3 - Capital Budgeting

Topic 3:
Capital Budgeting / Capital Investment

Decisions
What is Capital Budgeting?
It is also known as Capital investment analysis.
It is used to describe how managers plan
significant investment in projects that have long-
term implications such as the purchase of new
equipment or the introduction of new products.
Capital investment decisions are concerned with
the process of planning, setting goals and
priorities, arranging financing, and using certain
criteria to select long-term assets.
Importance of Capital Budgeting:
It creates accountability as it is used as a
control tool in an entitys operations.
It creates measurability.
It allows the company to make the best use of
its resources.

Riskiness of capital budgeting
decisions due to:
Uncertainty of outcome
Involvement of large amounts of money
Entailment of long-term commitment
Difficulty and/or irreversibility of capital
budgeting decisions already made

Difference between Master Budget
and Capital Budget
A master budget is recurring and is made on a
periodic basis. It is a comprehensive plan of action
for an organization for a future period.
In contrast, a capital budget is longer term in nature
and it is non-recurring. It is an investment and
financing plan for a major project or program that
has long range effects on operations. The resources
specified in the capital budget of the current period
are included in the master budget of the period.
Classifications of Capital Budgeting
Decisions:
Cost reduction decisions
Expansion decisions
Equipment selection decisions
Lease or buy decisions
Equipment replacement decisions
The Capital Budgeting Process:
Project proposals are requested from
departments, plants, and authorized
personnel.
Proposals are screened by a capital budget
committee.
Officers determine which projects are worthy
of funding.
Board of directors approves capital budget.
Steps in Capital Budgeting:
1. Identification of Capital Investment Needs
2. Formal Requests for Capital Investment
3. Preliminary Screening
4. Establishment of Acceptance-Rejection
Standard
5. Evaluation of Proposals
Categories of capital investment
projects:
Screening decisions
Relate to whether a proposed project is
acceptable: whether it passes a present hurdle.
Preference decisions
Relate to selecting from among several acceptable
alternatives.
Time Value of Money Concept and
Present Value Factors:
Since capital budgeting involves long term
decisions, the time value of money must be
recognized when evaluating investment
proposals.
Projects that promise earlier returns are
preferable to those projects whose returns
come later.
Types of capital budgeting projects:
Independent
Cash flows are not affected by the acceptance or
non-acceptance of other projects.
Mutually exclusive
A set of projects where only one can be accepted
and the others, rejected.
Mutually inclusive
A set of projects that are all related and that all
must be chosen if the primary project is chosen.
Elements of capital budgeting:
Project Cost or Net Investment
Cost of Capital
Annual cash inflow
An emphasis on cash flows
and not accounting income,
because cash is used to pay
for capital investments.
What comprises cash flows?
Cash outflows
Initial investment
Increased working capital needs
Repairs and maintenance
Incremental operating costs
Cash inflows
Incremental revenues
Reduction in costs
Salvage value
Release of working capital
What comprises Investment Cost?
Investment cost = purchase price of the asset +
incidental costs (freight and installation) +
installation related costs + required training fees
+ books or manuals for new equipment +any
taxes and fees + working capital requirements to
operate at desired level + market value of assets
already owned (idle) which will be transferred to
the project + any other required outlays *sale
of old equipment
*sale of old equipment = sales value + tax benefit
(loss)

Cost of Capital/Discount rate Review
Angel Company has a capital structure of 40%
debt and 60% equity. Cost of debt is 10%.
The risk free rate is 5%, beta is 1.2 and return
on the market is 12%. Tax rate is 40%.
Compute for the WACC.
Simplifying Assumptions:
All cash flows other than the initial investment
occur at the end of periods.
All cash flows generated by an investment
project are immediately reinvested at a rate of
return equal to the discount rate.
Methods in capital investment analysis:
Non-discounted Cash Flow Methods
Payback period
Payback reciprocal
Payback bailout
Accounting rate of return or ROI or Simple rate of return
Discounted Cash Flow Methods
Discounted payback period
Discounted payback bailout period
Profitability index
Net present value
Internal rate of return

