Capital budgeting

A capital expenditure is an outlay of funds made in the expectation of receiving

future benefits. Examples of capital expenditures are outlays for buildings, machinery
and research and development

Capital budgeting- the planning and control of capital expenditure, which are outlays of
funds made in the expectation of receiving future benefits.

Two Pseudocriteria

1. Payback Period Criterion. The payback period is defined as the length of time
required for the stream of future incomes produced by an investment to equal the
original cost of the investment. If the annual net proceed from the investment is a
constant amount, the payback period is easily computed by merely dividing the
total original cost by the annual income.

Example 1:

Year 0 1 2 3 ………… 10

Initial investment (10,000)

Net income 2,000 2,000 2,000 2,000 2,000

Payback period = 10000/2,000

= 5 yrs.
 If the yearly net proceeds are unequal, they must be totaled until they equal the
original investment. The payback period then covers all the years corresponding to the
periodic incomes included in this total.

Example 2:

Year 0 1 2 3 4 5

Initial investment 50,000

Initial investment 10,000 15,000 25,000 20,000 15,000

Year net income cumulative net income

1 10,000 10,000

2 15,000 25,000

3 25,000 50,000

4 20,000 70,000

5 15,000 85,000

Therefore, the payback period is three years since the cumulative income at the end of
three years equals the initial investment

The payback period criterion can be used in either of two ways

1. The decision maker could stipulate a maximum payback period and reject all
investment proposals whose payback periods excess the maximum.
2. To rank various alternative projects: the one with the shortest period is ranked
first and the one with the longest period is ranked last.

The payback criterion may be valid if the firm is faced with great difficulties in
generating cash internally and externally. The period from 2017-2019 is expected to be
one during which liquidity will become more important than profitability. In this case it
would be logical for the firm to accept only the projects with the short payback; two
years or less since it main concern would be a very high cash turnover.
 2. Accounting rate of return

Accounting rate of return = P/C

Where P= average yearly net profits. This is computed by dividing the total
estimated earnings of the project by its expected useful life

C= total cost of Investment

If the accounting rate of return is higher than the cost of capital, accept the proposal. If
not, reject. In theory, cost of capital should be the rate of return that would leave the
market price of the firm’s stock unchanged. It is more forward looking than the payback
period method. But like the payback period method, it does not take into consideration
the time value of money because it places incomes received at different times in the
future on equal footing

Discounted cash flow

DCF recognizes the time value and is the preferable method to use for capital-
budgeting decisions.

A peso today is worth more than a peso to be received three years from today because
the peso today could be deposited in a bank and could earn interest for three years.

Two variations of discounted cash flow method

a. Net present value- cash flows are discounted to present value using the cost of
capital of the firm. The prevailing interest rate is assumed as the firms cost of
capital
If the NPV is greater than 0, then the proposal is accepted; if it is less than 0,
then it is rejected; and if it is equal to 0, then the firm is indifferent

b. Internal rate of return- is the discount rate that equates the present value of the
expected cash flows with the cost of investment
The ranking process

The firm is often faced with the question of deciding which projects to undertake
among different possible projects. Since the financial resource of a firm is limited, it
cannot undertake all the possible projects that may be proposed by different managers
of the company. As long as the projects are independent of one another, the decision
on what projects to undertake can readily be made by using the net present value or the
internal rate of returns. Therefore, there is a need to rank the projects.

Example 1:

Project Estimated IRR Cost of Projects Cumulative Demand

for Capital Funds
A 75% 70,000 70,000
B 40% 80,000 150,000
C 22% 90,000 240,000
D 16% 60,000 300,000
E 9% 90,000 390,000
F 4% 70,000 460,000

Assuming a cost of capital of 15% the firm should undertake projects A,B,C, and D.
Since their IRR’s are greater than 15%. If the firm could muster only a total of P150,000
from retained earnings and debt and equity financing, then only A and B should be
undertaken.

Projects Estimated NPV Cost of Project Cumulative demand

for capital funds
1 20,000 50,000 50,000
2 15,000 80,000 130,000
3 5,000 70,000 200,000
4 2,000 80,000 280,000
5 -3,000 100,000 380,000
6 -8,000 50,000 430,000

The firm should undertake projects 1,2,3 and 4 since their NPV’s are greater than 0. If
the firm could muster only a total of 200,000, then only Projects 1,2 and 3 should be
undertaken.

The Importance of Capital Budgeting

The amount of cash involved in a fixed asset investment may be so large that it
could lead to the bankruptcy  of a firm if the investment fails. Consequently, capital
budgeting is a mandatory activity for larger fixed asset proposals. This is less of an
issue for smaller investments; in these latter cases, it is better to streamline the
capital budgeting process substantially, so that the focus is more on getting the
investments made as expeditiously as possible; by doing so, the operations of profit
centers are not hindered by the analysis of their fixed asset proposals.

