CAPITAL BUDGETING

UNIT 7
 OUTLINE OF PRESENTATION

1) Discuss the purpose for capital budgeting

2) Outline capital budgeting decision making
process
3) Discuss types of capital budgeting
decision
4) Mention the key challenges in capital
budgeting
5) Apply the various methods to capital
budgeting
OUTLINE OF PRESENTATION CONT’D

6) Sensitivity analysis in capital budgeting

7) Capital budgeting under risk &
uncertainty
8) Capital rationing decision- Soft & hard
9) Capital budgeting under hyper inflation
condition
10)Buy or lease asset decision under capital
budgeting
CAPITAL BUDGETING

 Capital budgeting is concerned with

making an investment decision. This is
so, because capital is scarce and have
alternative uses.

The desire to invest in the most optimal

investment opportunity is crucial, since
investment decisions are not reversible.
OBJECTIVE OF CAPITAL BUDGETING

1) To determine which specific investment

projects the firm should accept.

2) To determine the total amount of capital

expenditure which the firm should
undertake.

3) To determine how portfolio of projects

should be financed.
CAPITAL BUDGETING DECISION MAKING
PROCES

1) Set objective, to maximize

shareholders wealth

2) Search for investment opportunities

3) Identify state of nature

4) List the possible outcome

CAPITAL BUDGETING DECISION MAKING
PROCESS

4) Measure the pay offs

5)
6) Select investment project

7) Obtain authorization and implement

8) Review capital investment decisions

 CAPITAL EXPENDITURE BUDGET

1) Purchase of fixed assets such as plants and

machines
2) Construction of recreational facilities ,Clubhouse
3) Building of an infrastructural facility , Electricity,
roads
4) Provision of social facility ,Health care,
education
5) Development of new product lines and
technologies
OBJECTIVES OF THE APPRAISAL
PROCESS

1) To maximize return on investment

2) To reduce cost associated with any

investment
CHALLENGES TO CAPITAL BUDGETING

1) Cash flows estimation (Initial capital

outlay, inflows, and outflows during
the year)

2) The timing of cash inflows (payments

and return periods uncertain)
METHODS OF INVESTMENT APPRAISAL

1) Return on capital employed (ROCE)

2) Net Present Value Method(NPV)
3) Pay Back/ Discounted Pay Back
Method (DPBM)
4) Profitability Index (PI)
5) Internal Rate of Return (IRR
ACCOUNTING RATE OF RETURN (ROCE)

There are several acceptable definitions

of ROCE, but we will limit ourselves to
the definition below. It expresses the
Average Annual Profit before Interest
and Tax, as a percentage of the, initial
capital outlay.

× 100
ROCE = Average ( APBI T)
Initial Capital Outlay
QUESTION 1

A project involves the immediate purchase

of an item of plant costing GH₵110,000. It
would generate annual cash flows of
GH₵24,000 for five (5) years, starting in
year1. The plant purchased would have a
scrap value of GH₵10,000 in the fifth year,
when the project terminate. Depreciation is
on straight line basis.

Required:
Calculate the ROCE of the Project
SOLUTION
Annual cash flows are taken to be profit before
depreciation but for ROCE you need Profit After
depreciation.

1) Average Annual Depreciation ….working 1

= Cost of Asset – Residual Value

Number of years

= (₵110,000 - ₵10,000)/5

= GH₵20,000 = Annual Depreciation

SOLUTION CONT’D

2) Average Annual Profit…working 2

= Annual Profit - Annual Depreciation

= ₵24,000 - ₵20,000

= ₵4,000 = Average Annual Profit

 SOLUTION CONT’D

ROCE = Average (APBI T) x 100

Initial Capital Outlay

ROCE = ₵4,000 = 3.6%

₵110,000
ADVANTAGES ( ROCE )

1) Simple to calculate and explain

2) Uses accounting profit
3) Gives percentage measure
4) Appraise, motivate, evaluate
performance
DISADVANTAGES ( ROCE)

1) It ignores the time value of money

2) It is based on profit which is highly
subjected to window dressing by
managers
3) To make an investment decision a target
return is needed to compare actual
return with
4) Definition of investment base is
problematic
QUESTION 2
Tallow company plan to buy a machine costing GH₵ 250,000
which will last for four years and then be sold for GH₵ 5,000.
Net cash flows before tax are to be as follows:

Time (Year) T1 T2 T3 T4
Net Cash flows 122,000 143,000 187,000 78,000

Tallow company has a target return on capital employed of

20%. Depreciation is charged on a straight line basis over the
life of assets. Required, calculate the before tax Return on
Capital Employed based on the average investment and
comment on your findings.
SOLUTION
Step1: Cash flow before tax ( Annual Profit)

= Summation of NCF

=122 + 143 + 187 + 78 = ₵530

Total depreciation = (250,000 - 5,000) = ₵245,000

Step 2: Average annual accounting profit

=(530 - 245) / 4
= ₵71,250
SOLUTION CONT’D

Step 3: Average investment , At Book Value

Cost + Residual Value / 2

= (250,000 + 5,000) / 2= ₵127,500

Hence, ROCE = (71,250 / 127,500 x 100 = 56%

The target return is 20% and the expected ROCE

is 56% The purchase of the machine is
recommended
PAYBACK METHOD

This is the measure of time it takes to recoup

the initial cash outlay on a project. Pay back is
commonly used for initial screening of
projects. It is a risk reduction measure, project
with shorter life span are preferred to long-
term projects, by reducing the uncertainty
surrounding the cash flows.

Pay back = Initial Payment

Annual Cash flow
QUESTION 3

If ₵2,000,000 is invested to earn ₵500,000 per

annum for seven 7 years (these being net
cash earnings).What is the pay back period?

Payback Period = 2,000,000 = 4 year

500,000
It would take the project 4 years to recoup
the initial investment of ₵2,000,000 by
generating a constant cash inflow of
₵500,000 each year
DISCOUNTED PAYBACK METHOD

 It measures the time it will take before a

project’s cumulative NPV of cash inflows
from the projects begins to exceed the
initial outflows.