Non-discounted cash flow methods
Payback period
Payback reciprocal
Payback bailout
Accounting rate of return or ROI or Simple rate
of return
Payback Period
The expected time period to recover the initial
investment amount.
If projects are independent
Accept all the projects that fit into the firms acceptable
criteria. Otherwise, reject.
If projects are mutually exclusive
Accept the project with the shortest payback period and that
which fits into the firms acceptable criteria. Otherwise,
reject.
If projects are mutually inclusive
Accept the primary and the subsequent secondary projects
connected to the former if they fit into the firms
acceptable criteria. Otherwise, reject the projects.
Payback Period
Advantages:
It helps control the risks associated with the uncertainty of future
cash flows.
It helps minimize the impact of an investment on a firms liquidity
problems.
It helps control the risk of obsolescence.
It helps control the effect of the investment on performance
measures.
Easy to calculate and understand.
Disadvantages:
Does not take into account time value of money.
Ignores salvage value.
No concrete decision criteria to indicate if an investment increases
the firm value.
Does not consider the cash flows occurring after the payback
period, consequently ignoring a projects total profitability.
Payback Period Equal annual cash flows
Payback period = Investment required / Annual net
cash inflow
SS Shipping is considering an investment of
P130,000 in new equipment. The new equipment is
expected to last 10 years. It will have a zero salvage
value at the end of its useful life. The annual cash
inflows are P200,000 and the annual cash outflows
are P176,000. What is the payback period?
Further assume that at SS, a project is unacceptable
if the payback period is longer than 60% of the
assets expected useful life. Should the project be
accepted?
Payback Period Uneven annual cash flows
Chen Company proposes an investment in a new
website that is estimated to cost P300,000. The net
annual cash flows for Years 1 to 5 are P60k, P90k,
P90k, P120k, and P100k, respectively. Compute for
the payback period.
Payback Reciprocal
This is the reciprocal of payback period.
Payback Reciprocal = 1 / Payback Period
Often gives a quick and accurate estimate of the IRR of
an investment when:
The project life is more than twice the payback period.
Cash inflows are uniform every period.
If you have two or more projects which fit the firms acceptable
criteria, you should accept those projects.
If you have two or more projects which fit the firms acceptable
criteria, accept the project with the highest payback reciprocal.
If the primary project and all related secondary projects fit the
firms acceptable criteria, you should accept the project.

Payback Reciprocal
Advantages:
cash flows.
problems.
measures.
It indicates a projects risk and liquidity in percentage terms
Disadvantages:
Does not take into account time value of money.
the firms value.
Payback Reciprocal
ABC Company is contemplating three projects,
each of which would require an initial
investment of P10,000, and each of which is
expected to generate cash inflow of P2,000
per year. Project As useful life is 10 years,
Project Bs useful life is 15 years, and Project
Cs useful life is 20 years.
What is the payback reciprocal?
Payback Bailout Period
The length of time it would take to recover an
investment considering accumulated cash returns and
terminal (salvage) value.
Accept the project with the shortest payback bailout period
and that which fits into the firms acceptable criteria.
Otherwise, reject.

Advantages:
cash flows.
problems.
measures.
Considers salvage value
Disadvantages:
Ignores the time value of money.
the firm value.
bailout period, consequently ignoring a projects total profitability.
A project requires an investment of P25,000. Cash
returns and salvage value (in pesos) at the end of
each year are as follows:

What is the payback bailout period?

Cash Returns Salvage Value
Year 1 8,000 12,000
Year 2 6,000 10,000
Year 3 5,000 6,000
Year 4 8,000 2,000
Accounting Rate of Return or Return on
Investment or Simple rate of return
The second commonly used non-discounting model.
Measures the return on a project in terms of income, as opposed
to using a projects cash flow.
Based or original investment:
ARR = Annual incremental net operating income or Average NI after tax
/ Initial investment or Net investment
Based on average investment:
ARR = Annual incremental net operating income or Average NI after tax
/ Average Investment
Accept if ARR > or at least = cost of capital
Accept the project with the highest ARR, provided it is > or at least = cost of
capital.
Accept if the primary project and all related secondary projects overall ARR >
or at least = cost of capital

Accounting Rate of Return
Advantages:
Indicates a projects risk and liquidity.
Encourages managers to focus on relationship among sales,
expenses, and investment, cost efficiency, and operating
asset efficiency.
Disadvantages:
Ignores time value of money.
Can produce a narrow focus on divisional profitability at the
expense of overall firm profitability.
Dependent upon net income, which is most likely to be
manipulated by managers.
There are two ways of calculating ARR, which causes a
problem on comparability.
Accounting Rate of Return 1
An investment requires an initial outlay of P100,000
and has a five year life with no salvage value. The
yearly cash flows are P50,000, P50,000, P60,000,
P50,000, and P70,000. Calculate the accounting
rate of return. Would you accept the project if
WACC is 20%?
Accounting Rate of Return 2
The initial capital expenditure requirements are
P100,000 for a machine that will have a 5 year useful
life. Depreciation is calculated on a straight line basis.
The scrap value of the machine is P10,000 The project
is expected to have a P30,000 annual gross profit.
Assume that tax is 30%. Calculate the ARR.
Assume that an existing machine is to be replaced
when the new one is bought. The selling price of the
old machine is P8,000. It has a book value of P2,000.
Discounted Cash Flow Methods
Discounted payback period
Discounted payback bailout period
Profitability index
Net present value
Internal rate of return

