CAPITAL BUDGETING Before engaging in any kind of business activity, a businessman would want to know beforehand his resources

would go. The expected benefits he may derive therefrom and the number of years these benefits would be realized. When already engaged in business, he may have to make decisions involving additional requirements for long term funds such as whether to machine, and to buy or lease fixed assets.

Capital Budgeting- is the process of planning and controlling long term investment. It involves evaluation of capital investment proposal, allocation of capital investment funds among approved projects and programs, and control such expenditures.

What Does Capital Budgeting Mean? The process in which a business determines whether projects such as building a new plant or investing in a longterm venture are worth pursuing. Oftentimes, a prospective project's lifetime cash inflows and outflows are assessed in order to determine whether the returns generated meet a sufficient target benchmark. Also known as "investment appraisal".

Ideally, businesses should pursue all projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time. Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period.

The Administrative Process in Capital Budgeting #.Proposal Generation- Management encourages all levels within organization to make suggestions. #.Gathering of relevant data on proposal submitted.-Additional date needed before they can be objectively evaluated. #. Evaluation- Capital expenditure proposal, especially the major ones are reviewed to determine whether they are appropriate or not.

And the economic benefit that may be derived therefrom. Cost and benefit analysis is applied by comparing the different cash flows involved. #. Approval and ImplementationApproval for capital expenditures is done at different levels depending on the materiality thereof. In some organization, managers are given full authority to decide on expenditures required for continuous operations

Control of expenditures and Follow- up- Actual cost are recorded, reported and compared with budgeted figures so that in case there are deviations, prompt corrective measures can be adopted. Remedial measures costcutting improvement of benefits and even termination of the project.

What Problem Require Capital Budgeting:- capital budgeting techniques should be used in all decision- making problems requiring long-term use of funds. + Should an investment be made in a proposed business venture? + Would it be more advantageous for a business concern to expand or just maintain its current production/ sales capacity?

+ Should existing facilities be maintained, replaced or renewed? + Which would be more advantageous: continued ownership or sale and lease back? + Should facilities be leased out or used in operations?

Mutually exclusive is the situation in which only one of two projects designed for the same purpose can be accepted Independent projects is a project whose feasibility can be assessed without consideration of any others.

Cash Flow in Capital Budgeting Success of any business can be determined through its capacity to generate positive cash flows. Therefore, Cash inflow and outflow is considered as one of the most essential elements which gives us as idea about the continued existence of a business in future. Therefore, the stake-holders focus on two things while investing in business: first, how does business generate funds and second, where does business invest those funds for generating more.

Objectives of a cash flow statement: The main objective of a cash flow statement is to assist users: in assessing the businesss ability to generate positive cash flow . in assessing businesss ability to bridge the gap between out flow and inflow of funds. in assessing its ability to meet its short and long term obligations in assessing the rationale of differences between reported and related cash flows in assessing the effect on finances of major projects during the year.

Cash Return- refers to the net cash inflows expected to be realized when the business or special projects is already operational. This is not synonymous to net income for the latter is net of charges not requiring cash outlays ( depreciation and amortization) and those not related from cost allocations.

Annual revenue for 5 yrs. P 80,000 Annual out of pocket operating cost And expenses 31,000 Depreciable assets included in Investment with physical life of 8 yrs 120,000 Income tax rate 35%

Cash Return: Net Income Annual Revenue P 80,000 Less Annual out of pocket cost 31,000 Depreciation expenses ( 120,000/ 5 yrs) 24,000 55,000 Income before income tax P 25,000 Income tax 8,750 Net Income P 16,250 Add back depreciation ( 120,000/5) 24,000 Annual Cash Return P 40,250

Terminal cash flow refers to the cash flow, which takes place at the end of the project life. Terminal cash flow takes into account a net salvage value received at the end (liquidation) of the project (such as sale of the asset).
Terminal Cash Flows: * Is the last stage of a projects cash flows re: the cash flows that will occur only at the projects termination/ending. * Examples are: salvage/scrap value of new machines less tax and net working capital recovered

Illustration: Company XYZ intends to buy a new machine to increase its present sales. The machine costs $200,000 with five years of useful life and its salvage value is $25,000. By buying this machine, the company will incur additional yearly working capital requirements of $10,000. Calculate the terminal cash flows. Solution: Terminal cash flows= Salvage value = $25,000 + working capital recovered of $10,000 = $35,000

Economic Life What Does Economic Life Mean? The expected period of time during which an asset is useful to the average owner. The economic life of an asset could be different than the actual physical life of the asset. Estimating the economic life of an asset is important for businesses so that they can determine when it is worthwhile to invest in new equipment. In addition, businesses must plan so that they have sufficient funds to purchase replacements for expensive equipment once it has exceeded its useful life.

The concept of economic life is also connected to depreciation schedules. Accounting standards bodies usually set generally accepted guidelines for estimating and adjusting this time period. In theory, businesses recognize depreciation expenses on a schedule that approximates the rate at which economic life is used up.

