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Module 5
Capital Budgeting

When you are on a budget and have limited sources of funds, what do
you do when your mind thinks of many spending temptations? Now,
similar process may be applied in capital budgeting. This is important
because it creates accountability and measurability

After going over this chapter, you should be able to

Define Capital Budgeting

Familiarize with the Capital Budgeting Process
Know the Kinds of Capital Budgeting Decisions
Research and Learn about the Methods of Capital Budgeting
Evaluation
Learn the Risk and Uncertainly in Capital Budgeting

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5.1 Definition and Importance of Capital Budgeting

The word capital refers to the financial resources available for use.
This may be the total investment in form of money, tangible and
intangible assets. Budgeting on the other hand is the planning on
how and how much of the resources will be used for a certain
thing or event.

Capital budgeting is the process in which a business determines

and evaluates potential expenses or investments that are large in
nature. These expenditures and investments include projects such
as building a new plant or investing in a long-term venture
(Investopedia).

Examples of capital expenditure are the purchase of fixed assets

such as land and building, plant and machinery, expenses relating
to improvement or renovation these fixed assets and costs
incurred for the research and development projects

Capital budgeting has the most crucial part in financial decision

making because they have significant impact on the profitability of
the firm. Investments decisions are large, long-term and
irreversible. That’s why capital budgeting is very important in in
evaluating and choosing investments.

There are great financial risks involved in the investment

decisions. A good investment decision can result into great
returns while a bad investment decision can endanger the survival
of the entity. If higher risks are involved, then it needs careful
planning of capital budgeting. Usually, investment decisions
require large amount of funds from your limited resources that’s
why capital budgeting would help in making ways on how to make
these investments possible and more profitable. Capital budgeting
does not only reduces the cost but also increases the revenue in
long-term and will bring significant changes in the profit of the
company by avoiding over-investment or under-investment.

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5.2 Capital Budgeting Process

The following are the processes that must be done in capital
budgeting

1. Identification of Various Investment Proposals

Various investment proposals may be defined from the top

management or may even be from the lower rank. The heads of
various departments analyze the various investment decisions and
select proposals submitted to the planning committee of
competent authority.

2. Screening or Matching the Proposals

The planning committee will then analyze and screen the various
proposals. The selected proposals are considered with the
available resources of the concern.

3. Evaluation

After screening, the proposals are evaluated with the help of various
methods, such as payback period proposal, net discovered present
value method, accounting rate of return and risk analysis.

4. Fixing Property

In this part, the planning committee will predict which proposal will
give more profit or economic consideration. If the projects or
proposals are not suitable for the concern’s financial condition, the
projects are rejected without considering other nature of the proposals.

5. Final Approval

The planning committee approves the final proposals, with the help of
profitability, economic constituents, financial volatility and market
conditions.

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6. Implementing

The competent authority spends the money and implements the

proposals. They assign responsibilities to the proposal and ensures that
this will be completed within the time allotted.

7. Performance Review

The final stage of capital budgeting is actual results compared with the
standard results. The adverse or unfavorable results are identified then
they make solutions to remove the various difficulties in the project.

5.3 Kinds of Capital Budgeting Decisions

The Accept- Reject Decision

This type of decision making applies when the projects proposed

are independent from each other. The acceptance or rejection of
one proposal does not affect the decision on the other proposals.

Mutually Exclusive Decision

Mutually exclusive proposals are those that compete with other.

Therefore, the acceptance of one proposal will exclude the
acceptance of the other proposals.

Capital Rationing Decision

In this decision type of decision making, there are more than one
proposal to be chosen however the firm has limited funds so that’s
why they must ration these project proposals. Usually, they select
a group of projects that yield the highest total return given such
limited funds.

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5.4 Methods of Capital Budgeting Evaluation

Traditional or Non-discount Methods

Payback Period
Post Payback
Accounting Rate of Return

Modern or Discount Methods

Net Present Value
Internal Rate of Return
Profitability Index

Payback Period

Payback period is the time required to recover the initial

investment in a project.

Payback Period

Post Payback Profitability

This one measures and considers the cash inflows earned after
pay-back period.

Post Payback Period = Cash inflow (Estimated life – Pay-back

period)

Accounting Rate of Return

This is the amount of profit, or return, that an individual can

expect based on an investment made.

Return on investment =

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Internal Rate of Return

This is the discount rate that equates the present value of the
expected net cash flows with the initial cash outflow

Internal rate of Return =

Ct = net cash inflow during the period t

Co = total initial investment costs
r = discount rate, and
t = number of time periods

Net Present Value

Net Present Value is the difference between the present value of

cash inflows and the present value of cash outflows.

