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CHAPTER 8
Capital Budgeting

Capital Budgeting
• It is the process of allocating financial resources to new long-term investment projects.
• It is the process of identifying, evaluating, planning, and financing capital investment
projects of organizations.
• It helps to evaluate the acceptability of potential investments alternatives.

INVEST (Commit Funds) RECEIVE RETURNS

TODAY FUTURE

HIGH RISK AND For ADDITIONAL To REDUCE CASH

UNCERTAINTIES
CASF INFLOWS FLOWS

Importance of Capital Budgeting

1. It involves investments of different amounts. (Requires large commitments of resources)
2. It limits a firm’s flexibility.
3. It defines a firm’s strategic direction. (More difficult to reverse than short-term decisions)
4. It is concerned with the planning and control of investments.

Capital Budgeting usually used on the following decisions:

1. Replacement and acquisition of long-term assets
2. Improvements of products
3. Expansion of facilities
4. Trading/ exchanging of assets

Capital Budgeting Process

1. Identification and Definition
2. Search for potential investment projects
3. Information Gathering
4. Selection (*Capital Investment Screening)
5. Financing
6. Implementation and Monitoring (*Post audit Evaluation)

Types of Investment Projects

MUTUALLY EXCLUSIVE
INDEPENDENT PROJECTS PROJECTS

Decision making to ACCEPT ONE

PROJECT IS INDEPENDENT FROM Decision making is LIMITED TO ACCEPTING
ACCEPTING OTHER PROJECTS. ONE/NONE project only.

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BSMA BSA
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Capital Investment Decision Factors

To arrive at a long-term investment decision, a firm needs to identify the following:

1. Estimated cash flows - are inflows and outflows over the entire life of the investment proposal.
The cash inflows must exceed the cash outflows to be acceptable. The cash flow, generally are as
follows:
a. Initial investment - initial cash outlay needed to undertake the investment. (Net
Investments)
b. Annual cash return - are computed by adding the non-cash expense (e.g., depreciation
and amortization) to the firm’s net income after tax. (Operating Cash flows AFTER tax)
c. Terminal cash flow - associated with the termination of the project.
2. Estimated cost of capital or weighted average cost of capital. (Discount rate)
3. Acceptance criteria - rules that enable the firm to resolve issues about long-term investments.

Framework of Capital Budgeting

The basic concept underlying the capital budget is the cost-benefit analysis. Thereby:
Benefit > Cost Investment proposal is acceptable
Benefit < Cost Investment proposal is not acceptable

METHODS:
A. NON-DISCOUNTING (Time value of money is irrelevant)
1. Payback Period
It measures the length of time it takes to recover a project’s initial investment.
• Even Cash Inflow:
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠

• Uneven Cash Inflow:

Deduct annual cash inflow per year from the amount of the investment until it becomes
zero.

The acceptance criterion under the payback period is dependent on the firm’s minimum or required
payback. Thereby:
If the payback period < required payback Accept the project
If the payback period > required payback Reject the project

Formula: Payback period = Investment – Scrap Value

Annual after- Tax Cash Savings

*BAIL OUT PERIOD

-variation of payback period where cash recoveries include not only operating net cash inflows butt also
the ESTIMATED SALVAGE VALUE at the end of each year.

Advantages:
1. It is simple to compute and easy to understand.
2. It handles investment risks well.
3. It gives information about the Projects Liquidity. (Quick payback Period indicates a less
risky project)

Disadvantages:
1. It does not recognize the time value of money.
2. It ignores the impact of cash inflows received after the payback period.
3. There is a possibility of lower return.
4. There is no rational way of determining the payback period.

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2. Accounting Rate of Return (ARR)

• It is also called the average rate of return., (also Simple Rate of Return, Book Value Rate of
Return)
• Measures profitability based on income.
• It is more advantageous than the payback-period method because it considers the profits over the
life of the project, but it suffers from a number of shortcomings.

Formula: Accounting rate of return = Average Annual Profit after Tax

Investment

• If the problem is silent:

➢ With salvage value: (IF SILENT)
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒
2
➢ Without salvage value:
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 𝑜𝑣𝑒𝑟 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑃𝑒𝑟𝑖𝑜𝑑
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑌𝑒𝑎𝑟𝑠

*Salvage value, also known as the scrap value or residual value, is the amount that an asset is estimated
to be worth at the end of its useful life.

Rule on Investment:
If ARR < required ARR Reject the project
If ARR > required ARR Accept the project

Advantages:
1. It is easy to understand.
2. It is simple to compute.
3. It recognizes the profitability factor.

Disadvantages:
1. It ignores the time value of money
2. It uses accounting income instead of cash inflows.
3. It is difficult to determine the minimum acceptable rate of return.
4. It does not take into account the amount of the investment.

B. DISCOUNTING (Consider Time Value of Money)

1. Discounted Payback Period
• It refers to the number of years in which the investment may be recovered at its discounted cash
inflows.
• The computation and acceptance criterion are similar to those of the regular payback period
except that the annual cash inflows are discounted by the firm’s cost of capital.