 Itis similar to the payback method, but

uses discounted cash flows rather than
non- discounted cash flows used to
measure the ordinary payback period.
QUESTION 4
If you have a project with cost of capital
10% and with the following cash flows
shown below, what is the discounted
payback period?
Year Cash flows DF(10 $ PVs $C/NPV
$ %)
0 (100,000) 1.000 100,00 (100,000)
0
1 +30,000 0.909 27,270 (72,730)
2 +50,000 0.826 41,300 (31,430)
3 +40,000 0.751 30,040 (1,390)
4 +30,000 0.683 20,490 +19,100
5 +20,000 0.621 12,420 +31,520
SOLUTION

DPP = 3year + 1,390 /20,490 x 12

= 3 years, 1 month

DPP = is approximately 4 years.

ADVANTAGES (PAYBACK METHOD)

1) It is simple to calculate
2) It is a measure of liquidity of the
project
3) It is a measure of risk
4) It is used for initial screening of
projects
5) It is the most common and
widely use
PAYBACK METHOD (DISADVANTAGES)

1) Cash flows after the cut off periods are

ignored
2) It ignores the time value of money
3) Setting the cut off payback period is
subjective
4) There is no clear acceptance or
rejection criteria
NET PRESENT VALUE METHOD

The Net Present Value is the present

value of all the discounted cash flows of
the project less the initial cash outlay.

NPV = - CO + CI + C2 + C3 + Cn
(1+r)1 (1+r)2 (1+r)3
(1+r)n

Where:
NET PRESENT VALUE METHOD

Co = initial capital outlay.

n = cash flows in(n) number of

years

r = is the discount rate

1 = is the discount factor

(I + r)
NET PRESENT VALUE METHOD CONT’D

Criteria:

1) Accepts all positive NPV projects, and

for

2) Mutually exclusive projects accept

projects with the highest NPV.
 QUESTION 5

Assuming you have expected cash flows

of $10,000 for year 1, $35,000 for year 2,
$52,000 for year 3, the initial cost is
$50,000. Cost of capital is 10%. What is
the NPV for the project? Should the
project be accepted?
SOLUTION

YEAR 0 1 2 3

$ $ $ $
CASHFLOWS 50,000 10,00 35,000 52,000
0
Discounting Factor 1.00 0.91 0.83 0.75
(10%)
NPV=
PV $27,150
of cash flows 50,000 9,100 29,050 39,000
Decision:
Yes the project should be accepted since the
NPV is positive.
 QUESTION 6 – ICAG EXAMS QUESTION
MAY 2005 ADAPTED

Mr. Mensa has just returned to the country after

20 years in exile . In order to establish himself at
home, he formed a company, Mensa & Associates
Limited, located in the export processing zone.
The following information is provided:

1) Feasibility study costing ₵12 million had been

carried out.

2) The study suggested that a selling price of

₵5,000 per unit should be set and demand is
expected to be 50,000 units per annum.
QUESTION 6 CONT’D
3) The directors estimate that the company
will benefit from EDIF fund at a total cost
of capital 15%.
4) The manufacturer of the product will
require a new machine costing ₵200
million which will be worthless when
demand for the product ceases in 4 year
time.
5) The variable cost of producing the
product are estimated at 3,000 per unit
and an additional overheads of ₵25
million will be incurred each year if
QUESTION 6 CONT’D

Assume that all cash inflows and

outflows will rise on the final day of
each year except the cost of the
machine which will be payable at the
start of the first year.

Required :
a) Determine the worthwhileness of the
project
b) Explain why NPV is preferred to IRR in
SOLUTION

Computation of contribution GH₵

Selling price 5,000

Less variable cost (3,000)
Contribution 2,000

Annual Demand 50,000 units

Total contribution (50,000x ₵2,000) =

100,000,000
SOLUTION CONT’D

Annual net contribution GH₵

Annual contribution 100,000,000

Less incremental fixed cost (25,000,000)
Annual net contribution 75,000,000

Co = 200,000,000
n = 4 years
Incremental fixed cost 25,000,000
SOLUTION CONT’D

(a) NPV : Ordinary Annuity

NPV = Co + C x 1 -1 1+rt
r r
= (200) + 75 (1/0.15 -1/0.15) (1.15)
= (200) + 75 (2.8549)
= (200 )+ 214
NPV = 14.123

(b) List the advantages of NPV over IRR

 QUESTION 7 – ICAG EXAMS QUESTION
NOV 2003 ADAPTED

Abrafi has just set up a company and has

recently commissioned the service of a firm
of management consultants at an estimated
cost of ₵50million. The consultant’s report to
date indicates that if the company
introduces its new line ‘kaki’ the following is
likely to result:

1) Sales of 20,000 units could be achieved if

the price were set at ₵200,000.
QUESTION 7 CONT’D

2) Variable cost of ₵175,000 per unit

3) Additional fixed costs through acceptance
would amount to ₵80 million per annum.
4) Life of the project - 4 years
5) Cost of capital - 10%
6) An additional₵300 million will have to be
spent on development before production
can commence. Included in the figure is an
amount of ₵200million which represents the
time spent on R & D personnel .
QUESTION 7 CONT’D
If they were not working on this project, the people
involved would devote their time to “pure
research”.

7) Special plant will have to be purchased for

₵1billion. This should be depreciated at
₵200million per annum for four 4 year- the
balance representing the scrap value at year 4 .
Required:
As management accountant, you are required to
report to the Board of Abrafi Limited, indicating
whether or not the project is worthwhile.
SOLUTION

Computation of contribution GH₵

Selling price 200,000
Less variable cost (175,000)
Contribution 25,000

Annual demand equal 20,000

units
Total contribution (20,000 x ₵25,000) =
500,000,000
SOLUTION CONT’D

Total contribution
500,000,000
Les incremental fixed cost
(80,000,000)
Net cash inflows
420,000,000

Initial capital outlay (300 -200)

100,000,000
SOLUTION CONT’D

NPV : Annuity Due

NPV = Co + C 1 -1 1 + r t + Ci
r r 1 + rt
= (1,100) + 420(1/0.1 -
1/0.1(1.1)+200/1.1
= (1,100) + 420 x 3.1698 +200 /1.10
=(1,100) + 1,331.32 +136.602
=(1,100 ) + 1,467.922
= (1,100) +1,467.922
=367.92
QUESTION 8
Ghana Energy Project has identified the
following independent projects to improve
electricity supply in Accra

Energy Capital Year 1 Year 2

Projects
Thermal -100 -100 +302
Hydro -50 -100 +302
Solar -200 +100 +107
Biogas -100 -50 +308
Waste -200 -50 +334
QUESTION 8

