LESSON 3: CAPITAL BUDGETING

Special Topics in Financial Management

Lesson Objectives:

At the end of the lesson, the learners should be able to:

1. Understand capital budgeting and capital budgeting techniques.
2. Compute the payback period, net present value, and define the internal
rate of return.
3. Apply payback period and net present value in making investment
decisions; and
4. Analyze the risks and returns of long-term investments.

There are three major financial decisions made by companies. These are Investment
Decisions, Asset Management Decisions, and Financing Decisions. Asset Management
Decisions usually focus on the working capital of the firm. It mainly emphasizes managing cash,
receivables, and inventories. Financial Decisions focus on the capital structure of the firm. It
mainly emphasizes on the different sources of short-term and long-term financing. Usually, this
talks about liabilities and long-term debt. Whereas Investing Decisions focus on capital
budgeting and capital expenditure, that is, long-term investments such as entering into a big
project, buying fixed assets like buildings, or opening a new branch and other related activities
that will produce more profit and maximize the wealth of the shareholders. In this lesson, we will
learn the different techniques for investing decisions.

Long-term investments represent sizable outlays of funds that commit a firm to some
course of action. Consequently, the firm needs procedures to analyze and select its long-term
investments. Different tools can be used in evaluating which investments to take, and which to
forego. This introduces us to our topic on Capital Budgeting.
Payback, internal rate of return, and net present value are all methods that companies us
to evaluate potential investment projects. Each of these techniques has advantages and
disadvantages, but the net present value method has become the gold standard for analyzing
investments. This module explains why.

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CAPITAL BUDGETING
- Capital budgeting is a planning process used by companies to evaluate which large
projects to invest in, and how to finance them. It is sometimes called “investment
appraisal.”
- It is the process of evaluating and selecting long-term investments that are consistent with
the firm’s goal of maximizing owners’ wealth.
- Capital budgeting involves thorough financial analysis of each potential project.

CAPITAL EXPENDITURE (CapEx)

- Capital expenditure is an outlay of funds by the firm that is expected to produce benefits
over a period of time greater than 1 year. Whereas operating expenses or operating
expenditure is an outlay of funds by the firm resulting in benefits received within 1 year.
- Capital expenditure pertains to long-term investments. Examples of capital expenditure
are:
o Expand or enter into a new line of business
o Replace or renew fixed assets
o Construct new premises
o Opening a new branch
o Acquisition of machineries and equipment

THE CAPITAL BUDGETING PROCESS

The capital budgeting process consists of five distinct but interrelated steps:
1. Investment Proposal. Proposals for capital expenditure come from different levels within
a business organization. These are submitted to the finance team for thorough analysis.

2. Review and Analysis. Financial personnel performs formal review and analysis to assess
the benefits and cost of the investment proposals. These personnel makes use of several
financial tools which they see fit in evaluating the project.

3. Decision Making. Companies usually delegate capital expenditure decisions on the basis
of value limits. The analysis is presented to the proper approving body who will in turn
make the decision on whether to push through with the project or not.

4. Implementation. Release of funds and start of the project occurs after approval. Large
expenditures are usually released in phases.

5. Monitoring. Results are monitored and actual cost and benefits are compared with those
that were expected. Action may be required if deviations from the plan are significant in
amount.

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 Basic Terminologies!

Independent versus Mutually Exclusive Projects

Two Categories of Investments:

INDEPENDENT PROJECTS
Projects whose cash flows are unrelated to (or independent of) one another; the
acceptance of one does not eliminate the others from further consideration.

MUTUALLY EXCLUSIVE PROJECTS

Projects that compete with one another, so that the acceptance of one eliminates
from further consideration all other projects that serve a similar function.

Unlimited Funds versus Capital Rationing

The availability of funds for capital expenditures affects the firm’s decisions.

UNLIMITED FUNDS
The financial situation in which a firm has unlimited funds and all projects which
pass the risk-return criteria will be accepted and implemented.

CAPITAL RATIONING
The financial situation in which a firm will operate under capital rationing and will
accept only projects which provide the best opportunity to increase shareholder
wealth.

Accept–Reject versus Ranking Approaches

Two basic approaches to capital budgeting decisions:

ACCEPT–REJECT APPROACH
The evaluation of capital expenditure proposals to determine whether they meet
the firm’s minimum acceptance criterion.

RANKING APPROACH
The ranking of capital expenditure projects on the basis of some predetermined
measure, such as the rate of return.

THE CAPITAL BUDGETING TECHINIQUES

1. Payback Period / Method - this is the simplest method used in capital budgeting. It measures
the amount of time, usually in years, to recover the initial investment.