CAPITAL BUDGETING PROCESS

A) Project identification and generation:

The first step towards capital budgeting is to generate a proposal for investments. There
could be various reasons for taking up investments in a business. It could be addition of
a new product line or expanding the existing one. It could be a proposal to either
increase the production or reduce the costs of outputs.

B) Project Screening and Evaluation:

This step mainly involves selecting all correct criteria’s to judge the desirability of a
proposal. This has to match the objective of the firm to maximize its market value. The
tool of time value of money comes handy in this step.
Also the estimation of the benefits and the costs needs to be done. The total cash inflow
and outflow along with the uncertainties and risks associated with the proposal has to
be analyzed thoroughly and appropriate provisioning has to be done for the same. 

C) Project Selection:
There is no such defined method for the selection of a proposal for investments as
different businesses have different requirements. That is why, the approval of an
investment proposal is done based on the selection criteria and screening process
which is defined for every firm keeping in mind the objectives of the investment being
undertaken.
Once the proposal has been finalized, the different alternatives for raising or acquiring
funds have to be explored by the finance team. This is called preparing the capital
budget. The average cost of funds has to be reduced. A detailed procedure for
periodical reports and tracking the project for the lifetime needs to be streamlined in the
initial phase itself. The final approvals are based on profitability, Economic constituents,
viability and market conditions.

D) Implementation:
Money is spent and thus proposal is implemented. The different responsibilities like
implementing the proposals, completion of the project within the requisite time period
and reduction of cost are allotted. The management then takes up the task of
monitoring and containing the implementation of the proposals.

E) Performance review:
The final stage of capital budgeting involves comparison of actual results with the
standard ones. The unfavorable results are identified and removing the various
difficulties of the projects helps for future selection and execution of the proposals.

Capital Rationing and Profitability Index

Capital rationing is a form of capital budgeting

- We change the unlimited capital assumption of capital budgeting and

we try to choose projects with the finite capital that we have on hand.
- Finite capital maybe in the form of capital that the firm already has or it
may be in the form of decision to raise a limited amount of capital in
the future
- Is the act of placing restrictions on the amount of new investments or
projects undertaken by a company

Reason for restrictions

1. Raising more equity could dilute the existing ownership interest.

2. There may be debt covenants preventing the firms from raising more debt
3. Raising more funds either by debt or equity may make the firm appear riskier
and may take the cost of capital even higher
These restrictions placed on the amount of capital that the company has nullifies the
assumption inherent in capital budgeting.

Two types of capital rationing

Soft rationing- when the firm itself limits the amount of capital that is going to be used
for investment decision in a given time period.

Hard rationing- the limitation on capital that is forced by factors external to the firm.

Profitability index- also known as profit investment ratio (PIR) and the value
investment ratio (VIR), is the ratio of payoff to investment of a proposed project. It is a
useful tool for ranking projects because it allows you to quantify the amount of value
created per unit in investment.

Profitability Index = 1+ (NPV/Investment)

Or

Profitability index = PV of future net cash flow/ initial investment required

Example:

Company C is undertaking a project at a cost of $50 million which is expected to

generate future net cash flows with a present value of $65 million. Calculate the
profitability index

Solution:

Profitability index = PV of future net cash flow/ initial investment required

= $65/$50

= $ 1.3

Net present value =PV of future net cash flows / initial investment required

= $65-$50 = $15 M

The information about NPV and initial investment can be used to calculate profitability
index as follows:

Profitability index = 1+ ( NPV/ Initial investment required)

 = 1 + ($15/$50) = $1.3 m

Cost of Capital
Cost of capital is the required return necessary to make a capital budgeting project,
such as building a new factory, worthwhile. Cost of capital includes the cost of debt and
the cost of equity, and is used by companies internally to judge whether a capital project
is worth the expenditure of resources, and by investors who use it to determine whether
an investment is worth the risk compared to the return.

The cost of capital is often divided into two separate modes of financing: debt and
equity.

The Importance of Cost of Capital

The importance of cost of capital is that it is used to evaluate new project of company
and allows the calculations to be easy so that it has minimum return that investor expect
for providing investment to the company. It has such an importance in financial decision
making. It actually used in managerial decision making in certain field such as-

1) Decision on capital budgeting- It is used to measure the investment proposal to

choose a project which satisfies return on investment.

2) Used in designing corporate financial structure- it is used to design the market

fluctuations and try to achieve the economical capital structure for firm.
3) Top management performance- It evaluates the financial performance of top
executives. It involves the comparison of actual profit of the projects and taken projects
overall cost.

