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CORPORATE FINANCE
CAPITAL BUDGETING

INTRODUCTION

Corporate finance deals with the strategic financial issues associated with achieving the
goal of increasing the value of a firm to its shareholders while observing applicable laws
and responsibilities. In fact, such capital investment and the complex “capital
budgeting” “capital financing” and “cash management” decisions that underlie it can
take many forms. Should your company build a new factory-or perhaps modernize an
old one? Should your company buy that expensive new piece of heavy machinery or
computer hardware-or simply lease it? Should your company acquire a key rival-or
perhaps a key supplier? (What the best MBAs know. Pg 194, 2005) It’s all about how
the corporation should raise and manage its capital, what investments the firm should
make, what portion of profits should be returned to shareholders in the form of
dividends, and whether it makes sense to merge with or acquire another firm.
(http://en.wikipedia.org/wiki/Corporate_finance)

Corporate finance is otherwise known as investment decisions. Large businesses are

usually organized as corporations. Corporations differ from proprietorships and
partnerships in several important ways: - First, they are legally distinct from their owners
and they pay their own taxes. Secondly, unlike proprietorships and partnerships,
corporations have limited liability, which means that the shareholders who own the
corporation cannot be held responsible for the firm’s debts. Thirdly, the owners of a
corporation are not usually the managers.

The overall task of the financial Manager can be broken down into the investment or
capital budgeting decision and the financial decision. In other words, the firm has to
decide how much to invest and what assets to invest in and how to raise the necessary
cash. The objective of corporate finance is to increase the value of the shareholders’
stake in the firm.
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DEFINITION OF CAPITAL BUDGETING
The investment decisions of a firm are generally known as the capital budgeting or
capital expenditure decisions. According to Pandey I.M. (2005, pp 407) “A capital
budgeting decision may be defined as the firm’s decisions to invest its current funds
most efficiently in the long term assets in anticipation of an expected flow of benefits
over a series of years. The long term assets are those which affect the firm’s operations
beyond the one-year period”. It is the duty of the financial manager to provide
information for making decisions on the investment of capital funds. Adeniyi A.A. (2007,
pp 103) provides examples of capital budgeting decisions which include;

a) Expansion of business
b) Investment in new business ventures
c) Replacement investment ie decisions to replace a semi-automatic machine
with a fully automatic machine.
d) Mechanization of a production process for costs-saving
e) Introduction of a new product.
f) Investment because of statutory requirement of employees or community
welfare. Such investment will not usually have positive net present value, but
may be essential, for example, to satisfy environmental or safety regulations.

INVESTMENT PROCEDURES
These are processes to undergo in taking investment decisions. Although, they vary in
relation to the nature of investment.

a) Identification of Projects
Ideas concerning capital investments are generated at all levels of an
organization. The next step is to screen the project and identify the project.

b) Evaluation of Projects
This involves the application of well organized evaluation methods such as
Accounting Rate of return (ARR), pay Back period, Discounted cash flows.
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c) Authorization of Projects
At this stage, the project is submitted to the management for approval or
rejection. This is determined based on the re-assessment of the assumptions
and cash flows and for an appraisal of how the investment fits into the corporate
strategy.

d) Monitoring and Control of Projects:

After the implementation of the project, a review of the project is embarked upon
to ascertain whether any major variations exist from the estimated cash flows.
This has the benefits of ensuring that the capital expenditure project is meeting
the set objectives and also aid future planning process.

FEATURES OF CAPITAL BUDGETING:-

a) Large sums of capital and involved
b) The future benefits spread over a series of years
c) Recoupment of expenditure involved, takes a longer time
d) It involves investment programme covering the nature, direction and rate of
progress.

IMPORTANCE OF CAPITAL BUDGETING

In the words of I.M.Pandey (2005, pp 408-409) Capital Budgeting requires special
attention because of the following reasons.

a) They influence the firm’s growth in the long run

b) They affect the risk of the firm
c) They involve commitment of large amount of funds
d) They are irreversible, or reversible at substantial loss
e) They are among the most difficult decisions to make.

Growth: The effects of investment decisions extend into the future and have to be
endured for a longer period than the consequences of the current operating
expenditure. A firm’s decision to invest in long term assets has a decisive influence on
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the rate and direction of its growth. A wrong decision can prove disastrous for the
continued survival of the firm; unwanted or unprofitable expansion of assets will result in
heavy operating costs to the firm. On the other hand, inadequate investment in assets
would make it difficult for the firm to complete successfully and maintain its market
share.

Risks: A long-term commitment of funds may also change the risk complexity of the
firm. If the adoption of an investment increase average gain but causes frequent
fluctuations in its earnings, the firm will become more risky. Thus investment decisions
shape character of a firm.