2. Net Present Value (NPV) - This method is more sophisticated than the payback method
since it considers the time value of money and it considers all the cash flows during the life
of the project including the terminal value.

- The NPV can be computed by comparing the present value of cash inflows against the
present value of cash outflows. Cash flows are discounted using the firm’s cost of capital
(cost of acquiring funding needs) to get the present values.

3. Internal Rate of Return (IRR) - The IRR is one of the most widely used techniques in capital
budgeting. It is defined as the discount rate that equates the NPV of an investment to zero.
If this method is used for capital budgeting analysis, the project’s IRR is compared to the
company’s cost of capital.

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D. Discussing new concepts and practicing new skills #1

Before proceeding with discussion of the techniques, let us first introduce the concept of
relevant cash flows. Relevant cash flows include the initial investment, cash inflows from income
from the project, and the expected terminal value of the project, if any. These are the cash flows
considered in analyzing whether an investment adds value to the firm. Cash flows should be net
of tax. However, to simplify our discussion, we shall not include tax in our consideration.
Example 1:
Mr. Alfonso is deciding on which of the 2 mutually exclusive projects he should accept. Project A
requires an initial outlay of PHP72,000 and is expected to receive PHP17,000 annually for the
next 5 years. Project B, on the other hand, requires an investment of PHP80,000 but will earn
PHP21,000 annually for the next 5 years. In this example, we can see that the relevant cash flows
are the upfront investment and the annual income from investment.

Project A

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Project B

(80,000) 21,000 21,000 21,000 21,000 21,000

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

PAYBACK METHOD / PERIOD

Payback periods are commonly used to evaluate proposed investments. The payback
period is the amount of time required for the firm to recover its initial investment in a project, as
calculated from cash inflows.
In the case of an annuity (such as the project A and project B of Mr. Alfonso), the payback
period can be found by dividing the initial investment by the annual cash inflow.
- Annuity (Equal Cash Inflows):
𝐢𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
𝑷𝑨𝒀𝑩𝑨𝑪𝑲 𝑷𝑬𝑹𝑰𝑶𝑫 =
𝐚𝐧𝐧𝐮𝐚𝐥 𝐜𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰

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 From our Example 1, Project A has an initial investment of 72,000 and an annual cash
inflow of 17,000. Since this is an annuity (equal cash inflows), we will be dividing the initial
investment by the annual cash inflow:
𝟕𝟐,𝟎𝟎𝟎
𝑷𝑨𝒀𝑩𝑨𝑪𝑲 𝑷𝑬𝑹𝑰𝑶𝑫 = 𝟏𝟕,𝟎𝟎𝟎 = 4.24 yrs. → Project A

Project B has an initial investment of 80,000 and an annual cash inflow of 21,000. Thus:
𝟖𝟎,𝟎𝟎𝟎
𝑷𝑨𝒀𝑩𝑨𝑪𝑲 𝑷𝑬𝑹𝑰𝑶𝑫 = 𝟐𝟏,𝟎𝟎𝟎 = 3.81 yrs. → Project B

Example 2:
Find the payback period of a project with initial investment of 15,000,000 with a yearly cash inflow
of:
▪ Year 1 = 7,000,000
▪ Year 2 = 4,000,000
▪ Year 3 = 6,000,000
▪ Year 4 = 3,000,000

- Mixed Stream (Uneven Cash Inflows):

For a mixed stream of cash inflows or uneven cash inflows (such as Example 2), the yearly
cash inflows must be accumulated until the initial investment is recovered. we need to calculate
the cumulative net cash flow for each period and then use the following formula:
𝐁
𝑷𝑨𝒀𝑩𝑨𝑪𝑲 𝑷𝑬𝑹𝑰𝑶𝑫 = 𝐴 +
𝐂
Where:
- A is the last period number with a negative cumulative cash flow;
- B is the absolute value (i.e. value without negative sign) of cumulative net cash flow
at the end of the period A; and
- C is the total cash inflow during the period following period A.
Cumulative net cash flow is the sum of inflows to date, minus the initial outflow.
Solution for Example 2:

(cash flows in millions)

Year Annual Cumulative
Cash Flow Cash Flow
0 (15) (15)

1 7 (8)

2 4 (4)

3 6 2

4 3 5

𝟒
𝑷𝑨𝒀𝑩𝑨𝑪𝑲 𝑷𝑬𝑹𝑰𝑶𝑫 = 2 + 𝟔 = 2+ 0.67 = 2.67 years

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DECISION CRITERIA
When the payback period is used to make accept–reject decisions, the following decision criteria
apply:
- If the payback period is less than the maximum acceptable payback period, accept the
project.
- If the payback period is greater than the maximum acceptable payback period, reject
the project.
The length of the maximum acceptable payback period is determined by management. This
value is set subjectively on the basis of a number of factors, including the type of project
(expansion, replacement or renewal, other), the perceived risk of the project, and the perceived
relationship between the payback period and the share value. It is simply a value that
management feels, on average, will result in value-creating investment decisions.

