THE INVESTMENT / CAPITAL BUDGETING DECISION

• A firm’s profitability, growth, competitiveness

and long term survival depends to a great
extent on the availability and selection of
investment projects.
• Capital budgeting refers to the decision to
invest in long-term assets. The assets are
expected to be used over a long period of
time.
• Examples of capital budgeting decisions
include:
• acquisition of plant and equipment,
replacement of old equipment
• expansion of the existing production capacity
• introduction of a new production line and
investment in research and development.
 Importance of Capital Budgeting:

• The capital budgeting decision is a central decision to any

business because;
• It determines the asset mix and hence shapes the
business risk.
• It involves heavy initial outlays of the business resources.
• Benefits accrue in future which future is associated with
risk and uncertainty.
• Investment decisions are difficult to reverse and in the
event that they are reversed, the decision can be very
costly.
 Procedures/Steps of Capital Budgeting:

1. Review of the organisation’s policies, goals and

objectives
2. Identifying possible investment opportunities.
3. Screening to reduce the number of alternatives to
the most feasible alternatives.
4. Estimate cash flows for the feasible alternative and
acquiring relevant information.
5. Appraisal/evaluation of cash flows using the
techniques of investment appraisal i.e. NPV, IRR, PI etc
• Select and implement the most feasible
alternative based on the project with the
highest NPV, IRR, PI etc.
• Performance Review/Post-Audit for cost-
benefit analysis and compare budget
estimates with actual results.
 Approaches to capital budgeting/ Appraisal techniques

• Broadly, there are two approaches to capital

budgeting i.e.
• Decisions without any formal analysis –
Investment decisions are made based on past
experiences, intuition, peer advice, use of
Delphi techniques etc.
• Decisions with formal analysis – These are
categorized into two.
1. Making investment decisions based on
techniques of analysis that do not incorporate
time value of money such as Accounting Rate
of Return (ARR) and Payback period.
2. The second category involves making
investment decisions based on techniques
that incorporate time value of money such as
Net Present Value (NPV), Internal Rate of
Return (IRR) and Profitability Index (PI)
 DETERMINATION OF CASHFLOWS

• Determining the cash flow potential of the

business is central to making successful finance
decisions.
• It involves the estimation of the costs and
benefits anticipated to accrue to the
investment and it requires the help of different
departments i.e. marketing, accounting, etc.
who come together to forecast potential sales
and costs of the investment.
• Cash flows can either be inflows or outflows.
They can also be categorized on the basis of
when they are realized.
• They can be;- Initial cash outlays, Intermediate
operating Cash Flows and Terminal Cash Flows
1. Initial cash outlays –These are assets acquired
in the initial period).
 
2. Intermediate / operating Cash Flows - These are
realized between the first year and final of the useful
life of the asset, e.g. Sales Revenue, operating
expenses, Cost Savings i.e. decrease in expenses/cost
due to efficiency gains during intermediate years and
Adjustment of Depreciation and Tax Shield
3. Terminal Cash Flows – These are cash flows that
accrue in final year of asset’s useful life (nth year),e.g
net salvage value and recovered working capital
recoverable.
 Considerations in Cash flow Determination:

• Considerations for changes in working capital.

• Depreciation expense is added back because; although it’s a
tax deductible expense, it doesn’t involve actual cash flow.
The effect of depreciation is that it provides a tax shield.
• Salvage value/scrap value. This is the value at which an asset
can be sold when the firm ceases to use it.
• Sunk costs. These are costs of past investments that cannot
be recovered. They have no relevance to the new investment
and they should be ignored e.g. feasibility study costs.
• Opportunity costs i.e. the maximum value of net cash flows
that could be generated from the asset if the new investment
was not undertaken. endedhere
 Cash Outflows:

• These are comprised of expenditure that is made before

the assets becomes operational. Cash outflows include;
• Cost of the asset/invoice value of the asset.
• Capitalized expenditure/incidental costs (expenditure
required to make the asset operational) e.g. freight,
insurance installation, etc.
• Opportunity cost.
• Investment allowances (tax holidays) which reduce on
initial outlay.
• Changes in working capital.
Format:
• Invoice value xxx
Add: Capitalized expenditures/incidental cost.
• Clearingxx
• Transportation xx
• Installation, etc xx
Add: Increase in working capital. xx
• Opportunity Cost xx
Less: Decrease in working capital. xx
• Investment incentives / allowances xx xx
• Net Cash outflow. xxx
 Intermediate Cash flows:

