CAPITAL BUDGETING

Factors of Consideration
NET INVESTMENTS NET RETURNS COST OF CAPITAL
= COSTS less SAVINGS Direct Method: Used as a discount rate in
Cash Inflows discounted capital budgeting
Costs (Cash Outlows) - Cash Outflows techniques
- Purchase price, net of discount Net Cash Flows
- DACs (Incidental project related
expenses) Indirect Method:
- Additional working capital needed Net Cash Inflows b4 tax
(Added to Terminal Cash Flows at the - Depreciation Expense
end of project’s life + salvage value) Profit b4 tax
- Market value of idle assets to be used - Tax
- Training cost, net of tax Profit after tax
+ Depreciation expense
Savings (Cash Inflows) Net Cash Inflow after tax
- Proceeds from sale, net of tax.
Tax on Gain (-) Alternative Sol’n;
Tax Savings/Shield (+) Cash IN after tax
- Trade-in value of old asset - Tax Shield (DE x Tax Rate)
- Avoidable cost of immediate repairs on Net Cash IN after tax
old asset, net of tax
NOTE:
NOTE: Timing of CF - Present (Year 0) 1) Timing of CF - Future (Year 1-5)
2) For Salvage Value ignore tax
effect

NON- FORMULA DECISION PROS CONS

DISCOUNTE RULES
D
TECHNIQUE
S
Payback Net Investment ≤ Life / 2 simple to compute ignores TMV
Period Shorter: less risky easy to understand ignores salvage value
Net Cash Flows useful in evaluating ignores cash flows after
: greater
liquidity payback period
liquidity
good surrogate for risk more emphasis on R OF I
instead on ROI
Max PB period may be
arbitrary
Bail-out Net Investment ≤ Life / 2
Payback ¿ Net Cash Flows Shorter: less risky
Period : greater
liquidity
*Include salvage value
Accounting Net Income ≥ Cost of Capital emphasize project’s ignores TMV
Rate of Return profitability ignores inflationary effects
¿ Net Investment considers entire life and uses accrual than cash
(ARR)
project results
*Average consistent with FS values
= Cost + Salvage value / 2
Payback Net Cash Flows 1
Reciprocal =
Net Investment PB Period
Reasonable estimate of IRR
2 conditions:
1. PB Period is AT MOST
HALF of life
2. Net cash inflows are
uniform
DISCOUNTE FORMULA DECISION PROS CONS
D RULES
TECHNIQUE
S
Net Present PV of Cash IN – PV of Cash OUT NPV < 0 emphasizes cash flows cost of capital is not always
Value considers TMV available
assumes cost of capital as incomparable if projects
reinvestment rate have different lives or sizes
Profitability PV of Cash∈ ¿ ¿ PI ≥ 1
Index PV of CashOUT
Internal Rate PV of Cash IN = PV of Cash OUT IRR ≥ COC emphasizes cash flows difficult to compute for
of Return considers TMV uneven cash flows
(IRR) *requires Interpolation Process computes true rate of return requires estimation of CF
over a long period of time
*for CPALE: use trial and error
assumes IRR as the
reinvestment rate
may not be meaningful if a
project has negative earnings
Relationship:
Pattern 1: NPV = 0; PI = 1; IRR = COC
Pattern 2: NPV > 0; PI > 1; IRR > COC
Pattern 3: NPV < 0; PI < 1; IRR < COC

Other Notes
Crossover rate / NPV Point of Indifference: the discount rate at which the NPV of 2
Fisher Rate capital investments are equal.
Trial and error
Equivalent Annual Annualized NPV
Annuity NPV-based technique used to compare projects with unequal lives.
(EAA)
Formula: NPV / PV Factor
Capital Rationing given a budget, is the selection investment proposals that would
maximize the overall NPV of the firm
Profitability Index: project ranking method most useful in capital
rationing