NPV =
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
n = number of time periods

Profitability Index

This is also known as the benefit-cost ratio of a project. This is the

ratio of the present value of future net cash flows to the initial cash
outflow.

PI= ( )
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
n = number of time periods

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5.5 Risk and Uncertainty in Capital Budgeting

Risk refers to a situation in which possible future events can have
reasonable probabilities assigned while uncertainty refers to
situations in which there is no viable method of assigning
probabilities to future random events.

The following are the types of risks

Interest Rate Risk– refers to the variability in a security's return

resulting from the changes in the level of interest rates

Market Risk - refers to the variability of returns due to fluctuations

in the securities market which is more particularly to equities
market

Inflation Risk - rise in inflation leads to reduction in the

purchasing power which influences only few people to invest due
to Interest Rate Risk which is nothing but the variability of return
of the investment due to oscillation of interest rates due to
deflationary and inflationary pressures.

Business Risk - risk which arises only due to the presence of the
fixed cost of operations

Financial Risk -
the probability of loss inherent in financing methods which may
impair the ability to provide adequate return

Capital budgeting requires the projection of cash inflow and

outflow of the future. Of course these are just estimates and thus,
cannot be exact. Thus, we are dealing with probability

We have the following measures for risk and uncertainties

Expected Value
Standard Deviation
Coefficient of Variation
Decision Tree

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Expected Value

This is the weighted average of possible outcomes, with the

weights being the probabilities of occurrence.

Expected Value =

Where
Ri = value in a case
Pi = probability of a case
n = number of possible outcomes

Standard Deviation

Standard deviation is a statistical measure of the variability of a

distribution around its mean. It is the square root of the variance.
In comparing projects which have the same cash outflow and net
values, standard durations of the expected cash inflows of the two
Projects may be calculated to measure the comparative and risk of
the projects. The project having a higher standard deviation is said
to be more risky as compared to the other.

Standard deviation =

where

Ri = value
= mean
pi = mean

Coefficient of Variation

This is the ratio of the standard deviation of a distribution to the

mean of that distribution. This is simply a measure of relative risk
per unit of expected value.

Coefficient of Variation = (Standard Deviation)/(Expected Value)

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Decision Tree Analysis

This is a decision support tool that uses a tree-

like graph or model of decisions and their possible consequences,
including chance event outcomes, resource costs, and utility. In the
modern business world, putting the investments are become more
complex and taking decisions in the risky situations. So, the
decision tree analysis helpful for taking risky and complex
decisions, because it considers the possible events and each
possible event are assigned with the probability.

Exercise 5
Your score here will be recorded for both the exercise and activity

1. Conduct further research and make your own problems in each

of the methods of capital budgetting evaluation. Then provide
solutions. (18 pts)

2. Create 4 problems in incorporating solutions relating to the

four measures of risk. Provide solutions and explanations if
needed (12 pts)

Activity 5
1. Describe your planned business.

2. Make a financial budget regarding this business proposal.

3. Identify your sources of financing and compute for your cost of

capital.

4. Create an estimated Statement of Financial Position and

Income Statement.

5. Evaluate your plan using the methods described in this lesson.

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Glossary
Accounting rate of return - the amount of profit, or return, that an
individual can expect based on an investment made.

Capital - refers to the financial resources available for use.

Capital Budgeting - the process in which a business determines and

evaluates potential expenses or investments that are large in
nature.

Coefficient of Variation-this is the ratio of the standard deviation

of a distribution to the mean of that distribution.

Decision Tree Analysis-this is a decision support tool that uses a

tree-like graph or model of decisions and their possible
consequences, including chance event outcomes, resource costs,
and utility

Expected Value- this is the weighted average of possible outcomes,

with the weights being the probabilities of occurrence.

Internal rate of Return - this is the discount rate that equates the
present value of the expected net cash flows with the initial cash
outflow

Net Present Value - the difference between the present value of

cash inflows and the present value of cash outflows

Payback period -the time required to recover the initial

investment in a project.

Post-payback - measures and considers the cash inflows earned

after pay-back period.

Profitability Index - the ratio of the present value of future net

cash flows to the initial cash outflow

Standard deviation is a statistical measure of the variability of a

distribution around its mean.

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References
C. Paramasivan and T. Subramanian. (2005). “Financial
Management”, New Age International Ltd., Publishers.

Investopedia.com

J. Van Horne and J. Wachowics(2008). “Fundamentals of Financial

Management”, Pearson Education Limited.

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