TOPIC TWO

2. CAPITAL INVESTMENT APPRAISAL AND RISK ANALYSIS

2.1. Principles of Time Value of Money in Investment Evaluation

2.1.1.Time value of Money (TMV)

Time Value of Money (TVM) Defined
Time Value of Money (TVM) is a financial concept that explains why money available
now is worth more than the same amount in the future due to its potential earning
capacity. It underlies all calculations and decisions involving time and interest rates
in both business and personal finance.
That is, because money today can be used, invested or grown. Therefore, TZS100
earned today is not the same as TZS100 earned one year from now because the
money earned today can generate interest, unrealized gains or unrealized losses.

Key Assumption: Money can grow when invested any delay is a lost opportunity
for growth.

Fundamentals of Time Value of Money

The following are the basic fundamentals of the time value of money:
i) Money has value over time - Money today is worth more than the same
amount in the future.
ii) Opportunity cost - Money now can be invested or used to earn interest.
Money in the future has lost that time for investing and earning interest.
iii) Inflation - The purchasing power of money decreases over time due to
inflation. Meaning TZS100 today is worth more in real terms than TZS100 in
the future.
iv) Interest - Interest rates represent the cost of borrowing money or the return
available on investments. They reflect the time value of money.
v) Compounding - Interest that is earned on previous interest is called
compound interest. It allows money to grow over time.
vi) Present value - The current worth of a future sum of money or stream of
cash flows after accounting for the time value of money.
vii) Future value - The worth of a current sum of money or stream of cash flows
at some point in the future when accounting for the time value of money.
viii) Net present value - The present value of all cash inflows minus the
present value of all cash outflows from an investment project.
ix) Discounting cash flows - Removing for the time value of money by
discounting future cash flows to determine their present value.

What is the TMV Used in Finance?

The time value of money is the significant concept in discounted cash flow
(DCF) analysis, for valuing investment opportunities. It is also an integral part of
financial planning and risk management activities. E.g. Pension fund managers
consider the time value of money to ensure that their account holders will receive
adequate funds in retirement.

However: TMV does not count for the Capital loss

Importance of TMV
Understanding the time value of money concept is crucial in corporate finance for
several reasons including but not limited to:
i) TVM allows apples-to-apples comparison of cash flows at different times
using discounting and compounding techniques.
ii) It enables businesses to evaluate long-term projects with cash flows over
differing time periods.
iii) Calculating NPV and IRR using the TVM concept determines if an investment
has a positive economic value and an acceptable return rate to proceed.
iv) It serves as a guide to make informed investment decisions.
v) It helps investors to assess the value of future cash flows

Applications of TVM in Finance

Time value of money has many applications in corporate finance viz.
i) Capital Budgeting – TVM based methods like NPV and IRR are used to
evaluate project cash flows and decide which investments are economically
viable.
ii) Business Valuation – TVM helps determine the fair value of a business
based on future expected free cash flows to the firm.
iii) Stocks/Bonds – The concepts of present value and required return are
applied to valuing stocks, bonds and calculating yields to maturity.
iv) Risk Management – TVM concepts enables companies to model various risk
scenarios and stress test financial outcomes based on different discount
rates.
v) Retirement Planning – It helps assess savings growth requirements and
portfolio returns needed to achieve retirement goals.

2.1.1.1. Principles of the time value of money (TVM)

These are the fundamental in investment evaluation methods used for helping to
understand the value of money over time. These principles form the foundation for
evaluating investment projects and making financial decisions. The following are
the core principles:

1) Present Value (PV) Principle

i) It represents the current worth of a future sum of money or stream of cash
flows discounted at a particular rate (usually the required rate of return or
discount rate). It answers the question, "How much is a future amount worth
today?"
ii) It helps investors determine whether future cash inflows from a project are
worth investing in today. If the present value of future cash flows is greater
than the initial investment, the investment is considered worthwhile.

FV
Formula: PV =
( 1+ r ) n

Where:
PV = Present Value
FV = Future Value
r = Discount rate or interest rate per period
n = Number of periods
2) Future Value (FV) Principle
i) It is defined as the value of an investment at a specific point in the future
after earning interest or returns. It shows how much a current investment will
grow over time at a given interest rate.
ii) From the investment evaluation perception, the FV principle helps to
determine how much an investment today will be worth in the future. This
helps in comparing different investment options. (how much an
investment made today will grow over time)
Mathematically: FV = PV×(1+r)n
Where:
PV = Present Value
r = Interest or return rate per period
n = Number of periods

3) Discount Rate Principle

i) It is the rate is the rate of return used to discount future cash flows to their
present value. It reflects the risk associated with the investment and the
opportunity cost of capital.
ii) It is critical in investment appraisal because it determines how much the
future cash flows are "discounted" to calculate their present value. The
higher the risk or the opportunity cost, the higher the discount rate, which
lowers the present value of future cash flows.

iii) Higher-risk investments typically use a higher discount rate, reflecting the
need for a higher return to compensate for the risk (Risk Adjustment)

4) Net Present Value (NPV) Principle

i) The Net Present Value (NPV) is the difference between the present value of
cash inflows and outflows associated with an investment. It shows the net
value added by an investment, after accounting for the time value of money.
ii) It measures the profitability of an investment.
Thus, a positive NPV indicates that the investment will generate more
value than the cost, making it an attractive option. A negative NPV
indicates a loss.