• These are cash flows that the investment is

expected to generate after the initial outlay
has been made. They are normally generated
from operations e.g.
• Increased sales revenue offset by expenses
• Cost savings
• Adjustments of depreciation tax shield.
 Terminal Cash flows:

These occur at the end of the investment life

and they include;
The scrap/salvage value SVt = SV0 (1-t)
Where: SVt = Salvage value after tax
SV0 = Salvage value before
t = Tax rate
Working capital released/recovered.
 CAPITAL INVESTMENT APPRAISAL

CAPITAL INVESTMENT APPRAISAL

• Capital investment decisions will usually have
a direct effect on future profitability either
because they will result in an increase in
revenue or because they will result in
efficiency and reduction in costs. Proposed
investments should be properly evaluated and
be found to be worthwhile.
 PROJECT APPRAISAL TECHNIQUES

• Project appraisal involves examining cash flows on a

proposed investment to find out whether the proposal is
viable or not.
• Once the cash flow information has been derived and the RR
(discount rate) has been determined, this information should
be subjected to further analysis using the relevant
techniques of investment appraisal. These techniques fall
into three categories:
• Where there is no formal analysis
• Techniques that ignore time value of money
• Techniques that take into account time value of money 
• Techniques with no formal analysis ;
• Are advantageous in that decisions made are
quickly and are not costly but they are very
unreliable.
• Since investment decisions are very important,
these techniques are not recommended.
However, they can provide an indication of
potential investment projects.
 
 Techniques that ignore time value of money.

Techniques that ignore time value of money.

i) Payback Period Technique:
• This determines the period it takes for an investment
to generate sufficient incremental cash to recover its
initial capital outlay. The investment will be more
desirable if the payback period is very short.
• Determination of the payback period varies depending
on the nature of the cash flows which may either be
uniform or uneven. For a uniform cash flow pattern,
the payback period is calculated as:-
• Payback period = ___ Initial Outlay__
Annual cash inflow.
• For example if an investment has an initial outlay of Shs.700m
and it is projected that it will have a useful life of 30 years with
a uniform annual cash inflow of Shs.35m then its payback
period will be;
P.B.P = ___Initial Outlay__ = 700
Annual cash inflow 35
= 20 years
• This means that it will take 20 years for the cash inflows to
cover the initial outlay on the investment.
• Where the cash flow pattern is not uniform
(uneven), payback period will be determined
by accumulating cash inflows until such a time
when they cover the initial outlay (capital
expenditure). Suppose initial outlay was 600m
and cash inflows were as follows:-
• Year Cash inflow Accumulated Cash inflow
• 1 30 30
• 2 50 80
• 3 100 180
• 4 200 380
• 5 200 580
• 6 80 660
• 7 120 780
• 8 150 930
• 9 280 1,210
• 10 130 1,340
• The payback period lies between the fifth and
sixth year. To obtain the exact period, the
following formula is used;
• Year 5 + Amount of outlay yet to be recovered
• Cash inflow for year 6
• 5 + 20 = 5¼ years
• 80
 Decision rule/acceptance criteria:

• Decision rule/acceptance criteria:

Under this technique, the payback period determined for
the investment should be shorter than or equal to the
payback period desired by the firm for that category of
investments.

• If the desired payback period in the above example is

two years, then the investment should be rejected
because its payback period is longer than the
maximum payback period desired by management.
• Merits of the Technique:
• It is a simple technique to use and understand.
• It uses cash flow information, which is the relevant information
in the objective of the firm.
• Demerits of the Technique:
• It ignores time value of money. Cash inflows are simply added
together as if the investor is indifferent to the timing of the
cash inflows.
• It ignores cash flows after the payback period. 
• * Read more on merits and demerits and attempt some
questions cash flow determination.
 The accounting rate of return / average rate of return

• The ARR is the ratio of average annual profits after taxes to

average investment.
ARR = Average Annual profits after taxes__
Average investment on the project
• Average annual profits after taxes obtained thus;
• Average Annual profits = A1 + A2 + A3 + … + An
n
• Where Ai is profit after tax in year 1
• n is the number of years over which the profits are
projected.
 Illustration:

• Z.K. Company Limited intends to set up a fruit processing plant in

Mukono. It is estimated that the investment will cost Shs.500m.
Depreciation will be 10% on a straight line basis over 5 years of
useful life of the plant. The projected earnings after depreciation
and tax are:-

