NAGA COLLEGE FOUNDATION, INC.

M.T. Villanueva Avenue, Naga City

College of Business and Accountancy

Capital Budgeting

Capital budgeting is the process that a business uses to determine which proposed fixed asset purchases it should
accept, and which should be declined. This process is used to create a quantitative view of each proposed fixed
asset investment, thereby giving a rational basis for making a judgment.

Capital Budgeting Methods

There are a number of methods commonly used to evaluate fixed assets under a formal capital budgeting system.
The more important ones are:

Net present value analysis. Identify the net change in cash flows associated with a fixed asset purchase, and
discount them to their present value. Then compare all proposed projects with positive net present values, and
accept those with the highest net present values until funds run out.

Constraint analysis. Identify the bottleneck machine or work center in a production environment and invest in
those fixed assets that maximize the utilization of the bottleneck operation. Under this approach, a business is
less likely to invest in areas downstream from the bottleneck operation (since they are constrained by the
bottleneck operation) and more likely to invest upstream from the bottleneck (since additional capacity there
makes it easier to keep the bottleneck fully supplied with inventory).

Payback period. Determine the period required to generate sufficient cash flow from a project to pay for the
initial investment in it. This is essentially a risk measure, for the focus is on the period of time that the
investment is at risk of not being returned to the company.

Avoidance analysis. Determine whether increased maintenance can be used to prolong the life of existing assets,
rather than investing in replacement assets. This analysis can substantially reduce a company's total investment
in fixed assets.

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.

The capital budgeting process

1. Identify and evaluate potential opportunities

The process begins by exploring available opportunities. For any given initiative, a company will probably have
multiple options to consider. For example, if a company is seeking to expand its warehousing facilities, it might
choose between adding on to its current building or purchasing a larger space in a new location. As such, each
option must be evaluated to see what makes the most financial and logistical sense. Once the most feasible

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opportunity is identified, a company should determine the right time to pursue it, keeping in mind factors such as
business need and upfront costs.

2. Estimate operating and implementation costs

The next step involves estimating how much it will cost to bring the project to fruition. This process may require
both internal and external research. If a company is looking to upgrade its computer equipment, for instance, it
might ask its IT department how much it would cost to buy new memory for its existing machines while
simultaneously pricing out the cost of new computers from an outside source. The company should then attempt
to further narrow down the cost of implementing whichever option it chooses.

3. Estimate cash flow or benefit

Now we determine how much cash flow the project in question is expected to generate. One way to arrive at this
figure is to review data on similar projects that have proved successful in the past. If the project won't directly
generate cash flow, such as the upgrading of computer equipment for more efficient operations, the company
must do its best to assign an estimated cost savings or benefit to see if the initiative makes sense financially.

4. Assess risk
This step involves estimating the risk associated with the project, including the amount of money the company
stands to lose if the project fails or can't produce its previously anticipated results. Once a degree of risk is
determined, the company can evaluate it against its estimated cash flow or benefit to see if it makes sense to
pursue implementation.

5. Implement

If a company chooses to move forward with a project, it will need an implementation plan. The plan should
include a means of paying for the project at hand, a method for tracking costs, and a process for recording cash
flows or benefits the project generates. The implementation plan should also include a timeline with key project
milestones, including an end date if applicable.

Of course, there may be some publicly traded companies out there that you're interested in investing in. If you
don't know how to get started, we can lend a hand. Just head on over to our Broker Center to learn more.

Capital Rationing and Profitability Index

In the previous few articles we have come across different metrics that can be used to choose amongst
competing projects. These metrics help the company identify the project that will add maximum value and helps
make informed decisions to maximize the wealth of the firm. We saw how the NPV rule was better than IRR and
the profitability index and how decisions based on NPV are supposedly more accurate.

However, we need to understand that there is a difference between how the NPV rule is stated in text books and
how it is applied in real life worldwide. This difference arises because when we consider capital budgeting, we
are working under the fundamental assumption that the firm has access to efficient markets. This means that if
the required rate of return is greater than the opportunity cost of capital, or if the project has an NPV greater than
zero, the firm can always finance its projects by raising money from the markets even if it doesn’t have any.
Thus for practical purposes, the money at the firms disposal is unlimited.

