CAPITAL BUDGETING

CAPITAL BUDGETING
Your budget maintains your commitment.
After studying this chapter, you should be able to:

• Understand the different investments needed to start a business.

• Understand the project evaluation methods.
• Understand the concepts underlying payback period, internal rate of
return, net present value and profitability index.
 TERMS

Capital Budgeting refers to the planning and control of

capital expenditures.

Capital Expenditures refer to the substantial outlay of funds

that that increase net income for
several years in the future.
CLASSES OF CAPITAL EXPENDITURES

Replacement Investments
CLASSES OF CAPITAL EXPENDITURES

Expansion Investments
CLASSES OF CAPITAL EXPENDITURES

Product-line Investments
 CLASSES OF CAPITAL EXPENDITURES

Investment in Safety and Environmental Projects

CLASSES OF CAPITAL EXPENDITURES

Strategic Investments
CLASSES OF CAPITAL EXPENDITURES

Other Investments
PROJECT EVALUATION METHODS

• Payback Period (PBP)

• Internal Rate of Return (IRR)
• Net Present Value (NPV)
• Profitability Index (PI)
 PROJECT EVALUATION METHODS

Son Tan is evaluating a new project for his business, MaarTea Café. He
has determined that the after-tax cash flows for the project will be
P10,000; P12,000; P15,000; P10,000; and P7,000, respectively, for
each of the Years 1 through 5. The initial cash outlay will be P40,000.
 PAYBACK PERIOD (PBP)

Payback Period is the period of time required for the

cumulative expected cash flows from
an investment project to equal the
initial cash outflow.
 PAYBACK PERIOD (PBP)

Unrecovered at 𝟑
Cash Flow
year end PBP = 3 +
Year 0 -40, 000 40, 000 𝟏𝟎
Year 1 10, 000 30, 000
Year 2 12, 000 18, 000
Year 3 15, 000 3, 000
PBP = 3.3 yrs
Year 4 10, 000 - 7, 000
Year 5 7, 000 - 14, 000
 PAYBACK PERIOD (PBP)

𝟑
PBP = 3 +
𝟏𝟎 The management of MaarTea Café has set maximum. PBP of
5 years for projects of this type. Should this project be
accepted?
PBP = 3.3 yrs
 PAYBACK PERIOD (PBP)

𝟑
PBP = 3 + The management of MaarTea Café has set maximum. PBP of
𝟏𝟎 5 years for projects of this type. Should this project be
accepted?

PBP = 3.3 yrs Yes! The firm will receive back the initial
cash outlay in less than 5 years.
 PAYBACK PERIOD

Strengths: Weaknesses:
• Easy to use and • Does not account
understand. for TVM.
• Can be used as a measure • Does not consider cash
of liquidity. flows beyond the PBP.

• Cutoff period is
subjective.
 PROJECT EVALUATION METHODS

Son Tan is evaluating a new project for his business, MaarTea Café. He
has determined that the after-tax cash flows for the project will be
P10,000; P12,000; P15,000; P10,000; and P7,000, respectively, for
each of the Years 1 through 5. The initial cash outlay will be P40,000.

√ PBP □ IRR □ NPV □ PI

 INTERNAL RATE OF RETURN (IRR)

Internal Rate of Return is the discount rate that equates the

present value of the future net cash
flows from an investment project with
the project’s initial cash outflow.

√ PBP □ IRR □ NPV □ PI

INTERNAL RATE OF RETURN
 INTERNAL RATE OF RETURN

Find the interest rate (IRR) that causes the

discounted cash flows to equal $40,000.
INTERNAL RATE OF RETURN
 INTERNAL RATE OF RETURN

The management of MaarTea Café has has determined that

IRR= 11.57% the hurdle rate is 13% for projects of this type. Should this
project be accepted?

No! The firm will receive 11.57% for

each dollar invested in this project at a
cost of 13%.
 INTERNAL RATE OF RETURN

Strengths: Weaknesses:
• Accounts for TVM • Assumes all cash
• Considers all cash flows reinvested at the
flows IRR
• Less • Difficulties with
subjectivity project rankings and
Multiple IRRs
 PROJECT EVALUATION METHODS

Son Tan is evaluating a new project for his business, MaarTea Café. He
has determined that the after-tax cash flows for the project will be
P10,000; P12,000; P15,000; P10,000; and P7,000, respectively, for
each of the Years 1 through 5. The initial cash outlay will be P40,000.

√ PBP X IRR □ NPV □ PI

 NET PRESENT VALUE (NPV)

Net Present Value is the present value of an investment

project’s net cash flows minus the
project’s initial cash outflow.

√ PBP X IRR □ NPV □ PI

 NET PRESENT VALUE (NPV)

√ PBP X IRR □ NPV □ PI

 NET PRESENT VALUE (NPV)

√ PBP X IRR □ NPV □ PI

 NET PRESENT VALUE

The management of MaarTea Café has has determined that

NPV= -1,428 the hurdle rate is 13% for projects of this type. Should this
project be accepted?
 NET PRESENT VALUE

The management of MaarTea Café has has determined that

NPV= -1,428 the hurdle rate is 13% for projects of this type. Should this
project be accepted?

No! The NPV is negative. This means

that the project is reducing shareholder
wealth.
 NET PRESENT VALUE

Strengths: Weaknesses:
• Cash flows assumed to • May not include
be reinvested at the managerial options
hurdle rate. embedded in the project.
• Accounts for TVM.
• Considers all cash
flows.
 PROJECT EVALUATION METHODS

Son Tan is evaluating a new project for his business, MaarTea Café. He
has determined that the after-tax cash flows for the project will be
P10,000; P12,000; P15,000; P10,000; and P7,000, respectively, for
each of the Years 1 through 5. The initial cash outlay will be P40,000.

√ PBP X IRR X NPV □ PI

 PROFITABILITY INDEX (PI)

Profitability Index is the ratio of the present value of a

project’s future net cash flows to the
project’s initial cash outflow.

√ PBP X IRR X NPV □ PI

 PROFITABILITY INDEX (PI)

𝑷𝟑𝟖,𝟓𝟕𝟐 Should this project be accepted?

PI =
𝑷𝟒𝟎,𝟎𝟎𝟎
= .9643

√ PBP X IRR X NPV □ PI

 PROFITABILITY INDEX (PI)

𝑷𝟑𝟖,𝟓𝟕𝟐 Should this project be accepted?

PI =
𝑷𝟒𝟎,𝟎𝟎𝟎 No! The PI is less than 1.00. This means that
= 0.9643 the project is not profitable.

√ PBP X IRR X NPV X PI

 PROFITABILITY INDEX

Strengths: Weaknesses:
• Same as NPV. • Same as NPV.
• Allows comparison of • Provides only relative
different scale projects. profitability.
• Potential Ranking Problems.
 SUMMARY
MaarTea’s Independent Project
CAPITAL BUDGETING
helps you in...
BUDGETING
BUDGETING
IS THE BEGINNING OF ANYTHING YOU WANT.