• Year Profits after tax

• 1 10m
• 2 20m
• 3 40m
• 4 60m
• 5 80m
• To determine ARR, average annual profits after
tax are;
• 10 + 20 + 40 + 60 + 80 = 200m = 42m
• 5 5
• To determine average investment on the
project
• Average investment = Sum of Book Value of life of
asset
• No. of years of useful life of asset
• Year 1 book value = 500m less 10% depreciation.
• = 500m – 50 = 450m
• Year 2 book value = 450m – 50m = 400m
• Year 3 book value = 400m – 50m = 350m
• Year 4 book value = 350m – 50m = 300m
• Year 5 book value = 300m – 50m = 250m.
• Therefore average investment
• = 450 + 400 + 350 + 300 + 250
• 5
• = 1750
• 5
• = 350m
• Therefore ARR = 42m x 100%
• 350m
• ARR = 12%
• Decision rule/acceptance criteria:
• An investment is accepted if the ARR is greater than the RRR
(Required Rate of Return) by the investors. If the ARR is less
than the investors RRR, the project should be rejected.
•  
• Merits of the Technique:
• It is simple to use and understand
• It uses profit information and therefore there is no need to
make adjustments in financial statements.
• It takes into account all the profits of the project life.
• Demerits:
• It ignores time value of money by simply
adding together all expected profits without
discounting them to their present worth.
• It uses accounting profits which are vague and
inconsistent with the basic objective of
maximizing wealth.
•
• Techniques that take into account time value of money.
• Net Present Value (NPV)
• The NPV of an investment project is the difference between the
present value of initial outlays and the present value of the streams
of expected cash inflows.
• n

• NPV =  Ai - Io =0
• i=1 (1+K)i
• Where Ai is the cash flow in period i, K is the required rate of return
by the investor (discounting factor), Io is the cash outlay today and n
is the number of years of the useful life of the investment.
• Illustration:
• A.K. Ltd is proposing to expand its business by adding another
production line. The investment will cost Shs.200m and will realize
the following cash inflows over a period of 5 years.
• Year Cash inflow (in millions)
• 1 40m
• 2 60m
• 3 80m
• 4 50m
• 5 70m
• The companies required rate of return is 10%. The NPV of this
investment would be;
The companies required rate of return is 10%. The NPV of this investment would be;
Year Cash flow PV factor (10%) PV
(in millions)
0 (200) 1.000 (200)
1 40 0.909 36.36
2 60 0.826 49.56
3 80 0.751 60.08
4 50 0.683 34.15
5 70 0.621 43.47
NPV = 23.62
• For the case of uniform cash flow stream e.g. If
the investment will cost Shs.200m is 20m
expected per year over the 5 year period then PV
of inflows = Shs.200m [Present Value annuity
factor at 10% for 5 years]
• = 20m x [3.791]- 200m

• NPV = 75.82m – 200m

= (124.18m)
• Decision rule/acceptance criteria:
• All projects with positive NPV should be
accepted because they add value to the firm
while those with negative NPV should be
rejected because they reduce the value of the
firm. The firm should be indifferent if NPV is
zero since this would imply a break-even
position.
• Merits of NPV Technique:
• NPV takes into account time value of money by
discounting the cash flows to their present worth.
• It uses cash flow information which is relevant to the
objective of wealth maximisation.
• It is superior to all other techniques of capital
budgeting because an investment cannot have more
than one value of NPV.
• It shows the absolute contribution of an investment to
the wealth of the firm
• Demerits of NPV:
– Difficulty in estimating cash flows and then
computing it especially when long periods are
involved for example 100 years
– Determining the discount rate is complex
•  
• Internal Rate of Return (IRR)
• IRR is defined as the interest rate / discount rate
that equates the present value of the expected
future value of cash inflows to initial capital
outlays.
• Therefore IRR =
• n