Mathematilly: NPV =∑ ¿
Where:
CFt = Cash flow at time t
r = Discount rate
t = Time period
C0 = Initial investment

5) Compounding Principle
i) Compounding refers to the process where the value of an investment grows
over time as interest or returns are earned on both the original amount and
accumulated interest/returns.
ii) It simple means the interest that is earned on interest.
iii) From the Investment perception - The compounding principle demonstrates how
reinvested earnings grow exponentially over time. Investments with
compounding interest generate more wealth the longer they are held.
iv) Compounding Frequency: The more frequently compounding occurs (annually,
quarterly, monthly), the greater the future value of the investment.

Power of Compound Interest and its effects on TMV

i) Once money is invested, can grow over time earning interest, which over the
ensuing months and years, that interest will be added to the principal,
earning more interest. That's what's known as the power of compound
interest.
ii) Money not invested can lose value over time.
iii) Hiding TZS1,000 in a mattress for three years, will not only lose out on any
additional money that could have been earned by investing it, but it will have
even less buying power than it once did because inflation will have reduced
its value.

Effects of Inflation on TVM

iv) Inflation, or the tendency for the prices of goods/services to increase over
time, impacts the time value of money. As inflation rises, the purchasing
power of money decreases.
v) To account for inflation, calculations involving the TVM concept may use a
real interest rate alongside real cash flows. The real rate is the nominal
interest rate minus the inflation rate, whilst real cash flows will also exclude
any inflationary impact. Being consistent with type of rate used and the cash
flows used ensures TVM calculations reflect the real purchasing power of the
cash flows over time. This is crucial for obtaining an accurate picture of
investment worth and returns.

vi) For example, with 5% inflation and 6% nominal interest rate, a 1% real
interest rate can be used in TVM based calculations alongside cash flows that
have been adjusted to exclude the impact of inflations.
Failing to account for inflation consistently can lead to poor financial
modelling and uneconomic investment decisions.

6) Annuities and Perpetuities

A. Annuities: a series of equal cash flows received or paid over a specified
number of periods. In investment evaluation, it helps in valuing projects that
generate regular, fixed cash inflows or require regular outflows.

Present Value of Annuity (PVA)

Calculated as PVA = C× [(1+r)n -1]

r
Where:
C = Cash flow per period
r = Discount rate
n = Number of periods
B. Perpetuities - A perpetuity is an annuity that continues indefinitely
(forever). It is often used to value investments with endless cash flows, such
as preferred stocks or long-term bonds.

Present Value of Perpetuity (PVP)

Calculated using this formula:

Cr
PV = Where:
r
Cr = Cash flow per period
r = Discount rate

7) Internal Rate of Return (IRR) Principle

i) IRR is the discount rate that makes the NPV of an investment zero. It
represents the expected return on an investment.
ii) It helps to compare different investment opportunities. If the IRR of a project
exceeds the firm’s required rate of return or the cost of capital, the
investment is considered desirable.
iii) Decision Rule: If IRR > required rate of return, accept the project; otherwise,
reject it.

8) Opportunity Cost Principle

i) The opportunity cost refers to the return foregone by investing in a particular
project instead of the next best alternative.
ii) Used in evaluating whether an investment is worth pursuing compared to
other potential investments.
iii) In investment evaluation, the opportunity cost principle helps to ensure that
capital is allocated to projects that provide the highest possible return. The
discount rate often reflects the opportunity cost of capital.

9) Payback Period Principle

i) It is the amount of time it takes for an investment to recover its initial cost
through cash inflows.
ii) It provides a rough estimate of the time horizon for recovering an investment
which is useful in risk assessment.
iii) However, it ignores cash flows beyond the payback period and doesn’t
account for the value of money over time.

10) Reinvestment Assumption

i) The idea that the returns generated by an investment can be reinvested at
the same rate as the original project or investment’s IRR.
ii) When evaluating investments, assumptions about reinvestment rates are
crucial for assessing whether the returns from projects can generate
additional value.
iii) NPV assumes reinvestment at the discount rate, while IRR assumes
reinvestment at the IRR itself.

2.2. Long term investment

Long-term investment refers to the strategy of holding assets with the goal of
generating wealth over an extended period.

It is a strategy aimed at building wealth over time by capitalizing on the growth

of assets (stocks, bonds, real estate or mutual funds) typically for more than one
year.
It focuses on realizing capital appreciation, dividends or interest earnings over
time rather than seeking quick profits. This therefore demands patience, a high
tolerance for market fluctuations and a focus on achieving substantial growth or
income over an extended period.

2.2.1.Characteristics of Long Term Investments

Long-term investments is characterized by the following key aspects:
1. Time Horizon
i) Duration - They have a holding period of over one accounting period,
often five, ten, or even 20+ years. Investors expect that the value of their
assets will grow steadily over time.
ii) Compounding - Earnings (dividends or interest) are reinvested. This
results to exponential growth over the years by earning returns on both
your initial investment and the accumulated returns.

