Capital Budgeting Methods and Techniques

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CAPITAL BUDGETING
The capital budgeting decision is a predetermined cause of action for achieving objectives. It’s a
framework that details methods and tasks that are to be implemented to achieve organization goal
.The most important characteristics of capital budgeting includes
i) They are long term-extend beyond 1 financial period and they are expected to generate
benefit for a long period .Such ventures must yield a return acceptable to both owners,
its returns should not be lower than bank rate on fixed deposit. The benefits for this
investment are supposed to be in cash.
CAPITAL BUDGETTING METHODS
There are 2 methods of finalizing the viability of an investment.
1. Traditional method
a) Pay back period method
b) Accounting rate of return method (ARR)
2. Modern methods (Discounted cash flow technique).
a) Net present value (NPV)
b) Internal rate of return (IRR)
c) Profitability index (PI)
Traditional methods.
Payback period method
This method gauges the viability of a venture by taking the inflows and outflows of a time to
ascertain how soon a venture can pay back and for this reason payback period is that period of time
or duration it will take an investment venture to generate sufficient cash inflows to pay back the
cost of such investments.
The paybacks period of a perfect cash inflow is equal to PBP= initial investment
Annual cash flow
Example
Suppose a company has identified a project which will cost sh.100, 000 initially and it’s expected
to generate sh 20,000 per annum for 10 years calculate its payback period.
Solution

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UNPERFECT CASH INFLOWS: AN UNIFORM
The PBP computation will be in cumulative form; this means that the net cash inflows are
accumulated per year until the cost of investment is recovered.
March 2010 Q2B
AYZ is considering 2 mutually exclusive projects A&B .The project are expected to generate the
cash flow as follows.
Presentative table.
Year PROJECT PROJECT CUMMULATIVE
A B
0 (1000, 000) (1000, 000) (1000, 000)
1 300000 250000 (750000)
2 300,000 180,000 (570,000)
3 300,000 200,000 (370,000)
4 300,000 400,000 300,000
5 300,000 700,000
Solution
Disadvantages
Ignores the profitability of the project
Ignores the PBP.
Ignores the time value of money.
ACCEPTANCE RULES FOR P.B.P USING
The company will accept those ventures whose PBP is less than that set by the management and
will reject all those ventures whose PBP is more than that set by the management
The lower the P.B.P the better the investment thus in a mutually exclusive invest a project with a
lower P.B.P will be accepted.
MERITS OF P.B.P

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1. Simple to use and understand.
2. It’s ideal under high risk investment because it will identify which venture will payback earlier
thus minimizing the risk with the venture.
3. Its advantageous when choosing between mutually exclusive project because it will give a clue
as to which ventures is viable if one considers the shortest P.B.P
Demerits
1. It does not take into account time value of money and assumes that a sh received in 1st year and
in the later years will have the same value so as to rank them together to as certain the PBP
which is unrealistic given that a sh now is more valuable than a shilling in future.
2. PBP dose not measure the profitability but rather measures the period of time the venture pays
back the cost.
3. PBP ignores inflows after P.B.P and as such it does not accommodate the element of a return
on investment.
4. This method will not have any impact on the company share prices because profitability which
is one of the most important factors in gauging the company’s value of share is not a function
of P.B.P and as such the method falls short of meeting the criteria of investment appraisal.
ACCOUNTING RATE OF RETURN (ARR)
This method uses accounting profits from the financial statement to access the viability of
investment proposal by dividing the average Income by average investment. The investment will
be equal to either the original investment +salvage value or
2
Initial investment or dividing the total
2
Investment value after depreciation value by the life of project
The rate of return of asset or adjusted rate of return method is given by
ARR=Average income x100
Average Investment
Or

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Average income –Average depreciation x100
Average investment
Example
A company wants to invest in a project whose income before depreciation and tax are as follows
Year sh tax rate is 30%
1 100,000
2 120,000
3 140,000
4 160,000
5 200,000
The project has initial investment of sh 500,000 and a scrap value of sh 100,000.The company
provides the depreciation as straight line method. Calculate the A.R.R
Solution
Acceptance value of ARR
ARR will accept those projects whose accounting rate of return is higher than that set by
management or bank rate and it will give highest ranking to venture with highest ARR.
Merits
1. It’s simple to use and understand.
2. It’s readily computed from accounting data thus much easier to ascertain.
3. It’s consistent with profitability objective as it analyses the return from the entire inflows and
as such it will give a clue or hint to the profitability of the ventures
Demerits
1. Ignores the time value of money.
2. It does not consider how soon the investment should recover the cost.
3. Uses accounting profit instead of cash inflows some of which may not be realisable

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MODERN METHODS
They are also known as discounted cash flow techniques. They consider the time value of money.
Present value concept
It acknowledges that a Shilling today is not a shilling tomorrow, it looses value with time and such
if it’s to be compared with a sh to be received in the end year then the two must be at the same
value.
This is to mean that a sh today is more valuable than a sh in future thus an investor analytical
power is fixed by his or her ability to compare cash inflows and outflows separated by each other
by time.
The P.V of a lamp sum is given by PV= L/ (1 + K)n
Where L= Lamp sum
K=Cost of capital (Rate of r+n)
N=Number of years
P.V. = Present value
EXAMPLE.
Suppose that an investor can expect to receive 40,000 at the end of year 2, Ksh 70000 at the end of
year 6 and Ksh 100,000 at the end of year 8.
Compute the P.V. If the expected late of return is 12%.
solution
N.P.V METHOD
The method discounts inflows and outflows and ascertains the N.P.V by deducting discounted
outflows from discounted inflows to obtain the net cash inflows. The P.V method will involve
selection of rate acceptable to the management or equal to the cost of finance and thus will be used
to discount inflows and outflows. If the N.P.V is positive you invest, if its negative do not invest.
For mutually exclusive projects a project with highest N.P.V should be undertaken and for
independent projects all the projects with negative N.P.V should be undertaken.
N.P.V=A1 + A2 + A3--------AN
(1+K)1 (1+K)2 (1+K)3 1
A=Annual cash flows

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K=Cost of finance (Rate of Return)
N=No of years
C=Cost of investment
Example
Calculate the N.P.V at discounting rate of 8%
Year (project) A Project B
0 (1000000) (1000000)
1 300,000 250,000
2 300,000 180,000
3. 300,000 200,000
4. 300,000 400,000
5 300,000 700,000
solution
Merits of NPV
1. Recognizes time value of money and thus appreciate that a sh now is more valuable than a
sh tomorrow.
2. It takes into account the entire inflow of returns and as such its realistic in measurement of
profitability of a ventures.
3. It’s consistent with the value of shares in so far as positive N.P.V will have the implication
of fixing the value of the shares.
4. It’s consistent with the objective of maximizing the welfare of owner because a positive
N.P.V will increase the net worth of the owners.
Demerits
1. Its difficult to use
2. Its calculation uses cost of finance which is a difficult concept because it considers both
implicit and explicit cost.
3. Its ideal for a accessing the viability of an investment and a certainty and thus cannot be
used in the situation of uncertainty because it ignore the element of risk.

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4. It may not give good assessment of good alternative. If the project has an equal life.
I.R.R
This method is a discounted cash flow technique which uses the principle of N.P.V. it’s defined as
that rate which equates the PV of cash inflows to the present value of cash outflows. It’s also
called IRR because it depends on the outflow of the investment and the proceeds associated with
the project and not a rate determined outside the ventures.
The value of IRR can be found by.
1. P.B method (pay back)
2. Trial and error method
3. Interpolation.
4. Extrapolation
5. Dominoes
6. Weighted cash flows.
Calculate IRR using P.B method.
It’s used when the cash flows are perfect annuities
Examples
Initial investment (1000000)
Project life 5years
Cash flow 300000
Example
Maua limited is considering investing in a project which will cost sh 2,400 000 the project is
expected to have a useful life of 5 years with a residue value of sh.20,000 earning before
depreciation and tax is expected to be as follows.
Year EBD AND TAX
1 820,000
2 840,000
3 860,000
4 900,000
5 960,000
The corporate tax rate is 40% and depreciation is on straight line basis. The firms cost of capital is
20%.