• IRR =  Ai - Io
• i=1 (1+K)i
• Thus:
• n

• IRR =  Ai - I o = 0
• i=1 (1+K)i
• Determination of IRR is by trial and error. If at
first attempt using a certain rate K, the NPV is
positive then you should try a higher one. If
on the other hand on first attempt the NPV is
negative, then you should try a lower rate.
• Using the example of AK Ltd, since NPV is
positive, then we use a higher rate i.e. 15%.
Year Cash flow PV factor (15%) PV (in millions)
0 (200) 1.000 (200)
1 40 0.870 34.80
2 60 0.756 45.36
3 80 0.658 52.64
4 50 0.572 28.60
5 70 0.497 34.79
NPV 3.81
• IRR= Lower rate +
(difference between PV of lower rate and at IRR)
(difference between PV inflows at lower rate and at
high rate)
X (difference between the two rates)
10 % + (223.62-200) x 5%
( 223.2-196.19)
IRR = 14.305%
= 14.31%
• Decision rule/acceptance criteria:
• Accept investments whose IRR is greater than RRR and
reject those investments whose IRR is less than RRR.
This is because investments with IRR>RRR would imply
a positive NPV, while those with IRR<RRR imply a
negative NPV hence changes wealth of the firm;
• Advantages/Merits of IRR:
• Recognizes time value of money
• Uses cash flows which are consistent with objective of
firm
• Demerits:
• You may fail to get a rate that equates the
present value of benefits to that of outlays.
• Calculation of IRR is complicated.
• There is a problem of multiple internal rates of
return.
•  
 3.Profitability Index (PI):
Profitability index is the ratio of present value of cash
inflows to present value of initial outlay.
• PI = Present Value of Cash inflows
Present Value of Initial Outlay.
• In the example of A. K. Ltd.,
• PI = 223.62
200
= 1.1181
• PI = 1.1
• Decision rule/acceptance criteria:
• Investments with PI greater than one are accepted because
this would imply positive NPV hence increasing the wealth of
the firm. Investments with PI less than one should be
rejected.
• Merits:
• Recognizes time value of money.
• Easy to compute and use.
• Uses cash flows which are consistent to the objective of wealth
maximization.
 
• Demerits:
• Need to adjust financial statement figures to
determine cash flows which is time
consuming.
 
 SPECIAL CONSIDERATIONS IN CAPITAL BUDGETING DECISIONS

• Generally, all investments which have NPV>0,

IRR>RRR or PI>1 should be accepted. Special
considerations arise when the general
acceptance criteria above needs adjustments.
Under this acceptance criteria the following
assumptions are made, that;
•  
• Investment projects are independent of one another
and therefore in that acceptance of one project does
not preclude / prevent acceptance of another.
• The firm has no restrictions on the funds available for
capital expenditure / all the necessary capital to
finance its investment projects is available.
• That there is no risk associated cash flows which have
been projected on the investment. .
• However the above assumptions are unrealistic and
may not apply in reality because of:
• Mutually exclusive projects- Investment projects can be
dependent on one another i.e acceptance of one prevents
acceptance of another.
• Limited funds that leads to capital rationing. When firms ration
funds, viable investments are left out. (i.e. investments with
positive NPV may be left out).
• Risk exposure in the economy that affect expected returns.
Investment decisions are normally made under conditions of
risk. Assumptions are made before managers invest, but these
may change during implementation bringing about variability in
returns. Therefore firms have to incorporate risk in capital
budgeting decisions.
• HOW TO DEAL WITH MUTUALLY EXCLUSIVE INVESTMENTS.
• Mutually exclusive investments cannot be accepted at the same time.
Acceptance of one implies rejection of another. Therefore managers
have to know how to select the best. This can be done through ranking
the investment projects. However, this ranking can only be possible if
the following condition holds;
• If NPV, IRR & P.I rank / agree that one particular investment is superior
to all the others. If they consistently rank one a certain investment as
the best, then management should take it up. However situations arise
when NPV, IRR & P.I rank projects differently e.g if for two projects A
and B NPV of A is greater than NPV of B, but IRR of B is greater than
IRR of A
•  
• There are three conditions that may lead to such
situations.
• If the mutually investments have different sizes
• If the investments have different life spans.
• If the mutually exclusive investments have
different cash flow patterns. Especially if one has
large cash flows accruing earlier and smaller ones
later, and if the situation is the reverse for the
other investment.
• Example: Given two mutually exclusive
investments X and Y where project X has NPV
of 350m and project Y has NPV of 600m while
IRR of X is 24% and IRR of B is 16%. The RRR
rate of return for both projects is 14%. Select
the best investment.
• Both projects are acceptable hence you rank
them
Project X (ranks) Y(ranks)
NPV 2 1
1RR 1 2
• The results of ranking show a conflict on which
project to choose. The main cause of the conflict
here is what is known as the re-investment
assumption. With IRR, the assumption is that you
can re-invest cash flows at the yield from a given
investment. This is unrealistic because the yield
would be too high. With NPV the assumption is that
each cash flow can be re-invested at the cost of
capital or minimum required rate of return (RRR).
This assumption is more realistic.
• NB: When we have mutually exclusive investments and
there is a conflict in ranking them, then the investment
with the highest NPV should be preferred because:
• The underlying re-investment assumption is more realistic
• In addition to the re-investment assumption, NPV would
be preferred in ranking because it indicates the absolute
contribution of an investment to the wealth of the firm as
compared to IRR.
• IRR can have multiple rates which is not the case with NPV.
•  
CAPITAL BUDGETING UNDER CONDITIONS OF CAPITAL RATIONING (Ceiling)

