CHAPTER 13

CAPITAL INVESTMENT DECISION

CAPITAL BUDGETING
• It is the process of identifying, evaluating, planning, and financing capital investment
projects of an organization.

Capital expenditures
• These are long-term commitments of resources to realize future benefits and budgeting for
them is one of the most important areas of managerial decision.

Categories of Capital Investments

a. Independent capital investment projects or Screening decisions
- these are projects which are evaluated individually and reviewed against predetermined
corporate standards of acceptability resulting in an “accept” or “reject” decision.

b. Mutually exclusive capital investment projects or Preference decision

- these are projects which require the company to choose from among specific
alternatives. The project to be acceptable must pass the criteria of acceptability set by
the company and be better than the other investment alternatives.

Element of Capital Budgeting

The elements or factors to be considered in evaluating capital investment proposals are:

1. The net amount of the investment.

2. The operating cash flows or return from the investment.
3. The minimum acceptable rate of return on the investment/Cost of Capital.

Net Investment or Project Cost

• Net investment represents the initial cash outlay that is required to obtain future returns or
the net cash outflows to support a capital project.
Net Cash Returns

• The cash returns are the inflows of cash expected from a project reduced by the cash cost
that can be directly attributed to the project.

Minimum or Lower Acceptable Rate of Returns

• Also known as Discount Rate this is the weighted average cost of capital of long-term funds
obtained from different sources.

1. Cost of Debt:

𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 (1 − 𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒)

2. Cost of Preference Shares:

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑆ℎ𝑎𝑟𝑒𝑠

3. Cost of Ordinary Shares:

a. Stocked price-based

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐶𝑎𝑠ℎ
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
+ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑜𝑓 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑆ℎ𝑎𝑟𝑒𝑠
 b. Book-value based*

𝑁𝑒𝑥𝑡 𝑦𝑒𝑎𝑟 ′ 𝑠𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑓 𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑆ℎ𝑎𝑟𝑒𝑠

4. Cost of Retained Earnings – same as cost of ordinary equity

*This is used when dividend growth rate is not known.

Process of Capital Budgeting

➢ Finding Investment Opportunities
➢ Collect Relevant Information about Opportunities
➢ Select Decision Rate
➢ Financial Analysis of Cash Flows
➢ Decision
➢ Project Implementation
➢ Project Evaluation and Appraisal

Categories of Project Cash Flow

Cash Inflows:
1. Periodic cash inflows from operations, net of taxes
2. Investment tax credit
3. Proceeds from sale of old asset being replaced, net of taxes
4. Avoidable costs, net of taxes
5. Return of some working capital invested in the project *
6. Cash inflow from salvage of the new long-term asset at the end of its useful life. This will
be net of tax consequence.
Cash Outflows:
7. Acquisition cost of purchasing and installing assets (e.g., new equipment or machinery)
8. Additional working capital 9. Other cash flows such as severance payments, relocation
costs, restoration costs and similar costs.
* The end of a project’s life will usually result in some cash flows. These cash flows are
referred to as disinvestment flows.

SCREENING CAPITAL INVESTMENT PROPOSALS

There are several methods available for evaluation of alternative capital investment proposals.
One method may be used exclusively or in combination with another. The most commonly used
methods of evaluating capital investment projects are:

A. Non-discounted cash flow (unadjusted approach)

1. Payback Period
 2. Accounting rate of return (book value rate of return)
3. Payback reciprocal

B. Discounted cash flow (time-adjusted) approach

1. Net present Value
2. Discounted rate of return or internal rate of return
3. Profitability index
4. Discounted payback period

Non-discounted cash flow Techniques

Payback Period (Payoff and Payout period)

• measures the length of time required to recover the amount of initial investment.

𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑷𝑨𝒀𝑩𝑨𝑪𝑲 𝑷𝑬𝑹𝑰𝑶𝑫 =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑟𝑒𝑡𝑢𝑟𝑛𝑠

Decision Rule: If: PB period ≤ Maximum allowed PB period; Accept

If: PB period > Maximum allowed PB period; Reject

Advantages of Payback period method:

• It is easy to compute and understand

• It is used to measure the degree of risk associated with a project.
• Generally, the longer the payback period, the higher the risk.
• It is used to select projects which

Disadvantages of the payback period method:

• It does not recognize the time value of money.

• It ignores the impact of cash inflows after the payback period.
• It does not distinguish between alternatives having different economic lives.
• The conventional payback computation fails to consider salvage value, if any.
• It does not measure profitability - only the relative liquidity of the investment.
• There is no necessary relationship between a given payback and investor wealth
maximization so an investor would not know what an acceptable payback is.

Bail-out Period

• An approach which incorporates the salvage value in payback computations. This is

reached when the cumulative cash earnings plus the salvage value at the end of
particular year equals the original investment.
Accounting Rate of Return or Simple Rate of Return

• Also known as book rate of return, simple rate of return, unadjusted rate of return,
financial statement rate of return, measures the capital project’s profitability from
accounting standpoint by relating the required investment to the future annual net
income
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑨𝑹𝑹 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑟 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
or, if a cost reduction project is involved, the formula becomes
𝐶𝑜𝑠𝑡 𝑆𝑎𝑣𝑖𝑛𝑔 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑛 𝑛𝑒𝑤 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡
𝑨𝑹𝑹 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑟 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Decision rule: If: ARR ≥ Required rate of return; Accept
If: ARR < Required rate of return; Reject

Advantages of using the ARR:

• It is easily understood by investors acquainted with financial statements.
• It is used as a rough preliminary screening device of investment proposals.

Disadvantages of using the ARR:

• It ignores the time value of money by failing to discount the future cash inflows and
outflows.
• It does not consider the timing component of cash inflows.
• Different averaging techniques may yield inaccurate answers.
• It utilizes the concepts of capital and income primarily designed for the purposes of
financial statements preparation and which may not be relevant to the evaluation of
investment proposals.