2. Net Present Value (NPV)

• It is obtained by getting the present value of all the cash inflows using the discount rate (cost of
capital) less the initial investment.
• It recognizes the time value of money and it is easy to compute whether the cash flows form an
annuity or vary from period to period. Any positive net-present-value is acceptable.

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PV OF INFLOWS
Cash Flow After Tax (CFAT) xx
Salvage Value xx
Working Capital xx

PV OF OUTFLOWS
Net Investments (xx)
NET PRESENT VALUE XX

*PV FACTORS TO BE USED:

• CFAT-------- PV of 1 (even Cash flows) or PV of OA (uneven Cash Flows)
• Salvage Value--------- PV of 1
• Working Capital----------- PV of 1

Formula for even future cash flow is:

PV = 1 – (1 + i)-n
i

Formula for uneven future cash flow is:

PV = (1 + i)-n

Acceptance Criterion:
Positive Net Present Value Accept the proposal
Negative Net Present Value Reject the proposal

3. Internal Rate of Return (IRR)

• It is the rate of return that equates the present value of all the cash inflows to initial investment.
• This method is very tedious because there is no exact formula.
• NPV = 0

Decision Rules:
If IRR < required rate of return Reject the project
If IRR > required rate of return Accept the project

Advantages:
1. It acknowledges the time value of money.
2. It is more exact and realistic then ARR.
3. If not constantly changing, the streams of cash flow can provide a rate of return that is
useful in making a decision.
4. It provides a decision similar to the NPV if the project is independent.
Disadvantages:
1. It requires a lot of time to compute especially when the cash inflows are not even.
2. It provides multiple IRRs in situations were the movement of cash flows is erratic.
3. Under mutually exclusive projects, the IRR may provide results conflicting with the NPV.

 Modified Internal Rate of Return

• It resolves the problems regarding IRR (e.g., reinvestment-rate assumption, projects with altering
positive and negative cash flows result in more than one IRR).
• In this concept, no matter how many positive and negative cash flows are provided by a project,
only one value is used to compare with the firm’s cost of capital.

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Formula:

Distinction between NPV and IRR

Net Present Value ≠ Internal Rate of Return

Reinvestment Rate Uses cost of capital

= Cost of Capital as a basis of making
decisions (accept or
reject proposal)

4. Profitability Index
• It is used to rank projects in a descending order of attractiveness.
• If the profitability index is greater than 1, then the project is accepted.

Formula: Profitability Index = PV of future cash inflows

Initial investment

Formula: Profitability Index = _______NPV

+1
Net investment

Hierarchy:
Present value of future cash flows > 1 Accept proposal
Present value < 1 Reject proposal

Mutually Exclusive Projects

• Projects are mutually exclusive if they compete with other project in such way that the acceptance
of one precludes the acceptance of the others.
• It is not independent from accept-to-reject decisions.
If a firm is choosing among mutually exclusive investment, the NPV and IRR methods may result in
contradicting results. It occurs on the following condition:
1. The size and life of the project being studied are common (e.g. big, long-term project to a small,
short-term project)
2. The project whose cash flows are erratic.
3. The timing is problematic.

Capital Rationing
• It deals with the combination of acceptable projects that will provide the highest overall NPV.
• Here, the profitability index and the same information used in the NPV method to arrive at a
decision are applied. The only difference is that for each project, the sum of the discounted future
cash flows is divided by its corresponding investment to establish the profitability ranked index of
the projects.

Replacement Decision
• It is the process by which the management will decide on whether to replace an existing fixed
asset with a new one.
• The difference on the cash flows between the new asset and the old asset is used in making the
replacement decision.

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Formula for the Net Investment:

Capital Budgeting Decisions on Project with Unequal Lives

• If the project are mutually exclusive and have unequal lives, the impact of the different lives must
be considered over comparable periods.

The approaches are as follows:

1. Replacement chain (common life) approach
2. Annualized net present value (ANPV) approach

Replacement Chain (Common Life) Approach

• It is a process in which projects with unequal lives are compared using their respective NPVs.
• The short-lived project proposal is reinvested at the required rate of return until it is equal to the
longer-lived project proposal.
• A replacement is made until the project proposals arrive at a common terminal date.
• The NPV of each proposal is determined and one or more iterations can be completed to create
comparable time frames for the proposals. By comparing the proposals over like periods of time,
the accept-reject information for the various proposals becomes reliable.

Annualized Net Present Value (ANPV) Approach

• It is used when comparing mutually exclusive projects that have an unequal duration.
• It is an efficient method to convert the NPVs of projects with unequal durations into an ANPV for
each specific project which can then be compared.
• The project proposal with the highest ANPV is chosen.

Formula:
𝟏−(𝟏+𝒊)−𝒏
NPVx = Incremental Cash Return – Net Investment
𝒊

𝑁𝑃𝑉
𝟏−(𝟏+𝒊)−𝒏
ANPVx=
𝒊

-End-

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