Capital Budgeting Techniques and Investment Appraisal Methods for Evaluating Financing and Project Decisions

This report evaluates the use of capital budgeting techniques and investment appraisal methods for evaluating financing and project decisions. It discusses the significance of optimal capital structure for maximizing shareholder value and evaluates two scenarios related to financing and capital budgeting decisions. The report also provides information on short-term and long-term financing sources that can be employed by firms.

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Financial Management

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Contents
Introduction......................................................................................................................................3
Solution 1:........................................................................................................................................3
Solution 2:........................................................................................................................................5
Scenario 1: Financing Decision.......................................................................................................5
Scenario 2: Capital Budgeting Decision........................................................................................10
Conclusion and Recommendations................................................................................................16
References......................................................................................................................................18

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Introduction
The purpose this report is to examine the use of various capital budgeting techniques and
investment appraisal techniques to evaluate the two given scenarios. One scenario is related to
investment appraisal methods for evaluating options of financing for increasing the shareholder
value. Another scenario is related to the application of capital budgeting methods such as
payback, net present value and accounting rate of return to evaluate the given three projects. On
the basis of analysis best financing option and projects are being selected from scenario 1 and
scenario 2 respectively.
Solution 1:
Critical Evaluation of Significance of Optimal Capital Structure for an Organization to
Maximize the Value for Shareholders
Optimal capital structure of an organization can be referred as adequate mix of debt and
common stock that results in maximization of company stock and reducing the cost of capital.
The decision of capital allocation is regarded as the most critical responsibility of the Chief
Financial Officer (CFO) as the value created for shareholders is based on such strategic decision-
making (Martin, 2011). The major objective of the CFO in this regard is to develop a best
possible capital structure that reduces the financial risk of default and results in improving the
cash inflows for creating large returns for the shareholders. In this context, it is essential for CFO
to determine the ability of a business entity to meet the debt obligations and its effectiveness to
use tax shield. The use of debt and equity during capital structuring decision must be made by
considering such abilities of an entity (Ghosh, 2012). The optimal capital structure is referred to
as the best capital allocation decision made by a company that results in minimizing the
weighted average cost of capital and enhancing the market value. The reduction in the cost of
capital will result in maximizing the market value and thereby creating larger returns for the
shareholders. The business entities tend to adopt more use of debt in comparison to the equity as
the cost of debt financing is regarded to be lower than equity finance. This is because entities
tend to gain a tax benefit while dividend payments by adopting the use of equity finance need to
be paid from after-tax income (Peterson and Fabozzi, 2002).
However, the company should place a limit on the amount of debt it should incorporate in
its capital structure as it will lead to an increase in the financial obligation that is paying the
interest amounts. As such, it will ultimately lead to an increase in the financial risk to the
shareholders due to fluctuations in the cash flow realized by an entity. The increasing use of debt
in the financial structure can prove to be beneficial for the companies that have consistent cash
flows to maximize the returns realized by the shareholders. Thus, it can be said that optimal
capital structure for the companies having consistent cash inflows will be higher percentage of
debt and less use of equity. On the other hand, the business companies having fluctuations in the

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cash flows will consist of lower percentage of debt and higher proportion of equity (Martin,
2011).

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Solution 2:
There are two scenarios given in question 2 and both needs to be evaluated in order to
provide knowledge in optimizing the value of shareholders:
Scenario 1: Financing Decision
Part A:
Given Information for both the options
Paid Up Capital
160,000,000.0
0
Book Value per share 1 RM
Total number of shares 160000000
Amount to be raised 104000000.00
EBIT 60000000.00
Tax Rate 25%
Market price of ordinary share 3.00
Part A (i): Option: When right issue is made
Evaluation of option: When right issue is made
Market value of ordinary Share
market price per
share*total number of
shares
As calculation has to be after year of the option is taken so
in that case there is need to take factors.
Factors to be considered:
Change in earnings
Increase in number of shares
Tax impact
change in PE ratio
Ratio in which right issue is made 1.4
New shares issued under right issue 40000000
Current number of ordinary shares 200000000

