CAPITAL BUDGETING- the process of identifying, evaluating, planning, and financing capital investment

projects of an organization

 Financing Decision- judgement regarding the method of raising capital to fund an investment
 Investment Decision- judgement about which assets acquire to achieve the company’s stated
objectives.

CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS

1. Capital investment decisions usually require large commitments of resources (so therefore it
also involves long-term commitments)
2. Capital Investment decisions are more difficult to reverse than short-term decisions
3. Capital investment decisions involve so much risk and uncertainty

STAGES IN THE CAPITAL BUDGETING PROCESS

1. Identification and definition- The process begins by exploring available opportunities.

EXAMPLES OF OPPORTUNITIES ARE EXPANSION, IMPROVEMENT, AND REPLACEMENT (TYPES
OF INVESTMENT PROJECTS)
EXAMPLE: If a company is seeking to expand its warehousing facilities, it might have chosen
between adding its current building or purchasing a larger space in a new location. Each option
must be evaluated in which option is suitable and advantageous on the part of the company.

2. Estimate operating and implementation cost (Information gathering on both quantitative and
qualitative information)
Estimating how much it will cost on the company on both options using internal and external
research. Based on the example earlier, how much will be the cost related on purchasing a
larger space in a new location, and cost related on adding its current building and other costs
relevant on the decision making on the Top Management.

3. Estimate Cash flow or benefit (Selection)

This part determines how much cash flow of the project is expected to generate on both
options. Then compare the two options which provides more cash flow and how it is successful
in the past, and also take into consideration on the indirect cash flows that can generate cost
savings on the part of the company because of its efficiency.

4. Financing (Assess Risk)

This step is assessing the risk associated with the project. Including the amount of money, the
company stands to lose if the project fails or can’t meet the expected results. Once it is
determined, the company can compare it against the expected cash flow or benefit to see if
which of the two choices are more sense to pursue.

5. Implementation (which includes Monitoring)

If a company chooses to move forward with the project, it will need an implementation plan.
The plan should include a means of paying for the project at hand, a method of tracking costs,
 and a process for recording cash flows or benefits the project generates. Generally, it will
include a timeline which includes and end date if applicable.

TYPES OF CAPITAL INVESTMENT PROJECTS

1. Replacement (old asset to new one)

2. Improvement (purchased a new system for the company)
3. Expansion (my example before)

CAPITAL INVESTMENT FACTORS

1. Net Investment
= costs or cash outflows less cash inflows or savings incidental to the acquisition of the
investment projects

COSTS OR CASH OUTFLOWS:

1. The initial cash outlay covering all expenditures on the project up to the time when it is
ready for use or operation:
 EXAMPLES: Purchase Price of the Asset; incidental project-related cost such as
freight, handling, installation, test-runs etc.
2. Working Capital Requirement to operate the project at the desired level.
3. Market value of an existing, currently idle asset, which will be transferred or to be
utilized in the operations of the proposed capital investment project

SAVINGS OR CASH INFLOWS

1. Trade-in value of the old asset (in case of replacement)

2. Proceeds of the old asset to be disposed due to the acquisition of the new project (less
applicable tax, in case there is a gain on sale, or add tax savings, in case there is a loss of
sale)
3. Avoidable cost on immediate repairs of an old asset to be replaced, net of tax

2. Cost of Capital
 The cost of using funds; or it is called hurdle rate, required rate of return, cut-off rate
 The weighted average rate of return the company must pay it long-term creditors and
shareholders for the use of their funds

3. Net returns
1. Accounting net income
2. Net cash inflows

COMMONLY USED METHODS OF EVALUATING CAPITAL INVESTMENT PROJECTS

1. Methods that do not consider the time value of money

 Payback
 Bail-out
 Accounting rate of return (ARR)
 2. Methods that consider the time value of money (discounted cash flow methods)
 Net Present Value
 Present Value Index
 Present value payback
 Discounted cash flow rate of return

METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY

PAYBACK METHOD
𝑁𝑒𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑖𝑛𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑀𝑒𝑡ℎ𝑜𝑑 =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

 The result will be the length of time required by the project to return the initial cost of
investment

ADVANTAGES

 Payback gives information about the project’s liquidity

 It is a good surrogate for risk. A quick payback period indicates a less risk project.
 Does not include interest rate, so it’s easy to compute

DISADVANTAGES:

 Payback does not consider the time value of money. All cash received during the payback
method are assumed to be equal value in analyzing the project.
 It gives more emphasis on liquidity rather than profitability (liquidity is inversely related to
profitability). Therefore, it is more focused on return of investment than return on investment.
 It does not consider the salvage value of the project
 It ignores the cash flows that may occur after the payback method

BAIL-OUT PERIOD

 Cash recoveries on operating cash inflows and also includes the estimated salvage value
or proceeds from sale at the end of each year of the life of the project.