Capital rationing occurs when a firm cannot

undertake all its viable investment due to
insufficient funds for capital expenditure. The
insufficiency of funds could be due to internal
and external factors.
 Internal factors
• The risk profile of managers. Risk averse managers (fear
risk) will not go to raise funds from the market even
when they are readily available.
• Internal borrowing restrictions imposed on the financial
manager.
• Private ownership against expansion.
• Fixed budgets or divisional constraints.
• limited human resource for expansions,
• Agency problem/conflict for policy control and debt
covenants/constraints.
 External factors
• Financial distress
• External restrictions.
• Tight borrowing conditions
• New unproven product
• Market imperfections e.g. limited information,
high cost of capital
• Lack of capital markets
 How to deal with situations of capital rationing

• Capital rationing implies that the firm adjusts its

acceptance criteria Investments are now accepted as a
bundle, which meets the following conditions.
• The bundle of investments that gives the highest NPV
• The bundle should exhaust the available funds as much
as possible.
• The above tow conditions now become the criteria for
acceptance.
• Example: A firm has evaluated the following six
investments and found out the following results.
 Example
Project A B C D E F
Outlay 100m 30m 70m 90m 40m 80m
NPV 200M (15m) 140m 162m 76m 40m
P.I 2.01 0.86 1.40 1.96 1.45 1.00
• The firm has a capital budget ceiling of 200m.
You are required to select the best investment.
• Select the best i.e. one that has the highest
NPV and exhausts all available funds

• Projects
Project NPV Outlay Bundle Total NPV Total Outlay (Cost)
A 200m 100m A+D 362m 190m
B (15)m 30m A+C 340m 170m
C 140m 70m A+E 275m 140m
D 162m 90m A+F 240m 180m
E 76m 40m D+C+E 378m 200m
F 40m 80m C+E+F 256m 190m
Note: Exhaust all possible bundles
• The best bundle will be D+C+E because it has the highest NPV
and exhausts the budget completely hence we select these
investments.

• Implications of capital rationing:

• The best investment can be left out e.g. investment A which
has the highest NPV is left out because of insufficient funds
• The firm may lose competitive advantage in the market
because of leaving out investments like A.
• May lead to sub-optimal decisions by managers
• INCORPORATING RISK IN CAPITAL BUDGETING DECISIONS
• In capital budgeting risk refers to the possible variability between the
estimated cash flows and the actual
• cash flows realized when the project is implemented. This variability may
be due to economic changes, changes in government policy, changes in
social and cultural values, natural factors, etc.
• When this variation occurs, then there is risk. This risk is especially
associated with the cash inflows because they go further into the future.
Risk can be incorporated in capital budgeting by;
•   
• Measuring the extent of the risk associated with the investment
• Adjusting the techniques of analysis for this risk.
 