The cost of capital is 10%. Ghana Energy

Project has only $ 225m of finance available.
None of the projects can be delayed

Required:
which of the projects should the firm
accept? All projects are independent and
divisible
 SOLUTION

PROJECT CAPITAL NPV PV PI RAN

Thermal 100 58.00 158.6 1.59 3rd
7
Hydro 50 108.6 158.6 3.17 1st
7 7
Solar 200 -20.66 179.3 0.90 5th
7
Biogas 100 109.0 209.0 2.09 2nd
9 9
Waste 200 30.58 230.5 1.15 4th
8
SOLUTION

Capital Rationalization
PROJECTS CAPITAL AVAILABLE
$225
Hydro Power
(50)
Capital
Available 175
Biogas
(100)
Capital
Available 75
QUESTION 9 – ICAG EXAMS QUESTION
NOV2006 ADAPTED

Mr. Kofi Ntii is a young graduate who

has just qualified and has been
admitted into ICA membership. He has
inherited ₵50 million in his grandfather’s
estate and he intends to invest in either
of two projects. A consulting firm,
Quest and Associates limited, provided
the following information on the cash
flow of the two projects.
QUESTION 9 CONT’D

PROJECTS YEAR A B
Initial Outlay 0 5,000 5,000
Net Cash 1 2,600 1,800
inflows:
2 1,500 2,000
3 800 2,500
4 600 2,800
5 - 3,000
QUESTION 9 CONT’D

The initial cash outlays will occur

immediately and the net cash inflows will
arise at the end of each year. Given that the
cost of capital over the five (5) year life
span of the project is 12%.
Required:
Assess the two 2 projects above using:
I. Payback method
II. Net Present Value (NPV) method
III. Discuss two (2) merits and to (2)
demerits of the Pay Back Method and
QUESTION 10 – ICAG EXAMS QUESTION
NOV 2005 ADAPTED

It is often said that the Internal Rate of

Return (IRR) as a method of capital
investment appraisal has the basic
weakness that it does not highlight on
the absolute return on investment so that
for example a 20% return on ₵10,000,000
may be ranked higher than a 15% return
on ₵100,000,000 investment.
QUESTION 10 CONT’D

(a) Required:
I. Compare the NPV and IRR method of
investment appraisal, stating three (3)
strengths and three (3) weaknesses of
each method

II. Justify which of the two (2) methods will

be preferred in ranking mutually
exclusive projects
QUESTION 10 CONT’D

(b) You have been given the information

below with respect with to projects A
and B in Mobutu Limited.
PROJECTS
YEAR A B
0 30,000 300,000
1 7,200 69,000
2 8,640 79,200
3 10,380 91,200
4 12,420 105,000
5 14,940 120,600
QUESTION 10 CONT’D

Mobutu limited has an average

cost of capital of 10%.

Required:
I. Calculate Net Present Value
II. The Internal Rate of Return
ADVANTAGES (NPV)

Itconsiders the time value of money

Uses cash flows but not accounting
profit
Gives correct ranking for mutually
exclusive projects
Maximizes share holders wealth
DISADVANTAGES (NPV )

Use absolute figure which make

comparison difficult.
Determining the discount factor is
cumbersome.
Detailed long-term forecasting of
incremental cost and benefits are
required, and which is usually difficult.
INTERNAL RATE OF RETURN (IRR)

It is the discount rate at which when all

the cash flows from an investment are
discounted, NPV would be equal to Zero
(0). This is the break even point of the
project, where profit on the project just
equal to amount invested.

 IRR= A% + NPVa x (B% - A%)

(NPVa - (-NPVb)
QUESTION 11

Consider the following estimated cash flow

projections of Comma Limited. The cost of
capital is 15%. Given the information below
estimate the IRR.
YEAR 0 1 2 3
CASH FLOWS 75,00 20,00 30,00 50,000
0 0 0
SOLUTION

YEAR CASH FLOW DF( 12%) PVs

0 75,000 1.00 (75,000)
1 20,000 0.89 17,800
2 30,000 0.80 24,000
3 50,000 0.71 35,500
NPV 2,300
SOLUTION CONT’D

YEAR CASH DF( 14%) PVs

FLOW
0 75,000 1.00 (75,000)
1 20,000 0.88 17,600
2 30,000 0.77 23,100
3 50,000 0.67 33,500
NPV (800)
SOLUTION CONT’D

IRR = 12% + 2,300 x (%14 - 12%)

2,300 - (- 800)

= 12% + 0.74 x 2%

= 13.48%
SOLUTION

YEAR CASH FLOW PVs

DF( 13.48
%)
0 75,000 1.00 (75,000)
1 20,000 0.88 17,600
2 30,000 0.78 23,400
3 50,000 0.68 34,000
NPV
Decision: at the discount rate of 13.48% NPV0 is
equal to Zero (0). This is the break even point
of the project. Profit on the project just equal
to the cost.
ADVANTAGES OF IRR

1. It recognizes the time value of money

2. IRR calculation incorporate risk
3. It gives percentage measure
4. Cost of capital is not required to
compute IRR
5. Maximizes shareholders wealth
6. Uses relevant cash flows not
accounting profit.
DISADVANTAGES OF IRR

1. Its calculation is relatively

cumbersome.
2. Multiple IRR can be obtain on a given
project
3. Rejection / acceptance rules are not
clear
4. Sometimes no IRR exist
5. Statistical margin of error need to be
included in IRR calculation to make
PROFITABILITY INDEX (PI)

Profitability index is the ratio of the

present value of a project’s future net
cash flows to the initial outlay.

PI =
-Co
Where; PV = Present Value
t = Number of years
-C0 = the initial capital outlay
PROFITABILITY INDEX (PI)

Acceptance Criteria:

Accept all projects with profitability

index greater than one, and projects
with index less than one rejected.