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Required;
a) Calculate the project N.P.V
b) Calculate the project I.R.R
c) Should the company undertake the project?
Solution
Acceptance rule of IRR
-It will accept a venture if it’s IRR is higher than or equal to the minimum required rate of return
which is usually the cost of finance in mutually exclusive project, a project with the highest IRR is
chosen. In independent project, all the project with higher IRR than the cost of capital is under
taken.
All projects which IRR is lower than the cost of capital or the minimum required rate of return
should not be undertaken.
Merits of IRR.
1. It considers time value of money.
2. It considers cash flows of the entire life of the project.
3. It’s compatible with maximization of business wealth because if its highest than the cost of
finance owners wealth will be maximized.
Demerits
1. Difficult to use
2. It’s expensive to use because it calls for trained manpower and may use computers
especially where inflows are large and extending beyond the normal limits.
3. It may give multiple result some involving positive IRR in which case it may be difficult to
use in choosing which ventures is more viable.
Profitability Index
Also known as benefit cost ratio-it’s the ratio of P.V I and PV of cash out lay.
SOLUTION

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CAPITAL STRUCTURE AND COST OF CAPITAL
CAPITAL STRUCTURE
This refers the management of debt and equity used by a firm in financing its investment.
Cost of finance: This is the price the company pays to obtain and retain finance. To obtain finance
a company will pay implicit costs which are commonly known as floatation cost. This cost include
commission, brokerage cost, cost of printing prospectus, commission cost, legal fees, audit cost,
cost of printing show certificates, advertising cost etc.
MODELS OR METHODS OF COMPUTING COST OF CAPITAL
Market model/ investors expected yield: - This model is used to establish the percentage cost of
ordinary share capital cost of equity. If an investor is holding ordinary shares he can receive
returns in two forms (i) dividend
(ii) Capital gain
NB: Capital gain is assumed to constitute the difference between buying price of a share at the
beginning of the period and the selling price of the same share at the end of the period thus under
this model the total returns for an investor is equal to divided by share plus capital gain.
Returns=DPS + Capital gain
=DPS+ (P1-P0) P1= price at the end P0= original price
The cost of equity under this model is equal to
Ke = Total returns x 100
Total invest
Ke= Cost of equity
An example
For the past 5 years the machakos price per share and the divided per share were as follows.
Year 2007 2008 2009 2010 2011
MPS 40 45 53 50 52
DPS - 3 4 3 -
Required
Determine the estimated cost of equity for @ of the years involved.

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SOLUTION
2. Capital Asset Pricing Method. (CAPM)
Capital is a technique that is used to establish the required rate of return of an investment given a
particular level of risk. According to CAPM, the total business risk of the firm can be divided into
two:-
i) Systematic risk: This is the risk that affects all the firms in the market. This risk cannot be
eliminated on diversified .Its thus called undiversifiable risk since it affect all firms in the market,
the share price and profitability of the firm will be moving in the same direction
Examples of systematic risk are
-Political instability
- Inflation
- Power rationing
-Natural calamities like floods and earth quakes
-Increase in cooperate tax rate and personal tax rate systematic risk is measured by beta factor.
ii) Unsystematic risk: This affect only one firm in the market but not other firm. Its therefore
unique to the firm thus unsystematic trend in profitability of the firm relative to the profitability
trend of other films in the market ,This risk can be reduced through diversification thus its known
as diversified risk. This risk is measured by Alpha factor.
Example
-Strike by employees of the firm
-Exit of a prominent corporate personality
-Loosing a major contract
-Collapse of marketing and advertising program of the firm on launching of a new product.
-Failure to make research and develop break through by the firm.
NB, under CAPM the cost of equity is determined by considering ONLY systematic Risks.
Ke=RF+ (RM-RF) B
Where RF-is the interest rate of risk free investment e.g. treasury Bills
RM-Average rate of return in the market.
B-the beta factor of the investment
Example

