 1,000

- 10,000 + + + + = $ 788.2
1.1 1.12 1.13 1.14

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NPV of the project B

1,000 3,000 4,000 6,000

- 10,000 + + + + = $ 491.8
1.1 1.12 1.13 1.14

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).

· If A & B are independent, accept both; NPV > 0.

12.5 The internal rate of return (IRR)

Read: Chapter 8, Page 204, the internal rate of return - Book FCF, 2nd Ed.

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:

5,000 4,000 3,000 1,000

- 10,000 + + + + =0
(1+ IRR ) (1+ IRR ) 2 (1+ IRR )3 (1+ IRR ) 4

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%.

Similarly, the exact value of IRR for project B is 11.79%.

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%.

12.6 Accounting Rate of Return (ARR)

Read: Chapter 8, Page 202, the accounting rate of return - Book FCF, 2nd Ed.

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.

Average annual profit

ARR = ´ 100
Initial (or average) capital invested

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:

Year Average ARR

Profit
1 2 3 4
$ $ $ $ $ %
Project
A
Cash flow 5,000 4,000 3,000 1,000

Depreciation -2,500 -2,500 -2,500 -2,500

Profit 2,500 1,500 500 -1,500 750 750/10,000

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.

12.7 Profitability Index

Read: Chapter 8, Page 214, the profitability index - Book FCF, 2nd Ed.

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 Project A, PI is as follows;

PI= Present value all future cash flows/ initial cost=10788.2/10000=1.079

For Project B, PI is as follows;

PI= Present value all future cash flows/ initial cost=10491.8/10000=1.049

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:

Year Investment X Investment Y

0 -$400 -$4,00

1 $208 $164

2 $252 $176

3 $390.8 $760

· Calculate the paybacks on the two investments.

· If a desired 2-year payback period is required, which of these two is acceptable?

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%.

(i) Calculate the paybacks on the two investments.

(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:

Year Investment X Investment Y

0 -Rs100000 -Rs100000

1 Rs40000 Rs60000

2 Rs60000 Rs60000

3 Rs90000 Rs60000

a. Based on the payback period, which of these might you prefer?

b. Find the IRR for the two investments.

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Solution
Activity 1

Payback period X: 400 – 208 = 192; 192/252 = 0.76

Payback = 1.76 years
Payback period Y: 400 – 164 – 176 =60; 60/760 = 0.08
Payback = 2.08 years
Two-year payback required: Investment X would be accepted.

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

16,000 16,000 16,000 12,000

-40,000 + + + + = Rs4,251
1.14 1.142 1.143 1.144

NPV of the Y project

17,000 17,000 17,000 17,000

- 40,000 + + + + = - Rs467
1.14 1.142 1.143 1.144

HDR - LDR 20 - 18
IRR Project X = LDR + ´ NPVLDR = 18% + ´ 976 = 19.31%
NPVLDR - NPVHDR 976 + 510

The IRR for the Y project is 13.5%.

(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.

· Projects can be independent, dependent or mutually exclusive.

· 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 IRR is that discount rate which produces an NPV of zero.

· 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.

12.10 SUGGESTED READINGS

· 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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