PAYBACK RECIPROCAL

• This is the rate of recovery of investment during the payback period.

𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠

𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑹𝒆𝒄𝒊𝒑𝒓𝒐𝒄𝒂𝒍 =
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
or
1
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑹𝒆𝒄𝒊𝒑𝒓𝒐𝒄𝒂𝒍 =
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑
Discounted Cash Flow Techniques
Net Present Value (NPV)

• The excess of the present value of cash inflows generated by the project over the amount of
the initial investment.

Present value of cash inflows computed based

on minimum desired discount rate Pxx
Less: Present Value of investment xx
Net Present Value Pxx

Decision Rule: If: NPV ≥ 0; Accept

If: NPV < 0; Reject

Discounted Rate of Return/ Internal Rate of Return

• This is the rate which equates the present value of cash inflows to present value of cash
outflows. Simply stated, it is the rate where present value is zero.

Steps in the Computation of the Internal Rate of Return

A. Cash Inflows are evenly received:
If the cash returns or inflows are evenly received during the life of the project, the
computational procedures are as follows:
1. Compute the Present Value Factor by dividing Net Investment by Annual Cash Returns.
2. Trace the PV factor in the table for Present Value of P1 received annually using the life
of the project as point of reference
3. The column that gives the closest amount of the PV factor is the “Discounted rate of
return”
4. To get the exact Discounted Rate of Return, interpolation is applied.

B. Cash Inflows are not evenly received:

The steps in computing for the internal rate of return are:
1. Compute the Average Annual Cash Returns by dividing the sum of the returns to be
received during the life of the project by the total economic life of the project.
2. Divide Net Investment by the Average Annual Cash Returns to get the Present
Value Factor.
3. Refer to the Table for Present Value of P1 received annually to determine the rate that
will give the closest factor to the computed present value factor.
4. Using the rate obtained in Step No. 3, refer to the Table for Present of P1. If the returns
are increasing, use a discount rate lower than the rate obtained in Step No. 3, if
the returns are decreasing, use a higher rate. Compute the present value of the annual
cash returns.
 5. Add the present value of the annual returns and compare with the Net
Investment.
6. If the result in Step No. 5 does not give equality of present value of returns and net
investment, try at another rate.
7. Interpolate to get the exact discounted rate of return

Decision Rule: If: IRR ≥ Required rate of return; Accept

If: IRR < Required rate of return; Reject

Profitability Index

• Profitability index is designed to provide a common basis ranking alternatives that require
difference amounts of investment.
𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
𝑷𝑽 𝒊𝒏𝒅𝒆𝒙 =
𝑃𝑉 𝑜𝑓 𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Decision Rule: If: PV Index ≥ 1; Accept

If: PV Index < 1; Reject

DISCOUNTED PAYBACK PERIOD

• It is the period required for the discounted cumulative cash inflows on a project to equal the
discounted cumulative cash outflows (usually initial cost). It is the same concept as payback
period except that cash flows should be discounted.

PREFERENCE DECISION – THE RANKING OF INVESMENT PROJECTS

• Preference decisions are made after screening decisions to rank investment proposals
based on their rate return. They are more challenging due to limited funds and potential
foregone profitable opportunities.
• Internal rate of return or the net present value method can be used in making preference
decision.

Internal Rate of Return Method

• The preference rule when using the internal rate of return method to rank competing
investment project is:
“The higher the internal rate of return, the more desirable the project.”
This method is widely used for two main reasons, namely
1. No additional computations need to be made beyond those already performed in making
initial screening decisions.
2. The ranking data are easily understood by management.
Net Present Value Method

• The net present value method ranks equal-sized investment projects, while calculating
profitability index requires dividing cash inflows present value by required investment,
depending on funding requirements.
• The preference rule to rank competing investment projects using the profitability index is
“The higher the profitability index, the more desirable the project.”

Comparing the Preference Rates

If an independent project is being evaluated, then the NPV and IR criteria always lead to the same
accept/reject decision.
However, for mutually exclusive projects with differing scale and timing, conflicts may arise. The
IRR method may favor one alternative, while the NPV method may indicate otherwise. If conflicts
arise, the NPV method should be used, as it assumes cash flows will be reinvested at the firm's
cost of capital, which is generally a better assumption.
The profitability index is considered superior to the internal rate of return in making preference
decisions due to its ability to accurately indicate the desirability of alternatives, even if they have
different lives and earnings patterns, whereas the internal rate of return method can lead to
incorrect decisions in unequal lives.

Comparing Projects with Unequal Lives

In previous examples, replacement decisions involved comparing two mutually exclusive projects:
retaining the old asset versus buying a new one. It is also assumed that the new equipment had
a life equal to the remaining life the old equipment. However, if we were deciding between two
mutually exclusive alternative with significantly different lives, an adjustment would be necessary.

This problem may be dealt with using any one of these procedures,
1. The replacement chain method and
2. The equivalent annual annuity method (EAA)

Replacement Chain (Common Life) Approach

• This method compares project of unequal lines which assumes that each project can be
repeated as many times as necessary to reach a common life span. The Net Present Values
(NPVs) over this life span are then compared, and the project with the higher common life
NPV is chosen.
Equivalent Annual Annuity (EAA) Approach
• a method which calculates the annual payments a project would provide if it were an
annuity. Generally, when comparing projects of unequal lives, the one with the higher
equivalent annual annuity should be chosen.

Inflation and Capital Budgeting

• Does inflation affect a capital budgeting analysis? The answer is a qualified yes in that
inflation affects the number that are used in the analysis but does not affect the results of the
analysis of certain conditions are satisfied: