CAPITAL BUDGETING:

APPLICATIONS OF INVESTMENT DECISION TECHNIQUES

Making a capital budgeting decision is one of the most important policy decisions that a
firm makes. A firm that does not invest in long-term investment projects does not
maximize stakeholder wealth. Capital budgeting decisions determine the future of the
company. An appropriate investment decision can yield spectacular returns. On the other
hand, a misguided and incorrect decision can endanger the very survival of the firm. A
few wrong decisions and the firm may be forced into bankruptcy.
Capital budgeting decisions generally are either replacement decisions or expansion
decisions. Replacement decisions are for purchasing of assets to replace existing assets
that might be worn out, damaged or obsolete. Expansion decisions are made to add
capital projects to the existing assets so as to produce either more of its existing products
or entirely new products. Capital budgeting decisions are deciding which projects a firm
should accept and which it should reject. Various capital budgeting techniques may be
used to arrive at the most suitable decisions.
A company in Dubai is considering investments in the seven projects listed in Exhibit 1.
The company is approaching you asking you to rank the projects and recommend the
“three best” that the company should accept.
To keep it simple, you are required to consider only the quantitative factors for the
selection of the projects. That is, no other project characteristics are relevant in the
selection, except that management has determined that projects 4 and 5 are mutually
exclusive.
To guide your analysis, focus on the following questions:
1. Rank the projects simply by inspecting the cash flows (the excess of cash inflows
over cash outflows).
2. Rank the projects using various quantitative methods. Assume that all projects
are from the same risk class and the appropriate discount rate is 9%. Briefly
explain the various methods, and specify which quantitative ranking methods are
better and why?
3. Compare the ranking obtained by quantitative methods with the ranking obtained
by simple inspection of the cash flows. Do they differ, explain the reasons for
this?
4. Recommend the ‘three best’ projects that the company should accept (Project 4
and Project 5 are mutually exclusive).
 EXHIBIT 1 Project Free Cash Flows (UAE Dirhams in thousands)
Project number 1 2 3 4 5 6 7
Year
0 (5,000) (10,000) (15,000) (25,000) (25,000) (30,000) (35,000)

1 1,000 1,000 1,700 1,000 11,000 (3,000) (9,000)

2 1,000 2,000 1,700 1,200 10,000 10,000 (3,000)

3 1,000 2,000 1,700 3,000 9,000 9,000 6,000

4 800 3,000 1,700 4,000 8,000 6,000 6,000

5 800 3,000 1,700 5,000 7,000 6,000 8,000

6 700 4,000 1,700 6,000 6,000 6,000 12,000

7 600 4,000 1,700 7,000 5,000 4,500 12,000

8 600 2,000 1,700 8,000 4,000 4,500 14,000

9 500 2,000 1,700 9,000 3,000 3,000 14,000

10 500 2,000 1,700 11,000 5,000 3,000 14,000

Sum of cash-flow
benefits (cash
inflow) 7,500 25,000 17,000 55,200 68,000 52,000 86,000
Excess of cash
inflow over initial
investment (cash
outflow) 2,500 15,000 2,000 30,200 43,000 19,000 39,000
1 USD = 3.67 AED