CAPITAL INVESTMENT DECISIONS

CONTENTS
 Importance of investment analysis
 Methods of analysing /evaluating projects
 Comparisons of the Methods
 Replacement of Assets
INVESTMENT ANALYSIS
Any company will invest finance for the sake of deriving a return which is useful for four main reasons:

 To reward the shareholders of the business for staking their money and by foregoing their
current need for money for the sake of future return.
 To reward creditors by paying them regular return in form of interest for their capital and
eventually repayment of their principal when it falls due.
 Plough back earnings for the purposes of companies growth and of increasing the size of
the company,
 For the increase in share prices and thus the credibility of the company and its ability to
raise further finance.
 Such a return is necessary to keep the company’s operations moving smoothly and thus
allow the above objective to be achieved.

 A prudent financial manager will be concerned with how efficiently the company’s funds
are invested because it is from such investment that the company will survive.
Investments are important because:

i) They influence company’s size

ii) Influence growth
iii) Influence company’s risks

 Capital budgeting, involves the decision to invest the company’s current funds in viable
ventures whose returns will be realised for long term periods in future.
Characteristics of Capital budgeting

 Decisions of this nature are long term i.e. extending beyond one year in which case they
are also expected to generate returns of long term in nature.
  Investment is usually heavy (heavy capital injection) and as such has to be properly
planned.
 These decisions are irreversible and any mistake may cause the company heavy losses.

Importance of Investment Decisions

a) Such decisions are importance because they will influence the company’s size (fixed
assets, sales, and retained earnings).
b) They increase the value of the company’s shares and thus its credibility.
c) The fact that they are irreversible means that they have to be made carefully to avoid any
mistake which can lead to the failure of such investment.
d) Due to heavy capital outlay, more attention is required to avoid loss of huge sums of
money which in the extreme may lead to the closure of such a company.

However, these decisions are influenced by:

i) Political factors – Under conditions of political uncertainty, such decisions cannot be

made as it will entail an element of risk of failure of such investment. Thus political
certainty has to be analysed before such decisions are made.
ii) Economic factor such as the degree of competition, performance of economy,
changing tastes
ii) Technological factors – These influence the returns of the company because such
technology will affect the company’s ability to utilise its assets to the utmost ability in
particular if such assets become obsolete and cannot generate good returns .

Methods of Analyzing Investment

Capital Budgeting Methods.
There are two methods of analyzing the viability of an investment:

a) Traditional methods

 Pay back period method

 Accounting rate of return method

b) Modern methods (Discounted cash flow techniques)

  NPV – Net present value method
 IRR – Internal rate of return method
 PI – Profitability index method

Methods to be used, must meet the following:

i) They should rank ventures available in the investment market according to their viability
i.e. they should identify which method is more viable than others.
ii) They should rank a venture first if the venture brings in return earlier and in large
lumpsums than if a venture brought in late and less inflows over the same period.
iii)Should rank any other projects as and when it is available in the investment market.
iv)Such methods should take into account that all returns (inflows), must be cash returns as it is
necessary to be able to finance the cost of the venture.

TRADITIONAL METHODS

Pay back period method

 This method gauges the viability of a venture by taking the inflows and outflows over
time to ascertain how soon a venture can payback
 PBP (or payout period or payoff) is that period of time or duration it will take an
investment venture to generate sufficient cash inflows to payback the cost of such
investment.
 This is a popular approach among the traditional financial managers because it helps
them ascertain the time it will take to recoup in form of cash from operations the original
cost of the venture.
 This method is usually an important preliminary screening stage of the viability of the
venture and it may yield clues to profitability

Computation of payback period:

1.Under uniform annual incremental cash inflows – if the venture or an asset generates uniform
cash inflows then the payback period (PBP) will be given by:

PBP = Initial cost of the venture

Annual incremental cost

e.g. If a venture costs 37,910/= and promises returns of 10,000/= per annum indefinitely then the
PBP == 3.79 years

The shorter the PBP the more viable the investment and thus the better the choice of such
investments.

2.Under non-uniform cash inflows:

Under non-uniformity PBP computation will be in cumulative form and this means that the net
cash inflows are accumulated each year until initial investment is recovered.