Classification of Cost

1. Historical Cost and future Cost: represents the cost which has already been incurred
for financing a project. It is calculated on the basis of the past data. Future cost refers to
the expected cost of funds to be raised for financing a project. Historical costs help in
predicting the future costs and provide an evaluation of the past performance when
compared with standard costs. In financial decisions future costs are more relevant than
historical costs.

2. Specific Costs and Composite Cost -refer to the cost of a specific source of capital
such as equity shares, Preference shares, debentures, retained earnings etc.
Composite cost of capital refers to the combined cost of various sources of finance. In
other words, it is a weighted average cost of capital. It is also termed as ‘overall costs of
capital’.

3. Average Cost and Marginal Cost Average cost of capital refers to the weighted
average cost of capital calculated on the basis of cost of each source of capital and
weights are assigned to the ratio of their share to total capital funds. Marginal cost of
capital may consider more important in capital budgeting and financing decisions.
Marginal cost tends to increase proportionately as the amount of debt increase.

4. Implicit Cost and Explicit Cost - An implicit cost is a cost that has occurred but it is not
initially shown or reported as a separate cost. On the other hand, an explicit cost is one
that has occurred and is clearly reported as a separate cost.

Computation or methods of calculating cost of capital:

Weighted Average Cost of Capital

WACC COMPONENT

RD-COST OF DEBT (BOND)

RE- COST OF EQUITY (STOCK)

*COMMON STOCK

*PREFERRED STOCK

WACC FORMULA:
WACC= Wd*Rd(1-T)+We*Re

Example:

A company wants to raise money the company will sell $10 million of common stock;
the expected return is 15 percent. Moreover, the company will issue $5 million of debt,
the cost of debt is 12 percent and the tax rate is 30 percent

Total Value of the Company = $10+$5=$15

Weighted debt =5/15 =

Weighted equity =10/15

Wd =0.33

Rd=0.12

T=0.3

We=0.67

Re=0.15

WACC= Wd*Rd (1-T) + We*Re

WACC=0.33*0.12(1-0.3) + 0.67*0.15= 0.1282

Reviewing Investment Projects after Implementation

Post Implementation Review

- A process to evaluate whether the objectives of projects were met

- Also use to see how effective the project was managed
- Making sure that what you delivered actually works
- We can take things further and delivers even bigger benefits
- What lessons did we learn that we can apply to future projects.

Post Implementation Process

 Start review when members of the project team remembers the most
  List ideas and observations
 Allow a full cycle of business before conducting a post-implementation
review

PRACTICES OR TIPS

 TRUST
- Ask for openness
- Honesty from members
- The more critical and truthful their observations the more successful the
review
 OBJECTIVITY
- Be objective
- Describe what happened in objective terms
- Focus on improvements
 DOCUMENTATION
- Documents the practices and procedures to follow them in future projects
 HANDSIGHTS
- Pay attention to unknown that may have increased the implementation risk
- Helps you look forward for future
 IMPROVEMENTS
- Be future focused
- Avoid blaming individuals for mistake
- Learn from mistakes for future and projects
- Look for positives and negatives

METHODS IN CONDUCTING THE REVIEW

1. Gap analysis
- Assessing how a plan differed from actual application
- Evaluate how closely the project results
- Look at deliverables; are they at a quality level you expected?
- If there is a gap, how can they be closed
2. Projects goals
- Are deliverables functioning as planned?
- Did you achieve the goals of your project?
- What was the error rates of the project
- Is it functioning well, what way that will adjust smoothly to future operating
demands?
 - Are users adequately trained? Are there enough confident, skilled people
in the place?
- Are the controls and systems in place? Are they working properly?
- If there are problem, how will these be addressed?
- Did you planned goals align with your results?
3. Stakeholders
- Were users’ needs met
- What are the effects on the clients or end user?
- If the key individuals aren’t satisfied, how should this be addressed?
4. Cost
- What was the final cost?
- What will it cost to operate the solutions?
- How do the costs compare with the benefits achieved?
- If project hasn’t delivered a sufficient large return, how can these be
improved?
5. Benefits
- Did the project achieve the benefits projected? If not what is needed to
achieve them?
- What opportunities are there to further the results?
- Are there other changes you can apply to help maximize the results?
- Are there other additional benefits that can be achieved?
6. Lessons
- How well were the project’s deliverables assessed and how well were
timescales and cost assessed?
- What went wrong? How could those problems be avoided most time?
- What went well and needs to be learned from?
7. Report
- What have you learned from the review?
- What lessons have you learned that need to be carried forward to future
projects?
- How the project can impact future projects so you can build a success and
avoid problems?

Final thought

- Define the scope of the review beforehand

- Review key documents
- Consider key independent reviewers
- Use appropriate data collection
- Deliver appropriate reports
- Present recommendations