Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)

BSBA 3A

Material No. 3 : CAPITAL BUDGETING

CONCEPT MAP

Definition and
Purpose

Capital Budgeting
Process
Basic Concepts
Types of Project s

P V of 1
Time Value
of Money PV of Ordinary Annuity of 1

Net Inves tment

Elements of Capital
Budgeting Cash Flows
CAPITAL
BUDGETING Discount Rate

Profits Accounting Rate of

Return (ARR)
Payback Period
Techniques in Capital Non-
Budgeting discounted Bail-out Period
Investment Decisions Payback Reciprocal
Capital Rationing Cash Flows Discounted Payback
Net Present Value
( NPV )
Discounted
Internal Rate of Return
( IRR )
Profitability Index (PI)

DEFINITION AND PURPOSE

Capital budgeting is the process of identifying, evaluating, planning, and financing capital
investment projects of an organization.

Capital budgeting is an investment concept by committing funds in current time with the
purpose of receiving desired returns in the future in the form of additional cash inflows or
reduced cash outflows.

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA

 Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)
BSBA 3A

Material No. 3 : CAPITAL BUDGETING

Capital budgeting involves long-term decision making with a large amount of resources and
funds involved with so much risk and uncertainty. Also, since it is a long-term decision
making, decisions are usually more difficult to reverse than short-term decision making.

Capital budgeting is usually used on the following decisions:

(1) Replacement and Acquisition of Long-term Assets (3) Trading or Exchanging Assets
(2) Improvement of Products
(3) Expansion of Facilities CAPITAL BUDGETING PROCESS
(1) Identification and definition
(2) Search for potential investment projects
(3) Information gathering - both quantitative and qualitative information
(4) Selection- choosing the investment projects after evaluating their projected costs and
benefits
(5) Financing
(6) Implementation and monitoring (Monitoring part is known as POST-AUDIT evaluation)

NOTE: Capital investments screening is being done by the CAPITAL BUDGETING COMMITTEE
and approved by BOARD OF DIRECTORS

TYPES OF PROJECTS
(A) INDEPENDENT PROJECTS (MUTUALLY INCLUSIVE PROJECTS)
These are projects which are evaluated individually and reviewed against predetermined
corporate standards of acceptability resulting to an accept or reject decision.

(B) MUTUALLY EXCLUSIVE PROJECTS

These are projects which require the company to choose among projects under
consideration. The project to be acceptable must pass the criteria of acceptability set by
the company and must be better than other investment alternatives.

TIME VALUE OF MONEY

Discounting is mostly used in capital budgeting. The question is when to use present value
factors.
Present value of 1 (PV of 1) – used if the cash flows flow on a lump-sum basis.
Present value of ordinary annuity – used if the cash flows flow evenly on an annual basis.

ELEMENTS OF CAPITAL BUDGETING

These are the factors of capital budgeting used in evaluating capital investment proposals.

(1) NET INVESTMENT

Net investment represents the initial cash outlay that is required to obtain future returns
or the net cash outflows to support a capital project.
Simply stated, net investment is net cash flows at time zero.
SOLUTION GUIDE
To compute net investment, let us divide it into three (3) parts

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA

 Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)
BSBA 3A

Material No. 3 : CAPITAL BUDGETING

OLD ASSET NEW ASSET WORKING CAPITAL Trade in value (-)
Acquisition Costs (+) Increase in Working Capital (+) Proceeds from
sale (-) Other Direct Costs (+) Decrease in Working Capital (-)
Tax on
gain on
sale
(+)
Tax on
loss on
sale (-)
Avoidable repairs,
net of tax (-)
Removal cost, net of
tax (+)
NOTE: If the decision is an acquisition decision, computation of net investment is limited
only to new asset and working capital section. If it is a replacement decision, the three
sections are complete.

(2) CASH FLOWS

These are the expected returns directly attributable to the investment project. Cash
flows could be
OPERATING CASH FLOWS AFTER TAX or END OF LIFE CASH FLOWS
OPERATING CASH FLOWS AFTER TAX
The incremental changes in cash arising from cash inflows and cash outflows directly
attributable to the project. These cash flows are assumed to occur at the end of the year.