2. Risk Tolerance and Volatility

i) Risk tolerance - the degree of variability in investment returns which an
individual is willing to withstand in their investment portfolio.
ii) Risk-Reward Relationship - Long-term investments usually involve
some level of risk, but because the investor holds the asset for an
extended period, short-term fluctuations in the market are less of a
concern. Markets (stock markets) tend to recover from short-term declines
and generate positive returns over the long run. The more risk willing
to take on, the higher the potential reward or loss could be.
iii) Volatility - Long-term investors need to have a high tolerance for market
volatility. Over short periods, investments like stocks may experience
dramatic ups and downs but long-term investors expect that these
fluctuations will smooth out over time.

2.2.2. Types of Long-Term Investments

i) Equities (Stocks) - Investing in company shares is a common long-term
strategy. Investors buy stocks expecting the company's value to grow
over time, increasing share prices and providing dividends.
ii) Bonds - These are fixed-income securities issued by governments or
corporations, where the investor earns interest over a long period. Some
bonds mature in 10, 20 years or even above.
iii) Real Estate - Long-term real estate investments involve purchasing
property with the expectation that its value will increase over time, while
potentially generating rental income.
iv) Mutual Funds/Exchange-traded funds (ETFs) - These pooled
investments, which hold a diversified mix of stocks, bonds or other
securities are often designed for long-term growth, spreading risk across
multiple assets.
v) Retirement Accounts (e.g. Individual Retirement Account (IRAs) -
These accounts are geared specifically for long-term investment, often
with tax advantages for holding assets until retirement.
vi) Commodities and Precious Metals: Some investors buy commodities
(like gold, silver, or oil) as a hedge against inflation or for potential
appreciation over many years.

2.2.3. Objective of Long Term Investment

The following are the key objectives of long-term Investment
a) Wealth Building Over Time
i) Capital Appreciation - The primary objective of long-term investing is to
increase the initial capital by benefiting from the growth of the asset's
value over time.
ii) Income Generation - For some investments, (e.g. dividend-paying
stocks or rental real estate), the goal may also include generating a
steady income stream.
iii) Retirement Planning - Long-term investments are a fundamental
component of retirement planning by allowing investors to accumulate
wealth gradually, often benefiting from tax-deferred or tax-free growth.

b) Impact of Market Cycles

i) Market Fluctuations - Long-term investors accept that financial markets
move through cycles of booms and busts. They are not concerned with
short-term market timing but focus on the overall trend of growth.
ii) Patience - Long-term investing requires patience, as it can take years or
even decades for the investment's value to reach its full potential.
c) Diversification
Spreading Risk: Long-term investors often diversify their portfolios
across various asset classes (stocks, bonds, real estate, etc.) to reduce
risk. Diversification helps mitigate the impact of poor performance in any
one investment, increasing the likelihood of achieving a steady growth
over time.
d) Inflation Protection
Real Value Maintenance - Long-term investments can help protect
against inflation, as certain assets, like equities and real estate, tend to
appreciate in value at a rate that outpaces inflation, preserving the
purchasing power of the invested capital.
e) Tax Considerations
Capital Gains - Long-term investments often benefit from lower tax rates
on long-term capital gains (profits made from selling investments held for
more than a year). This encourages investors to hold onto their
investments longer to take advantage of these tax breaks.
f) Tax-Deferred Growth - Accounts like retirement accounts (IRAs) allow
investments to grow tax-deferred until withdrawal, making them popular for
long-term strategies.

2.2.4. Advantages of Long-Term Investment

Long-term investment is associated with several advantages including but not
limited to:
i) Compounding Returns - Reinvesting earnings can result in exponential
growth over time.
ii) Lower Transaction Costs - Long-term investors save on frequent
trading fees and commissions.
iii) Reduced Emotional Trading - With a focus on the long-term, investors
are less likely to react emotionally to short-term market movements.
iv) Tax Efficiency - Lower taxes on long-term capital gains and tax-deferred
accounts can enhance overall returns.

2.2.5. Disadvantages of Long-Term Investment

The contra side of Long-term investment benefits include:
i) Market Risk - Over the long term, markets can experience significant
downturns, leading to potential losses.
ii) Liquidity Risk - Long-term investments can tie up capital for years,
limiting an investor’s ability to quickly access funds.
iii) Opportunity Cost - Capital invested long-term may miss out on higher
short-term gains in other opportunities.

2.3. Assessment of Projects Using Discounted Cash Flow (DCF)

Methods
Discounted Cash Flow (DCF) methods are among the most widely used
techniques for assessing the viability and profitability of projects.
A DCF is a method used to estimate the value of a project based on the present
value of its expected future cash flows.
These methods take into account the time value of money ensuring that future cash
flows are properly valued in today’s terms.

Importance of the Techniques

The following are the real world scenarios where the DCF methods can be
applied practically:
i) Capital investment projects (e.g., building a new plant).
ii) Business valuations (mergers and acquisitions).
iii) Infrastructure investments (highways, bridges, energy projects).