Note:
The longer the payback period of a project, the higher the risk. Between mutually
exclusive projects having similar return, the decision should be to invest in the project having
the shortest payback period.
In our Example 1. Project A has 4.24 years of payback period, whereas, Project B has
3.81 years of payback period. Since these 2 are mutually exclusive projects. Mr. Alfonso should
decide to invest in the project having the shorter payback period, and that is – Project B.

Activity 1: PAYBACK PERIOD

A project has an initial cost of ₱550,500. The cash inflows are ₱ 146,000, ₱155,200, ₱165,000,
and ₱170,900 over the next four years, respectively. What is the payback period?

NET PRESENT VALUE (NPV)

The method used by most large companies to evaluate investment projects is called net
present value (NPV). Because the NPV method takes into account the time value of investors’
money, it is a more sophisticated capital budgeting technique than the payback rule. The NPV
method discounts the firm’s cash flows at the firm’s cost of capital.

The net present value (NPV) is found by subtracting a project’s initial investment (CF0)
from the present value of its cash inflows (CFt) discounted at a rate equal to the firm’s cost of
capital (r).
NPV = Present value of cash inflows - Initial investment

We can also get the NPV by adding the project’s initial investment (-CF0) and all present
value of its cash inflows (CFt). Note that we will use the negative value of project’s initial
investment since it is an outlay or a cash outflow.

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Thus,

𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝒕

𝑵𝑷𝑽 = −𝑪𝑭𝟎 + + + + ⋯ +
𝟏 + 𝐫 (𝟏 + 𝒓)𝟐 (𝟏 + 𝒓)𝟑 (𝟏 + 𝒓)𝒕

where:
-CF0 = Initial investment
CF = Cash flow
r = discount rate / cost of capital
t = time

DECISION CRITERIA
If the NPV of a project is zero or positive, it should be accepted. In finance, if these
projected cash flows are realized, the NPV of the project should be equivalent to the increase in
total shareholder’s value.
Note:
Between mutually exclusive projects having similar return, the decision should be to
invest in the project having the higher NPV.

Let us go back with Example 1:

Mr. Alfonso is deciding on which of the 2 mutually exclusive projects he should accept. Project A
requires an initial outlay of PHP72,000 and is expected to receive PHP17,000 annually for the
next 5 years. Project B, on the other hand, requires an investment of PHP80,000 but will earn
PHP21,000 annually for the next 5 years.
Assuming that the cost of capital is 8%. Let us compute for the NPV.

Project A

Given: -CF0 = -72,000 r = 0.08

CF = 17,000 t = 5 yrs
Solution:
17,000 17,000 17,000 17,000 17,000
𝑁𝑃𝑉 = −72,000 + + + + +
1.08 (1.08)2 (1.08)3 (1.08)4 (1.08)5

𝑁𝑃𝑉 = −72,000 + 67,876.07

𝑵𝑷𝑽 = −𝑷𝑯𝑷 𝟒, 𝟏𝟐𝟑. 𝟗𝟑 𝒐𝒓 − 𝑷𝑯𝑷 𝟒, 𝟏𝟐𝟒

Project B

Given: -CF0 = -80,000 r = 0.08

CF = 21,000 t = 5 yrs
Solution:
21,000 21,000 21,000 21,000 21,000
𝑁𝑃𝑉 = −80,000 + + + + +
1.08 (1.08)2 (1.08)3 (1.08)4 (1.08)5

𝑁𝑃𝑉 = −72,000 + 83,846.91

𝑵𝑷𝑽 = 𝑷𝑯𝑷 𝟑, 𝟖𝟒𝟔. 𝟗𝟏 𝒐𝒓 𝑷𝑯𝑷 𝟑, 𝟖𝟒𝟕

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Results:
Project A = NPV is – PHP 4,123.93 Project B = NPV is PHP 3,846.91
We can see that Project A’s NPV is negative and Project B’s NPV is positive, thus, we
only accept project B.

Tip!

