BRYAN T.

LLUISMA FIN 3
BSA-4 TTH 5-6:30PM

1. WHAT IS CAPITAL BUDGETING?

 Capital budgeting addresses the issue ofstrategic long-term investment

decisions.

 Capital budgeting can be defined as the process of analyzing, evaluating,

and deciding whether resources should be allocated to a project or not.

 Process of capital budgeting ensure optimal allocation of resources and

helps management work towards the goal of shareholder wealth
maximization.

2. SIGNIFICANCE OF CAPITAL BUDGETING

Capital budgeting is important because it creates accountability and

measurability. Any business that seeks to invest its resources in a project
without understanding the risks and returns involved would be held as
irresponsible by its owners or shareholders.

Furthermore, if a business has no way of measuring the effectiveness of its

investment decisions, chances are the business would have little chance of
surviving in the competitive marketplace. 
Businesses (aside from non-profits) exist to earn profits. The capital budgeting
process is a measurable way for businesses to determine the long-term
economic and financial profitability of any investment project. 
 
A capital budgeting decision is both a financial commitment and an
investment. By taking on a project, the business is making a financial
commitment, but it is also investing in its longer-term direction that will likely
have an influence on future projects the company considers.
3. EXPLAIN PROJECT CLASSIFICATION

1. Replacement: One category consists of expenditure to replace worn-out

or damaged equipment used in the production of profitable products.
Replacement projects are necessary if the firm is to continue in business.

2. Replacement: Cost reduction. This category includes expenditures to

replace serviceable but obsolete equipment. The purpose here is to lower the
costs of labor, materials, and other inputs such as electricity.

3. Expansion of existing products or markets.

Expenditures to increase output of existing products, or to expand retail
outlets or distribution facilities in markets now being served, are included here.

4. Expansion into new products or markets.

These are investments to produce a new product or to expand into a
geographic area are not currently being served.

5. Safety and/or environmental projects-expenditures necessary to comply

with government orders, labor agreements, or insurance policy terms fall into this
category.

4. STEPS IN CAPITAL BUDGETING

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.

3. Determine the appropriate cost of capital (%).

4. Find NPV ($), IRR (%) and/or MIRR (%).

5. Accept if NPV > 0 and/or IRR > WACC.

5. FIVE KEY METHODS ARE USED TO RANK PROJECTS IN THE CAPITAL
BUDGET

1. Payback

2. Discounted payback

3. Net present value(NPV)

4. Internal Rate of return(IRR)

5. Modified internal rate of return

6. THE DIFFERENCE BETWEEN INDEPENDENT AND MUTUALLY ECLUSIVE

PROJECTS.

Independent projects – if the cash flows of one are unaffected by the

acceptance of the other – more than one project may be accepted.

Mutually exclusive projects – if the cash flows of one project can be

adversely impacted by the acceptance of the other – accept one or the other.

7. PAYBACK PERIOD

The length of time required for an investment’s net revenues to cover its
cost. Defined as the expected number of years required to recover the original
investment, was the first formal method used to evaluate capital budgeting
projects.
The payback period refers to the amount of time it takes to recover the cost
of an investment or how long it takes for an investor to reach breakeven.

8. NET PRESENT VALUE (NPV)

is the sum of the present values of the cash inflows and outflows.