PI
PI 1 = NPV 0
QUESTION 12

Assuming you have expected cash flows

of $20,000 for year 1, $55,000 for year
2, $62,000 for year 3, the initial cost is
$100,000. Cost of capital is 12%. What
is the Profitability Index of the project?.
What is your decision, accept or reject
the project.
SOLUTION

YEAR 0 1 2 3
Cash flows 100,00 20,00 55,00 62,00
0 0 0 0
DF 12% 1.00 0.893 0.797 0.712
100,00 17,86 43,83 44,14
0 0 5 4
PV = $105,839
SOLUTION CONT’D

PI = 105,839
100,000
= 1.06

 Accept the project at the PI of 1.06,

since this is greater than one and will
give NPV greater than zero 0
 MERITS (PROFITABILITY INDEX )

1) It uses cash flows not accounting

profits
2) It recognizes the time value of money
3) Maximizing shareholders wealth
4) Appropriate for capital rationing
decision
DEMERITS (PROFITABILITY INDEX )

 It required detailed long term forecasting

of the incremental cost and benefits.
Doing this is cumbersome.
 BUDGETING UNDER RISK AND
UNCERTAINTY
 Risk:
refer to a situation where the future
is unclear and there is more than one
possible outcomes. It is the chance that
the actual outcome will differ from that
predicted. Risk is measured by standard
deviation.

 Uncertainty: are events whose outcome

can not be estimated with statistical
probabilities. Risk can be so measured
with statistical probabilities.
 BUDGETING UNDER RISK AND
UNCERTAINTY CONT’D
 Certainty: refers to state where only one
outcome will arise from taking a
decision. Example, investment in
treasury bill is a risk free (rf) investment.

Total Risk is equal to Business risk plus

(+) Financial risk (Systematic and
Unsystematic risks). Standard deviation
is used to measure total risk,
 TOTAL RISK – SYSTEMATIC &
UNSYSTEMATIC

 Systematic risks are those risk pervasive in

the economy and cannot be diversify away.
Beta is used to measure systematic risk.
Example, changes in the rate of inflation,
changes in exchange rate.

 Unsystematic risk are those risks that can be

diversify away. Investors are not compensated
for bearing unsystematic risk. Example,
flooding of the company’s premises, war
TECHNIQUES FOR DEALING WITH RISK

1) The expected NPV rules

2) The Risk Adjusted Discount Rate
3) Sensitivity Analysis
4) Decision Tree
5) Expected Values
QUESTION 13
Shorten Limited needs to purchase a
machine to manufacture a new product. The
choice lies between two machines (A & B).
Each machine has an estimated life of three
years with no scrap value.

Machine A will cost $30,000 and machine B

will cost $40,000 payable immediately in
each case. The total variable cost of
manufacture of each unit are $2.00 if made
on machine A , but only $1.00 if made on
machine B. This is because machine B is
QUESTION 13 CONT’D

The demand for the product is uncertain

but is estimated at 2,000 units for each
year, 3,000 units for each year or 5,000 for
year. These are the various forecasted
demand conditions facing the product each
year.

The sales manager has placed probabilities

on the level of demand as follows;
QUESTION 13 CONT’D

Annual Demand Probability

2,000 0.2
3,000 0.6
5,000 0.2
Shorten Limited’s cost of capital is 6% per year.
The decision is unaffected by taxation and fixed
costs.

Required:
The expected NPV for each machine and state
your conclusion.
 CONTRIBUTION - CASH FLOWS FOR
MACHINE “A”

YEAR CONT= $8- $2 = D= D= 3,000

$6 2,000 D=5,00
0
EXTIMATED CASH FLOWS

0 $30,00
$30,000 $30,000 0
1 ($6 X 2,000) = ($6 X3,000) = ($6 30,000
12,000 18,000 X5,000) =
2 ($6 X 2,000) = ($6 X 3,000) = ($6X5,000) 30,000
12,000 18,000 =
3 ($6 X2,000) = ($6 X 3,000) = ($6 30,000
12,000 18,000 X5,000) =
 EXPECTED NPV FOR MACHINE
“A”
YEAR D. FACTOR D= 2,000 D= 3,000 D=
5,000
DISCOUNTED CASH FLOWS
0 1.00 (30,000 ) (30,000 )
1.00 1.00 (30,000)
1 (12,000 x 0.94 11,280 (18,000x 16,920 (30,000 28,200
= 0.94) = x0.94) =
2 (12,000 10,680 (18,000 16,020 (30,000 x 26,700
x0.89) = x0.89) = 0.89) =
3 (12,000 x 10,080 15,120 (30,000 25,200
0.84) = (18,000x0.84) = x0.84) =
a NPV $2,040 $18,060 $50,100
b EXPECTED NPV = (0.2 X $2,040) + (0.6 X $ 18,060) + ($0.2 X
$50,100) = $21,264
 CONTRIBUTION - CASH FLOWS FOR
MACHINE “B”

YEAR CONT= ($8- $1) = D= D= 3,000 D=5,000

7 2,000
EXTIMATED CASH FLOWS
0 $40,00
$40,000 $40,000 0
1 ( $7 X 2000) = ($7 X3,000) = ($7 X5,000) 35,000
14,000 21,000 =
2 ($ 7 X 2000) = ($7 X 3,000) = ($7X5,000) 35,000
14,000 21,000 =
3 ($7 X2000) = ($7 X 3,000) = ($7 X5,000) 35,000
14,000 21,000 =
 EXPECTED NPV FOR MACHINE “B”

YEAR D. FACTOR D= 2000 D= 3000 D=

5000
DISCOUNTED CASH FLOWS
0 (40,000 ) (40,00 1.00
1.00 1.00 0) (40,000)
1 (14,000 x 13,160 (21,000) 19,740 (35,000 x 0. 94) =
0.94) = x0.94) = 32,900
2 (14,000 12,460 (21,000 x 18,690 (35,000 x0.89) =
x0.89) = 0.89) = 31,150
3 (14,000 x 11,760 (21,000 x 17,640 (35,000 x0.84) =
0.84) = 0.84)= 29,400
a NPV ($2,260) $16,07
0 $53,450
b EXPECTED NPV = (0.2 x – 2,260) + (0.6 x $16,070) + ( 0.2 x
$53,450) = $19,808
Decision: Select machine “A” since it produces the highest
QUESTION 14 – ICAG EXAMS QUESTION
MAY 2003 ADAPTED
A firm , private sector development company ,
receives $90 billion from one of the donor
countries to invest in any three of the various
presidential initiatives. The outcome of these
projects depends on two state of economic
circumstances. Each outcome will last one year
and the Circumstances
Economic cash flows alternatives are estimated
Stable Fragile
to be as follows:
Probability of Economic 0.5 0.5
Circumstances
Cash flows:
Industrial starch project ($40billion $60 billion
)
Cassava project $50 billion ($50
QUESTION 14 CONT’D
The cash flows are gotten after deducting initial outlay
of:
$40 billion for the industrial starch project
$50 billion for cassava project
$90 for cotton project
The following alternatives are available for the
investment of the $90 billion.