However, in reality this may not be the case. True, that firms can always raise money and bigger firms can raise
as much funds as they want to, but many times firms themselves place restrictions on the amount of fund raising
that they undertake.

These restrictions could be placed because of the following reasons:

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Raising more equity could dilute the existing ownership interest
There may be debt covenants preventing the firm from raising more debt
Raising more funds either by debt or equity may make the firm appear riskier and may take the cost of capital
even higher
This restriction placed on the amount of capital that the company has, nullifies the assumption inherent in capital
budgeting. Thus, what happens in real life is a slightly modified version of capital budgeting. Financial analysts
have a name for this. They call it “Capital Rationing”.

So capital rationing is nothing but capital budgeting with modified rules. Now instead of choosing every project
that has an NPV greater than zero, the firm uses a different approach. All projects with a positive NPV qualify
for a possible investment. These projects are then ranked according to their attractiveness. The firm then invests
in the top3 or top 5 projects (based on their resources). So, here a finite amount of capital is being rationed
amongst projects as opposed to an infinite capital assumption.

Profitability Index

But, how does the firm decide which projects are the most attractive? Simply ranking the projects with higher
NPV will be incorrect. This is because we are not paying attention to the input we are putting in. We are simply
paying attention to the output which is obviously incorrect. What if a project with a slightly higher NPV requires
double the investment as compared to another project? Is it still a good bet?

Obviously not and to solve this problem and ration capital effectively, companies have come up with a metric
called the Profitability Index. The profitability index is nothing but the NPV of the project divided by the amount
of its investment.

Profitability Index = NPV / Investment

So we are simply looking at the NPV amount per dollar of investment. Projects with highest NPV per dollar of
investment are considered more attractive and the investment dollars are first allocated to them so that the
returns of the firm are maximized.

TOOLS OF BUDGETING

Net Present Value

The Net Present Value (NPV) of a project is determined by getting the difference of the present value of the cash
flows expected to be generated by a project and its initial investment requirement given a particular cost of
capital or discount rate. In decision making, projects that have a positive net present value is preferred than
negative net present value. A positive net present value would imply that a firm should invest in a particular
project such as endeavor would add” value” to the firm. Generally, this project is attractive to invest money in
while projects that have a negative net present value are typically rejected. The net present value of a particular
project can be determined by summing the discounted future cash flows then subtracting the amount of initial
investment.

Hence,

NPV = - CFo + CF1 + CF2 + . . . + CFn

1 2
( 1 +r) (1 + r) ( 1 + R)n

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Where:
R – is the cost of capital or discount rate
NVP – is the net present value
CFo - is the initial investment
CF1 - is the cash flow in the first year
CF2 - is the cash flow in the second year
CF3 - is the cash flow in the third year

Sample Problem:

You are tasked to decide on which project the management company that you are working for will work on.
Both projects cost P 500,000.00 initial investment and funding can be obtained from bank at a rate of 10%. The
following are the projected cash flow for both projects over a span of 4 years:

Year Project A Project B

1 P 250,000.00 P 100,000.00
2 P 200,000.00 P 150,000.00
3 P 150,000.00 P 200,000.00
4 P 100,000.00 P 250,000.00
Determine which project is best for management to undertake. Show the supporting calculations.

Solution:

NPV A = -500,000.00 + 250,000 + 2000,000 + 150,000 + 100,000

(1 + 0.1) 1 (1 + 0.)2 (1 + 0.1)3 ( 1 + 0.1)4

= P 35,892.36

NPV A = -500,000.00 + 100,000 + 150,000 + 200,000 + 2500,000

(1 + 0.1) 1 (1 + 0.)2 (1 + 0.1)3 ( 1 + 0.1)4
= P 73,560.55

Given the two projects and its respective projected cash flows and using the net present value criterion, it is
recommended that management should pursue Project A over Project B since the net present value of the former
is greater than that of the latter.

Internal Rate of Return

The Internal Rate of Return (IRR) is a particular discount rate than generates zero net present value of a project
and breaks even the project. This helps the management identify investments or projects that will yield a return
that is acceptable for the company. A project should be accepted if its internal rate of return is greater than the
required rate of return oof the company, otherwise, such project should be rejected.