Funding: Capital budgeting decisions generally involve large amount of funds which
make it imperative for the firm to plan its investment programmes very carefully and
make an advance arrangement for procuring finances internally or externally.

Irreversibility: Most capital Budgeting decisions are irreversible. It is difficult to find a

market for such capital items once they have been acquired. The firm will incur heavy
losses if such assets are scraped.

Complexity: Capital budgeting decisions are among the firm’s most difficult decisions.
They are an assessment of future events which are difficult to predict. It is really a
complex problem to correctly estimate the future cash flow of an investment. The
uncertainty in cash flows is caused by economic, political, social and technological
forces.

TYPES OF CAPITAL BUDGETING DECISIONS

There are many ways to classify capital budgeting decisions. These include:
i) Expansion of existing business
ii) Expansion of new business
iii) Replacement and modernization
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EXPANSION AND DIVERSIFICATION
A company may add capacity to its existing product lines to expand existing operations.
For example, a fertilizer company may increase its plant capacity to manufacture more
area. Expansion of a new business requires investment in new products and a new
kind of production activity within the firm.

If a package manufacturing company invests in a new plant and machinery to produce

ball bearings, which the firm has not manufactured before, this represents expansion of
new business or diversification. Sometimes, a company acquires existing firms to
expand its business. In either case, the firm makes investment in the expectation of
additional revenue. Investments in existing or new products may also be called as
revenue-expansion investments.

REPLACEMENT AND MODERNIZATION

The main objective of modernization and replacement is to improve operating efficiency

and reduce costs. Cost savings will reflect in the increased profits, but the firm’s
revenue may remain unchanged. Assets become outdated and obsolete with
technological changes. The firm must decide to replace those assets with new assets
that operate more economically. If a cement company changes from semi-automatic
drying equipment to fully automatic drying equipment, it is an example of modernization
and replacement. Replacement decisions help to introduce more efficient and
economical assets and therefore, are also called cost-reduction investments.

However, replacement decisions which involve substantial modernization and

technological improvements expand revenue as well as reduce costs.

CAPITAL BUDGETING EVALUATION OF APPRAISAL METHOD

Three steps are involved in the evaluation of an investment:
i) Estimation of cashflows
ii) Estimation of the required rate of return
iii) Application of a decision rule for making the choice.
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The investment decision rules may be referred to as capital budgeting techniques or
investment criteria. A sound appraisal technique should be used to measure the
economic worth of an investment project. The essential property of a sound technique
is that it should maximize the shareholder’s wealth. The following other characteristics
should also be possessed by the a sound investment evaluation criteria.

a) It should consider all cashflows to determine the true profitability of the project
b) It should provide for an objective and unambiguous way of separating good
projects from bad projects.
c) It should help ranking of projects according to their true profitability
d) it should recognize the fact that bigger cash flows are preferable to smaller
ones and early cashflows are preferable to later ones.
e) It should help to choose among mutually exclusive projects, that project which
maximizes the shareholder’s wealth.
f) It should be a criterion which is applicable to any conceivable investment
project independent of others.

A number of capital budgeting techniques are in use in practice. Adejoh S.A. (2008,
pp 88-91) grouped them in the following two categories.
a) Traditional methods
b) Discounted cashflow methods.

a) Traditional Methods
The traditional investment appraisal techniques can be categorized into two as
follows:

1) Payback period (PBP)

2) Accounting Rate of Return (ARR)

1) Payback Period (PBP)

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This refers to how long it will take to recover all the money invested on
such project. The method makes use of cashflow in the determination of
the time it will take to recover all funds invested on a project.
PBP = Cash outlay
Annual Cash inflow

If cash inflows are not constant, then a cumulative cash inflow allows management to
determine when pay back occurs. In essence the payback period for unequal cash
inflows can be cash inflow until the total is equal to the initial cash outlay.

ILLUSTRATION FOR EVEN CASH FLOW OR CONSTANT CASHFLOWS:

Assume that a project requires an outlay of N50,000 and yields an annual cash inflow of
N12,500 for 7 years. The payback period for the project is:

PBP = N50,000
N12,000 = 4 years

Incase of unequal cash flows, the payback period can be found out by adding up the
cash inflows until the total is equal to the initial cash outlay.

Illustration
Cost of project - N100,000
Lifespan - 4 years
Depreciation - Straight line

Cash flows:
Year 1 - 40,000
Year 2 - 50,000
Year 3 - 60,000
Year 4 - 10,000
Working capital 10,000

Required:
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Calculate the payback period.

Solution
Total outlay = 100,000 +10,000 = N110,000
Less year 1 - 40,000
Less year 2 - 50,000 90,000
20,000

Year 3 = 20 = 1
60 3
= 2yrs 1 x 12 = 2yrs: 4 months
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Accept or Reject Rule:
If the payback period calculated for a project is less than the maximum payback period
set by the management, it would be accepted and if greater, it will be rejected. If a firm
has to choose among two mutually exclusive projects, project with shorter payback
period will be selected.