Discounted Payback Period
Refers to the length of time required for the present
value of an investments cash flows (discounted at the
investments cost of capital) to recover a projects cost.
Accept the project with the shortest discounted payback
period and that which fits into the firms acceptable
Discounted Payback Period
Advantages:
cash flows.
problems.
measures.
It considers the time value of money.
Disadvantages:
the firm value.
Discounted Payback Period 1
You have invested in a project that costs
P20,000. The estimated annual cash inflows
are P5,000. Assuming a cost of capital of 10%,
what is the discounted payback period?
Discounted Payback Period 2
You have invested in a project that costs
P10,000. The estimated annual cash inflows
for Years 1 to 3 are P5000, P4,000, and P3,000,
respectively. Assuming a cost of capital of
10%, what is the discounted payback period?
Discounted Payback Bailout Period
The length of time it would take to recover an
investment considering discounted accumulated cash
returns and terminal (salvage) value,
Accept the project with the shortest discounted payback
bailout period and that which fits into the firms acceptable

Discounted Payback Bailout Period
Advantages:
It helps control the risks associated with the uncertainty of
future cash flows.
It helps minimize the impact of an investment on a firms
liquidity problems.
measures.
Considers salvage value and time value of money.
Disadvantages:
No concrete decision criteria to indicate if an investment
increases the firm value.
bailout period, consequently ignoring a projects total
profitability.
Payback Bailout Period vs. Discounted
A machine costs P100,000. Annual cash
inflows relating to the machine is estimated to
be P25,000. Salvage values at the end of 7
years are 60k, 50k, 40k, 30k, 20k, 10k, and
zero. Assume that cost of capital is 10%.
Compute for the payback bailout period.
Compute for the discounted payback bailout
period.
Profitability Index
Also known as profit investment ratio, present value index,
value investment ratio, benefit-cost rate, or desirability index.
Refers to the ratio of discounted benefits over discounted
costs.
PI = PV of future cash flows / Initial investment
Accept all the projects whose Profitability Index > or at least = 1.
Otherwise, reject.
Accept the project with the highest Profitability Index, provided
that the PI > or at least = 1. Otherwise, reject. If a necessity,
accept the project with the highest PI.
Accept if the primary project and all related secondary projects
lead to an overall PI > or = 1. Otherwise, reject the projects.

Profitability Index
Advantages:
Considers all cash flows and time value of money.
Tells whether a project will increase or decrease a firms
value.
Disadvantages:
Not in peso amount does not give a direct measure as
to the projects contribution to the increase in firm
value.
It does not consider the size of the project when
evaluating projects and may be incorrect when
evaluating mutually exclusive projects.

Profitability Index
A company invests in a project that costs P5
million. P2 million is expected to be
generated for the next 3 years, and P1 million
subsequently. The project is expected to last
for 5 years. Assuming a cost of capital of 10%,
what is the profitability index?
Net Present Value
The difference between the PV of cash inflows and
outflows associated with a project and it measures the
profitability of an investment.
Accept all the projects with + NPV. Otherwise, reject. If NPV
is positive, it means that that (1) initial investment has been
recovered, (2) the required rate of return has been
recovered, and (3) a return in excess of (1) and (2) has been
received.
Accept the project with the highest + NPV. If the project is a
necessity, then accept the project with the highest NPV.
Accept if the primary project and all related secondary
projects lead to an overall + NPV. Otherwise, reject.

Net Present Value
Advantages:
Gives a direct measure of the peso benefit of the project
to the shareholders.
Considers all cash flows and the time value of money.
Considers the total profitability of the project.
Disadvantages:
Expressed in terms of pesos, not as a percentage, the
latter of which is preferred by business managers.
Along with other discounted methods, it requires
projections of cost of capital and cash flows . These
projections may be difficult to determine with exact
precision.