Example
Assume a project costs Sh.80,000 and will generate the following cash inflows:

Cash inflows Accumulated inflows

Inflows year 1 = 10,000 10,000
Inflows year 2 = 30,000 40,000
Inflows year 3 = 15,000 55,000
Inflows year 4 = 20,000 75,000
Inflows year 5 = 30,000 105,000

The Sh.80,000 cost is recovered between year 4 and 5.

During year 5 (after year 4) Sh.5,000 is (80,000 – 75,000) is required out the total year 5 cash
flows of 30,000.
5,000
Therefore the PBP = 4yrs  = 4.17 years
30,000
Example
Cedes limited has the following details of two of the future production plans. Only one of these
machines will be purchased and the venture would be taken to be virtually exclusive. The
Standard model costs £50,000 and the Deluxe cost £88,000 payable immediately. Both
machines will require the input of the following:

i) Installation costs of £20,000 for Standard and £40,000 for the Deluxe
ii) A £10,000 working capital through their working lives.

Both machines have no expected scrap value at end of their expected working lives of 4 years for
the Standard machine and six years for the Deluxe. The operating pre-tax net cash flows
associated with the two machines are:

Year 1 2 3 4 5 6

Standard 28,500 25,860 24,210 23,410 - -

Deluxe 36,030 30,110 28,380 25,940 38,500 35,100

The deluxe machine has only been introduced in the market and has not been fully tested in the
operating conditions, because of the high risk involved the appropriate discount rate for the
deluxe machine is believed to be 14% per annum, 2% higher than the rate of the standard
machine. The company is proposing the purchase of either machine with a term loan at a fixed
rate of interest of 11% per annum, taxation at 30% is payable on operating cash-flows one year
in arrears and capital allowance are available at 25% per annum on a reducing balance basis.

Required
For both the Standard and the Deluxe machines, calculate the payback period.

Solution
Establish the cash flows as follows:

Pre-tax inflows (EBDT) XX

Less depreciation = capital allowance (XX)
Earnings before tax XX
Less tax (XX)
Earnings after tax XX
Add back capital allowance/depreciation XX
Operating cash flows XX

Note
Capital allowance/depreciation is a non-cash item thus when deducted for tax purposes, it should
be added back to eliminate the non-cash flow effects.

Cash flows for standard machine:

Year 1 2 3 4 5

Pretax inflow 28,500 25,850 24,210 23,410 -

Less allowance (depreciation) 17,500 13,125 9,844 7,383 -
Taxable cash inflows 11,000 12,735 14,366 16,027
Tax @ 30% 1 yr in arrears -___ 3.300 (3,831) (4,310) (4,808)
11,000 9,435 10,545 11,717 (4,808)

Add back capital allowance 17,500 13,125 9,844 7,383 -

Operating cash flows 28,500 22,560 20,389 19,100 (4,808)
Add working capital realised - - - 10,000 -
Total cash flows 28,500 22,560 20,389 29,100 (4,808)
CASHFLOW FOR DULEX MACHINE
Year 1 2 3 4 5 6 7

Pretax inflows 36,030 30,110 28,380 25,940 38,560 35,100 -

Less 32,000 24,000 18,000 13,500 10,125 7,594 -
(depreciation) 4,030 6,110 10,380 12,440 28,435 27,506 -
Tax @ 30% in - (1,209) (1,833) (3,114) (3,732) (8,531) (8,252)
arrears
Inflows after tax 4,030 4,901 8,547 9,326 24,703 18,975 (8,252)
Add back capital
Allowance 32,000 24,000 18,000 13,500 10,125 7,594 -
Add back 28,901 26,547 22,826 34,828 26,569 (8,252)
w/capital - - - - - 10,000 -
Total cash flows 36,030 28,599 26,547 22,826 34,828 36,569 (8,252)

*Pay back period for standard: Initial capital of Sh.7,000 is recovered during year 3. After year
2, we require 70,000 – 9,060 = 18,940 to recover initial capital out of year 3 cash flows of
Sh.20,389.