2.3.1.Key Aspects of DCF techniques for project evaluation

To understand and manage the DCF techniques, the following concepts should be considered
i) Cash Flow Projections - Understanding the concept of forecasting all future inflows and
outflows related to the project.
ii) Discount Rate - Introducing the idea of the time value of money and how the discount rate
reflects the cost of capital and the risk of the project.
iii) Time Period - How to define the relevant timeframe over which cash flows will be analyzed.

The following are the key DCF techniques for evaluating various investment
projects:

a) Net Present Value (NPV)

The Net Present Value is the most widely used method for project evaluation. It
calculates the present value of all cash inflows and outflows associated with a
project, discounted at the required rate of return (discount rate).
Formula:
NPV =∑ ¿

Where:
CFt = Cash flow at time t
r = Discount rate or required rate of return
C0 = Initial investment
n = Total number of periods
Decision Rule:
 If NPV > 0, the project is expected to generate value, it should be accepted.
 If NPV < 0, the project is expected to destroy value, it should be rejected.

Advantages:
i) It takes into account the time value of money.
ii) It provides a direct measure of the increase in value to the firm.
iii) It works well for projects with varying cash flows.
iv) Easy to interpret as it returns a single dollar value that's easy to understand.
v) Compares investments with different sizes, durations, and cash flow patterns.
vi) It offers clear decision rule (i.e. NPV >0)

Disadvantages:
i) Sensitivity to Inputs - The results depend heavily on assumptions about
future cash flows and the discount rate.
ii) Long-term Uncertainty - Forecasting far into the future involves
considerable uncertainty.
iii) Ignores Real Options - It doesn’t account for flexibility in the project (e.g.,
the option to delay or expand contract terms).
iv) NPV calculations rely on many assumptions and estimates, such as future
cash flows and discount rates, which can be difficult to estimate.

b) Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate at which the NPV of all
cash flows equals zero.
It represents the break-even rate of return for the project.

Formula:

IRR = ∑ ¿
Where:
IRR = the rate that makes the NPV equal to zero
CFt = cash flow
Co = Initial investment
r = discount rate.
t = time period

Decision Rule:
 If IRR > required rate of return, the project is expected to generate
returns greater than the cost of capital and should be accepted.
 If IRR < required rate of return, the project should be rejected.

Advantages:
 Intuitive measure of profitability.
 Easily comparable with the firm’s required rate of return or other project
IRRs.

Disadvantages:
 May lead to incorrect decisions in the case of non-conventional cash flows
(multiple IRRs or no IRR).
 Does not always account for project scale, which NPV does better.

c) Modified Internal Rate of Return (MIRR)

The Modified Internal Rate of Return (MIRR) addresses some of the limitations
of the IRR, such as the unrealistic assumption of reinvesting intermediate cash flows
at the project’s own IRR.
Instead, MIRR assumes reinvestment at the firm’s cost of capital.
Formula:

MIRR = MIRR ( PVp

PVn )
1/n−1

Where:
FVp = Future value of positive cash flows, reinvested at the cost of capital.
PVn = Present value of negative cash flows, discounted at the cost of capital.
n = Project duration.

Decision Rule:
 If MIRR > required rate of return, accept the project.
 If MIRR < required rate of return, reject the project.

Advantages:
i) More realistic reinvestment assumption than IRR.
ii) Solves the issue of multiple IRRs with unconventional cash flows.

Disadvantages:
i) More complex to calculate than IRR or NPV.
ii) Requires assumptions about the reinvestment rate.

d) Profitability Index (PI)

The Profitability Index (PI) is the ratio of the present value of future cash flows to
the initial investment.
It helps to measure the value created per unit of investment.

Formula:
PI = Present Value of Cash Flows ≥ 1
Initial Investment
Decision Rule:
 If PI > 1, the project generates more value than its cost and should be
accepted.
 If PI < 1, the project should be rejected.

Advantages:
i) Useful for ranking projects when capital is limited.
ii) Helps in comparing projects of different sizes.
Disadvantages:
 May lead to incorrect project prioritization if used in isolation, as it does not
measure absolute return.

e) Discounted Payback Period

The Discounted Payback Period is the time it takes for a project to recover its
initial investment in present value terms.
Unlike the traditional payback period, this method discounts future cash flows.
Formula:
The discounted payback period is found by calculating the cumulative discounted
cash flows and determining the point where the cumulative NPV turns positive.

Decision Rule:
 If the payback period is less than a predetermined threshold, accept the
project.
 If the payback period exceeds the threshold, reject the project.
Advantages:
 Provides a measure of liquidity and risk by showing how quickly the initial
investment is recovered.
 Takes into account the time value of money, unlike the traditional payback
method.
Disadvantages:
 Ignores cash flows beyond the payback period.
 Does not measure overall project profitability, unlike NPV or IRR.

Conclusion
When evaluating capital projects, each of these DCF methods offers unique insights:
 NPV and PI focus on value creation.
 IRR and MIRR provide rate-of-return measures.
 The Discounted Payback Period highlights liquidity and risk in the context
of time.

2.4. Assessment of Projects Using Non-Discounted Cash Flow

Methods
Non-discounted cash flow methods provide simpler approaches to evaluating
projects without accounting for the time value of money. These methods are
generally easier to compute but are less accurate than discounted cash flow
techniques. Two common non-discounted methods are the Payback Period and
the Accounting Rate of Return (ARR).