  
METHODS OF INCORPORATING RISK

• 1. Certainty Equivalent Factor Technique

• This technique adjusts risky of cash inflows to a risk free level
by using a risk free rate of return. The risky cash flows are
adjusted using certainty equivalent factors that range on a
continuum of between one to zero. The further you go into the
future the riskier it becomes. On the continuum 1 represents a
100% certainty that the cash flows will be realized. The further
you go into the future you become less certain that the
anticipated ash flows will be realized and hence a decrease in
certainty from 100% to 95%, 70%....... till 0%.
•
Risk Continuum
1 0
• The certainty equivalent factors(1.00, 0.95.0.8, 0.65……)
indicate the varying certainty for events to occur as
anticipated. Therefore risk is incorporated into the risky cash
flows anticipated to get the risk adjusted cash flows or the risk
free cash flows. We adjust the risky cash flows to risk free cash
flows by incorporating Certainty Equivalent Factors(generated
by judgment and experience) to generate the risk free cash
flows, and which risk free cash flows are discounted using the
a risk free rate of return(determined by government treasury
bills) and the NPV thereon. If the NPV attained is Positive the
investment can still be accepted and if Negative, Reject.
Example. A new firm has estimated its cash flows as follows
Year 0 1 2 3 4
Cash flow (100m) 50m 70m 40m 60m
• The certainty equivalent factors associated with
these cash flows are 1.00, 0.95, 0.8.0.72 and
0.6respectively. The risk free rate of return as
determined by government treasury bills is 8%
while the required rate of return is 12%.
• Determine the NPV using risky cash flows
• Determine NPV using risk adjusted cash flows
•  
a)

Year Cash flow PVfactor(12%) Present Values

0 (100) 1.00 (100)
1 50 0.893 44.65
2 70 0.797 55.79
3 40 0.712 28.48
4 60 0.636 38.16
NPV= 67.08
a) Using risk adjusted cash flows.
Year Risky Cash C.E.F Risk free cash PVF 8% PV of risk free
A flows C flows Risk free rate Cash flows
B D = (B x C )
0 (100) 1.00 (100) 1.00 (100)
1 50 0.95 47.5 0.926 43.99
2 70 0.80 56.0 0.857 47.99
3 40 0.72 28.8 0.794 22.87
4 60 0.60 36.0 0.735 26.46
NPV= 41.31
NB. Before risk was incorporated the investment looked very
attractive i.e. NPV= 67.08m but when risk was incorporated the
investment was not as attractive as before i.e. NPV=41.31m
 2. Risk Adjusted Discount rate

In this technique it is the discount rate (K) that is adjusted. The K

normally represents two major components of risk i.e. the risk
free rate (minimum rate of return) and the risk premium. The risk
premium is the additional rate of return that the investor requires
for undertaking extra risk on an investment. Therefore discount
rate (K) is made up of Rf+ Rp.
 
 Sensitivity Analysis
• This technique recognizes the fact that there are several
variables which determine the actual cash flows obtained
from an investment.
• It therefore attempts to show how revenues and costs
would behave if there were changes in variables such as;
( changes in prices, labor, changes in demand, taxes, Fixed
costs…)
• The approach incorporates risk by asking questions of what
if nature, e.g. What if the price of the product fell by 10%.
• This would affect revenues and consequently NPV. The next
step is to find out by how much the variable will change
before the NPV becomes negative.
 Advantages of sensitivity analysis

• Simplicity in spreadsheet packages e.g. MS

Excel
• Insight of risk characteristics in a project i.e.
how risky is the project
• Highlights critical variables and predictions
• Research guidance
 Limitations of sensitivity analysis
• Not risk measuring/reducing technique/no clear-cut decision rule.
• Measuring one variable ceterus peribus/ ineffective isolation.
• Range of values/Results without sense of likelihood.
• Subjective analysis can reject viable proposal.
• Variables beyond control of financial manager

Other techniques include

• Use of probability decision trees to show the impact on cash flows
• Use of simulation to develop profiles of possible NPV outcomes
 
 THE CONCEPT OF COST OF CAPITAL

• Cost of capital refers to the minimum required

rate of return that must be generated from an
investment in order to justify commitment of
funds in such an investment/project.
•  
• Cost of capital is also known as the hurdle rate
of return or cut off rate. It can also be seen as
the compensation to the investor for the time
and risk in the use of capital by the project.
• Importance of the Concept of Cost of Capital
The concept of cost of capital is crucial in
financial management and can be pegged to the
four important finance decisions of working
capital management, investment decision,
earnings management decision and the
financing decision.
•  
• Cost of capital can be used as a financial standard for
evaluating investment decision. An investment is
accepted if it has positive NPV.
• In calculating this NPV, cash flows are discounted to
their present worth using an appropriate discount
factor (K), which is the cost of capital in that case.
This factor is common to all the other discounted
appraisal techniques i.e. IRR and profitability index.
 EXERCISE
Year Cash inflow Accumulated Cash inflow
• 1 30
• 2 50
• 3 100
• 4 200
• 5 200
• 6 80
• 7 120
• 8 150
• 9 280
• 10 130