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Change in EBIT 30%
Existing EBIT RM 60,000,000.00
New EBIT RM 78,000,000.00
Interest Payment RM -
Existing tax expenses @ 25% RM 15,000,000.00
New Tax Expenses @ 25% RM 19,500,000.00
Existing EAT or Net profit RM 45,000,000.00
New EAT or Net Profit RM 58,500,000.00
Existing EPS RM 0.28
New EPS RM 0.29
Existing PE Ratio
Existing MPS/Existing
EPS
10.67 Times
Change in PE Ratio No change
New PE Ratio 10.67
Time
s
New MPS RM 3.12
Market Value of ordinary shares when right issue is
made RM 624,000,000.00
Part A (ii): Option: When right issue is made
Evaluation of option: When loan issue is made
Market value of ordinary Share
market price per
share*total number of
shares
As calculation has to be after year of the option is taken so
in that case there is need to take factors.
Factors to be considered:
Change in earnings
Increase in number of shares
Tax impact
Interest expenses
Total amount raised through long term loans 104000000.00
Interest Rate 10%
Interest Expenses 10400000.00

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Change in EBIT 30%
Existing EBIT RM 60,000,000.00
New EBIT RM 78,000,000.00
Interest Payment RM 10,400,000.00
Existing EBT RM 60,000,000.00
Current EBT RM 67,600,000.00
Existing tax expenses @ 25% RM 15,000,000.00
New Tax Expenses @ 25% RM 16,900,000.00
Existing EAT or Net profit RM 45,000,000.00
New EAT or Net Profit RM 50,700,000.00
Existing EPS RM 0.28
New EPS RM 0.32
Existing PE Ratio
Existing MPS/Existing
EPS
10.67 Times
PE ratio reduced Reduced by 10%
New PE Ratio 9.60
Time
s
New MPS RM 3.04
Market Value of ordinary shares when loan issue is
made RM 486,720,000.00
Part B: Comment on the finding gathered from the above analysis
The decision that has to be taken is to optimize the shareholders value through evaluating
the different options to raise the capital for expansion purpose. The two options that have been
provided in the scenario 1 are long term financing options and these are options are issue of right
shares and long term loan at fixed interest rate of 10%. The required amount of capital that
Octopus Limited needed to finance the expansion plan is RM 104 million. The decision was to
chose one option that has highest market value of ordinary shares through evaluating the both the
options of financing (Baker and Nofsinger, 2010).
The evaluation of both the options have provided following information:
Comparasion of both the financing options
Various Parameters When right issue has
been used When loan issue is made
Price Earning Ratio 10.67 9.60
EPS RM 0.29 RM 0.32

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MPS RM 3.12 RM 3.04
Market Value RM 624,000,000.00 RM 486,720,000.00
As the decision has to be based on the market value of ordinary shares it is highly
recommended that Octopus Plc to chose right issue for the purpose of making the funding
for expansion purpose.
Part C:
Two sources of short-term financing and two sources of long-term financing that could be
employed by firms
The short-term sources of finance can be referred as the financing needs of a company for
small period of time that is usually less than a year. This type of financing need of a business
corporation is also referred as working capital financing that is mainly used to finance the
inventory, accounts receivables and others. This type of financing option is mainly used by a
business corporation requiring quick loan for meeting the operational expenses that will be
repaid within a year.
Short-term Financing Source
The major sources of short-term financing options available to a business corporation can
be discussed as follows:
Accounts Receivables
This method of financing is used by businesses mainly to borrow up to 90 per cent of the
amount they owned in their outstanding invoices. In this method, a business entity usually takes
the invoices to the banks providing discounting facilities and they make a payment in exchange
of a small fee. The bank collects the due amount from the customer in a future date. The method
is largely used by the businesses that provide large amount of credit. Such businesses can carry
out their operational activities without relying on customers to pay the bills (Martin, 2011).
Bank Overdraft
The overdraft agreement enables a business corporation to gain funds to a specific limit
from the bank. The businesses are required to pay the security in the form of some collateral and
also are required to pay an interest amount daily on a variable rate on the outstanding debt. The
business corporations that possess the ability of replying the funds taken quickly then they can
adopt the use of overdraft agreement as a potential source of financing.
Long-term Financing Source
Long-term financing can be referred as the use of financing methods by a business
corporation that have the time-frame of more than a year. Thus, it converts the sources of

