INVESTMENT DECISIONS

REVIEW OF CAPITAL BUDGETING TECHNIQUES

Capital budgeting (investment) decisions may be defined as the firm's decisions to invest its current funds
most efficiently in the long-term assets in anticipation of an expected flow of benefit over a series of
years. The firm therefore:

(a) exchanges current funds for future benefits

(b) invests the funds in long-term assets
(c) expects future benefit over a series of years

2. INVESTMENT APPRAISAL TECHNIQUES

The investment appraisal techniques can be categorized into two groups:

(a) Discounted Cash flow methods

i. Net present value method

ii. Internal rate of return
iii. Profitability index

(b) Non-discounted cashflow method

i. Accounting rate of return

ii. Payback period

DISCOUNTED CASHFLOW METHODS

1. Net Present Value (NPV)

This is defined mathematically as the present value of cashflow less the initial outflow.
n
NPV = 
Ct
-
t Io
t=1 (1 + K )

Where Ct is the cashflow

K is the opportunity cost of capital
Io is the initial cash outflow
n is the useful life of the project

Decision Rule using NPV

The decision rule under NPV is to:

- Accept the project if the NPV is positive

- Reject the project if NPV is negative

Note: if the NPV = 0, use other methods to make the decision.

2. Internal Rate of Return (IRR)

The internal rate of return of a project is that rate of return at which the projects NPV = 0

Therefore IRR occurs where:

n
NPV = 
Ct
- =0
t Io
t=1 (1 + r )

Where r = internal rate of return

Note that IRR is that ratio of return that causes the present value of cashflows to be equal to the
initial cash outflow.

Decision Rule under IRR

If IRR > opportunity cost of capital - accept the project

- IRR < opportunity cost of capital - reject the project

- IRR = opportunity cost of capital - be indifferent

3. Profitability Index

This is a relative measure of projects profitability. It is given by the following formula.

(1+CK )
t=1
t
t
PI =
Io

Decision Rule

If PI > 1 - Accept the project

PI < 1 - Reject the project
PI = 1 - Be indifferent

NON-DISCOUNTED CASHFLOW METHODS

1. Accounting rate of return (ARR)

ARR = Average annual income

Average investment

Where Average annual income = Average cashflows - Average Depreciation

Average investment = 1/2 (Cost of investment - Salvage value)
(assuming straight line depreciation method).
Projects with higher ARR are preferable.
 2. Payback Period

This is defined as the time taken by the project to recoup the initial cash outlay.
The decision rule depends on the firms target payback period (i.e. the maximum period beyond
which the project should not be accepted.

ILLUSTRATION

A company is considering two mutually exclusive projects requiring an initial cash outlay of Sh 10,000 each and
with a useful life of 5 years. The company required rate of return is 10% and the appropriate corporate tax rate
is 50%. The projects will be depreciated on a straight line basis. The before depreciation and taxes cashflows
expected to be generated by the projects are as follows.

YEAR 1 2 3 4 5
Project A KShs 4,000 4,000 4,000 4,000 4,000
Project B KShs 6,000 3,000 2,000 5,000 5,000

Required:

Calculate for each project

i. The payback period
ii. The average rate of return
iii. The net present value
iv. Profitability index
v. The internal rate of return

Which project should be accepted? Why?