7. INVESTMENT DECISIONS (CAPITAL BUDGETING)
7.1. REVIEW OF CAPITAL BUDGETING TECHNIQUES
Capital budgeting (investment) decisions 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
benefit over a series of years. The firm therefore:
(a) exchanges current funds for future benefits
(b) invests the funds in long-term assets
(c) expects future benefit over a series of years
7.2. INVESTMENT APPRAISAL TECHNIQUES
The investment appraisal techniques can be categorised into two groups:
(a) Discounted Cashflow methods
i. Net present value method
ii. Internal rate of return
iii. Profitability index
(b) Non-discounted cashflow method
i. Accounting rate of return
ii. Payback period
7.3 DISCOUNTED CASHFLOW METHODS
1. Net Present Value (NPV)
This is defined mathematically as the present value of cashflow less the initial outflow.
Where Ct is the cashflow
K is the opportunity cost of capital
Io is the initial cash outflow
n is the useful life of the project
Decision Rule using NPV
1
, The decision rule under NPV is to:
- Accept the project if the NPV is positive
- Reject the project if NPV is negative
Note: if the NPV = 0, use other methods to make the decision.
2. Internal Rate of Return (IRR)
The internal rate of return of a project is that rate of return at which the projects NPV =
0
Therefore IRR occurs where:
Where r = internal rate of return
Note that IRR is that ratio of return that causes the present value of cashflows to be
equal to the initial cash outflow.
Decision Rule under IRR
If IRR > opportunity cost of capital - accept the project
- IRR < opportunity cost of capital - reject the project
- IRR = opportunity cost of capital - be indifferent
3. Profitability Index
This is a relative measure of projects profitability. It is given by the following formula.
2
7.1. REVIEW OF CAPITAL BUDGETING TECHNIQUES
Capital budgeting (investment) decisions 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
benefit over a series of years. The firm therefore:
(a) exchanges current funds for future benefits
(b) invests the funds in long-term assets
(c) expects future benefit over a series of years
7.2. INVESTMENT APPRAISAL TECHNIQUES
The investment appraisal techniques can be categorised into two groups:
(a) Discounted Cashflow methods
i. Net present value method
ii. Internal rate of return
iii. Profitability index
(b) Non-discounted cashflow method
i. Accounting rate of return
ii. Payback period
7.3 DISCOUNTED CASHFLOW METHODS
1. Net Present Value (NPV)
This is defined mathematically as the present value of cashflow less the initial outflow.
Where Ct is the cashflow
K is the opportunity cost of capital
Io is the initial cash outflow
n is the useful life of the project
Decision Rule using NPV
1
, The decision rule under NPV is to:
- Accept the project if the NPV is positive
- Reject the project if NPV is negative
Note: if the NPV = 0, use other methods to make the decision.
2. Internal Rate of Return (IRR)
The internal rate of return of a project is that rate of return at which the projects NPV =
0
Therefore IRR occurs where:
Where r = internal rate of return
Note that IRR is that ratio of return that causes the present value of cashflows to be
equal to the initial cash outflow.
Decision Rule under IRR
If IRR > opportunity cost of capital - accept the project
- IRR < opportunity cost of capital - reject the project
- IRR = opportunity cost of capital - be indifferent
3. Profitability Index
This is a relative measure of projects profitability. It is given by the following formula.
2
