CAPITAL

BUDGETING:
APPLICATION OF
INVESTMENT
DECISION
TECHNIQUES

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ANUM

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 Exercise:
118-0060-1

Exercise 1 All values are in AED (Thousands)

Year Project Project Project Project Project Project Project

1 2 3 4 5 6 7
0 (5,000.0 (10,000.0 (15,000.0 (25,000.0 (25,000.0 (30,000.0 (35,000.0
0) 0) 0) 0) 0) 0) 0)
1 1,000.0 1,000.00 1,700.00 1,000.00 11,000.0 (3,000.00 (9,000.00
0 0 ) )
2 1,000.0 2,000.00 1,700.00 1,200.00 10,000.0 10,000.0 (3,000.00
0 0 0 )
3 1,000.0 2,000.00 1,700.00 3,000.00 9,000.00 9,000.00 6,000.00
0
4 800.00 3,000.00 1,700.00 4,000.00 8,000.00 6,000.00 6,000.00
5 800.00 3,000.00 1,700.00 5,000.00 7,000.00 6,000.00 8,000.00
6 700.00 4,000.00 1,700.00 6,000.00 6,000.00 6,000.00
12,000.0
0
7 600.00 4,000.00 1,700.00 7,000.00 5,000.00 4,500.00 12,000.0
0
8 600.00 2,000.00 1,700.00 9,000.00 4,000.00 4,500.00 14,000.0
0
9 500.00 2,000.00 1,700.00 12,000.0 3,000.00 3,000.00 14,000.0
0 0
10 500.00 2,000.00 1,700.00 20,000.0 5,000.00 3,000.00 14,000.0
0 0
Net Cash 2,500.0 15,000. 2,000.00 43,200.0 43,000.0 19,000.0 39,000.0
flow 0 00 0 0 0 0

The current scenario is about selecting the best optimal project whose NPV is
positive of Al hammadi enterprise which is a fast growing firm in the Dubai,
with the practice of investing in a few profitable projects each year. For this
year, the operation manager has identified seven projects that listed in the
Exhibit 1 and present to the management committee, the CEO of the firm is
impressed with the projects but the finance manager raises the concern that
the funds available with the firm for investment is limited to AED 65 million.
Then the CEO asks the finance manager to select the best projects.
Ms. Alya, the finance manager is looking for your assistance to suggest the "best
undertakings" that firm ought to acknowledge. Operation manager proposed seven
projects however the organization has facing the problem of the finance . Finance
manager suggested to pick the best project under the restriction of AED 65 million and
will choose by the quantitative analysis such as Payback period, DPBP, NPV, IRR and
Profitability Index.
 Discounted
Quantitative Payback
Payback
Net Present Internal Rate Profitability
Methods Period Value of Return Index
Period

Projects Projec Projec Projec Projec Projec Projec Projec

t1 t2 t3 t4 t5 t6 t7
Net Cash flow 2,500 15,000 2,000 43,200 43,000 19,000 39,000
Payback periods 5.57 4.67 8.82 6.69 2.44 5.33 7.21
Discounted 9.50 5.75 15.70 8.50 2.93 8.68 9.76
Payback Period
NPV 106 5,562 (4,089 11,224 22,488 1,710 1,406
)
IRR 10% 19% 2% 15% 32% 10% 10%
Profitability Index 1.02 1.56 0.73 1.45 1.90 1.06 1.04

Ranking of Projects
Projects Projec Projec Projec Projec Projec Projec Projec
t1 t2 t3 t4 t5 t6 t7
Net Cash flow 6th 5th 7th 1st 2nd 4th 3rd
Payback periods 4th 2nd 7th 5th 1st 3rd 6th
Discounted 5th 2nd 7th 3rd 1st 4th 6th
Payback Period
NPV 6th 3rd 7th 2nd 1st 4th 5th
IRR 6th 2nd 7th 3rd 1st 4th 5th
Profitability Index 6th 2nd 7th 3rd 1st 4th 5th

In capital budgeting, mutually-exclusive projects refer to a set of projects out of which

only one project can be selected for investment. A decision to undertake one project
from mutually exclusive projects excludes all other projects from consideration. Unlike
independent projects, in which a decision to invest in one project has no bearing on the
decision to make investment in another, investment decision in case of mutually
exclusive projects is dependent on the relative merit of the projects.

Capital budgeting decisions are made on the basis of net present value, IRR, payback
period and other techniques. In case of mutually exclusive projects, the project with
highest net present value or the highest IRR or the lowest payback period is preferred
and a decision to invest in that winning project excludes all other projects from
consideration even if they individually have positive NPV or higher IRR than hurdle rate
or shorter payback period than the reference period.

