Chapter 13: Capital Investment Decisions

Capital Budgeting Decisions: 4. Plans must be made well into an uncertain

- Process whether or not to commit resources to
projects
- an action relation to planning and financing
capital outlays for the purpose as the purchase
of machinery, modernization of plant
facilities and introduction of product lines
- a commitment of funds now in order to
receive some desired return in the future.
It involves: a. The preparation of annual budget for
capital investment
b. the assessment of funding capacities
the allocation of resources to the
renewal and expansion of projects
Characteristics of Capital investment Decisions
Capital Expenditure-long term commitment of
resource to realize future benefits and budgeting
1. Substantial Amount of funds are required in
capital projects
2. The elements of uncertainty becomes more
critical
3. The effects of managerial errors will be more
difficult to reverse
future
5. Success or failure of the company may depend
on the single or relatively few investment
decisions
Categories of capital Investment
1. Screening Decisions – projects evaluated
individually and reviewed against
predetermined corporate standards of
acceptability resulting in an “accept” or
“reject “decision. Example: Investment in
long term assets such as PPE.
2. Preference Decisions-require the company
to chose from among specific alternatives,
the project must be pass on the criteria of
acceptability set by the company. Example:
Replacement against renovation of
equipment or facilities
Elements of Capital Budgeting:
1. The net amount of the investment
2. The operating cash flow or return from the
investment
3. The minimum acceptable rate of return on
the investment? Cost of Capital.

Net Initial Invest or project cost

Initial Cash Outlay xx
Add: Additional cash outlay related to asset xx
Additional working capital xx xx
Less: Cash inflow arising from sale of
old asset being replaced xx
Avoidable Cost xx xx
Net Investment xx
Example:
The management of Maingat Company plans to replace a sorting machine that was acquired several years ago at
a cost of 60000. The machine has been depreciated to its residual value of 10000.
A new sorter can be purchased for 96000. The dealer will grant a trade in allowance of 16000 on the old
machine. If a new machine is not purchased, Maingat Company will spend 10000 to repair the old machine.
Gains and loses on trade-in transactions are not subject to income taxes. The cost to repair the old machine can
be deducted in computing income taxes. Income taxes are estimated at 40% of income subject to tax.
Additional working capital required is 50000.
REQUIRED: Compute the net initial investment in this project.
Solution: Maingat Company
Purchase price of new sorter 96000
Add: additional working capital 50000
Less: Trade-in allowance on sold sorter 16000
Avoidable cost on old sorter 6000 22000
Net Investment 124000

Screening Capital Investment Proposals

A. Non - discounted cash flow (unadjusted) Decision Rule:
approach
If: PB period < Maximum allowed PB period;
1. Payback period Accept
2. Accounting rate of return (book value rate of If: PB period > Maximum allowed PB period;
return) Reject
3. Payback reciprocal
B. Discounted cash flow (time - adjusted) Advantages of Payback period method:
approach
1. It is easy to compute and understand.
1. Net present value
2. It is used to measure the degree of risk associated
2. Discounted rate of return or internal rate of return with a project.
3. Profitability index 3. Generally, the longer the payback period, the
higher the risk.
4. Discounted payback period
4. It is used to select projects which provide a quick
return of invested funds.
Payback Period
Disadvantages of the payback period method:
- Also known as payoff and payout period
1. It does not recognize the time value of money.
2. It ignores the impact of cash inflows after the
When the periodic cash flows are uniform, payback period.
payback is computed as follows:
3. It does not distinguish between alternatives
having different economic lives.