However, their main limitation is that they ignore the time value of money.
1. Payback Period (PP)
The time it takes for a project to recover its initial investment from its net cash
inflows. It calculates how quickly an investment can pay for itself, emphasizing
liquidity and risk, but it does not consider the time value of money.

Formula:
Payback Period = Initial Investment
Annual Cash Inflow

 If cash flows are uniform (i.e., the same each year), the formula above
applies.
 If cash flows are uneven, the payback period is determined by summing the
annual cash flows until the initial investment is fully recovered.

Example:
If Initial Investment is TZS 100,000 and the Annual Cash Inflow is TZS 25,000,
then
Payback Period = 100,000 = 4 years
25,000

If cash flows are uneven, the payback period is determined by accumulating the
cash inflows year by year until they equal or exceed the initial investment.

Decision Rule
i) If the payback period is less than or equal to a pre-determined threshold, the
project is accepted.
ii) If the payback period exceeds the threshold, the project is rejected.

Advantages
i) Simplicity - Easy to calculate and understand.
ii) Focus on Liquidity - Helps to determine how quickly the firm can recover its
initial investment, thus highlighting liquidity and risk.
iii) Useful for Risk-Averse Investors - Suitable for businesses with limited
cash or high risk. It emphasizes quick recovery of funds.

Disadvantages:
i) Ignores the Time Value of Money: Future cash flows are not discounted,
which means the payback period may overstate the attractiveness of projects
with large future cash flows.
ii) Ignores Cash Flows After Payback: It does not consider cash flows
beyond the payback period, potentially ignoring a project's long-term
profitability.
iii) No Measure of Profitability: The payback period focuses only on the
recovery of the initial investment and does not provide a measure of total
return.

2. Accounting Rate of Return (ARR)

It is a profitability measure that calculates the expected return on an investment
based on accounting income rather than cash flows. Also known as Average Rate of
Return. It is expressed as a percentage of the initial or average investment and is
based on net income rather than cash inflows.

Formula
Average Annual Accounting Profit
ARR= X 100
Initial Investment

Or, if using average investment:

Average Annual Accounting Profit
ARR= X 100
Average Investment

Where
 Average Annual Accounting Profit = Net income after depreciation, taxes
and other expenses (not cash flows).
Initial Investment +Salvage(Residual )Value
 Average Investment =
2

Decision Rule:
 If ARR exceeds a required rate of return, the project is accepted.
 If ARR is lower than the required rate of return, the project is rejected.

Advantages
i) Simplicity: Easy to compute and understand, as it uses readily available
accounting information.
ii) Ties to Financial Statements: The method is based on accounting profits,
which makes it more familiar to managers and stakeholders.
iii) Relative Profitability: Provides a profitability measure in percentage terms.
This allows easy comparison with other projects or the company’s required
return.

Disadvantages:
i) Ignores the Time Value of Money: Like the payback period, ARR does not
discount future earnings, which can lead to misleading conclusions about
long-term projects.
ii) Relies on Accounting Profits: ARR is based on accounting profits, not cash
flows, which means non-cash expenses like depreciation can affect the result.
This may not accurately reflect the economic profitability of the project.
iii) Does Not Consider the Project's Life: ARR does not factor in the lifespan
of the project, which could result in favoring shorter-term projects even if
longer-term ones are more profitable.

Worked Examples
1. LD Consulting is considering an investment that requires an initial investment of
TZS 100 Million. The project is expected to generate an annual profit of TZS 15
Million over five years. What is the expected rate of return of the initial investment
annually?
2. Axels Associates are considering a project that requires an initial investment of TZS
200M/- and is expected to generate profits over a five-year period as summarized in
the table.
Year 1 2 3 4 5
Profit (TZS) 20 25 M 30 M 35 M 40 M
M
What is the Average Rate of Return from this project for Axels?

3. Utambuzi Co Ltd is considering to invest into a new project demanding initial investment
of TZS 75 Million in equipment with an expected lifespan of 5 years with no residual value
(considering the effect of depreciation), to be generating annual revenue of TZS 21 Million.
What should Utambuzi Co. Ltd expect as an Average Rate of Return from
this project?

2.5. Impact of Non-Financial Factors in Investment Decision-Making

 Non-financial factors determine whether a project is strategically sound,
sustainable and feasible.
 Non-financial factors also ensure that investment decisions align with broader
strategic objectives, operational considerations and external influences.
 They can significantly impact the long-term success, sustainability and
alignment of the investment with the organization’s goals.
 A comprehensive investment assessment must balance both financial and
non-financial factors to make well-rounded decisions that lead to long-term
success.

The key non-financial factors that influence investment decisions include but
are not limited to:
2.5.1. Strategic Alignment
Investments should align with the overall strategic goals and objectives of the
company. It ensures that resources are deployed in projects that strengthen
competitive advantage and contribute to long-term growth and competitive
positioning. An investment that is financially attractive but does not support the
company’s mission, vision or long-term goals may not be ideal.

Examples of Strategic Alignment

i) Investing in R&D to drive innovation and long-term competitiveness.
ii) Expanding into new geographic markets to support the company’s growth
strategy.
iii) Acquiring a company that enhances technological capabilities.

