FIN2603 – Finance for Non-Financial Managers (2023)
Study Unit 06: Capital Budgeting (PB: Chapter 6)
Capital budgeting refers to the process of identifying and evaluating potential investments in
long-lived assets to determine whether they will add value to the firm, and the
implementation and monitoring of such investments.
Capital budgeting places the emphasis on cash flows associated with the investments, rather
than on accounting profit figures. The goal of the financial manager is to maximise
shareholders’ wealth. This may be accomplished by investing in assets that will add value to the firm.
An investment in assets can only add value if its return is greater than the required rate of return. The
return may best be measured in terms of the net present value (NPV) and the internal rate of return
(IRR).
1. Approaches to Decision making:
There are 2 basic approaches to making capital budgeting decisions:
1. The accept-reject approach:
The accept-reject approach involves evaluating capital expenditure proposals to
determine whether they are acceptable. It can be used if the firm has unlimited funds
at its disposal. If the firm is evaluating projects with a view to capital rationing, only
acceptable projects should be considered.
2. The ranking approach:
This approach involves ranking projects based on some predetermined criterion, such as
the rate of return. The project with the highest return is ranked first and the project
with the lowest acceptable return, last.
2. Capital budgeting techniques:
A distinction can be made between capital budgeting techniques that do not discount cash
flows (in other words that do not involve the time value of money) and those that do discount
cash flows.
1. Non-discounted cash flow methods:
There are various non-discounted cash flow methods for determining the acceptability
of capital expenditure alternatives. One of these techniques is the payback period.
EXAMPLE
The marketing manager proposes the introduction of a new product as part of the firm's
differentiation strategy. The operations manager has indicated that the cost of procurement and
installation of the assets required to manufacture the product will require an initial investment of RI
200 000. The annual net cash flow may be determined by calculating the expected net operating profit
(after tax) NOPAT and adding back depreciation. A marketing and finance task team estimates that the
project will create the following net cash flows over the next five years:
Lyana Petzer Page 1 of 8
, FIN2603 – Finance for Non-Financial Managers (2023)
Year Net Cash flow (CF)
1 R 350 000
2 R 650 000
3 R 400 000
4 R 300 000
5 R 201 025
The treasury department has indicated that the firm has a weighted average cost of capital WACC) of
12%. The financial manager has recommended that only projects with payback periods of less than five
years should be considered for analysis by means of the NPV, profitability index (Pl) and IRR.
Each of the following techniques will now be applied to the afore-mentioned data:
• Payback period
• Net present value (NPV)
• Profitability index (PI)
• Internal rate of return (IRR)
The payback period - is the number of years required to recover the initial investment. It gives
some consideration to the timing of cash flows and therefore the time value of money, in that
the payback period should be as short as possible.
EXAMPLE continue…
Since the project in our example generates a mixed net cash flow stream, the calculation of the
payback period has to be determined in the following manner. In year 1, the firm will recover R350 000
of its initial investment of R1 200 000. At the end of year 2, R1 000 000 (R350 000 from year 1 plus
R650 000 from year 2) will have been recovered. By the end of year 3, R1 400 000 (R1 000 000 from
years 1 and 2 plus the R400 000 from year 3) will have been recovered. Since the amount received by
the end of year 3 exceeds the initial investment of R1 200 000, the payback period ends somewhere
between two and three years. While only R200 000 (R400 000 - R200 000) must be recovered during
year 3 to make up the initial investment of R1 200 000, R400 000 is actually recovered. Thus only 50%
(R200 000 ÷ R400 000) of the net cash flow in year 3 is needed to complete the payback of the initial
R1 200 000. The payback period for the project is therefore 2,5 years (2 years plus 50% of year 3)
Three Disadvantages:
1. You cannot determine the appropriate payback period in light of the wealth maximising goal.
2. Fails to take the time-factor of money into consideration.
3. Failure to recognise cash flows that occur after the payback period.
2. Discounted cash flow techniques (DCF):
Discounted cash flow techniques (DCF) consider the time value of money explicitly. Net
cash flows of a project are discounted to a present value at a specified rate. The
concept of present value is based on the belief that the value of money is affected by
the time at which it is received.