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AB limited is an all equity firm whose beta factor is 1.2 the interest rate on treasury bill is 8.5%
and the market rate of return is 14.5 %. determine the (ke) cost of equity for the company.
SOLUTION
DIVINDEND YIELD GORDON MODEL
Thus model is used to determine the cost of various capital components in particular.
1. Cost of equity
2. Cost of preference share capital
3. Cost of preference debentures
Cost of equity under this model is determined by assuming a constant growth of the firm or 0
growth of the firm. In the case of zero growth firm cost of equity is equal to Ke =D1/P0X100
where
D1=Current dividend
P0=Market price per share
Incase of constant growth firm
Ke=DI x 100+g
P0
An illustration
XYZ ordinary share has a nominal value of sh 10 it’s currently paying a dividend per share of sh
2.5 and has a current market price per share of sh 20. determine the cost of equity if.
a) There is no growth rate.
b) If the dividend is expected to grow @ 5%per annum in future.
SOLUTION
Cost of redeemable debentures and preference
Redeemable fixed return securities have a definite maturity period. The cost of such securities is
called yield to maturity and their cost can be determined using approximation method as follows.
Kd=int (1-T) + (M-vd)1/n
(m+ vd)1/2
Where
Int=interest charged per year
T=Corporation tax rate
M=per value

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VD=Current Market value
N=No of years.
Kd=int(1-T) when period is not definite
e.g
Determine the cost of 12% debentures in company ABC If it has a per value of sh 100 and its
expected to mature in 10 years .Its currently selling @ sh 90 in the market .The corporation n tax
rate is 30%
SOLUTION
WEIGHED AVERAGE COST OF CAPITAL
This is also known as overall cost of capital. It’s the minimum average cost of all the sources of
capital .Its determined on the basis of percentage cost of @ capital component weighted cost of
capital relate to existing capital structure. In order to determine weighted capital the following are
followed.
1. Determine the component cost or source of finance
2. Calculate the weight of each source of finance.
3. Get the product of step 1 and 2 above.
4. Get the product of step 3
ILLUSTRATION
The following information was extracted film the books of expo Limited.
Sh
1. Ordinary share (sh25 .Per value) 8000000
Retained earnings 4000000
10% preference shares (sh20 per value) 4000000
10%debentures (sh 20 per value) 4000000
20,000000
Additional information
Market values
1. Ordinary shares sh 31 inclusive of sh1 floatation cost per share.
1o% reference share sh 25

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10% debentures sh 30
2. Ordinary share holders expect a cash dividend of sh 3.8 per share and a growth rate of
3.33% per annum.
3. Corporation tax rate is 40%
Required
a) Weighted average cost of capital using market values.
SOLUTION
MARGINAL COST OF CAPITAL
It’s the cost of additional capital which is intended to be raised. It’s computed by multiplying the
cost after tax of @ source of finance with weights and by adding the resultant and figures of
different sources of finance taking into A/C only additional capital.
The steps followed to calculate the weighted average cost of capital also applies when computing
the weighted marginal cost of capital.
Capital structure optimal means (cheap) where the debt equity ratio should remain the same.
An illustration
ABC Investment Company has a net asset of sh 400,000,000 at the end of 2007 made up as
follows.
shs 000
6% Preference share capital 40,000
Ordinary share capital sh 10 per 80,000
Retained profit 120,000
8%debentures 80,000
9% Debentures 80,000
Total 400,000
Due to increased demand from its consumers, product management is contemplating an expansion
program to the tune of sh 100,000 000 in 2008. The chief accountant of the company has
assembled the following information about the sources of finance.