Accept the industrial starch project and reject the others

Accept Cassava project and reject the remaining
projects
Accept Cotton project and reject the remaining projects
Accept both Industrial Starch and Cassava projects
QUESTION 14 CONT’D

The company has not identified any

other profitable projects

Required:
Compute the expected values for each
alternative and advise management if a
decision is to be made on the basis of
maximizing expected values and
minimizing risk.
SOLUTION
Industrial Starch STABLE FRAGILE TOTAL
Cash flows (40billion 60billion 0
Probability 0.5 0.5 0
EMV ($20 $30 billion $10
billion) billion

Cassava Project STABLE FRAGILE TOTAL

Cash flows $50 billion ($50 0

billion)
Probability 0.5 0.5 0
EMV $25 billion ($25 0
billion)
SOLUTION CONT’D

Cotton Project STABLE FRAGILE TOTAL

Cash flows $9 $8 billion 0
billion
Probability 0.5 0.5 0
EMV $4.5 $4 billion $8.5
billion billion
Both Industrial & STABLE FRAGILE TOTAL
Cassava
Industrial Starch project - ($20billio $30 billion 0
EMV n)
Cassava project - EMV $25 ($25 0
billion billion)
$5 billion $5 billion 10
SOLUTION CONT’D

Decision :

This is the expected monetary value

which will give the maximum return on
the investment and less risk associated
with the various investment.
QUESTION 15 - ICAG EXAMS QUESTION
NOV 2001 ADAPTED – Decision Tree

Volta Merchant Bank Limited is

considering developing a new banking
product to achieve its deposit
mobilization plan. The Finance Director
estimated that development cost of
₵250million will be incurred and there is
a 75% probability that the development
efforts will be successful and a 25%
probability that the development efforts
will be unsuccessful (failure).
QUESTION 15 CONT’D

If the development of the new product

is successful , the product will be
marketed and it is estimated that:

I. If the product is very successful,

profit will be ₵540 million .

II. If the product is moderately successful, profit

will be ₵100 million.
QUESTION 15 CONT’D

III. If the product is a failure, there will be a loss

of ₵400 million.

The estimated probability of each of the

above events are as follows:

Very successful ------------------------0.4

Moderately successful-----------------0.3
Failure------------------------------------0.3
QUESTION 15 CONT’D

Required:
a) Present the above information in a decision
tree analysis and expected values to indicate
the available alternatives courses of action (10
marks).

b) Distinguish between Risk and Uncertainty in

business decisions (6 marks)

c) Identify four (4) measures of risk and

uncertainty (4 marks)
SENSITIVITY ANALYSIS

 Itis a procedure that calculates the changes

in the Net Present Value (NPV), given a
change in one of the cash flows elements
such as product price. Sensitivity analysis
helps mangers to gain better understanding
of the nature and degree of risk associated
with a project. It reveal the margin of safety
associated with each key variable relating to
a project. It is a form of break even analysis.
The point at which NPV is equal to Zero is
the break – even point.
SENSITIVITY ANALYSIS
 Sensitivity analysis test how the overall
expected outcome of the project is likely to
alter in response to changes in any of the
input variables (selling price, initial outlay,
NPV and the like).

 Objectives: to determine how sensitive the

NPV is to change in any of the key variable
and to identify which variable has most
significant impact on NPV. The aim is not to
quantify risk, but to identify the impact on
NPV of the changes to key assumptions.
 QUESTION 16

Swift Limited, which has a cost of capital of

12% percent is considering the investment of
$7,000,000 in an improved molding machine
project with a life of four 4 years. The garden
ornaments produced will retail at $9.20 each
and cost $6.00 each to make. It is expected
that 800,000 ornaments will be sold each year.

Required: What is the level of change in the

key variables for the project?
SOLUTION TO QUESTION 16

Contribution = (Selling Price – Variable cost)

= $9.20 - $6)
= $3.2
YEAR 0 1 2 3 4
Capital 7,000 0 0 0 0
Contributi 0 2,560 2,560 2,560 2,560
on
NCF 7,000 2,560 2,560 2,560 2,560
DF ( 12%) 1.00 0.893 0.797 0.712 0.636
PVs (7,000) 2,286. 2,040. 1,823. 1,683.1
08 32 72 6
SOLUTION TO QUESTION 16 CONT’D

2) Change in Investment:
NPV = (S - V) x Demand) x CDF – 1 = 0
= ($9.20 - $6) x 800,000 x 3.038 –1 =
0
= 7,831,280 – 1 = 0
Hence 1 = 7,831,280 – 7,000,000 x100
7,000,000
= 11.104%
This means that, the Initial investment should
increase by 11%
SOLUTION TO QUESTION 16 CONT’D

(3)Changes in Selling Price:

NPV = (S - V x Demand x CDF – Co)
= (S - $6) x 800,000 x3.038 –
7,000,000)
S = 6.00 +(7000,000)/(800,000x3.038)
= $8.88
Change = $9.20 – $8.88 x100
9.20
3.5%
Selling price should decrease by 3.5%
SOLUTION TO QUESTION 16 CONT’D

(4)Change in Variable Cost:

NPV = (9.20 - V) x (Demand x CDF – CO) = 0

V = 9.2 – (7000,000)/800,000 x3.038) = 6.32
% = 6. 32 - 6.0 x 100
6.0
= 5.33%
Decision:- Variable cost must increase by 5.33%
SOLUTION TO QUESTION 16 CONT’D

5) Changes in Sales Volume:

NPV = (9.20 – 6) x Demand x 3.038 – 7000,000

=0
D = 7000,000/ (9.20 – 6.00) x 3.038
= 7000,000/ 9.7216 = 720,046
% = 720,046 – 800,000 x100
800,000
= 10%
To break even quantity sold should be reduce
by 10%
SOLUTION TO QUESTION 16 CON’D

(5) Change in discounting Factor:

NPV= (9.20 – 6) x 800,000 x 3.038 – 7000,000 = 0

= 7000,000 /(9.20 - 6.00) x (800,000) = 0
= 700,000 / 2,560,000 = 2.734375

From the annuity table 2.734 = 17%

Hence, 3.038 = (12%)
Change in DCF 5% or 42%
QUESTION 17- ICAG EXAMS QUESTION
NOV 2005 ADAPTED
The Directors of Modern Cylinder Company
Limited are considering an expansion program
which will involve the following:
Capital investment ---------------------------------
1.25 billion
Annual Cash flows ----------------------------------
450 million
Life of project-----------------------------------------5
years

The Directors are positive that due to the

QUESTION 17 CONT’D
However, they are concerned that, in the
past, forecast have proved inaccurate. You
have been asked to calculate the extent to
which each of the following variables can
differ from the forecast before the project is
rejected on the basis of NPV appraisal.

I. Capital investment
II. Annual Cash inflows
III. Life of project
SOLUTION TO QUESTION 17

NPV = Co + C 1 -1 1+rt
r r
= (1250) + 450 (1/0.12 -1/0.12)
(1.12)
= (1250) + 450 (3.6047)
= (1250) + 1622
NPV = 372
SOLUTION TO QUESTION 17 CONT’D

(i) Initial investment / Capital Outlay:

Hence the rate of change
= PVs – Co
Co
=1622 – 1250
1250

= 29.8%

If the initial capital outlay increases beyond 1622

then the project will produce negative NPV.
SOLUTION TO QUESTION 17 CONT’D

ii) Annual cash inflows

NPV = 0
= Co + x (CDF)
0 = (1250) + x ( 3.6047)
= 1250 = x 3.6047
x = 1250
3.6047
x = 346.77
SOLUTION TO QUESTION 17 CONT’D

Rate of change in Annual Cash inflows

=450 - 346.77
450
= 22.9%

If the cash inflows decreases beyond

346.77 the project will produce negative
NPV.
SOLUTION TO QUESTION 17 CONT’D

iii) Life span of the project:

NPV = 0
= 1250 = 450 1 -1 (1.12)
0.12 0.12
= 1250 = 1 -1 (1.12)
450 0.12 0.12
=2.7778 – 8.3333 = - 1
0.12 (1.12)
SOLUTION TO QUESTION 17 CONT’D

- 5.5555 (0.12 ( 1.12) = 1

0.12 (1.12) = 1
5.5555
= 0.12(1.12) = 0.18
1.12 = 0.18
0.12
1.12 = 1.5 ( find the log of each
variable)
SOLUTION TO QUESTION 17 CONT’D

n log 1.12 = log 1.5

n ( 0.0492) = 0.17609
n = 0.17609
0.0492
= 3.58

Rate of change
5 – 3.6 x 100 = 28%
5
BUDGETING UNDER INFLATION

Inflation:Is a situation where there is

a sustained increase in the general
price levels of goods unaccompanied
by any other changes- such as
increase in quantity. With inflation,
one must pay more money across
time to acquire the same goods and
services.
BUDGETING UNDER INFLATION

Question:
Inflation is 5% on goods costing $100 at
the beginning of the year. How much will
you pay to buy the same goods at the
end of the year. ?

Solution:
(1.05 x $100) = $105
PROBLEMS IN BUDGETING UNDER
INFLATION

1) The estimation of future cash flows is

made more troublesome.

2) The rate of return required by the

firm’s security holders such as
shareholders will rise with inflation.
 RATES OF RETURN
NORMINAL VRS REAL RATES

Nominal Interest Rate: this is the rate of

interest in an inflationary economy -
say15%.
Nominal Rate = ( I + r) (1 + inflation) -
1

Real Interest Rate: this is the interest

rate existing in an inflation free economy
- say 10%.
QUESTION 18
Assume the real return is 10% and inflation is
expected to be 5%.What is the nominal rate
of return and what is your proof?

Solution to Question 18
Nominal Rate = I + r 1+ inflation - 1
= 1.10 1.05 -1
= 15.5%

Real Rate = 1+N / 1+Inflation - 1

= 1.155 / 1.05) -1
= 10% your proof
QUESTION 19

You invest in a project that will produce real

cash flows of -$100, year zero, and then $35,
$50 and $30 in the three respective years. If
the nominal discount rate is 15% and the
level of inflation in the economy is 10%.
Required: What is the NPV of the project?

NB: You must discount nominal cash flows

with nominal rate, and real cash flows with
real discount rate. Hence, inflate the cash
flows before discounting it at the nominal
 SOLUTION TO QUESTION 19

Step 1: Inflate the Real CF to obtain Nominal

CF
Year Real CF Inflate CF at Nominal
10% CF
0 100 1.00 x 100 (100)
1 35 1.10 x 35 38.5
2 50 1.10 x 50 60.5
3 30 1.10 x 30 39.9
SOLUTION TO QUESTION 19 CONT’D

Step 2: Discount the Nominal CFs with

Nominal Rate
Year Cash flow DF (15%) PVs
0 100 1.00 (100)
1 38.5 0.869 33.50
2 60.5 0.756 45.73
3 39.9 0.658 26.25
NPV $5.5
QUESTION 20
DJ Limited has generated the following forecasted
cash flows for capital budgeting project:
Year 0 1 2
Capital $1,210
Revenue (Real terms) 1,900 2,000
Cash expenditure (Real 950 1,000
Depreciation (Straight Line 605 605
Inflation is estimated to be 10% per year over next 2
years. Cash flows of the project to be discounted at
the nominal rates of 15.5%. Tax is 40%. Estimate the
NPV using Real and Nominal approaches.
SOLUTION: Real Approach

Step 1: Generate cash flows using Real

Approach
Year 0 1 2
Capital 1,210 - -
Revenue +1,900 +2,000
Expenses -950 -1,000
Depn. 605/1.1= - 605/1.1 -500
550
Income 400 500
Tax 40% -160 -200
PAT 240 300
Depn + 550 500
SOLUTION CONT’D
Step 2: Discount CF Using Real
Discount Rate (5%)

Real discount rate = (1+N) / (1+

inflation) -1
= (1.155) / (1.10) - 1
= 5%

NPV = -1,210 + 790

+ 800
SOLUTION CONT’D – Nominal Approach

Step 1: Generate Cash flows using Nominal

Approach
YEAR 0 1 2
Capital 1,210 - -
Revenue (1,900x 1.1 = 2090 (2,000x1.1) = 2420
Expense (950 x1.1) = -1045 (1000x1.1 = -1210
Dep -605 -605
Income 440 605
Tax (40%) -176 -242
PAT 264 363
+ Dep 605 605
Cash 1,210 869 968
SOLUTION CONT’D

Step 2 : Discount CF Using Nominal

Discount Rate given in question (15.5%)

NPV = - 1,210 + 869 + 968

(1.155) (1.155)2
= $268
CAPITAL RATIONING

Capital Rationing: This occurs when

funds are not available to finance all
positive NPV projects/ or wealth
enhancing projects. We have two types
of capital rationing - soft and hard
capital rationing.