2.5.2. Regulatory and Legal Considerations

 Regulatory and legal factors can heavily influence investment decisions
especially in industries where compliance with regulations is critical (energy,
pharmaceuticals and finance).
 New laws, changes in environmental regulations, labor laws, or trade
restrictions can alter the costs and feasibility of a project. Failure to comply
attracts fines, sanctions or even closure.
 Therefore, when evaluating investments, regulatory and legal
considerations is a critical factor.
 A project whose regulatory burden is too high or uncertain should be
rejected.

Examples:
i) Environmental regulations that require a company to invest in cleaner
technologies.
ii) Labor laws impacting a company’s ability to expand or restructure.
iii) Data privacy laws influencing investments in IT infrastructure.

2.5.3. Environmental and Sustainability Factors

Sustainability and environmental impact are important in investment decisions.
They are driven by regulatory pressures, societal expectations and corporate
social responsibility (CSR) commitments.

Note:
 Companies that prioritize "green" projects to align with ESG (Environmental,
Social, Governance) criteria attract socially responsible investors.
 Projects that promote resource efficiency or support sustainable practices are
often prioritized, even if their immediate financial returns are modest.

Examples Environmental and Sustainability Factors include but not

limited to:
i) Investments in renewable energy to reduce carbon emissions.
ii) Projects focusing on waste reduction, recycling, or water conservation.
iii) Sustainable supply chain initiatives.

2.5.4. Social and Community Impact

 Investments that impact society and local communities positively (enhance
employee well-being, create jobs or contribute to the development of local
communities) may be viewed favorably even if they don’t offer the highest
financial returns.
 Companies are increasingly measured by their impact on stakeholders
beyond shareholders.
 Projects with strong social benefits may be pursued for long-term
reputational gains.

Examples of Social and Community Impact factors include:

i) Investing in local infrastructure or education initiatives in areas where the
company operates.
ii) Building facilities in underdeveloped regions to support local economic
development.
iii) Initiatives aimed at improving workplace safety and employee satisfaction.

2.5.5. Technological Advancements

 Adoption or innovative response to technological advancements is a key non-
financial factor.
 Technology changes rapidly. Companies need to invest in projects that keep
them competitive or adopt new technologies that increase operational
efficiency.
 Investments in technology may not yield immediate financial returns but can
be essential for long-term competitiveness, operational efficiency, and
customer satisfaction.
 Projects that modernize infrastructure or enhance technological capabilities
are often prioritized for future-proofing the business.

Examples of Technological Advancements Factors include but not

limited to:
i) Investing in automation to improve production efficiency and reduce costs.
ii) Upgrading IT systems to improve data security and enhance business
processes.
iii) Adopting artificial intelligence (AI) or machine learning to enhance decision-
making and customer service.

2.5.6. Market Trends and Consumer Preferences

 Changes in market trends, consumer behavior and preferences can drive
investment decisions.
 To stay competitive Companies should adapt to shifts in demand, lifestyle
changes or new consumer preferences.
 Projects that position a company at the forefront of evolving trends can be
highly valuable in the long run.

Examples of Market Trends and Consumer Preferences

i) Investment in new product lines that cater the consumer preferences
changing (e.g., organic food, electric vehicles, Evening/Executive
Postgraduate studies).
ii) Expansion into digital platforms to meet increasing demand for online
services.
iii) Investments in personalized customer experiences and technology.

2.5.7. Risks and Uncertainties

 These factors (political instability, supply chain disruptions or operational
risks) can significantly impact the success of an investment.
 Companies should consider the broader risk environment (geopolitical
factors, macroeconomic conditions, industry-specific risks) before committing
to a project.
 A robust risk assessment is recommended before injecting resources into any
project.
 Projects with significant non-financial risks should be avoided no matter there
attractive financial returns.

Examples of Risks and Uncertainties factors

i) Political risk in a region where the company plans to expand operations.
ii) Supply chain risk due to reliance on a single supplier or region.
iii) Uncertainty in market demand or technological disruption.

2.5.8. 8. Organizational Culture and Management Capabilities

 The company’s internal culture, management strength and ability to execute
the project are crucial non-financial factors.
 A project that is not aligned with the organization’s culture or lacks the
necessary managerial expertise may fail despite having strong financial
metrics.
 Investments that fit well with the company’s culture and management
capabilities are more likely to succeed.
 Misaligned projects may face internal resistance or execution challenges
resulting into failure.

Examples:
i) A company’s ability to manage cross-border expansion based on previous
experience.
ii) Alignment of a project with the company’s innovation culture.
iii) The company’s track record in integrating acquisitions.

2.6. Assessment of Projects with Consideration of Taxes and

Inflation
The impact of taxes and inflation on cash flows should be considered for a true
profitability and long-term sustainability of an investment.
Both factors can significantly alter the financial viability of a project and
influence decision-making.

2.6.1. Taxes in Project Evaluation

Taxes can have a significant impact on the cash flows and overall profitability of
an investment. Most companies pay taxes on earnings and tax policies can
directly affect investment returns.