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1. Ordinary share currently sell sh 50 per share and has a floatation cost of 5/= per
share.
2. Debentures financing @ 11% will sell at par and sh 20,000 000 will come from this
source.
3. 11.5 % preference shares can sell at par for sh 100 per share.
4. There is 20,000 000 of internal financing available from retained profit.
5. Over the past years dividend has been paid @ sh 6 while the firms growth rate has
been 8% per annum.
6. Assume the capital structure is optimal and the tax rate is 40%.
REQUIRED
a) Weighted average cost of capital.
b) Weighted marginal Cost of capital
NBWACC-Existing capital
WMCC- Additional capital + additional sources.
When trading @ par the percentage is the same as quotation.
SOLUTION
IMPORTANCE OF COST OF CAPITAL
The cost of capital is important because of its application in the following areas.
i) Long term investment decisions: in capital budgeting decision using NPV method the cost
of capital is used to discount the cash flows. Under IRR method the cost of capital is compiled
with IRR to determine whether to accept or reject a project.
ii) Capital structure decisions: The composition of various components of capital is
determined by the cost of capital component.
iii) Evaluation of performance of Management: A high cost of capital is an indicator of high
risk attached to the firm .This is usually attributed to poor performance of the firm.
iv) Lease of buying decision: A firm may finance the acquisition of an asset through leasing
or borrowing long term debts to buy an asset. In lease or buying decisions the cost of debts is
used as a discounting rate.

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vi) Dividend Policy and Decisions: if the cost of retained earnings is low compared to the cost
of new ordinary share capital the firm will retain more and pay less dividend.
Additionally the use of R.E as an internal source of capital is preferred because it does not
dilute ownership and control of the firm since no new share are issued and does not involve
any floatation cost.
FACTORS THAT INFLUENCE THE COST OF FINANCE
i) Terms of reference : if short term the cost is usually low and vice versa
(payment period)
ii) Economic conditions prevailing: If a company is operating under inflationally
conditions such a company will pay high cost in so for as inflationally effect. of
financed will be passed unto the company.
iii) Risk exposedto venture: If a company is operating under high risk conditions
such a company will pay high cost to induce renders to avail finance to it
because the element of risk will be added on the cost of finance which may
compound it.
iv) Size of business: A small company will find it difficult to raise finance and as
such will pay heavily inform of cost of finance to obtain debt from renders.
v) Availability: The cost if finance raised will also be influenced by the forces of
demand and supply such that high demand and low supply will lead to high cost
of finance.
vi) Effect of taxation: Debt finance is cheaper by the amount equal to tax on
interest and this means that debt finance will entail a saving in cost of finance
equivalent to tax on interest.
vii) Nature of security : Insecurity given depreciate fast then this will compound
implicit cost (cost of maintaining that security)
viii) Company growth stage; Young companies usually pay less dividends in which
case the cost of this finance will be relatively cheaper at an earlier stage of
companies development.
FACTORS THAT AFFECT CAPITAL STRUCTURE

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1. Availability of securities: This influences the companies’ use of debts finance which
means that if a company has sufficient securities it can afford to use debt finance in large
capacities.
2. Cost of finance: if low then, a company can use more debt or equity finance.
3. Capital growing level: If high the company may not be able to use more debt or equity
finance because potential investors will not be willing to invest in such a company.
4. Sales stability: if a company has stable sales thus profit, it can afford to use various
finances in particular debt in so far as it can service such finances.
5. Competitiveness of the industry in which the company operates: if the company
operates in a highly competitive industry, it may be risky to use high levels of debts
because chances of servicing this debt may be low and may lead a company into
receivership.

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