Sample Problem:

You are tasked by the management to help determine the minimum acceptable discount rate for two projects
which both require an initial outlay of P 600,000.00 and the following projected cash flows:

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 Year Project A Project B
1 P 1,000,000.00 0
2 0 0
3 0 P 1,000,000.00

Solving for the internal rate of return yields:

For Project A: 1,000,000 = 600,000

(1+r)

600,000 (1 + r) = 1,000,000
1 + r = 1.6667
r = 0.6667 or 66.67%

For Project B: 1,000,000 = 600,000

(1 + r)3
600,000 (1 + r)3 = 1,000,000
(1 + r)3 = 1.6667
1 + r = 1.185631101
r = 0.1856 or 18.56%
Sample Problem:

The firm requires a rate of 20% return. Which project should be accepted?

To answer the question, compare the two IRRs as computed. Since the firm requires a rate of 20% return,
proceed with project A since its IRR of 66.67% is greater than 20% as required. Project r’s IRR of 18.58% is
below the required rate of 20% return. Hence Project B is rejected.

The payback period is another tool used in capital budgeting defined as the length of time in order to recover the
initial investment. Unlike the previous two tools discussed, the payback period does not consider the time value
of money. Using the criterion, projects that have a shorter payback period are preferred than longer payback
period. The payback period is computed as follows:

PBP = CF0
CFA
Where: PBP is the payback period
CF0 is the initial investment
CFA is the estimated annual cashflow

Risk and Return

When assessing various options, an investor or a decision maker may need to examine the risk and return of
several investments before arriving to a conclusion or a recommended course of action. The expected value is a
measure of the return of a particular asset or financial instrument or investment while the standard deviation is a
measure of risk.

Aside from profitability and returns, economists and finance professionals also need to consider risk when
evaluating investments. Risk refers to the likelihood that some unfavorable result will happen. The chance of
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incurring a loss is a risk that businessmen have to face. Same goes with investors who wish to determine which
investment product is best to put in their hard earned money.

The standard deviation value of a particular investment is a measure of the risk of the investment. Usually, the
higher the standard deviation, the higher the risk involved and the lower the standard deviation, the lower the
risk involved. Basic knowledge of probabilities is needed to successfully hurdle problems on risk and return.

The expected value of a particular investment is determined by:

n
∞=EV =∑ Pi X i
i=1

Where: EV is the expected value or expected return of an asset.

Pi is the probability of the ith state of nature
Xi is the payoff of the said investment
In the ith state of nature

A state of nature is regarded as a future event that is beyond the decisions maker’s or investor’s control. For
example, the investor or decision maker cannot fully and accurately predict what whether conditions or
situations will prevail tomorrow or the following month or year in the Philippine Stock Exchange. Hence, there
is a risk of gain or loss in the future.

Sample Problem: An investor is offered three types of financial instruments: stocks, bonds, and treasury bills.
Economists have predicted that over the course of twelve months, the economy may boom, remain stable or
become bust. It was estimated that the probabilities for each of the three states of nature mentioned are 0.20,
0.50, and 0.30 respectively. Historical returns for three types of instruments given the states of nature are
summarized in the given table:

State of Nature Stocks Bonds t-bills

Boom 24% 18% 7%
Stable 5% 5% 7%
Bust -13% -2% 7%

Which financial instrument should be invested in and why?

Using the expected value criterion yields the following calculations:

EV stocks = 0.20 (24%) + (0.50) (5%) + 0.30 (-13%) = 3.4%

EV bonds = 0.20 (18%) + (0.50) (5%) + 0.30 (-2%) = 5.5%
EV t-bills = 0.20 (7%) + (0.50) (7%) + 0.30 (7%) = 7%

Hence, the investor should invest in treasury bills since its expected return is the highest compared to stocks and
bonds.

