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Overview
• CAPITAL BUDGETING involves a
“decision-making process with respect to
Capital Budgeting investment in fixed assets.”
Techniques
• It involves “evaluating and selecting long-
presented by term investments that are consistent with
C.K.S. Almonte the firm’s goal of maximizing owner
wealth.”*

Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting
Decision Criteria, p. 290. Pearson Prentice Hall.
Source (with *): Gitman, L. J. (2003). Principles of managerial finance (10th ed.), Chapter 8: Capital Budgeting Cash Flows, p. 356. Addison Wesley.
1 2

cont. Overview cont. Overview

• Main Reasons for Capital Expenditures • Kinds of Projects
– Expansion INDEPENDENT PROJECTS are investments
– Replacement “whose cash flows are unrelated or independent
– Renewal of one another”.
– Others
MUTUALLY EXCLUSIVE PROJECTS are
• Advertising campaigns
investments “that have the same function and
• Research & Development (R & D)
therefore compete with one another.”
• Management consulting
• New products

Source: The list was obtained from Principles of managerial finance (10th ed.) (Chapter 8: Capital Budgeting Cash Flows) (p. 357) (Table 8.1), by L. J. Gitman, 2003,
Boston, MA. Printed in the United States. Addison Wesley. Copyright 2003 by Lawrence J. Gitman.
3 Source: Gitman, L. J. (2003). Principles of managerial finance (10th ed.), Chapter 8: Capital Budgeting Cash Flows, p. 358. Addison Wesley. 4

cont. Overview cont. Overview

• Types of Cash Flows • Important Cash Flows (CFs)
A CONVENTIONAL CASH FLOW PATTERN has – Initial Outlay (or Initial Investment)
“an initial outflow followed only by a series of – Annual Free Cash Flows (FCFs)
inflows.” – Terminal Cash Flow (TCF)

A NONCONVENTIONAL CASH FLOW

PATTERN occurs when “an initial outflow is
followed by a series of inflows and outflows.”

Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 10: Cash Flows and
Source: Gitman, L. J. (2003). Principles of managerial finance (10th ed.), Chapter 8: Capital Budgeting Cash Flows, p. 359. Addison Wesley. 5 Other Topics in Capital Budgeting, p. 332. Pearson Prentice Hall.
6

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Selected Capital Budgeting

cont. Overview
Techniques
• Classification of Capital Budgeting Techniques • The PAYBACK PERIOD (PP) refers to
Unsophisticated Sophisticated how long will it take to get back the initial
Book Rate of Return Discounted Payback investment.
(BRR) Period (DPP)
Payback Period (PP) Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return
(IRR)
Modified Internal Rate of
Return (MIRR)
Source (Unsophisticated & Sophisticated Capital Budgeting Techniques): Gitman, L. J. (2003). Principles of managerial finance (10th ed.), Chapter 9: Capital Budgeting
Techniques, pp. 398, 401, 403. Addison Wesley. Note: Based on the Gitam (2003) classification, Almonte, C. K. S. (n.d.) placed the DPP, PI, & MIRR under the
“sophisticated” techniques.
Source (BRR): Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of corporate finance (10th ed., global ed.), Chapter 5: Net Present Value and Other Investment
Criteria, pp. 132-133. McGraw-Hill/Irwin.
Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting
Source (PP, DPP, NPV, PI, IRR & MIRR): Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), 7 Decision Criteria, p. 292. Pearson Prentice Hall.
8
Chapter 9: Capital-Budgeting Decision Criteria, pp. 315-317. Pearson Prentice Hall.

cont. Selected Capital cont. Selected Capital

Budgeting Techniques Budgeting Techniques
• Formulae: • The DISCOUNTED PAYBACK PERIOD
(DPP) refers to how long will it take to get
b back the initial investment “from the
PP = A +
c Accept: discounted free cash flows.”
PP ≤ maximum
acceptable PP
Initial Investment
PPannuity =
Annual FCF

Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting
Decision Criteria, pp. 292, 315. Pearson Prentice Hall. Note: The formula for PP was “formalized” by Almonte, C. K. S. (n.d.).
Source (PP for an Annuity): Gitman, L. J. (2003). Principles of managerial finance (10th ed.), Chapter 9: Capital Budgeting Techniques, pp. 397-398. Addison Wesley. Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting
Note: The formula was slightly modified by Almonte, C. K. S. (n.d.): She used “Annual FCF” instead of “annual cash inflow” (see Gitman (2003), pp. 397-398).
9 Decision Criteria, p. 293. Pearson Prentice Hall.
10

cont. Selected Capital cont. Selected Capital

Budgeting Techniques Budgeting Techniques
• Formula: • The NET PRESENT VALUE (NPV) is “the
present value of the free cash flows after
bdiscounted Accept: tax less the project’s initial outlay.”
DPP = A discounted + DPP ≤ maximum
c discounted
acceptable DPP

Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting
Decision Criteria, pp. 292-293, 316. Pearson Prentice Hall. Note: The formula for DPP was “formalized” by Almonte, C. K. S. (n.d.).
11 Decision Criteria, p. 295. Pearson Prentice Hall.
12

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cont. Selected Capital cont. Selected Capital

Budgeting Techniques Budgeting Techniques
• Important Characteristics of the NPV • Formula:
– Considers the “time value of money” (p. 131)
– Relies on two things: (1) “forecasted cash n
FCFt
NPV = ∑ − Initial Outlay
flows” (p. 131) & (2) “opportunity cost of t =1 (1+ k )t
capital” (p. 132)
– May be summed up (for several projects)
Accept:
NPV ≥ 0

Source: Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of corporate finance (10th ed., global ed.), Chapter 5: Net Present Value and Other Investment Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting
Criteria, pp. 131-132. McGraw-Hill/Irwin.
13 Decision Criteria, pp. 295, 316. Pearson Prentice Hall. Note: Almonte, C. K. S. (n.d.) modified the presentation of the formula.
14

cont. Selected Capital cont. Selected Capital

Budgeting Techniques Budgeting Techniques
• The PROFITABILITY INDEX (PI), also • Formula:
known as the BENEFIT/COST RATIO, is n
FCFt
computed by dividing the present value of ∑ (1 + k ) t
the FCFs by the initial investment. PI = t =1

Initial Outlay
Note: It is advantageous when there
is CAPITAL RATIONING.* Accept:
PI ≥ 1

Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting
Decision Criteria, p. 298. Pearson Prentice Hall.
Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting
Source (with *): Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of corporate finance (10th ed., global ed.), Chapter 5: Net Present Value and Other Investment
Criteria, pp. 143-145. McGraw-Hill/Irwin.
15 Decision Criteria, pp. 298, 316. Pearson Prentice Hall. Note: Almonte, C. K. S. (n.d.) modified the presentation of the formula. 16

cont. Selected Capital cont. Selected Capital

Budgeting Techniques Budgeting Techniques
• The INTERNAL RATE OF RETURN (IRR) • Formula:
is “the rate of return a project earns.”
n
FCFt
IRR = ∑ = Initial Outlay
It is the rate where the present value (PV) t

of inflows is the same with the PV of

t=1 (1+ IRR)
outflows.
Accept:
IRR ≥ required return

Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting Source: Keown, A. J., Martin, J. D., Petty, J. W., & Scott, Jr., D. F. (2005). Financial management: principles and applications (10th ed.), Chapter 9: Capital-Budgeting
Decision Criteria, p. 299. Pearson Prentice Hall.
17 Decision Criteria, pp. 299, 316. Pearson Prentice Hall.
18

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cont. Selected Capital cont. Selected Capital

Budgeting Techniques Budgeting Techniques
• Conflict in Ranking: NPV vs. IRR • Preference: NPV vs. IRR
– Stems from the “differences in the magnitude – In Theory : NPV is preferred over IRR
and timing of cash flows.” – In Practice : IRR is preferred over NPV
– Cause: The rate assumed for re-investing the
cash flows

Source: Gitman, L. J. (2003). Principles of managerial finance (10th ed.), Chapter 9: Capital Budgeting Techniques, p. 408. Addison Wesley. 19 Source: Gitman, L. J. (2003). Principles of managerial finance (10th ed.), Chapter 9: Capital Budgeting Techniques, pp. 411-412. Addison Wesley. 20

Solution:
Integrative Example
Integrative Example
• A firm is thinking of investing in Project “C” & Project “H”. • PP: Project “C”:
Other data:
Project “C” Project “H”
Initial Investment (in PHP) 1,000 1,000
FCFs (in PHP)
Year 1 700 100
Year 2 700 800
Year 3 700 900