The Key Areas Where Taxes Affect Project Assessment include but are
not limited to:
i) Tax on Operating Income: Taxes are levied on the company’s operating
profits (EBIT). This reduces the net cash flows available to the project.
ii) Depreciation Tax Shield: Depreciation is a non-cash expense that reduces
taxable income (tax liability) to improving the project’s cash flows.
iii) Capital Gains Tax: Taxes may be applied to gains from the sale of assets at
the end of the project’s life.
iv) Tax Incentives: Some projects in certain industries or regions may qualify
for tax credits or incentives improving the project’s overall returns.

2.6.2. Incorporating Taxes in NPV and Other DCF Models

Taxes are typically incorporated into project evaluations to reflect the after-tax
impact.

Steps to Account for Taxes

i) Calculate Taxable Income: Subtract operating expenses and depreciation
from revenue to get Earnings Before Taxes (EBT).
ii) Apply the Corporate Tax Rate: Calculate the taxes payable by applying
the corporate tax rate to EBT.
iii) Determine After-Tax Cash Flows: Subtract taxes from the project’s pre-
tax operating income to get after-tax cash flows.
iv) Include Depreciation Tax Shield: Depreciation expense reduces taxable
income, which results in tax savings.
The tax shield calculation:
Depreciation Tax Shield = Depreciation Expense x Tax Rate
Then add the depreciation tax shield back to the after-tax cash flows.

Example:
During the financial year 2023 Tibenda Investment earned TZS 500 Million. The
operating expenses associate with such revenue were TZS 200 Million.
Depreciation during the year was TZS 50 Million. If the applicable tax rate is 30%
what is the NPV of such Co?

Soln:
Earning before Tax (EBT) = Revenue – Operating Expenses –Depreciation
 EBT = 500 – 200 −50
= 250

Taxes Payable = 250M x 30%

=75 M/-

After-Tax Operating Income = 250−75

=175

Depreciation Tax Shield = 50 x 30%

= 15 M/-

 After-Tax Cash Flow = 175 + 15 =190 M/-

The Net Present Value (NPV) and other calculations will therefore be
based on after-tax cash flows, which more accurately reflect the profitability
of the project.

Impact of Taxes on IRR and Payback Period

 IRR - Taxes reduce the cash flows, which in turn lowers the Internal Rate of
Return (IRR) compared to pre-tax cash flow estimates. When evaluating IRR,
it's crucial to use after-tax cash flows.
 Payback Period - The payback period will be extended if after-tax cash
flows are smaller, as it will take longer to recover the initial investment.

2.6.3. Inflation in Project Evaluation

Inflation erodes the purchasing power of money over time. Thus future cash flows
may be worth less in today’s terms. It affects both costs and revenues. So it must
be factored into project assessments to ensure accurate results.

Types of Inflation Adjustments

i) Nominal vs. Real Cash Flows: Cash flows can be estimated in nominal
terms (including inflation) or in real terms (excluding inflation). It’s important
to be consistent when applying discount rates:
o Nominal Cash Flows should be discounted using a nominal
discount rate (which includes inflation).
o Real Cash Flows should be discounted using a real discount rate
(which excludes inflation).

2.7.Assessment of Projects Under Capital Rationing

 Capital rationing occurs when a company has limited financial resources
and must carefully select which projects to undertake.
 Under capital rationing a firm cannot fund all available projects even if they
have positive NPVs.
 It needs to prioritize projects based on financial and strategic criteria to
maximize value within the given capital constraints.

Two major types of capital rationing:

i) Hard Capital Rationing - External limitations imposed by capital
markets or lending institutions restricting the firm’s ability to raise funds.
ii) Soft Capital Rationing - Internal restrictions set by management (desire
to limit debt or preserve cash reserves) for other strategic purposes.

In either case, the company must assess which projects to select and how to
allocate capital efficiently.

Approaches for Assessing Projects Under Capital Rationing

When evaluating projects under capital rationing the objective is to maximize
the firm’s total value within the budget constraint.

Approaches and techniques used to assess projects in a capital rationing

situation include the following:

2.7.1. Profitability Index (PI)

The PI helps rank projects based on the value generated per unit of investment.
It’s particularly useful when capital is limited. It allows comparison of different-
sized projects.

Formula:
PI = Present Value of Future Cash Flows
Initial Investment

Decision Rules
i) If PI > 1, The project generates more value than its cost, and thus it is
acceptable.
ii) Rank Projects based on their PI values to allocate capital efficiently.

Worked Examples
1. Bigirwa Investments are thinking of investing into three projects whose
particulars are summarized in the table below (all amounts in TZS ‘Million:
Particular NPV I/ Invest
s
Project A 50 100
Project B 60 200
Project C 50 80
Advise the Co. on the Projects viability based on their respective Project
indexes.

2. You are a finance Manager of Matendo Co. Ltd whose Shareholders have set
aside TZS 1Bln/- and approached you to advise them for the most profitable
projects among the list of their prospects as indicate in table below (all
amounts in TZS ‘Million:
Particulars I/ Invest. NPV
New School 350 150
Whole sale 510 90
Hardware
Transportation 400 170
Consultancy 450 270
services
Medical Store 160 125

Advise the Co. on the Projects to be considered most to exhaust such capital.