Conversely, there is no such dependence in case of independent projects. Independent

(or non-mutually exclusive project) is favorable if the net present value is positive and/or
IRR is higher than the hurdle rate and/or the payback period is shorter than a specific
reference period. Based on the rationed capital or investment of AED 45 million, investor
prefer to make decisions as discussed above and choose the project 4 and 5 with the
highest NPV’s and will prefer after than to select the project 1 and 2 with positives NPV’s.
Further, NPV and IRR results are similar and shows the same results and ranking so there
would be no difference in the decision rule to choose the decision between these two
methods. Profitability index or cost-benefit ratio or benefit-cost ratio or capital rationing
is a tool for measuring profitability of a proposed corporate project by comparing the
cash flows created by the project to the capital investments required for the project.
Profitability index gives a better result as the NPV and IRR. Decision rule for the PI is if
the PI is greater than 1, project will be accepted or if it is less than 1, project will be
rejected. PI for the project 5 and 3 gives the higher index among these 7 investment
projects and investors will choose these two project in priority due to the higher ratio of
PI.

Bottom Line:
Various organizations uses different valuation methods to either accept or reject
projects. Decisions are made on the basis of NPV method, is considered as the decision
rule for many investors and analyst, the IRR and PB methods are frequently uses also in
specific situations.

Project four and five gives the highest NPV’s should be select first for making an
investment. To maximize the wealth of shareholders, investor further can invest on other
two more projects such as project one and two or project seven either.

Exercise:
118-0060-1B

Exercise 1B Amounts in AED (Thousands)

Year Project 1 Project Project 3 Project Project Project Project 7

2 4 5 6
0 (5,000.00 (10,000.0 (15,000.0 (25,000.0 (25,000.0 (30,000.0 (35,000.0
) 0) 0) 0) 0) 0) 0)
1 1,000.00 1,000.00 1,700.00 1,000.00 11,000.0 (3,000.00 (9,000.00
0 ) )
2 1,000.00 2,000.00 1,700.00 1,200.00 10,000.0 10,000.0 (3,000.00
0 0 )
3 1,000.00 2,000.00 1,700.00 3,000.00 9,000.00 9,000.00 6,000.00
4 800.00 3,000.00 1,700.00 4,000.00 8,000.00 6,000.00 6,000.00
5 800.00 3,000.00 1,700.00 5,000.00 7,000.00 6,000.00 8,000.00
6 700.00 4,000.00 1,700.00 6,000.00 6,000.00 6,000.00 12,000.0
0
7 600.00 4,000.00 1,700.00 7,000.00 5,000.00 4,500.00 12,000.0
0
8 600.00 2,000.00 1,700.00 9,000.00 4,000.00 4,500.00 14,000.0
0
9 500.00 2,000.00 1,700.00 12,000.0 3,000.00 3,000.00 14,000.0
0 0
10 500.00 2,000.00 1,700.00 20,000.0 5,000.00 3,000.00 14,000.0
0 0
Sum of 7,500.00 25,000.0 17,000.0 68,200.0 68,000.0 52,000.0 86,000.0
the Cash 0 0 0 0 0 0
inflows
Net Cash 2,500.00 15,000.0 2,000.00 43,200.0 43,000.0 19,000.0 39,000.0
flow 0 0 0 0 0

Requirement 1
Rank the projects simply by inspecting the cash flows (excess of cash
inflows over cash outflows)

Project are generally ranked on the ground of higher return. Project that gives the very

best return could be ranked first and with the lowest return is ranked at the last.

Investor usually have a habit of accept the ones projects which gives a better result and that

meet the objective of wealth maximization. The detail is given as follows;

Projec Project Projec Project Project Project Project

t1 2 t3 4 5 6 7
Net Cash flow 2,500.0 15,000. 2,000.0 43,200. 43,000. 19,000. 39,000.
0 00 0 00 00 00 00
Ranking 6th 5th 7th 1st 2nd 4th 3rd

Requirement 2
Rank the projects using the various quantitative methods, assume that
all projects are from the same risk class and appropriate discount rate is
9%. Briefly explain the various methods, and specify which quantitative
ranking methods are better and why?

There are four type of quantitative techniques like Payback Period, Net Present Value,

Internal fee of return and profitability index. Projects are analyzed and ranked consistent
with these quantitative techniques as follows;

Project Project Project Project Project Project Project

1 2 3 4 5 6 7
Payback periods 5.57 4.67 8.82 6.69 2.44 5.33 7.21
Ranking 4th 6th 1st 3rd 7th 5th 2nd

NPV 106.13 5,562.8 (4,089.9 11,224. 22,488. 1,710.4 1,406.6

4 8) 35 69 7 7
Ranking 6th 3rd 7th 2nd 1st 4th 5th
 IRR 9.56% 19.13% 2.34% 15.03% 32.39% 10.26% 9.51%
Ranking 5th 2nd 7th 3rd 1st 4th 6th