Net Present Value 1
Calculate the NPV of a project which requires an
initial investment of P243,000 and is expected to
generate cash inflows of P50,000 each month for 12
months. Assume that the cost of capital is 12%.
Net Present Value 2
An initial investment of machinery of P8,320,000 is
expected to generate cash inflows of P3,411,000,
P4,070,000, P5,824,000, and P2,065,000 at the end
of each of the next four years. At the end of the
fourth year, the machine will be sold for P900,000.
If discount rate is 18%, what is the NPV?
Net Present Value 3
You have a choice between 2 mutually exclusive
investments. If you require a 15% return, which
investment should you choose?

Year Cash Flow (Proj. A) Cash Flow (Proj. B)
0 - 100,000 - 125,000
1 20,000 75,000
2 40,000 45,000
3 80,000 40,000
Profitability Index vs. NPV
Independent Projects
There would not be a conflict between PI and NPV
because they yield same accept/reject rules. This
is because PI can be greater than 1 only when NPV
is positive.
Mutually Exclusive Projects
There may be a conflict between PI and NPV
because the size of the project does not matter
for PI but it matters for NPV.
Conflict: Profitability Index vs. NPV
Project X Project Y
PV of cash inflows 200,000 100,000
Initial investment 100,000 40,000
PI
NPV
In case of conflict, the NPV method must be
followed (except under capital rationing)
because the NPV reflects the net increase in
the firms wealth.
Internal Rate of Return
The interest rate that sets the present value of a
projects cash inflows equal to the present value of the
projects cost. It is the interest rate that forces the NPV
to be zero, so PV of inflows = PV of outflows.
Accept all the projects whose IRR > or at least = WACC. If IRR
> than WACC, NPV is positive.
Accept the project with the highest IRR, provided that the
IRR > or at least = WACC. If it is a necessity, accept the
project with the highest IRR.
Accept if the primary project and all related secondary
projects overall IRR > or at least = WACC.

Internal Rate of Return
Advantages:
Tells whether an investment increases value or not.
It contains information regarding a projects safety margin.
Considers all cash flows and the time value of money.
It is more appealing to business managers because it
provides a basis (rate of return) for decision making, rather
than just a peso amount.
Disadvantages:
Unrealistic assumption of using IRR as the reinvestment rate
whereas using WACC would have been more realistic.
IRR cannot rank mutually exclusive projects properly all the
time.

Internal Rate of Return 1
Find the IRR of an investment having initial
cash outflow of P213,000. The annual cash
inflows for 6 years is expected to be P40,000.
If WACC is 4%, will you accept this project?
Internal Rate of Return 2
Find the IRR of an investment having initial
cash outflow of P213,000. The cash inflows
for Years 1 to 4 is expected to be P65,200,
P98,000, P73,100, and P55,400 respectively.
If WACC is 10%, will you accept this project?
Factors that complicate capital budgeting:
Taxes
Proposals with unequal lives
Leasing versus purchasing
Uncertainty
Changes in price levels
Qualitative factors
Post-audit
Must be done by an independent party so that more
objective results can be obtained.
By evaluating profitability, post audits ensure that
resources are used wisely.
It enables corrective action to be taken to improve
performance.
It holds managers accountable for their decisions and
force them to make decision that serves the best
interests of the firm.
Supply feedback to managers that should help them
improve future decision making.
They are costly so accountability must be qualified to
some extent by the impossibility of foreseeing every
possible eventuality.

Special Considerations for Advanced
Manufacturing Environment
Standard
Manufacturing
Environment
Advanced Manufacturing
Environment
Investment
Direct costs of
acquisition
Direct costs of acquisition
Software costs
Engineering costs
Training costs
Implementation costs
Estimates
of
Operating
Cash Flows
Directly
identifiable
tangible benefits
(direct savings
from labor, power,
and scrap)
Directly identifiable tangible benefits
Intangible benefits (greater quality,
more reliability, reduced lead time,
improved customer satisfaction,
enhanced ability to maintain market
share., reduction of labor in support
areas)
Kaizen Budgeting
A budgeting technique which takes into account
the costs of improving the product. It projects
costs on the basis of improvements yet to be
implemented rather than upon current
conditions.
Kaizen is a Japanese term for improvement and
refers to the philosophy or practices that focus on
continuous improvement of processes in
manufacturing, engineering, and business
management.
Activity-based Budgeting
The traditional approach to budgeting which
emphasizes the estimation of revenues and costs
by organizational units and the use of a single
unit-based driver such as direct labor hours. It
focuses on the costs of activities necessary for
production and sales.
In contrast to traditional budgeting which directly
budgets costs for functional or spending
categories, ABB estimates the costs of performing
various activities.
Thank you!!!

3 - Capital Budgeting

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Topic 3:

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