FNCE 220: BUSINESS FINANCE

LECTURE 6: CAPITAL INVESTMENT DECISIONS

UNDER CERTAINTY

0722909421

KAIBOS MOSES
Devotional Meditation

Proverbs 1:7
The fear of the LORD is the beginning of
knowledge, but fools despise wisdom and
instruction.
Definition of capital budgeting

Process of identifying, analyzing and selecting investment projects

whose returns (cash flows) are expected to extend beyond one year.

It is decisions that involve long-lived assets.

When a business makes a capital investment, it incurs a current cash

outlay in the expectations of future benefits. E.g. Investments in assets,
e.g. equipment, buildings, land, introduction of a new product or a new
program.
 
 
Reasons why investment decisions require special attention:
IMPORTANCE OF INVESTMENT DECISIONS/ANALYSIS

 They influence the firm’s growth in the long run

 They affect the risk of the firm
 They involve commitment of large amount of funds
 They are irreversible or reversible at substantial loss
 They are among the most difficult decisions to make
Types of investment decisions

Classifications:
(A) (i) Expansion of existing business
 It may increase its plant capacity to manufacture/produce more.
Expansion of current lines of business i.e. related diversification
Introducing a new line of business i.e. unrelated diversification
(ii) Expansion of new business
(iii) Replacement and modernization
 to improve operating efficiency and reduce costs, e.g.
Replacing obsolete assets
Replacing ageing assets
(B) (i) Mutually exclusive investments - serve the same purpose
and compete with each other. If one investment is undertaken,
others will have to be excluded

(ii) Independent investments - serve different purposes and do

not compete with each other

(iii) Contingent investments - dependent projects. The choice of

one investment necessitates undertaking one or more other
investments
METHODS OF ANALYZING /EVALUATING PROJECTS
(a) Discounted cash flow (DCF) criteria
Net present value ( NPV)
Internal rate of return (IRR)
Profitability index (PI)

(b) Non- discounted cash flows

Payback period ( PB)
Discounted payback period(DPB)
Accounting rate of return(ARR)
 
NET PRESENT VALUE METHOD (NPV)

 DCF
Recognizes the time value of money.
It correctly postulates that cash flows arising at different time periods differ
in value and are comparable only when their equivalents are found out.

Steps of calculation of NPV:

Forecasting of cash flows of the investment project
Appropriate discount rate should be identified for discounting cash flows
Calculation of present values of cash flows
Net present value should be found out
General formula:
NPV = ∑n Cn / ( 1 + k)t – Co
t-1

C1, C2, C3------------Cn – represents net cash inflows at time n

Co – represents the initial cost of the investment
n- represents the expected life of the project
k - represents the cost of capital
Acceptance rule
Accept the project when NPV is positive (NPV > 0 )
Reject the project when NPV is negative (NPV < 0 )
You may be indifferent when NPV is zero(NPV = 0)

When the NPV method is used to select mutually exclusive projects,

the one with the higher NPV should be selected
Example 1:

Assume that project X costs sh.7, 500,000 now and is expected to

generate year –end cash inflows of sh.2, 700,000, sh.2, 400,000, sh.
2,100,000, sh. 1,800,000 and sh.1, 500,000 in years 1 through to 5.
The opportunity cost of capital may be assumed to be 10%.
Required: (a) Calculate the NPV of project X (b) Advice the investor
whether he/she should invest in the project
NPV = ( 2.7/(1+ 0.1)1 + 2.4/(1+0.1)2 + 2.1/(1+0.1)3 + 1.8/(1+0.1)4 + 15/(1+0.1)5) - 7.5m
Solution
(a)NPV = (2,700,000/ (1+ 0.1)1 + 2400,000/(1+ 0.1)2 +
2,100,000/(1+0.1)3 +1,800,000/(1+0.1)4 + 1.500,000/(1+0.1)5) –
7,500,000
= 8,176,583.80 – 7,500,000
= sh.676, 583.80
(b) Advice:
Accept to investment sh. 7,500,000 in the project x
Example 2:Consider the following two mutually exclusive projects:

The discount rate is 15%

Required:
(a) Determine net present value for each project
NPV(A) = sh.43,189.70
NPV(B) = sh.-2,407.60
(b) Which project will you choose and why? A, why – positive NPV i.e. the project will
add wealth.
 
