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Investment Decision Rules (Capital

Budgeting Techniques)

Chapter 4

Investment Decision Rules (Capital


Budgeting Techniques)

Capital budgeting is the process of planning for


purchases of assets whose returns are expected to
continue beyond one year. A capital expenditure is a
cash outlay that is expected to generate a flow of future
cash benefits lasting longer than one year.

A number of relatively simple (unsophisticated)


techniques for performing such analyses do exist, but
they are less valuable than the more sophisticated
techniques currently available.

Investment Decision Rules


These techniques integrate time value procedures, risk
and return considerations and valuation concepts in order
to select capital expenditures that are consistent with
achievement of the firms goal.

The focus here is on application of the present value


techniques to relevant cash flows to evaluate capital
expenditure proposals for decision-making purposes.

Investment Decision Rules


Cost of Capital
A firms cost of capital is defined as the cost of the
funds supplied to it. It is also called the required rate
of return because it specifies the minimum
necessary rate of return required by the firms
investors.
In this context, the cost of capital provides the firm
with a basis for choosing among various capital
investment projects.

1. Unsophisticated Capital Budgeting


Techniques
There are two basic unsophisticated techniques for
determining the acceptability of capital
expenditure alternatives:
1.
2.

One is to calculate the average rate of return,


And the other is to find the payback period.

1.Unsophisticated
Capital
1.1. AVERAGE RATE OF RETURN

Budgeting

Techniques

The average rate of return is typically calculated from


accounting data (profits after taxes).

Average rate of return =

Average profits after taxes - are found by adding up the


after-tax profits expected for each year of the projects life
and dividing the total by the number of years.
In the case of an annuity, the average after-tax profits are
equal to any years profits.

1.Unsophisticated Capital Budgeting Techniques


1.1. AVERAGE RATE OF RETURN

Average investment - is found by dividing the


initial investment by 2.
This averaging process implies that the cost of
the asset is written off at a constant (straightline) rate over the life of the project.
This means that, on the average, the firm will have
one-half of the assets initial purchase price on
the books.

1.Unsophisticated Capital Budgeting Techniques


1.2. PAYBACK PERIOD

The payback period is the number of years required to


recover the initial investment from cash inflows.

In the case of any annuity the payback period can be


found by dividing the initial investment by the annual cash
inflow. If a project generates a mixed stream of cash
inflows, the calculation of the payback period is not quite
as clear-cut.

1.Unsophisticated Capital Budgeting Techniques


1.2. PAYBACK PERIOD

The payback period for project A = $42000 / $14000 = 3 years


The payback period for project B: in year 1, the firm will recover $28000 of its
$45000 initial investment.
At the end of year 2, $40000 ($28000 from year 1 + $12000 from year 2) will be
recovered.
At the end of year 3, $50000 ($40000 from years 1 and 2 plus the $10000 from
year 3) will be recovered.

1.Unsophisticated Capital Budgeting Techniques


1.2. PAYBACK PERIOD
EXAMPLE
Since the amount received by the end of year 3 is more than the initial
investment of $45000, the payback period is somewhere between 2 and
3 years. Only $5000 must be recovered during year 3. Actually, $10000
is recovered, but only 50% of this cash inflow is needed to complete the
payback of the initial $45000.
The payback period for project B is therefore 2,5 years (2 years plus
50% of year 3).
Project B would be preferred to project A since the former has a shorter
payback period.

1.Unsophisticated Capital Budgeting Techniques


1.2. PAYBACK PERIOD

Pb = payback period
n = number of years when
we find that the investment
left to be recovered is less
than the cash flow of the
following year;
Irn = the investment to be
recovered in n year;
CFn+1 = cash flow from the
n+1 year

1.Unsophisticated Capital Budgeting Techniques


1.2. PAYBACK PERIOD

There are two primary disadvantages of using the payback


period:
1. like the average rate of return, this method is not able to
specify the appropriate payback period in light of the wealth
maximization goal.
2. he failure to recognize cash flows that occur after the payback
period. If we look beyond the payback period, we see that
project B returns only an additional $14000 ($5000 in year 3
and $8000 in year 4), while project A returns an additional
$28000 ($14000 in year 4 and $14000 in year 5). Based on
this information, it appears that project A is preferable.