ACCOUNTING RATE OF RETURN

 Also called as book value rate of return, financial accounting rate of return, average
return of investment and unadjusted rate of return.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
ADVANTAGES:

 The ARR computation closely parallels accounting concepts of income measurement (income recognition)
and investment return.
 It facilitates re-evaluation of projects due to the ready availability of data from the accounting records
 This method considers income over the entire life of the project
 It indicates the projects profitability
DISADVANTAGES

 It does not consider the time value of money like the payback method and bail-out method
 With the computation of income book value based on the historical cost of accounting data (so the effect of
inflation is ignored)

METHODS THAT CONSIDER THE TIME VALUE OF MONEY

PRESENT VALUE (PV)- of the amount is the value now of some future cash flow
1
𝑃𝑉 𝑜𝑓 1 𝑜𝑓 𝑃𝑉 𝐹𝑐𝑎𝑡𝑜𝑟 = (1+𝑖)𝑛
or ( 1 + i)-n

Where: I =discount rate; n= number of periods

PV of Future cash flows = Future cash flows x PVF

 FUTURE VALUE (FV) of an amount is the amount available at a specified future time based on a
single investment (or deposit) now
o FV of PV 1 of FV Factor = (1+i)n
o FV of Present Cash Flows = Present Cash Flows X FVF

ANNUITIES- a series of equal payments at equal intervals of time

 Ordinary Annuity (annuity in arrears)- cash flows occurred at the end of the periods involved
 Annuity Due (Annuity in Advance)- cash flows occurred at the beginning to the periods involved

NET PRESENT VALUE

1. Present value of cash inflows

Less: Present value of Cash outflows
Net Present Value
or
2. Present value of cash inflows
Less: Present value of cost of the Investment
Net Present Value
Or
3. Present value of cash inflows
Less: Cost of Investment
Net Present Value

ADVANTAGES

 Emphasizes cash flows

 Recognizes the time value of money
 Assumes the discount rate as the reinvestment rate
 Easy to apply
DISADVANTAGES

 It requires predetermination of the cost of capital or the discounted rate of return.

 The net present values of different competing projects may not be comparable because
of the differences in magnitudes or sizes of the projects

PROFITABILITY INDEX
𝑇𝑜𝑡𝑎𝑙 𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 =
𝑇𝑜𝑡𝑎𝑙 𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒𝑠 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
Or
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝐼𝑛𝑑𝑒𝑥 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒

𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝐼𝑛𝑑𝑒𝑥 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

INTERNAL RATE OF RETURN

 The rate of return which equates the present value (PV) of cash inflows to PV of cash outflows. It
is the rate of return where NPV=0. When the cash flows are uniform, the IRR can be determined
as follows:
1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of
the following formula:
𝑁𝑒𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑃𝑉𝐹 𝑓𝑜𝑟 𝐼𝑅𝑅 =
𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
2. Using the present value annuity table, find the line n (economic life) the PVF obtained in
Step 1. The corresponding rate is the IRR
When the cash flows are not uniform, the IRR is determined using trial and error

ADVANTAGES:

 Emphasizes cash flows

 Recognizes the time value of money
 Computes the true rate on return of the project

DISADVANTAGES:

 Assumes that the IRR is the re-investment rate

 When the project includes negative earnings during the economic life, different rates of
return will result.

PAYBACK RECIPROCAL
  A reasonable estimate of the internal rate of return, provided that the following conditions are
met:
1. The economic life of the project is at least twice the payback period
2. The net cash inflows are constant (uniform) throughout the life of the project

𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑅𝑒𝑐𝑖𝑝𝑟𝑜𝑐𝑎𝑙 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Or
1
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑅𝑒𝑐𝑖𝑝𝑟𝑜𝑐𝑎𝑙 = 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑

DISCOUNTED PAYBACK OR BREAK-EVEN TIME

 The period required for the discounted cumulative cash inflows on a project to equal the
discounted cumulative cash outflows (generally initial cost)