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financing options that borrows funds for a longer period of time. The business may require such
type of finances for expansion, diversification or innovation in the business operations. As such,
it can be said that the use of such type of financing options enables a business entity to gain
capital for meeting its long-term objectives and to manage the financing risk in a better way. The
major types of long-term financing option that can be used by a business corporation are
discussed as follows:
Long-term loan
The business companies having long-term growth plans and higher credibility often
adopts the use of loans that are taken from a bank to repay in longer period of time. The loans are
usually taken by a business entity for meeting adequately the working capital needs. The use of
bank loans enables a banking corporation to pay back it within a time frame of more than one
year. This type of funding method is used by businesses to gain access to large amount of capital
that does not need to be repaid immediately. The businesses are required to pay interest on the
loan amount at regular intervals of time usually on a monthly basis. Bank loans are usually
provided at a cost that is generally the interest amount paid by a banking corporation (Ghosh,
2012).
Equity Issue
Equity capital is also regarded as major source of long-term finance used by a business
corporation that is raised in exchange for the share of ownership. This type of financing method
gains funds from the owners of a business who possess a significantly control over its
operational activities. The funds are realized by the investors who possess company shares and
are paid divided in return of the amount contributed by them in the capital structure of a business
entity. This type of financing method is also known as equity capital or share capital and the
major advantage to a firm by using this type of financing method is that it does not have an
obligation to redeem the equity shares (Shim, 2012).

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Scenario 2: Capital Budgeting Decision
This scenario is related to the application of capital budgeting technique to evaluate the
three projects (A, B and C) through using payback, accounting rate of return and net present
value. Octopus Limited is considering three projects which have different life cycle period and
different cash inflows and outflows. So, it can be said that all the projects are mutually exclusive
project and has no link with each other (Batra and Verma, 2014).
Cash flow generated by the different projects has been provided below:
Year Project A Project B Project C
0 $ (80,000.00) $ (20,000.00) $ (20,000.00)
1 $ 26,600.00 $ 4,600.00 $ 11,200.00
2 $ 26,600.00 $ 6,200.00 $ 8,600.00
3 $ 26,600.00 $ 8,000.00 $ 6,600.00
4 $ 26,600.00 $ 10,000.00 $ -
Part A (i): Payback Period
Year Project A Project A
Cash Flows
Cumulative Cash
Flows
0 $ (80,000.00) $ (80,000.00)
1 $ 26,600.00 $ (53,400.00)
2 $ 26,600.00 $ (26,800.00)
3 $ 26,600.00 $ (200.00)
4 $ 26,600.00 $ 26,400.00
Payback period 3.0075
Year Project B Project B
Cash Flows
Cumulative Cash
Flows
0 $ (20,000.00) $ (20,000.00)
1 $ 4,600.00 $ (15,400.00)
2 $ 6,200.00 $ (9,200.00)
3 $ 8,000.00 $ (1,200.00)
4 $ 10,000.00 $ 8,800.00
Payback period 3.1200
or 3 years 44 days

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Year Project C Project C
Cash Flows
Cumulative Cash
Flows
0 $ (20,000.00) $ (20,000.00)
1 $ 11,200.00 $ (8,800.00)
2 $ 8,600.00 $ (200.00)
3 $ 6,600.00 $ 6,400.00
4 $ -
Payback period 2.0303
or 2 years 11 days
Part A (ii): Accounting Rate of Return
Accounting rate of return of Project A
Year Project A
Cash
Flows
0
$
(80,000.00)
1
$
26,600.00
2
$
26,600.00
3
$
26,600.00
4
$
26,600.00
Initial Investment
$
80,000.00
Depreciation
$
-
Salvage Value Assumed to be zero
Average investment
$
40,000.00
Annual Depreciation (Initial Investment − Scrap Value) ÷ Useful Life in Years
$
20,000.00
Average Accounting
Income Year
Cash
inflows
Depreciatio
n
Net Cash
inflows
1
$
26,600.00
$
20,000.00
$
6,600.00