Advantages:
i) It directly relates value to cost making it ideal for capital rationing.
ii) It allows comparison of projects of different sizes.

2.7.2. Linear Programming (Optimization Technique)

 Linear programming can be used to find the optimal combination of
multiple projects that maximize total NPV within the capital limits.
 It considers the interdependencies between projects and constraints ensuring
an optimal allocation of funds.

Steps in Linear Programming for Project Selection:

1. Define Projects and Resources: Determine the projects under
consideration, their respective costs, expected returns, and any unique
characteristics that could influence selection (e.g., risk level, strategic
importance).
2. Formulate the Objective Function: Establish a function to represent the
primary goal (e.g., maximizing total return). This function would sum the
returns of each project, weighted by the decision variable (indicator for

 NPV1⋅X1+NPV2⋅X2+⋯+NPVn⋅Xn
project selection).

Where
X1, X2, …, Xn are binary decision variables indicating whether a project
is selected (1) or not (0).

3. Set Up Constraints: Implement budget constraints to ensure the sum of

project costs does not exceed the available capital. Additional constraints can

Capital Constraint = Invest1⋅X1 + Invest2⋅X2 +⋯+ Investn⋅Xn ≤ Available Capital

incorporate specific criteria relevant to the organization.
4. Solve the linear program: Use linear programming methods (such as the
Simplex method) to determine the optimal project selection.

Example
Maisha Ltd has a budget of TZS 500 Million to allocate among three potential
projects with the following details:
Projec Cost Mil. Expet. Return
t TZS TZS
A 200 70
B 300 100
C 150 40

Assuming XA = 1 (when Project A is Selected) and X A = 0 (when Project A is Not

Selected)
XB and XC represent Projects B and C in the same way.

Their LP model would look like this:

Maximize 70,000⋅XA+100,000⋅XB+40,000⋅XC

Where XA, XB, XC ∈ {0,1}.

Subject to: 200⋅XA+300⋅XB+150⋅XA ≤ 500 Million

Then; Identify the optimal project combination within the budget constraint.

Advantages:
 Optimizes the allocation of capital across multiple projects ensuring the
highest possible return within budget limits.
 Takes into account multiple constraints and dependencies between projects.
 Systematic Decision-Making: Helps avoid subjective selection biases by
providing a data-driven approach.
 Flexibility: Allows for the inclusion of various types of constraints while
adapting to specific organizational needs.

Disadvantages:
 Requires advanced mathematical tools and software.
 May be complex when applied to large portfolios of projects.

2.7.3. NPV Ranking and Combination of Projects

 Aims to rank projects based on their Net Present Value (NPV) followed
projects combination trials in a way that maximizes NPV within the capital
budget.
 It is done in a trial and error to find the best combination of projects.

Steps:
 Rank Projects by NPV: Rank all available projects in descending order of
NPV.
 Combine Projects: Select the top-ranked project, then continue adding
projects in descending order until the total investment reaches the capital
constraint.
 Consider Combinations: If a high NPV project exceeds the capital limit,
consider alternative combinations of smaller projects that collectively
provide a higher total NPV.

Advantages:
 Simpler than linear programming.
 Relatively easy to apply when the number of projects is manageable.
Disadvantages:
 May not guarantee the absolute optimal allocation.
 Requires manually evaluating different combinations, which can be time-
consuming.

Worked example
LD consulting have set aside the investment capital of TZS 300Milion to be
distributed into four projects as summarized the table below all amounts in TZS
Million:
Project NPV Investmen
t
A 60 100
B 50 150
C 40 80
D 20 50

What combination of projects should be considered within the capital limit of TZS
300Million?

Soln
The combination of Projects A, C and D provides the highest total NPV (60 +
40 + 20 = 120)

2.7.4. Consideration of Project Divisibility

In some cases, projects may be divisible, If a partial investment in a project can
yield proportional returns.
Useful when a project can be scaled and capital rationing doesn’t allow for full
funding of all projects.

Example:
 Project A requires TZS 200 Million for full investment, with an NPV of
40Million.
 The company only has TZS 100 Million to invest.

If the project is divisible, the company could invest TZS 100 Milion yielding an
NPV of TZS 20 MIl (half the total NPV).

Decision Rule:
 Invest partially in projects with the highest returns per dollar until the budget
is fully utilized.
Advantages:
 Provides flexibility in capital allocation.
 Allows companies to invest in high-NPV projects even when full funding is not
possible.

Disadvantages:
 Not all projects are divisible (e.g., you cannot build half a factory).

2.7.5. Risk and Strategic Considerations

 Even under capital rationing, non-financial factors like risk, strategic
alignment and regulatory compliance should not be ignored.
 Projects that carry excessive risk even with high NPVs, might not be selected
if the firm has limited capital and wants to avoid risky investments.
 Similarly, projects that align better with long-term strategic goals may be
chosen over higher NPV alternatives.

Example:
 Project A has a high NPV but is in a politically unstable region.
 Project B has a lower NPV but aligns with the company’s strategic goals and
is in a stable market.
In this case, the company might prefer Project B, considering long-term stability
and strategic fit.