Advantages of using NPV method

It recognizes the time value of money

It is a measure of the true profitability since is
uses all cash flows occurring over the entire life of
the project
Value additivity –NPV (A+B) = NPV(A) + NPV(B)
Shareholder value – the NPV method is always
consistent with the objective of the shareholder
value maximization
Disadvantages of NPV method

Cash flow estimation - it is quite difficult to estimate cash flows

due to uncertainty.
It also difficult in practice to precisely measure the discount
rate.
Mutually exclusively projects - the NPV rule may give
ambiguous results for project with unequal lives in these
situations.
Ranking projects- ranking of investment projects as per the
NPV rule is not independent of the discount rates. At different
discount rates, a project maybe ranked differently.
PROFITABILITY INDEX METHOD (PI)

 PI is the ratio of the present value of cash inflows at the required

rate of return, to the initial cash outflows of the investment.

Formulae:
PI = PV of cash inflows/ initial cash outlay(initial investment cost)
PI= PV (CI)/Co

Where : PV(CI)= ( ∑n Cn / (1 +k )t
t-1
Acceptance rule
 
 Accept the project when PI is greater than 1 (PI > 1)
 Reject the project when PI is less than 1 (PI <1)
 We are indifferent when PI is equal to one (PI = 1)
 
Example:

The initial cash outlay of a project is ksh.300,000 and it can generate cash inflows of sh.120,000,sh.90,000,
sh.150,000 and sh.60,000 in years 1 through to year 4. Assume a 10% discount rate. (a) Calculate the PI (b) Advice
whether sh.300,000 should be invested in the the project or not.

Solution
Step 1: Calculate the present value of cash inflows

PV = sh.120, 000/(1.1)1 + sh.90, 000/(1.1)2 + sh.150,000/(1.1)3+ sh.60,000/(1.1)4

 
PV = sh.337, 149.10
 
Step 2: PI

PI = 337,050/300,000
PI = 1.1238 – invest sh. 300,000 in this project
 
Example 2
Discount rate = 15%

Required: (a) Determine PI for each project (b) Which project should be accepted for
investment
PI ( A) = 3.3994
PI( B) = 0.866

Advice: Accept to invest sh.18,000 in Project A, because it has PI greater than 1 . The
investment will add wealth
Advantages of PI
 Time value of money – it recognizes the time value of money
 Value maximization – it is consistent with the shareholder value maximization
principle. A project with PI greater than one will have positive NPV and if accepted, it
will increase shareholders wealth.
 Relative profitability – in the PI method, since the present value of cash inflows is
divided by the initial cash outflow, it’s a relative measure of a project’s profitability.

Disadvantages of PI
Like NPV method, PI criterion also requires calculations of cash flows and estimate of
the discount rate. in practice estimation of cash flows and discount rate pose problems.
INTERNAL RATE OF RETURN METHOD (IRR)

 DCF
 Takes account of the magnitude and timing of cash flows.
 IRR is the rate that equates the investment outlay with the present value of cash flows
received over after one period.
 This also implies that the rate of return is the discount rate which makes NPV = 0.

The formula for calculating the IRR is the same as that of the NPV.

NPV = ∑n C1 / (1+ k)t - Co = 0

t-1
OR
 
Co = ∑n C1 / (1+ k)t
t-
Acceptance rule

 Accept the project when IRR (r) > k

 Reject the project when IRR (r) < k
 Indifferent when IRR (r) = k

Where,
r – the internal rate of return
k-the opportunity cost of capital
(a) By trialofand
Methods Error method
calculating IRR
(b) By interpolation method
Calculating IRR by trial and Error method

 Select any discount rate to compute the present value of cash inflows.

 NB: If the calculated present value of the expected cash inflows is lower than
the present value of cash outflows, a lower rate should be tried.
 On the other hand, a higher value should be tried if the present value of inflows
is higher than the present value of outflows.
 This process will be repeated until the net present value becomes zero
(NPV = 0).
Example 1:

A project costs sh.48, 000,000 and is expected to generate cash inflows of sh.32,
000,000, Sh.21, 000,000 and sh.18, 000,000 at the end of each year for the next 3
years.
Required:
(a) Determine the IRR ( 25.40%)
(b) If the cost of capital(k) is 20%, should we accept to invest sh.48m in the
project?
Trial and error method
CO = 48,000,000
Take 15%
Pv0 = 32,000,000/(1+0.15)1 + 21,000,000/(1+0.15)2 + 18,000,000/(1+0.15)3=
55,540,396
Take = 23%
PV0 = 49,569,797
Take 25%
PV0 = 48,256,000
Take 25.45%
PV0 = 47,969,102
Take 25.34%
PV0 = 48,038,945.21
Take 25.37%
PV0 = 48019878.70
Take 25.4% ( IRR)
PV0 = 48,000,826
IRR = ( Z/ 48,019,878 – 48,000,000 = 25.45- 23.37/48,019,878 – 47,969,102) + 25.37%
IRR = ( Z/19,878 = 0.08/50,776) +25.37%
IRR = ( Z = 0.0313%) + 25.37%
IRR = 0.0313 + 25.37 = 25.401%
TRIAL AND ERROR METHOD
Co = 48,000,000
Take = 30%
PV = 32,000,000/(1+0.3)1 + 21,000,000/(1+ 0.3)2 + 18,000,000/(1+0.3)3 = 45,234,410.60

Take = 25%
PV = 32,000,000/(1+0.25)1 + 21,000,000/(1+ 0.25)2 + 18,000,000/(1+0.25)3 = 48
,256,000

Take = 25.55% PV = 47,905,769.00

Take = 25.35% PV = 48,032,588.20
Take = 25.45% PV = 47,969,102.00
Answer= 25.4% PV = 48,000,826.10, ACCEPT, to invest s.48m in this project, because it will
add wealth
solution

C0 = 48,000,000
PV0 = 32,000,000/ (1+0.2)1 + 21,000,000/(1+0,2)2 + 18,000,000/(1+0.2)3 = 51,666,667
Take : 25%
PV0 = 48,256,000
Take: 25.05%
PV0 = 48,223,969
Take: 26%
PV0 = 47,622,647
Take.25.55%
PV0 = 47,937,417
Take:25.52%
PV0 = 48,128,105
(a) IRR (r) = 25.4%= 48,000,826
(b) Verdict: Accept to invest sh.48m in this project BECAUSE 25.4% is greater than 20%
Computation of IRR using interpolation method

Steps:

(a) Choose a rate at random and compute the present value of cash inflows or
returns which should be above the cost of the project i.e. the first rate should
generate present value of the inflows greater than the cost.

(b) Choose another rate and compute the present value of cash inflows. Such rate
should get a present value which is below the cost of the investment ;
then
Take the higher present value of cash inflows in (a), let it be x and let the rate used in
(a) be r. let the amount in (b) above be y and let rate in (b) above be w, and take c to
represent the cost of the venture and let z, represent the unknown rate between the
cost of the venture and the figure for the highest present value figure.
IRR = (z /x-c = w-r /x- y) + r

Co = 48,000,000
C1 = 32m, c2= 21m, c3 = 18m
What is IRR using interpolation method?
take 25.43%(W) = 47,981,787.15( Y)
take 25.35% (r) = 48,032,588.20 ( X)
IRR = (z /48,032,588.20 – 48,000,000 = 25.43-25.35 /48,032,588.2 -
47,981,787.15) + 25.35% =
IRR = (z /x-c = w-r /x- y) + r
Example 1:
Pv0 = 48,007,175(x), rate, 25.39%(r)
PV0 = 47,994,478(y),rate, 25.41%(w)
EXAMPLE 2

Discount rate = 15% ( cost of capital, k )

Required:
(a) Use interpolation method to determine the IRR (r ) for each project
(b) Advice whether sh.18,000 should be invested in which project ( A or B)
Merits of IRR

(i) IRR recognizes the time value of money

(ii) Profitability measure. It considers all cash flows occurring over
the entire life of the project to calculate its rate of return
(iii) Acceptance rule i.e. it generally gives the same acceptance rules
as the NPV method
(iv) Shareholders value i.e. It is consistent with the shareholders
wealth maximization objective. Whenever a project IRR is greater
than the opportunity cost of capital, the shareholders wealth will
be enhanced.
Demerits of IRR

(i) Multiple rates – a project may have a multiple rates, or it may not have a
unique rate of return. These problems arise because of the mathematics of
IRR computation.

(ii) Mutually exclusive projects – it may also fail to indicate a correct choice between
mutually exclusive projects under certain situations.

(iii) Value additivity – unlike the case of NPV method, the value of additivity does
not hold when the IRR method is used. IRR of projects do not add thus, for project
A and B, IRR (A) + IRR (B) need not be equal to IRR(A+B).