Advantages of Payback Period

i) It is very simple and easy to understand
ii) It makes use of cash income rather than using the conventional accounting
profit.
iii) By emphasizing project cost recovery, the cost so recovered can be put on
other available investment even before the expiration of project line.
iv) It lays emphasis on the safety of investment thereby minimizing the firm’s risk
exposure.
v) It is cost-saving than the most of the sophisticated techniques which require
lot of analysis time and the rise of computer.

Disadvantages
i) It ignores the time value of money
ii) The method does not indicate relative profitability of the project
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iii) It ignores the cashflow after the payback period, thereby may be leading to
sub-optimal decisions
iv) There is no rules for determining the maximum payback period, therefore, it is
highly subjective.

ACCOUNTING RATE OF RETURN (ARR)

The Accounting Rate of Return (ARR), also known as the Return on investment (ROI),
uses accounting information as revealed by financial statements, to measure the
profitability of investment. The Accounting Rate of Return is found out by dividing the
average after – tax profit by the average investment.

It measures profit to capital investment to determine the percentage (%) return on

capital invested.

ARR = Estimated Average Profits x 100%

Estimated Average Investment

Accept or Reject Rule

Accept projects with ARR higher than the minimum set by management. This method
will rank a project as number one if it has higher of ARR.

Advantages of Accounting Rate of Return:-

1. It is easy to calculate and understand
2. It makes use of readily accounting data
3. It considers a profit of a project throughout its working life
4. It could be used to compare performance for many years.

Disadvantages of Accounting Rate of Return

1) There are no set of rules for setting the minimum acceptable ARR
2) It takes no account of the time value of money
3) It uses Accounting profit rather than cash as the measure of benefit
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4) There is no clear definition in Accounting of profit and capital employed

Illustration
Cost of project - N100,000
Lifespan - 4 years

Accounting Profits
Year 1 - N50,000
“ 2 - 50.000
“ 3 - 50,000
“ 4 - 50,000

Required: calculate the ARR

Solution:
ARR = 50,000+50,000+50,000+50,000
4
X 100%
100,000
50,000 = 50,000 X 100%
50,000

= 100%

If the profits are not constant,

Illustration:
Project - N100,000
Accounting Profits:
Year 1 - 50,000
Year 2 - 60,000
“ 3 - 70,000
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“ 4 - 20,000
Working capital - N10,000
Required: Calculate the ARR
Solution:
ARR: = Average Profit
Average Investment X 100%

;. ARR = 50,000+60,000+70,000+20,000 = 50,000

4

100,000 + 10,000 = 110,000

2 2 = 55,000
= 50,000
55,000 X 100% = 91%

In both examples, the projects are viable because the utility as required by ARR is very
high.

Discounted Cashflow Method:

Discounted cashflow techniques are considered the single most effective method of
evaluating capital projects because they take account of:
a) They recognize time value of money
b) The pattern of cashflows
c) All cashflows, whenever they occur are considered.

ASSUMPTIONS OF DCF APPRAISAL

Lucey T. (2003, pp 414) points out the following as the assumptions of DCF appraisal.
i) Uncertainty does not exist
ii) Inflation does not exist
iii) The appropriate discount rate to use is known
iv) A perfect capital market exists, ie unlimited funds can be raised at the market
rate of interest.
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The Advantages of the Discounted cash flow method over the payback periods
are

i) The DCF methods consider the time value while the undiscounted payback
method does not.
ii) DCF methods especially the Net present value (NPV) method, are constant
with the objective of maximizing the welfare of the owners.
iii) The DCF methods consider all cash flows over the entire life of the project in
their calculations while the undiscounted payback method does not.

The Discounted cashflow techniques are classified into three viz:

i) Net present value (NPV)
ii) Internal Rate of Return (IRR)
iii) Profitability index (PI)

NET PRESENT VALUE METHOD

The Net present value (NPV) method is the classical economic method of evaluating the
investment proposals. It is one of the discounted cashflow (DCF) techniques explicity
recognizing the time value of money. It correctly postulates that cashflows arising at
different time periods differ in value and are comparable only when their equivalents –
present values are found out.

Step that are involved in calculating NPV

i) Cash flows of the investment project should be forecasted based on realistic
assumptions.
ii) Appropriate discount rate should be identified to discount the forecast cash
flows. The rate of return expected by investors on investment of equivalent
risk.
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iii) Resent value of cashflows should be calculated using opportunity cost of
capital as the discount rate.
iv) Net present value should be found out by substracting present value of cash
outflows from present value of cashinflows. The project should be accepted if
NPV is positive (i.e NPV > o).
v) If there are two mutually exclusive projects, both with positive Net Present
values, the one with the higher expected NPV should be selected.