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2
$
26,600.00
$
20,000.00
$
6,600.00
3
$
26,600.00
$
20,000.00
$
6,600.00
4
$
26,600.00
$
20,000.00
$
6,600.00
Total
$
26,400.00
$
6,600.00
Accounting Rate of Return
(A) Average accounting income /Average Investment
16.50%
Accounting rate of return of Project B
Year Project B
Cash
Flows
0
$
(20,000.00)
1
$
4,600.00
2
$
6,200.00
3
$
8,000.00
4
$
10,000.00
Initial Investment
$
20,000.00
Depreciation
$
-
Salvage Value Assumed to be zero
Average investment
$
10,000.00
Annual Depreciation (Initial Investment − Scrap Value) ÷ Useful Life in Years
$
5,000.00
Average Accounting
Income Year
Cash
inflows
Depreciatio
n
Net Cash
inflows

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1
$
4,600.00
$
5,000.00
$
(400.00)
2
$
6,200.00
$
5,000.00
$
1,200.00
3
$
8,000.00
$
5,000.00
$
3,000.00
4
$
10,000.00
$
5,000.00
$
5,000.00
Total
$
8,800.00
$
2,200.00
Accounting Rate of Return
(B) Average accounting income /Average Investment
22.00%
Accounting rate of return of Project C
Year Project C
Cash
Flows
0
$
(20,000.00)
1
$
11,200.00
2
$
8,600.00
3
$
6,600.00
4
$
-
Initial Investment
$
20,000.00
Depreciation
$
-
Salvage Value Assumed to be zero
Average investment
$
10,000.00
Annual Depreciation (Initial Investment − Scrap Value) ÷ Useful Life in Years
$
6,666.67

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Average Accounting
Income Year
Cash
inflows
Depreciatio
n
Net Cash
inflows
1
$
11,200.00
$
6,666.67
$
4,533.33
2
$
8,600.00
$
6,666.67
$
1,933.33
3
$
6,600.00
$
6,666.67
$
(66.67)
4
$
-
$
-
Total
$
6,400.00
$2,133.33
Accounting Rate of Return
(C) Average accounting income /Average Investment
21.33%
Part A (iii): Net present Value
Net Present Value Project A
Year Project A PVF @ 10% Present Value
Cash Flows
0 $ (80,000.00) 1.000 $ (80,000.00)
1 $ 26,600.00 0.909 $ 24,181.82
2 $ 26,600.00 0.826 $ 21,983.47
3 $ 26,600.00 0.751 $ 19,984.97
4 $ 26,600.00 0.683 $ 18,168.16
NPV (A) $ 4,318.42
Net Present Value Project B
Year Project B PVF @ 10% Present Value
Cash Flows
0 $ (20,000.00) 1.000 $ (20,000.00)
1 $ 4,600.00 0.909 $ 4,181.82
2 $ 6,200.00 0.826 $ 5,123.97
3 $ 8,000.00 0.751 $ 6,010.52
4 $ 10,000.00 0.683 $ 6,830.13
NPV (A) $ 2,146.44
Net Present Value Project C