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The standard deviation will give the measure of consistency. When applied in finance, if a financial
instrument’s returns have a high standard deviation, then it is considered to be a risky asset and when a financial
instrument has a lower standard deviation, then it is considered to be a less risky asset. A financial instrument’s
standard deviation is given by:

n
ơ =∑ Pi ( X i−µ2)
i=1

where: ơ is the standard deviation

µ is the expected value
Pi is the probability if the ith state of nature
Xi is the payoff of the said investment
In the iith state of nature

Sample Problem: Referring to the sample problem presented, determine the standard deviation for each of the
financial instruments. Which instrument is the riskiest among the three?
Probability State of Nature Stocks Bonds i-bills
0.20 Boom 24% 18% a
0.50 Stable 5% 5% 7%
0.30 Bust -13% -2% 7%
For stocks:

Ơ = √ 0.20(24 %−3.4 %)2 +0.50(5 %−3.4 %)2 +0.30(−13 %−3.4 %)2

= 12.92%

For bonds:

Ơ = √ 0.20(18 %−5.5 %)2 +0.50(5 %−5.5 %)2+ 0.30(−2 %−5.5 %)2

= 6.95%

For t-bills:

Ơ = √ 0.20(7 %−7 %)2+ 0.50(7 %−7 % )2 +0.30 (7 %−7 %)2

= 0%

The stocks show a standard deviation of 12.9%, means that the return on stocks and on the average, deviates by
+ 12.92% from a mean of 3.4%. Hence, stocks are the riskiest among all three financial instruments presented.
The t-bills appear to be the most attractive as far as risk is concerned. Since the return on treasury bills are
essentially the same regardless of the state of nature, it consequently yields a standard deviation of 0%.

Another measure of risks is the coefficient of variation. This expresses the standard deviation as a percentage of
the mean. A higher coefficient of variation also implies that the risk is greater. The coefficient of variation is
determined as follows:

CV = Ơ . 100%
µ

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 Sample Problem: Referring to the sample problem presented, determine the coefficient of variation for each of
the financial instruments. Which instrument is the riskiest among the three?

For stocks: CV = 12.92% . 100% = 380%

3.4%

For bonds: CV = 6.95% . 100% = 126%

5.5%

For t-bills: CV = 0% . 100% = 0%

7%

Using the coefficient of variation as a criterion, it is apparent that stocks are the riskiest financial instrument
among the three while treasury bills appear to be the least risky among the three.

The Cost of Capital

Cost of capital is a necessary economic and accounting tool that calculates investment opportunity costs and
maximizes potential investments in the process.

The cost of capital is tied to the opportunity cost of pouring cash into a specific business project or investment.
Once those costs are evaluated, businesses can make better decisions to deploy their capital to maximize profit
potential.

Here's the skinny on the cost of capital, and why it's so important in business and in investing circles.

What Is Cost of Capital?

Cost of capital is the amount of return an investment could have garnered if that investment was executed.
Loosely defined in general, cost of capital can involve debt, equity or any source of capital.

Basically, cost of capital is the opportunity cost of investing the same amount of cash into different investment
opportunities, with the real cost of capital the amount of money that could have been earned by choosing one
investment over the other.

Like many accounting principles, the meaning of cost of capital can vary from one scenario to another. For
example, cost of capital can also be defined as the return of investment (ROI) that could be gained if the right
amount of money is steered into a specific investment, like a large construction project or the purchase of a
company's stock.

How Cost of Capital Works

In defining the cost of capital, it's also helpful to know the different cost of capital categories, as follows:

 Cost of equity. This is the cost of leveraging the capital supplied by company shareholder, repayable in
(hopefully) stronger capital gains and a higher share price.

 Cost of debt. This type of capital represents the cost of a company or individual that borrows money from a
bank or financial institution to invest money in a project or other investment opportunity. The financial
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institution earns its money back in the form of interest paid, along with any appropriate fees and charges as
noted in the loan contract.
A company can raise funds in limited ways. It can sell bonds, borrow money and leverage equity financing.

By and large, companies often apply their cost of capital in two definitions:

Cost of capital is defined as the financing costs a company has to pay when borrowing money, using equity
financing, or selling bonds to fund a big project or investment. In each case, the cost of capital is expressed as an
annual interest rate, such as 7%.

When weighing a big investment, like funding a new manufacturing plant, the cost of capital represents the
return rate the company could garner if it invested cash in an alternative investment, with the same risk applied.
That's why economists equate the cost of capital with the opportunity cost of a company using financial capital
for a significant project or investment.

Why Is Cost of Capital So Critical?

Cost of capital is a useful finance and accounting tool that companies and investors can use to make better
decisions on how they allocate their money.

How companies will finance a project or make an investment is an important decision, since that choice will
determine a firm's capital structure. Ideally, businesses seek a fair balance in this scenario, with enough
financing to get a project or investment done, while reducing or limiting the cost of capital.