This is not always true for tax purposes, however. Because owners may have superior information about specific assets, the economic life used in internal calculations may differ significantly from the depreciable life required for tax purposes. In addition, many businesses recognize depreciation expense differently based on management's goals. For example, a business might want to recognize costs as quickly as possible in order to minimize current tax liabilities and may do this by choosing accelerated depreciation schedules.

Cut-Off Rate Used in Evaluating Long-Term Investment Proposal Management adopts standards and one of these is the cut-off rate or the lowest acceptable rate of return. It may be the cost of capital or the opportunity cost of capital. In some cases A certain Percentage (%) is added based on the risks involved.

Methods of Evaluating Capital Investment Proposal Methods that do not consider time value of money: Payback period Payback reciprocal Accounting rate of return Average rate of return Payback bailout

Methods that consider the time value of money: Internal rate of return Net present value Profitability index (bcr or present value index) Discounted payback period

Example: An investment of P 100,000 ( including depreciable assets of P 80,000) is expected to enable ABC corp to realize an annual net income of P 12,000 for 10 years. Cost of capital is 12%

Annual Cash Returns: Net income P 12,000 Add back Depreciation ( P 80,000/10 yrs) 8,000 Annual Cash Return P 20,000 Payback Period = 100,000 = 5 yrs 20,000 This refer to the length of period or number of years it would take to recover an investment

Payback Reciprocal = P 20,000 = 20% P 100,000 Or 1/ 5 yrs = 20% This indicates the percentage of investment that is expected to recover in one year. Accounting rate of return = P 12,000 P 100,000 = 12% It indicates the amount of net income realized per peso investment

Average of return = P 12,000 = 24% P 100,000/2 It indicates the amount of net income per peso of average investment. It double the accounting rate of return. Internal Rate of Return * Payback period = P 100,000 = 5 yrs 20,000
Locate the payback period of 5 periods in the PV of annuity table on line 10 period ( economic life) and it can be found between 15% ( 5.019) and 16% ( 4.833)

The (discounted or internal) rate of return is therefore higher than 15% and lower than 16%
Table: Present Value of an Annuity of 1 n
1 2 3 5 10

14%
0.877192962 3.433080969 5.216115846

15 %
0.869565217 3.352155098 5.018768626

16%
0.862068966 3.274293654 4.833227478

Net Present Value:

Present value of annual cash returns Discounted at 12% ( P 20,000 x 5.650) P 113,000 Less: Investment 100,000 NET PRESENT VALUE P 13,000 This refers to the excess of the present value of cash return discounted at a chosen cut-off rate over the amount of investment. When net present value is positive, it implies that the rate of return on the proposed investment is higher than the cut- off rate and vice- versa. A zero (0) difference indicates that the rate of return on the investment shall be equal to the cut-off rate used.

Profitability ( present value ) Index Or Benefit/ cost ratio Present value of annual cash return Discounted at 12% ( P 20,000 x 5.650) P 113,000 Divide by INVESTMENT 100,000 Profitability index 113%

This refers to the ratio of the present value of cash return discounted at a chosen cutoff rate to the investment requirement.
A ratio higher than 100% indicates that the proposed investment will be earning at a rate higher than cut off rate and vice versa. A 100% ratio implies that the rate of return on the investment shall be equal to the cut-off rate used.

Discounted Payback Period Acc.

Yr PV of CR
1 P 20k x 0.893 = 17,860.00 2 20k x 0.797 = 15,940.00 3 20k x 0.712 = 14,240.00 4 20k x 0.635 = 12,700.00 5 20k x 0.567 = 11,340.00 6 20k x 0.507 = 10,140.00 7 20k x 0.452 = 9,040.00 8 20k x 0.404 = 8,080.00 Fraction of the 9th yr. 9 20k x 0.361 = 7,220.00 Investment 8.09

No. of
Years
1 1 1 1 1 1 1 1

PV of CR
P 17,860.00 33,800.00 48,040.00 60,740.00 72,080.00 82,220.00 91,260.00 99,340.00

*660.00 ** .09 100,000.00

* (100K 99,340) ** ( 660/ 7,220)

This refer to the number of years it would take the present value of cash return to equal the investment.

Payback Bailout Period- this refers to the length of period or number of years it would take to recover an investment considering accumulated cash returns and terminal values. Example: A project requires investment of 25,000. cash returns and salvage value at the end the year are as follows: Cash Return Salvage Value
Yr 1 Yr 2 Yr 3 Yr 4 P 8,000 6,000 5,000 8,000 P 12,000 10,000 6,000 2,000

Yr 1 Yr 2 Yr 3

Accumulated Cash Return P 8,000 14,000 19,000

Salvage V. Total P 12,000 P 20,000 10,000 P 24,000 6,000 25,000

The payback bailout period is three (3) years because as of the end of the third year, the total of accumulated cash return and salvage value at the end of 3 year period is expected to be equal to the investment for the particular project.