Profitability Index
1.02 1.55 0.72 1.44 1.89 1.05 1.04
Ranking 6th 2nd 7th 3rd 1st 4th 5th

Quantitative method’s explanation;

1. NPV
The difference between the present value of
the future cash flows from an investment
and the amount of investment. Present value
of the expected cash flows is computed by
discounting them at the required rate of
return.
2.IRR
The internal rate of return (IRR) is a measure
of an investment’s rate of return. The
term internal refers to the fact that the
calculation excludes external factors, such as
the risk-free rate, inflation, the cost of
capital, or various financial risks.
3. Payback periods
The payback period refers to the amount of time
it takes to recover the cost of an investment.
Simply put, the payback period is the length of
time an investment reaches a breakeven point.
4. Profitability Index
Profitability index (PI), also known as profit
investment ratio (PIR) and value investment
ratio (VIR), is the ratio of payoff to investment
of a proposed project. It is a useful tool for
ranking projects because it allows you to
quantify the amount of value created per unit
of investment.

Which quantitative method is better and why?

The project can’t be ranked just genuinely by way of analyzing the cash flows. In order to rank
the project, we should deliver all cash flows to the identical factor in time (present) before we
can even compare.
There are different quantitative methods can be used to rank the project (take delivery of or
reject) decision which includes IRR, payback period, NPV and profitability index.
NPV in the high-quality ranking primarily based at the realistic  result and
reinvestment price while IRR most effective works if there is a chain of cash flows
that shows consequences in an preliminary outlay observed by destiny inlay.
Any sequence of cash flows that doesn't guide this, will now not yield correct results with the
IRR technique. Also, IRR just offers a percentage, with a view to ignore the significance of
cash flows.
Payback period ignores the time price of money, which is taken into consideration to be flaw of
this methodology. Profitability index also gives the good result to rank the
project but it offers the short time period projects greater 
rating than the long time tasks. All of the drawbacks of IRR and Payback duration and PI, NPV
is typically the great 
approach for capital budgeting.
Requirement 3
Compare the ranking obtained by quantitative methods with the ranking
obtained by simple inspection of cash flows. Do the differ, explain the
reasons for this?
Answer:

Comparison this project is made among the various quantitative methods and rank accordingly;
Projec Projec Projec Projec Projec Projec Projec
Comparison t1 t2 t3 t4 t5 t6 t7
Net Cash flow 6th 5th 7th 1st 2nd 4th 3rd

Payback periods 4th 6th 1st 3rd 7th 5th 2nd

NPV 6th 3rd 7th 2nd 1st 4th 5th

IRR 5th 2nd 7th 3rd 1st 4th 6th

Profitability Index 2nd 6th 1st 5th 7th 4th 3rd

Comments:
In estimate with the simple cash flow method vs payback periods, project four is ranked at
the 1st and Project five is ranked on the second number even as reliable with the Payback period
project three is ranked at the 1st and Project 7 is ranked on the second in addition all of
the projects have different rating among with these two strategies.
In a result, payback period will be provide greater preference over
the simple cash flow approach.

Similarly, while we compare Simple Cash flow technique with NPV, the ranking of

the projects are show above project5 is ranked on 1st whilst under simple CF approach project4
is ranked on 1st. NPV remember the time period of money and 
offer absolute degree of go back on funding and additionally result the maximization of
shareholder's wealth, whereas 
simple cash flow techniques do not offer sensible measures.

Therefore, NPV technique offers better result than another quantitative techniques.

IRR gives additionally a better result because the NPV method whilst it shows the results in the
proportion to simply accept or reject the project. Therefore, project five again more on
the ranked 1st in keeping with the IRR technique. On the other hand simple CF approach ranked
the Project four on 1st. Investors will tend to simply accept the mission based at
the NPV technique.

Profitability Index offers a completely specific photograph of the appraisal of projects. Under the

PI, projects are regular
with PI added than 1 and inside the modern-
day scenario assignment three gives simplest PI extra than 1. So based totally on
this approach only project3 will be usual.
Requirement 4
Recommend the best projects that the firm should accept when the
funds available are limited to AED 65 Million, project 4 and 5 are
mutually exclusive.

Answer:

If the funds are limited to the AED 65 million as opposed to AED 145 million,

then we've to perform the quantitative analysis to accept the
ones initiatives whose present values are positives and gives great return

s. As we discussed above that NPV gives the most higher result than any other method, so first

of all, we can be given the project four and five as these are together exclusives and offers the
highest NPV than every other tasks.

Along with these jointly exceptional projects we are able to in addition accept the challenge 1

and 2 to use the contrasted funds and get the option/decisions to growth the wealth
as those initiatives additionally have fantastic NPV and ranked additionally on 3rd and 6th.

However, project 1 gives a very low NPV however we are able to diversify portfolio and take

delivery of these projects to get the most returns.

THANK YOU