Pearce J.A. and Robinson R.B. 2004. (pp 20 - 24) give the formula for Net Present
Value as follows.

NPV = C1 + C2 + C3 + Cn
(1+k) (1+k)2 (1+k)3 (1+k)n - Co

or NPV = 1
1+R

Where C1, C2 ….represents net cashflows in year 1, 2 …., K is the opportunity cost of
capital, n is the expected life of the investment, K is assumed to be known and is
constant. Co is the initial cost of the investment.

Advantages of Net Present Value

i) Net present value is simpler to calculate
ii) NPV is an absolute measure of appraisal and as such will show the effect
upon the wealth of the company generated by the project
iii) NPV gives clear accept/reject decisions
iv) NPV implicitly assumes re-investment of the interim proceeds at the cost of
capital.

Disadvantages
i) It fails to take account of uncertainty
ii) It requires cost of capital in the final comparison for project acceptance.
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Internal Rate of Return (IRR)
Internal Rate of Return is the discount rate that gives a Nil NPV. This method is also
known as discounted cashflow yield, marginal efficiency of capital, trial and error
method, Actuarial rate of return and discount yield.

For IRR – accept any project which has an IRR greater than the cost of capital.

Advantages
i) From a practical view point, it is more easily understood.
ii) A “Cost of capital” is not required, although in the final comparison for project
acceptance, it would be.

Disadvantages
1) For mutually exclusive projects, if a company is using the IRR criterion, then
there is a danger that they may choose the project with the greatest IRR and
this should possibly lead to a wrong decision

The IRR, where NPV is 0, can be calculated as:

a+ A X (b-a
(A-B)

Where:
a = is the lower interest rate
b = is the higher interest rate
A = is the NPV (positive) at the lower rate a.
B = is the NPV (Negative) at the higher rate b.

Without a computer or calculator programme, the calculation of the internal rate of

return is made with discount tables using a hit and miss technique known as the
interpolation method. (Ama G.A.N. 2004, pp 166).
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The first step is to calculate Net present values, both as close as possible to zero using
discount rates which are whole numbers. Ideally, one NPV should be positive and the
other negative.

Illustration:
A project costs N556,000 to initiate and it will generate annual cash flows (receipts less
payments) of N200,000 for a period of five years. The expected scrap value is
N56,000. Depreciation is provided on straight line method while the cost of capital is
22%.
You are required to calculate
i) The Net Present Value; (NPV)
ii) The Internal Rate Of Returns (IRR)

Should the project be accepted?

Solution:

NPV
Year cashflow DCF NPV
22%
0 (556,000) 1 (556,000)
1 200,000 0.82 164,000
2 200,000 0.67 134,000
3 200,000 0.55 110,000
4 200,000 0.45 90,000
5 256,000 0.37 94,720
NPV N36,720
IRR
1) Positive and Negative NPV

Yr Cashflow DCF 22% PV DCF30% PV

O (556,000) 1 (556,000) 1 (556,000)
1-5 200,000 2.86 572,000 2.43 486,000
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5 56,000 0.37 20,720 0.27 15,120
NPV 36,720 54,880

2) Using interpolation to drive IRR

IRR = 22+ 36720 X 30-22
(54880) -36720

22+ = 36720 X 30-22

54880 - - 36720

= 25.2%
To proof:
= 22 + 30 = 26%
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CONCLUSION
Investments involve cashflows. Profitability of an investment project is determined by
evaluating its cash flows. NPV, IRR and PI and the discounted cashflow (DCF) criteria
for appraising the worth of an investment project.

In practice, two other methods have found favour with business executives. They are
the payback period and Accounting Rate of Returns (ARR) methods.

Payback period is the number of years required to recoup the initial cash outlay of an
investment project. The project would be accepted if its payback is less than the
standard payback.

Accounting Rate of Return is found out by dividing the average profit after tax by the
average amount of investment. A project is accepted if its ARR is greater than a cut off
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rate. This method is based on accounting flows rather than cashflows, therefore, it does
not account for the time value of money.

REFERENCES

Navarro, Peter (2005) What the best MBAs know: how to apply the greatest ideas
taught in the best business schools. McGraw-Hill Professional

Adejoh S.A. (2008), Management Accounting: Theory and practice. Lokoja: Bamise
printers.

Adeniyi A.A. (2007), Simplified Management: Accounting. Yaba: EL-toda Ventures Ltd

Ama G.A.N, (2004), Management and cost Accounting, Current Theory and Practice.
Umabia: Amasons publishing ventures

Lucey T. (2003), Management Accounting. New York: Tower Building Publishers

Pandey I.M. (2005), Financial Management. India: Vikas Publishing House PVT. Ltd

Pearce J.A and Robinson R.B (2004), strategic Management Formulation,

Implementation and Control. New York: McGraw – Hill