Payback Period- Uneven Cash Return When cash return are uneven, the payback period is computed by accumulating the cash returns until the total is equal to investment. Example: On investment of P 50,000, cash return are as follows:

Yr 1 P 17,000 Yr 2 P 22,000 Yr 3 P 11,000

Yr 4 P 18,000 Yr.5 P 25,000 Yr.6 P 10,000

P 17,000 + 22,000 + 11,000 = P 50,000

Internal Rate of Return ( IRR) Uneven Cash Return

When cash return are uneven, the discounted or IRR is computed by using average annual cash return in estimating the tentative payback period. tentative period is The subsequent located in the present value of annuity table.

The rate of return is arrived at when at that rate, the present value of cash return is equal to investment. When present value of cash return arrived at is smaller than investment, it means that the rate of return is lower than the rate used in discounting the cash returns so that the analyst should try the next lower rate and vice versa.

When cash inflows are bigger in earlier years, the rate of return must be higher than what it seems and vice versa. Example: On an investment of P 7,407, cash return have been estimated as follows: Yr 1 P 3,000 Yr 2 2,000 Yr 3 5,000

The discounted rate of return is computed: Tentative Payback = P 7,407 =2.222 Period (3K + 2K + 5K)/3 yrs. Locating 2.222 yrs in the PV of an annuity table is 16% to 18%.
Cash return on 3rd year is much bigger than the 1st and 2nd year ( there a delay in cash in flows) it is advisable to start with the lower rate. 16%

At 16% Yr 1 P 3,000 x .862 = P 2,586 Yr 2 2,000 x .743 = 1,486 Yr 3 5,000 x .641 = 3,205 P 7,277
The present value of cash return exceeds investment. So try the next lower rate 15%

At 15% Yr 1 Yr 2 Yr 3

P 3,000 x .870 = P 2,000 x .756 = 5,000 x .657 = P

2,610 1,512 3,285 7,407

The PV of cash return is equal to investment of P 7,407, the rate must be 16%

Net Present Value- Uneven Cash returns Even if the cash return are uneven, the procedure in determining the net present value remains the same. The different cash returns are discounted using cut-off rate and the total of the present value is compared with the amount of investment. Using the same figure in the example Assuming the cost of capital is 12%. the NPV is...

Net Present Value: Present value of cash return discounted at 12%. Yr.1 P 3,000 Yr.2 2,000 Yr. 3 5,000 x x x .893 = P 2,679 .797 = 1,594 .712 3,560 P 7,833 7,407 P 426

Less investment Net Present Value

Exact Internal Rate of Return When the payback period does not exactly fall in one column in the PV of an annuity table, interpolation* is applied to arrive at the exact discounted rate of return.
*calculation of the value of a function between the values already known

Example: annual cash return amount to P 20,000 on an investment of P 80,000 having economic life of 10 years.

payback period P 80,000 / P 20,000= 4 years Rate of return must be between 20% and 22% ( see line 10 of the PV of an annuity table) At 20% At 22% 2% 4.192 4.0 3.923 .269 .077 .192

Exact discounted rate of return .192 = 20 % + ( .269 x 2% ) = 21.4% Or .077 22 % - ( .269 x 2% ) = 21.4%

Uncertainty in Capital Budgeting. Long term commitment of funds involves risk arising from uncertainty regarding the future. Although the business climate may be very conducive to an investment proposal at the time it is made. The possibility of changes therein and the effects of these changes on annual cash return must be considered.

Thus, Optimistic, most likely and pessimistic estimates of cash returns are made and the range of variation therein may indicate the degree of risk involved.

Project A NPV Prob.

Opt. M. L Pess.

Project B NPV Prob.

P 25,000 11,000 3,000 P 5,000 7,150 750 P 12,900 .20 .65 .25

P 18,000 12,000 8,000

.25 .60 .15 P 4,500 7,200 1,200 P 12,900

Optimistic Most Likely Pessimistic Expected NPV

Project A is superior to Project B

( 18,000- 8,000) ( 25,000- 3,000)

Range from optimistic to pessimistic

normal distribution curve In statistics, the theoretical curve that shows how often an experiment will produce a particular result. The curve is symmetrical and bell shaped, showing that trials will usually give a result near the average, but will occasionally deviate by large amounts. The width of the bell indicates how much confidence one can have in the result of an experiment the narrower the bell, the higher the confidence. This curve is also called the Gaussian curve, after the nineteenth-century German mathematician Karl Friedrich Gauss.

Replacement of Fixed Assets: When management is faced with the problem of whether to replace its fixed assets or not. The analysis differs from that of a proposed acquisition of new unit ( expansion). This is because a replacement problem involves cash flows arising from the use of the old asset and incremental cash flows from the replacement.