Cost of capital is especially important in the following ways:

 The cost of capital aids businesses and investors in evaluating all investment opportunities. It does so by
turning future cash flows into present value by keeping it discounted.

 The cost of capital can also aid in making key company budget calls that use company financial sources as
capital.

 In a cost of opportunity scenario, the cost of capital can be used to evaluate the progress of ongoing projects
and investments by matching up the progress of those investments against the cost of capital.

How Cost of Capital Works

Cost of capital is very important to companies who need capital to expand their operations and fund their
business, while keeping debts as low as possible to satisfy shareholders.

In the cost of capital game, there are two main forms of capital - implicit cost of capital and explicit cost of
capital.

 Implicit cost. This represents the opportunity cost cited above, i.e., the cost of an investment opportunity
considered, but ultimately not taken. There is no bottom-line reduction in revenues - it's implied. But under
the cost of capital model, it can be factored into opportunity costs not earned.

 Explicit cost. The explicit cost of capital is the cost that companies can actually use to make capital
investments, payable back to investors in the form of a stronger stock price or bigger dividend payouts to
shareholders.

Company accountants use the cost of capital to estimate the cost of financing a project or engaging in a large
investment opportunity.
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At minimum, any capital used by a company for such initiatives must have a minimum return that's in line with
what shareholders, stakeholders, and lenders expect for the use of their money. In short form, the cost of capital
represents a benchmark which any company investment or project must meet or exceed in financial returns.

Cost of Capital Examples

In a real-life example, here's what cost of capital means in two common scenarios:

Cost of Capital for Investing

In investing, the cost of capital is the variation between an investment that you make and one that you could
have made - but didn't.

Consider a stock market trader or real estate investor that invests $10,000 into a particular opportunity. The
opportunity cost is the difference between any profit actually earned, and the profit that could have been earned.
Let's say the investor earned a 5% profit on the actual investment (Opportunity "A") but could have earned 10%
on the investment opportunity not chosen (Opportunity "B".) The difference between the profit earned on
Opportunity "A" and Opportunity "B" (5%) is the actual cost of capital.

Cost of Capital for Business

In business, the goal with the cost of capital is to improve on the rate of return that might have been generated by
steering the amount of money into a separate investment, and with the same amount of risk.

After all, companies count on the cost of capital to be the return rate it earns on business-related investment
projects, in order to maximize opportunities to attract investors, and to stay profitable and competitive in its
marketplace.

How to Calculate the Cost of Capital

Calculating the cost of capital means taking the total costs of debt, common stock and preferred stock and using
separate calculations for each of those three components. Ultimately, you'll need to combine all three
calculations to figure out the total cost of capital on a weighted average basis.

 To derive the cost of debt, multiply the interest expense associated with the debt by the inverse of the tax
rate percentage, and divide the result by the amount of debt outstanding.

 The amount of debt outstanding that is used in the denominator should include any transactional fees
associated with the acquisition of the debt, as well as any premiums or discounts on the sale of the debt.

 These fees, premiums, or discounts should be gradually amortized over the life of the debt, so that the
amount included in the denominator will decrease over time.

The formula for the cost of debt is as follows:

(Interest Expense x (1 - Tax Rate) ÷

Amount of Debt - Debt Acquisition Fees + Premium on Debt - Discount on Debt

Key Things to Know About Cost of Capital

Lean on these takeaways to learn more about the cost of capital:

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  Figuring out the cost of capital generally relies on two key criteria - a lender's required rate of return and
a borrower's weighted average cost of capital.

 Two key themes in calculating the cost of capital are recognizing the time value of money and knowing
how to discount cash flows and returns into present value.

 Investors looking for a better grip on the cost of capital should focus on the opportunity cost of
alternative investments, stemming from that investment's risk level and the investment's estimated
return.

 In formulating the total cost of equity and the cost of debt, companies need to calculate a weighted
average cost of capital (WACC), combing all company financing sources into the calculation.

 In general, the definition of cost of capital is two-fold: For businesses, it's the cost of an organization's
debt and equity funds. For investors, the cost of capital is the required rate of return on a particular
investment.

In general, the definition of cost of capital is two-fold: For businesses, it's the cost of an organization's debt and
equity funds. For investors, the cost of capital is the required rate of return on a particular investment.

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