Lyana Petzer Page 2 of 8
Study Unit 06: Capital Budgeting (PB: Chapter 6)
Capital budgeting refers to the process of identifying and evaluating potential investments in
long-lived assets to determine whether they will add value to the firm, and the
implementation and monitoring of such investments.
Capital budgeting places the emphasis on cash flows associated with the investments, rather
than on accounting profit figures. The goal of the financial manager is to maximise
shareholders’ wealth. This may be accomplished by investing in assets that will add value to the firm.
An investment in assets can only add value if its return is greater than the required rate of return. The
return may best be measured in terms of the net present value (NPV) and the internal rate of return
(IRR).
1. Approaches to Decision making:
There are 2 basic approaches to making capital budgeting decisions:
1. The accept-reject approach:
The accept-reject approach involves evaluating capital expenditure proposals to
determine whether they are acceptable. It can be used if the firm has unlimited funds
at its disposal. If the firm is evaluating projects with a view to capital rationing, only
acceptable projects should be considered.
2. The ranking approach:
This approach involves ranking projects based on some predetermined criterion, such as
the rate of return. The project with the highest return is ranked first and the project
with the lowest acceptable return, last.
2. Capital budgeting techniques:
A distinction can be made between capital budgeting techniques that do not discount cash
flows (in other words that do not involve the time value of money) and those that do discount
cash flows.
1. Non-discounted cash flow methods:
There are various non-discounted cash flow methods for determining the acceptability
of capital expenditure alternatives. One of these techniques is the payback period.
EXAMPLE
The marketing manager proposes the introduction of a new product as part of the firm's
differentiation strategy. The operations manager has indicated that the cost of procurement and
installation of the assets required to manufacture the product will require an initial investment of RI
200 000. The annual net cash flow may be determined by calculating the expected net operating profit
(after tax) NOPAT and adding back depreciation. A marketing and finance task team estimates that the
project will create the following net cash flows over the next five years:
Lyana Petzer Page 1 of 8
, FIN2603 – Finance for Non-Financial Managers (2023)
Year Net Cash flow (CF)
1 R 350 000
2 R 650 000
3 R 400 000
4 R 300 000
5 R 201 025
The treasury department has indicated that the firm has a weighted average cost of capital WACC) of
12%. The financial manager has recommended that only projects with payback periods of less than five
years should be considered for analysis by means of the NPV, profitability index (Pl) and IRR.
Each of the following techniques will now be applied to the afore-mentioned data:
• Payback period
• Net present value (NPV)
• Profitability index (PI)
• Internal rate of return (IRR)
The payback period - is the number of years required to recover the initial investment. It gives
some consideration to the timing of cash flows and therefore the time value of money, in that
the payback period should be as short as possible.
EXAMPLE continue…
Since the project in our example generates a mixed net cash flow stream, the calculation of the
payback period has to be determined in the following manner. In year 1, the firm will recover R350 000
of its initial investment of R1 200 000. At the end of year 2, R1 000 000 (R350 000 from year 1 plus
R650 000 from year 2) will have been recovered. By the end of year 3, R1 400 000 (R1 000 000 from
years 1 and 2 plus the R400 000 from year 3) will have been recovered. Since the amount received by
the end of year 3 exceeds the initial investment of R1 200 000, the payback period ends somewhere
between two and three years. While only R200 000 (R400 000 - R200 000) must be recovered during
year 3 to make up the initial investment of R1 200 000, R400 000 is actually recovered. Thus only 50%
(R200 000 ÷ R400 000) of the net cash flow in year 3 is needed to complete the payback of the initial
R1 200 000. The payback period for the project is therefore 2,5 years (2 years plus 50% of year 3)
Three Disadvantages:
1. You cannot determine the appropriate payback period in light of the wealth maximising goal.
2. Fails to take the time-factor of money into consideration.
3. Failure to recognise cash flows that occur after the payback period.
2. Discounted cash flow techniques (DCF):
Discounted cash flow techniques (DCF) consider the time value of money explicitly. Net
cash flows of a project are discounted to a present value at a specified rate. The
concept of present value is based on the belief that the value of money is affected by
the time at which it is received.
Lyana Petzer Page 2 of 8