* Applying the same concept for Deluxe, payback period would be:
= 4.39 years

Accounting Rate of Return Method (ARR)

This method uses accounting profits from financial status to assess the viability of investment
proposal by diving the average income after tax by average investment. The investment would
be equal to either the original investment plus the salvage value divided by two or the initial
investment divided by two or dividing the total of the investment book value after depreciating
by the life of the project. This method is also known as financial statement method or book
value method. The rate of return on asset method or adjusted rate of return method is given by:

ARR = Average income x 100 or Average income – Average depreciation

Average investment Initial investment
Unlike PBP, this method will ascertain the profitability of an investment and it will give results
which are consistent with those given by return ratios e.g.

Shs.
Project X cost 500,000
Scrap value 100,000

Stream of income before depreciation and taxes are as follows:

Shs.
Year 1 100,000
Year 2 120,000
Year 3 140,000
Year 4 160,000
Year 5 200,000

Let tax = 50% and depreciation straight line. Calculate the accounting rate of return.

Solution
Depreciation = 500,000 – 100,000 = Shs.80, 000
5 years

Year 1 2 3 4 5

Income
Less depreciation
Earnings before tax EBT
Less tax @ 50%
EAT
100,000
80,000
20,000
(10,000)
10,000
120,000
80,000
40,000
(20,000)
20,000
140,000
80,000
50,000
(30,000)
30,000
160,000
80,000
80,000
(40,000)
40,000
200,000
80,000
120,000
(60,000)
60,000

Average income (EAT) = 32,000

Average investment = (500,000 + 100,000) ½ = 300,000

Or ARR = Average income x 100 = 32,000 x 100 = 10.67%
Average investment 300,000

Note
The best method of depreciation to use should be that which will produce larger depreciation
changes in the 1st few years of the assets life and lesser changes in the later years because this
will produce a higher tax shield to the company with higher value of inflows. Thus reducing
balance is preferred as compared to sum of digits and straight line method.

The salvage value should be treated as follows:

If the asset produces a salvage value at the end of the year, this will increase inflows for payback
period. This value is only used to ascertain how much the company will reduce original cost of
investment to obtain average investment.

Acceptance Rule of Payback Period (Pbp)

Using PBP method a company will accept all those ventures whose payback period is less than
that set by the management and will reject all those ventures whose PBP is more than that set by
the management. Alternatively, PBP may be gauged against the term of the loan in which case
the PBP method will give a high ranking to all those ventures paying back before the term of the
loan and the highest ranking will be given to those projects with shortest PBP. However, in
assessing the viability of a venture it is also important to see which venture brings returns earlier,
other things being equal.

Advantages of Payback Period

1. Simple to use and understand and this has made it popular among executives especially
traditional financial managers in ascertaining the viability of a venture.
2. Ideal under high-risk investments because it will identify which venture will payback
earlier thus minimising the risks with a venture.
3. Advantageous when choosing between mutually exclusive projects because it will give a
clue as to which venture is viable if one considers the shortest PBP and the highest inflow of a
venture.

Disadvantages of Payback Period

1. Does not take into account time value of money and assumes that a shilling received in
the 1st year and in the Nth year have the same value so as to rank them together to ascertain the
PBP which is unrealistic given that a shilling now is valuable than a shilling N years from now.
2. PBP method does not measure the profitability of a venture but rather measures the
period of time a venture takes to pay back the cost. The method is outside looking (lender
oriented rather than owner oriented).
3. PBP method ignores inflows after PBP and as such, it does not accommodate the element
of return to an investment.
4. This method will not have any impact on the company’s share prices because profitability
which is one of the most important factors in gauging the company’s value of shares is not a
function of PBP and as such the method fall short of meeting the criteria of investment appraisal.

Acceptance Rule of Accounting Rate of Return (Arr)

ARR method will accept those projects whose ARR is higher than that set by management or
bank rate and it will give highest ranking to ventures with highest ARR and vice versa.

Advantages
1. Simple to understand and use.
2. Readily computed from accounting data thus much easier to ascertain.
3. It is consistent with profitability objectives as it analyses the return from entire inflows
and as such it will give a clue or a hint to the profitability of venture.

Disadvantages
1. It ignores time value of money.
2. It does not consider how soon the investment should recover the cost (it is owner looking
than creditor oriented approach).
3. It uses accounting profits instead of cash inflows some of which may not be realisable.