The maximum acceptable PP is 2.85 years. The cost of

capital is 12% p.a. Determine each project’s PP, DPP, NPV, (PHP 300)
PP = 1+ = 1.43 years
PI, & IRR. Which project(s) should be accepted? PHP 700
Source (idea for the problem, basic table format): Gitman, L. J. (2003). Principles of managerial finance (10th ed.), Chapter 9: Capital Budgeting Techniques, p.
421 (Problem 9-20). Boston, MA. Printed in the United States. Addison Wesley. Copyright 2003 by Lawrence J. Gitman. Note: Almonte, C. K. S. (April 11,
2022) modified the problem. 21 Solved by: Almonte, C. K. S. (April 11, 2022; the format of the presentation of the solution was updated on May 2, 2022). The screenshot was taken from 22
the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310).

cont. Solution: cont. Solution:

Integrative Example Integrative Example
• PP: Alternative Solution for Project “C”: • PP: Project “H”:

PHP 1,000
PP = = 1.43 years
PHP 700

(PHP 100)
PP = 2 + = 2.11 years
PHP 900

Solved by: Almonte, C. K. S. (April 11, 2022). 23 Solved by: Almonte, C. K. S. (April 11, 2022; the format of the presentation of the solution was updated on May 2, 2022). The screenshot was taken from 24
the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310).

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cont. Solution: cont. Solution:

Integrative Example Integrative Example
• DPP: Project “C”: • DPP: Project “H”:

(PHP 375) (PHP 272.9592)

DPP = 1+ = 1.67 years DPP = 2 + = 2.43 years
PHP 558.0357 PHP 640.6022

Solved by: Almonte, C. K. S. (April 11, 2022; the format of the presentation of the solution was updated on May 2, 2022). The screenshot was taken from 25 Solved by: Almonte, C. K. S. (April 11, 2022; the format of the presentation of the solution was updated on May 2, 2022). The screenshot was taken from 26
the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310). the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310).

cont. Solution: cont. Solution:

Integrative Example Integrative Example
• NPV: Project “C”: • NPV: Project “H”:

Thus, the NPV is PHP 681.28. Thus, the NPV is PHP 367.64.

Solved by: Almonte, C. K. S. (April 11, 2022). The screenshot was taken from the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310). 27 Solved by: Almonte, C. K. S. (April 11, 2022). The screenshot was taken from the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310). 28

cont. Solution: cont. Solution:

Integrative Example Integrative Example
• PI: Project “C”: • PI: Project “H”:

Thus, the PI is 1.68. Thus, the PI is 1.37.

Solved by: Almonte, C. K. S. (April 11, 2022). The screenshot was taken from the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310). 29 Solved by: Almonte, C. K. S. (April 11, 2022). The screenshot was taken from the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310). 30

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cont. Solution: cont. Solution:

Integrative Example Integrative Example
• IRR: Project “C”: • IRR: Project “H”:

Thus, the IRR is 48.72%. Thus, the IRR is 27.76%.

Solved by: Almonte, C. K. S. (April 11, 2022). The screenshot was taken from the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310). 31 Solved by: Almonte, C. K. S. (April 11, 2022). The screenshot was taken from the solution done via Microsoft Excel for Mac 2011 Version 14.1.0 (110310). 32

cont. Solution:
Integrative Example
• Summary & Decision:
Technique Project “C” Project “H” Decision Preferred
Project
PP 1.43 years 2.11 years Accept both “C”
DPP 1.67 years 2.43 years Accept both “C”
NPV PHP 681.28 PHP 367.64 Accept both “C”
PI 1.68 1.37 Accept both “C”
IRR 48.72% 27.76% Accept both “C”

Thus, both projects are acceptable. However,

preference should be given to Project “C”.

Source (idea for the summary & decision-making): Gitman, L. J. (2003). Principles of managerial finance (10th ed.), Chapter 9: Capital Budgeting Techniques,
p. 421 (Problem 9-20). Boston, MA. Printed in the United States. Addison Wesley. Copyright 2003 by Lawrence J. Gitman.
Answered by: Almonte, C. K. S. (April 11, 2022). 33