Soft Capital Rationing: Occurs when

internal management imposed limits on
investment expenditure. Such limits
CAPITAL RATIONING

 Hard Capital Rationing: This relates to

restrictions imposed on the amount of
capital available to a firm by external
sources, say a financial institution.

 For instance, the external market may

disagree with the company as to the
viability of the investment. In finance,
capital rationing is used to deal with such
situations.
QUESTION 20
Suppose that your company had the
following investment opportunities:

PROJECT OUTLAY YEAR 1 YEAR 2

A 10,000 20,000 5,000
B 5,000 5,000 20,000
C 5,000 5,000 15,000
Only $10,000 of finance is available to undertake the
investments. Cost of capital is 10%. Which of the
projects should be selected.?
SOLUTION

PROJ OUTLAY PV NPV PI RANK

A 10,000 22,31 12,310 2.2 3rd
0
B 5,000 21,06 16,065 4.2 1st
5
C 5,000 16,93 11,935 3.38 2nd
5
Decision: Select the project that offers the
highest NPV value per $UDS of initial outlay. As
the capital available is $10,000, only projects B
THE EQUIVALENT ANNUAL COST
METHOD

It is the process of finding annuity payment

per year in such a way that the PV of all
payment is equal to NPV. Suppose ABC has
to choose between two machines of unequal
lives. Both machines can do the same job,
but they have different time periods.

EAC = NPV
Annuity Factor
QUESTION 21
DAC Limited has to choose between 2 machines.
Machine A costs less than Machine B but will not last
long . Below are the cash flows from the 2 machines:
YEAR & CASH FLOWS
Machine 0 1 2 3 4
A 500 120 120 120 -
B 600 100 100 100 100

Maintenance expenses of machine A= $120, B= $100

to be paid each year for the project life. Discount rate
is 10%. Revenue for the year are assumed to be same
regardless of the machine. Required: Which Machine
should DAC limited select
SOLUTION

Using Annuity = 1–1 (1+r)t

r r

A =10% for 3 years = 1/.10-1/.10(1.10)3 =

2.487
B =10% for 4 years = 1/.10-1/.10(1.10)4 =
3.169

NPV a = (2.487 x$120 + $500) = 798.42 = A

NPV b = (3.169 x $100 + $600) = 916.99 = B
ALTERNATIVE SOLUTION

NPVa = Co + C (1/r - 1/r ( 1+ r)n

= 500 + 120 (1/.10 -1/.10(1.10)
= 500 + 120 x2.486
= 500 +298.42
= 798.44

NPVb = 600 + 100 (1/.10 -1/.10(1.10)4

= 600 + 100 x 3.169
= 600 + 316.9
= 916.9
SOLUTION

EAC = NPV
Annuity Factor

EAC (Machine A) = 798.44

2.487
= $ 321.04
SOLUTION

EAC ( Machine B) = 916.9

3.169
= $289.36

Decision :

Select machine B with the lowest EAC.

LEASE OR BUY DECISIONS

A firm may be faced with a decision to

lease or buy an asset outright, to do so,
the firm need to decide which of the
options offers the lowest cost.

A lease is a contract between a lessor and

a leasee for hire of a specific asset by the
leasor from a manufacturer or a vendor of
such an asset.
LEASE OR BUY DECISIONS CONT’D
 Lease is categorized into three 3 main forms:
1) Operating lease
2) Finance lease
3) Sales and lease back

 Operating Lease: Here leasee has the possession

and the use of the asset on payment of specific
rentals over a period of time. Ownership and the
tittle of the asset is reserved by the owner, the
leasee can only have possession over the asset at
the end of the lease, after making a certain
minimum rental payment, and condition specified
in the lease agreement.
LEASE OR BUY DECISIONS CONT’D

 Finance lease: Is a lease arrangement that

transfers substantially all of the risk and
rewards of ownership of an asset to the
leasee. It is an agreement between the
leasee and the leasor for the most or all of
the asset’s expected useful life. The
leasee is responsible for the keeping,
servicing and maintenance of the asset.
LEASE OR BUY DECISIONS CONT’D
 Sales and lease back: This is a lease
arrangement where a business that owns an
asset agrees to sell the asset to a financial
institution and lease the same asset back on
terms specified in the sales and lease back
agreement.

 Hire purchase: Unlike lease arrangement,

hire purchase is a form of installment credit
whereby the business purchases a good on
credit and pays them by installment. The
periodic payments include both an interest
 QUESTION 22- ICAG EXAMS QUESTION
MAY 2015 ADAPTED

Howgil company is the leasing subsidiary of a major

commercial bank. It is approached by a Clint company,
a company entirely financed by equity, which operates
in the pharmaceutical industry, with a request to
arrange a lease contract to acquire new computer-
controlled manufacturing equipment to further
automate its production line. The outlay involved is
₵20m. The equipment will have only a four 4 year
operating life due to the fast rate of technical changes
in the industry, and no residual worth. The basic project
has a positive net present value when operating cash
flows are discounted at the shareholders required rate
of return .
QUESTION 22 CONT’D
Howgil would finance the purchase of the
machinery by borrowing at a pre-tax annual rate
of 14.5%. The purchase would be completed on
the final day of its accounting year, when it
would also require the first of the annual rental
payments. Howgil currently pays tax at 30%, 12
months after its financial year end. A writing -
down allowance is available based on a 25%
reducing balance.
Under the terms of the lease contract, Howgil
would also provide maintenance services,
valued by Clint at GH₵750,000 per annum.
These would be supplied by Howgill's computer
maintenance sub- division at no incremental
QUESTION 22 CONT’D

Clint has the same financial year as Howgill,

also pays tax at 30% and its own bank will
lend at 17.5% before tax.
Required:
1) Calculate the minimum rental which
Howgill would have to charge in order to
just break even on the lease contract.
2) Explain the main features of the
following: Sales and Lease back, Hire
purchase and Finance lease.
SOLUTION

Tutorial on the solution

This is a dicey question, that you need to study
carefully. If a firm lease an asset under finance lease,
the leasee, will be entitled to capital allowance, as if he
was the owner of the asset. Also the leasee, will benefit
from tax shield on the capital allowance/depreciation.
All these represent a stream of inflows /revenue to the
leasee.