If the cash inflows are equal (annuity), you can use the Present Value of an Ordinary Annuity
(PVOA) Table to get the present value of all cash inflows. (See PVOA Table – Week 6 Module)

Project A
PV = 17,000 x (PVOA factor: 3.9927 period=5, rate=8%))
PV = 67,875.9

NPV = -72,000 + 67,875.9

NPV = PHP – 4,124.10 or PHP – 4,124
Project B
PV = 21,000 x (PVOA factor: 3.9927 period=5, rate=8%))
PV = 67,875.9

NPV = -80,000 + 83,846.7

NPV = PHP 3,846.70 or PHP 3,847

Activity 2: NET PRESENT VALUE

A project has an initial cost of ₱550,500. The cash inflows are ₱ 146,000, ₱155,200, ₱165,000,
and ₱170,900 over the next four years, respectively. Discount rate is 12%. What is the NPV?

INTERNAL RATE OF RETURN (IRR)

The IRR is one of the most widely used techniques in capital budgeting. It is defined as
the discount rate that equates the NPV of an investment to zero. If this method is used for capital
budgeting analysis, the project’s IRR is compared to the company’s cost of capital. If the IRR is
greater than the cost of capital, the project should be accepted otherwise, it should be rejected.
Manual computation of the IRR involves trial and error; however, this IRR computation is a lot
easier using computation applications like MS Excel.
Example 3:
You are planning to build a branch for your business at PHP350,000 and expect to receive
PHP400,000 in 1 year.
First, compute for the rate of return (profit/investment).
Rate of return = 50,000/350,000 = 14.3%

We compute for the rate of return because the NPV of a project with cost of capital equal to the
rate of return is equal to zero. To illustrate:
NPV = 400,000/(1+0.143) – 350,000 = 0

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The IRR can easily be computed using MS Excel using the IRR function.

NPV and IRR

The NPV and IRR are interrelated techniques. An IRR greater than the cost of capital
equates to a positive NPV and vice versa. On a purely theoretical view, NPV is the better measure
since it measures the actual cash value a project creates for shareholders. However, IRR is also
a widely used tool since financial managers usually like to think in terms of ratios and percentages.

RISK AND RETURN TRADE-OFF

Taking a higher risk gives you the opportunity to earn higher returns. Low risk
investments like treasury notes, also called risk-free instruments, earn a low- and steady-
income flow. In making investment decisions, financial managers ensure that the proposed
business will earn more than the risk-free rate since they need to compensate for the risk the
investment will entail. This introduces us to the Required Rate of Return. It is the minimum
expected yield investors require in order to select a particular investment.

SUMMARY:

The financial manager must apply appropriate decision techniques to assess whether
proposed investment projects create value. Net present value (NPV) and internal rate of return
(IRR) are the generally preferred capital budgeting techniques. Both use the cost of capital as the
required return. The appeal of NPV and IRR stems from the fact that both indicate whether a
proposed investment creates or destroys shareholder value.

Capital budgeting techniques are the tools used to assess project acceptability and
ranking. Applied to each project’s relevant cash flows, they indicate which capital expenditures
are consistent with the firm’s goal of maximizing owners’ wealth. There are three capital budgeting
techniques namely, payback period, net present value and the internal rate of return.

The payback period is the amount of time required for the firm to recover its initial
investment, as calculated from cash inflows. Shorter payback periods are preferred. The payback
period is relatively easy to calculate, has simple intuitive appeal, considers cash flows, and
measures risk exposure. Its weaknesses include lack of linkage to the wealth maximization goal,
failure to consider time value explicitly, and the fact that it ignores cash flows that occur after the
payback period.

Because it gives explicit consideration to the time value of money, NPV is considered a
sophisticated capital budgeting technique. NPV measures the amount of value created by a given
project; only positive NPV projects are acceptable. The rate at which cash flows are discounted
in calculating NPV is called the discount rate, required return, cost of capital, or opportunity cost.
By whatever name, this rate represents the minimum return that must be earned on a project to
leave the firm’s market value unchanged.

Like NPV, IRR is a sophisticated capital budgeting technique. IRR is the compound annual
rate of return that the firm will earn by investing in a project and receiving the given cash inflows.
By accepting only those projects with IRRs in excess of the firm’s cost of capital, the firm should
enhance its market value and the wealth of its owners. Both NPV and IRR yield the same accept–
reject decisions, but they often provide conflicting rankings.

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Activity:

Answer the following questions:

1.

a. Given the cash flows above and a discount rate of 5%, compute the payback period
and NPV of Project Pizza.

b. If PHP50,000 is earned on the 3rd year of the project, what is the new NPV of the
project? What is the payback period?

2.

a. If the opportunity cost of capital is 11%, which of these projects is worth pursuing? Find
the NPV of both projects.

b. Suppose that you can only choose one of these projects. Which is more favorable to
the firm given that the discount rate remains at 11%? (Which has the higher NPV)

c. Which project would you choose if the opportunity cost of capital were 16%? (NPV/IRR)

d. What is the payback period for each project?

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