NET INVESTMENT 4. The conventional payback computation fails to

consider salvage value.
ANNUAL CASH RETURNS
5. It does not measure profitability - only the
relative liquidity of the investment
DISCOUNTED RATE OF RETURN / INTERNAL RATE OF RETURN
 also known as Internal Rate of Return (IRR) and time adjusted rate of return, is the rate which equates
the present value of the future cash inflows with the cost of the investment which produces them. It is
also the equivalent maximum rate of interest that could be paid each year for the capital employed over
the life of an investment without loss on the project.
Decision Rule:
If: IRR ≥ Required rate of return; Accept
If: IRR < Required rate of return; Reject
PROFITABILITY INDEX
 Also known as present value index, benefit cost rate , desirability index.
 The ratio of the total present value of future cash inflows to the initial investment.
FORMULA:

PV index = PV of Cash Inflows__

PV of Net Investment

DECISION RULE:
The higher the profitability index, the more desirable the project. Thus:
If: PV index > 1; Accept
If: PV index < 1; Reject

Solution: Company XYZ

1. Computation of Profitability or PV index
P244 000
PROJECT A: = P200 000

= 1.22
P130 000
PROJECT B: = P100 000

= 1.30

P130 000
PROJECT C: = P100 000
 = 1.30
2. Rankings of projects
Rank Project
1 B and C
2 A

3. The company should invest in Project B and C for the following reason:
a) The PV indexes of Project B and C are higher than Project A.
b) The combined net present value of Project B and C is higher than Project A.
c) The company can afford to invest in both A and B.

DISCOUNTED PAYBACK PERIOD

 Method that recognized the time value of money in a payback context is the discounted payback
method.
 Used to compute the payback in terms of discounted cash flows received in the future.
 Periodic cash flows are discounted using an appropriate cost of capital rate.
 Computed using the discounted cash flow values rather than actual cash flows.

SOLUTION:
The discounted payback period is determined as follows:

 The discounted payback period is 4 years.

  If the maximum allowable DPB is 3 years, the project should be rejected.

PREFERENCE DECISIONS- THE RANKING OF INVESTMENT PROJECTS

 Comes from the screening decisions and attempt to resolve the question of “How do the investment
proposals, all of which have been screened and provide an acceptable return, rank in terms of
preference?”.
 Either internal rate of return method or the net present value method can be used in making preference
decisions.
INTERNAL RATE OF RETURN METHOD
Preference rule when using the IRR method to rank competing investment is:

“The higher the internal rate of return, the more desirable the project”

Widely used for two main reasons:

1. No additional computation need to be made beyond those already performed in making the initial
screening decisions.
2. The ranking data are easily understood by management.
NET PRESENT VALUE METHOD
 Can be used to rank competing investment projects if the projects are equal size, that is, investment
funds required are the same.
 Competing projects require different amount funding, it may be necessary to compute for Profitability
index.
Preference rule to rank competing investment projects using profitability index is:
“ The higher the profitability index, the more desirable the project.”

Comparing the Preference Rates

The NPV method assumes the cash flows will be reinvested at the firm’s cost capital while the IRR
method assumes reinvestment at the project’s IRR. Because reinvestment at the cost of capital is generally a
better assumption to NPV is superior to the IRR.
The Profitability index is conceptually superior to the internal rate of return as method of making
preference decisions.
Comparing Projects with Unequal Lives
Replacement decisions involved comparing two mutually exclusive projects: retaining the old asset
versus versus buying a new one.
1. Replacement chain method – This method compares project of unequal lines which assumes that each
project can be repeated as many lives as necessary to reach a common life span.
Project N Project M
Investment required
Annual Cash Inflows P(400,000) P(200,000)
 Year 1 80,000 70,000
Year 2 140,000 130,000
Year 3 130,000 120,000
Year 4 120,000 -
Year 5 110,000 -
Year 6 100,000 -

Net Present Value of the

Cash Flows discounted
@12% P64,910 P51,550
Internal Rate of Return 17.5% 25.2%

2. The Equivalent Annual Annuity method (EAA) – is a method which calculates the annual payments a
project would provide if it were an annuity.

Project M

Year 0 = (200,000)
Year 1 = 70,000*0.8929 62,500
Year 2 = 130,000*0.7972 103,635
Year 3 = 120,000*0.7118 85,415
NPV 51,550
Project N

Year 0 = (400,000)
Year 1 = 80,000*0.8929 71,430
Year 2 = 140,000*0.7972 11,607
Year 3 = 130,000*0.7118 92,531
Year 4 = 120,000*0.6355 76,262
Year 5 = 110,000*0.5674 62,417
Year 6 = 100,000*0.5066 50,663
NPV 64,910