But the leasee will pay a rental to the lessor, also this
rental payment has a tax saving component. If you net
the outflows and inflows an the lease arrangement, the
resultant is the breakeven point. Now let us illustrate it.
SOLUTION

Net of tax cost of borrowing / Cost of

capital
= R x ( 1 – T)
= 14.5% x (1-.30)
= 10% approximately
SOLUTION CONT’D

Step 1: COMPUTE CAPITAL ALLOWANCE ON ASSET

YEAR 0 1 2 3 4
Cost at Start 11,25 8,438 6329
20,000 15,00 0
0
Capital All 5,000 3,750 2,813 2109 -
(25%)
STEP2: COMPUTE
Cost at close TAX SAVING
15,000 11,25 ON CAPITAL
8,438 6,329 6329
ALLOWANCE 0
Year 0 1 2 3 4 5
Capital All 5,00 3,75 2,813 2,10 6,329 -
0 0 9
Tax save - 1,50 1,125 844 633 1,89
SOLUTION CONT’D

Step 3 : COMPUTE THE NPV

YEAR 0 1 2 3 4 5
Cost 20,00 0 0 0 0 0
0
Tax save - 1,50 1,125 844 633 1898
0
DF 1.00 0.90 0.826 0.751 0.683 0.621
(10%) 9
PVs - 1,36 929 634 432 1,178
20,00 4
0
SOLUTION CONT’D

STEP 4: COMPUTE TAX SAVINGS ON ANNUAL RENTAL

PAYMENT
YEAR 0 1 2 3 4 (5th)
Tax Save (1- 0.7 0.7 0.7 0.70 (0.3)
30%)
DF (10%) 1.00 0.909 0.826 0.751 0.683
PVS 1.00 0.636 0.578 0.526 (0.205)
NPV = 1+ 0.636 + 0.579 + 0.526 +
(0.205) = 2.535
SOLUTION
Break even point on the lease payment:

R= NPV of tax savings on capital allowance

NPV of tax saving on rental payment

R= 15.463
2.536
R = 6.10m
The minimum rental income required for
Howgill to break even is GH₵6.10 million per
annum.
 QUESTION 23 – 27 Mining Company
(Page 21)
A mining company is considering an investment in new
technology that will reduce operating costs through
increasing energy efficiency and decreasing pollution. The
new technology will cost GH₵1million and have a four- year
life, at the end of which it will have a scrap value of GH₵
100,000. A licence fee of GH₵104,000 is payable at the
end of the first year. This license fee will increase by 4%
per year in each subsequent year.

The new technology is expected to reduce operating costs

by GH₵5.80 per unit in current price terms. This reduction
in operating costs is before taking account of expected
inflation of 5% per year. Forecast production volumes over
the life of the new technology are expected to be as
follows:
QUESTION 23CONT’D

Time T1 T2 T3 T4
Units 60, 0000 75,000 95,000 80,000

If mining company bought the new technology, it would

finance the purchases through a four year loan paying
interest at an annual before – tax rate of 8% per year.
Alternatively, Mining Company could lease the new
technology. The company would pay four annual lease
rentals of GH₵ 380,000 per year, payable in advance at
the start of each year.

.
QUESTION 23 CONT’D
The annual lease rentals include the cost of the license fee. If
mining company buys the new technology it can claim tax
allowable depreciation on the investment on a 25% reducing
balance method. The company pays taxation one year in
arrears at an annual rate of 30%. Mining company has an
after tax weighted average cost of capital
of 11% per a year

Required:
(i) Based on financing cash flows only, calculate and
determine whether mining company should lease or buy the
new technology
(ii) Discuss the three 3 forms of leasing showing clearly their
features
 EFFECT OF TAXATION ON PROFIT,
INVESTMENT INCENTIVES ON FIRMS
INVESTMENT DECISION

Firms may invest in capital assets with the view to

expand operations, to encourage investment and
employment, many modern economies grants capital
allowance and cash grants. Cash grants received
should be brought into the stream of cash flows for
purpose of appraisal in the year in which those grants
occurred.

Firms in discharging their obligations towards the state

pays corporation tax on profits earned, this represent
an outflows, and its effect on the investment decision
need to be appraised.
QUESTION 24 - CIMA EXAMS QUESTION ADAPTED

Electronic limited is considering the purchase of

a die casting machine at a cost of $20,000.The
project cash flows are estimated as follows:
Time 0 1 2 3
4
Cash flows 20,000 +7,000 +5,000 +11,000
+5,000
The following may be assumed :
1) The existence of other taxable profit
2) 25% writing down allowances
3) 30% corporation tax
QUESTION 24

4) Machine was sold for $4,500 at the 4th

year
5) One 1 year lag on all tax effects
6) The company can borrow and purchase
the machine at a pre-tax annual rate of
14.5%.

Required
Compute the NPV of the project
SOLUTION

Net of tax cost of borrowing / Cost of

capital
= R x (1 – T)
= 14.5% x (1-.30)
= 10% approximately
SOLUTION

YEAR Cash CA Tax on NCF DF PVs

Flows Tax Profit (10%)
Save
0 20,000 0 0 - 1.00 (2,00
20,000 0)
1 7,000 1,500 0 +8,50 0.909 7,726
0
2 5,000 1,125 -2,100 +4,02 0.826 3,325
5
3 11,000 844 -1,500 +10,3 0.751 7,768
44
4 5,000 633 -3,300 +6,83 0.683 4,667
3
WORKINGS 1

a) COMPUTATION OF CA
YEAR 0 1 2 3 4
Cost at start 15,00 11,25 8,43 6,329
20,00 0 0 8
0
CA (25%) 5,000 3,750 2,812 2,10 (4,500)
9
b)
CostCOMPUTATION
at close 15,00OF11,25
TAX SAVINGS ON C1,829
8,438 6,32 A
YEAR 00 1 0 2 3 9 4 5
CA 5,00 3750 2,81 2,10 1,82
0 2 9 9
Tax save 1,500 1,12 844 633 549
WORKING 2

CALCLATION OF TAX EFFECT ON PROFIT

YEAR 1 2 3 4 5
Profit 7,000 5,000 11,00 5,000
0
Tax paid (30%) 0 2,100 1,500 3,300 1,500