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Year Project C PVF @ 10% Present Value
Cash Flows
0 $ (20,000.00) 1.000 $ (20,000.00)
1 $ 11,200.00 0.909 $ 10,181.82
2 $ 8,600.00 0.826 $ 7,107.44
3 $ 6,600.00 0.751 $ 4,958.68
NPV (A) $ 2,247.93
Part B: Comparison of Results/Findings
Comparison of Results
Methods Project A Project B Project C
Payback Period 3 years 3 days 3 years 44 days 2 years 11 days
Accounting Rate of return 16.50% 22.00% 21.33%
Net Present Value $ 4,318.42 $ 2,146.44 $ 2,247.93
In regards to payback period method, Project C must be selected as it has very payback
period among all three given projects. Project that has higher accounting rate of return must be
selected, therefore project B must be consider when evaluating the project on the basis of
accounting rate of return. On the basis of net present value, Project A must be considered as it
has very net present value as compared to all three projects.
In my opinion, Project C is the best choice as it has almost same accounting rate of return
as project B and has also lowest payback period which is the biggest factor to consider it for
project investment. Although it has lower net present value as compared to Project A but one
thing that should be considered here is that Project A requires high value of investment while
project C requires only one fourth of investment as compared to project C. So in my context, best
choice is to select the project C. Accounting rate of return and payback period ignores the time
value of money but the comparison has to be made in same context as all projects are evaluated
under same method capital budgeting (Deegan, 2013).
Part C: Advantages and Disadvantages of two important investment appraisal tools
NPV
Advantages
· The use of Net Present Value (NPV) enables a business manager to undertake the
long-term investment decision by determining the present value of the projected future
income
· It enables a business manager to compare the future returns to be realized by two
projects and select the project with maximum returns
· It takes into account the time value of money for determining the future worth of a
project

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· It also takes into account the cost of capital and the inherent risk while make future
projections
Disadvantages
· The major drawback of the method is that it determines the potential feasibility of a
project on the basis of assumptions about the cost of capital of a firm
· It is also not regarded to be a suitable method for making a comparison of the two
projects that are of varying size
· The project manager can often face difficult while calculating the appropriate
discount rate
· It is not useful in taking an accurate decision when the initial amount of investment
of two projects is not equal (Götze, 2015)
Payback
Advantages
· The method is relatively easy to implement and determine the feasibility of a
project
· It helps in making an evaluation about the risk associated with a project as the
project with less payback period is regarded to have less risk
Disadvantage
· The method does not take into account the concept of time value of money
· It does not consider the cash flow realized after the pay-back period in maintaining
capital structuring decisions (Erickson, 2013)
Conclusion and Recommendations
The complete analysis of both the scenarios it is highly recommended to Octopus to
select long term debt financing in scenario 1 and Project C in scenario 2. This recommendation is
based on calculation performed in both the scenarios as per the information provided. While
making analysis all the factors affecting the scenarios are being listed and taken into
consideration for analysis purpose. The recommendations are based on the facts and figures
provided in the scenarios and no other information has been used to make the analysis. In
scenario 1, long term debt financing has been recommended because it provided highest market
value of ordinary shares despite of decrease in net earnings. Long term loan financing option
creates a fixed charge of interest expenses on the profits of the company but this option also
helpful in increasing the value of shareholders. In scenario 2, Project C is recommended to the
Octopus Plc despite of lower NPV as compared to Project A because it lowest payback period
and also provides highest (almost) accounting rate of return among all three projects which is
very important factor to be consider. Although my choice ignores the time value of money but
one thing is certain that project A requires cash outflow of RM 80000 give net present value of

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RM 4318 in 4 years while project C gives RM 2247 in 3 years with investment of only RM
20000. Keeping in this mind the project C has been recommended to the company.

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References
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Markets. John Wiley & Sons.
Batra, R. and Verma, S. 2014. An Empirical Insight into Different Stages of Capital Budgeting.
Global Business Review, 15 (2), pp. 339-362.
Brigham, E. 2012. Fundamentals of Financial Management. Cengage Learning.
Deegan, C., 2013. Financial accounting theory. McGraw-Hill Education Australia.
Erickson, K.H. 2013. Investment Appraisal: A Simple Introduction. K.H. Erickson.
Ghosh, A. 2012. Capital Structure and Firm Performance. Transaction Publishers.
Götze, U. 2015. Investment Appraisal: Methods and Models. Springer.
Martin, G. 2011. Capital Structure and Corporate Financing Decisions: Theory, Evidence, and
Practice. John Wiley & Sons.
Moles, P. and Kidwekk, D. 2011. Corporate finance. John Wiley &sons.
Peterson, P,P and Fabozzi,F,J,. 2002. Capital budgeting: theory and practice. John Wiley & sons.
Shim, J. 2012. CFO Fundamentals: Your Quick Guide to Internal Control. John Wiley & Sons.
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