SOLUTION GUIDE
EBITDA / Cost Savings / Cash Operating Income xxx
Incremental Depreciation (xxx) Cash Inflow before Tax xxx
Incremental tax (xxx) Incremental Net Income xxx
Add back Incremental Depreciation xxx
OPERATING CASH FLOWS AFTER TAX xxx

NOTE: EBITDA or cash operating income is used if the purpose of the capital project is
to increase net cash flows. On the other hand, cost savings is used if the purpose of the
capital project is reducing the
operating costs.
ALTERNATIVE SOLUTION GUIDE
EBITDA / Cost Savings after tax [EBITDA / CS x (1-tax rate)] xxx
Tax Shield on Incremental Depreciation (Incremental Depreciation x tax rate) xxx
OPERATING CASH FLOWS AFTER TAX xxx

END OF LIFE CASH FLOWS

These are the net cash flows occurring at the end of the investment project’s life.

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA

 Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)
BSBA 3A

Material No. 3 : CAPITAL BUDGETING

SOLUTION GUIDE
Operating Cash Flows After-tax xxx
Salvage Value or Net Proceeds from sale xxx Return of Increase in Working
Capital xxx Return of Decrease in Working Capital (xxx)
END OF LIFE CASH FLOWS xxx

(3) DISCOUNT RATE

A.K.A. minimum required rate of return or cut-off rate or target rate or desired rate of
return or hurdle rate.
This is the weighted average cost of capital of long-term funds obtained from different
sources. (The computation of this is to be discussed on the cost of capital material)

CAPITAL BUDGETING TECHNIQUES

NON-DISCOUNTED TECHNIQUES
(1) ACCOUNTING RATE OF
RETURN (ARR) A.K.A.
Book rate of return (BRR).
This is a conventional or traditional technique of measuring profitability by relating the
required investment to its incremental net income.
ADVANTAGES DISADVANTAGES
(1) ARR closely parallels
accounting concepts of income
(1) Ignores time value of money
measurement and investment
return.
(2) With the computation of
(2) It facilitates re-evaluation of
income and book value based on
projects due to the ready
the historical cost
availability of data from the
accounting data, the effect of
accounting records.
inflation is ignored.
(3) ARR considers income over
the entire life of the project.
(4) ARR emphasizes profitability
rather than liquidity
SOLUTION GUIDE

ARR = Average Annual Net IncomeNet

Investment*

NOTE: Net investment could be based on original investment or average investment.

Average investment is computed as original investment plus salvage value divided by
two.

(2) PAYBACK PERIOD

Payback period is the length of time required for a project’s cumulative cash flows to
equal its net investment. Simply stated, it is the measure of time for the project to
break-even. With that, PAYBACK PERIOD is a measure of LIQUIDITY rather than
PROFITABILITY.

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA

 Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)
BSBA 3A

Material No. 3 : CAPITAL BUDGETING

ADVANTAGES DISADVANTAGES
(1) Payback is simple to compute
(1) Ignores time value of money
and easy to understand.
(2) More emphasis is given on
return of investment rather
(2) Payback gives information than the return on investment.
about the project's liquidity After reaching the payback period,
subsequent cash flows are
ignored.
(3) It is a good surrogate for risk.
(3) It does not consider the
A quick payback period indicates a
salvage value of the project.
less risky project.
SOLUTION GUIDE
The below solution guide is used only if the operating cash flows after tax are even.
Otherwise, payback period computation is done manually.
Net Investment
Payback Period = Operating Cash Flow After-tax

(3) BAIL-OUT PERIOD

Is a variation of payback period where cash recoveries include not only the operating
net cash inflows but also the estimated salvage value or proceeds from sale at the end
of each year of the life of the project.

(4) PAYBACK RECIPROCAL

Payback reciprocal measures the rate of recovery of investment during the payback
period, thus emphasizes profitability rather than liquidity.

Payback reciprocal is a reasonable estimate of Internal Rate of Return (IRR) provided

the following conditions are present:
(a) The payback period is at most half of the life of the project.
(b) The operating cash flows after-tax are even throughout the life of the project.
SOLUTION GUIDE
1
Payback Reciprocal =
Payback Period
or
= Operating Cash Flows AfterNet
Payback Reciprocal Investment -tax

DISCOUNTED TECHNIQUES
(1) NET PRESENT VALUE
NPV is the excess of the present value of cash inflows over present value of cash outflows
generated by the project throughout its life.
SOLUTION GUIDE
Present Value of Cash Inflows xxx Present Value of Cash Outflows
(xxx) NET PRESENT VALUE xxx

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA

 Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)
BSBA 3A

Material No. 3 : CAPITAL BUDGETING

NOTES:
(a) Cash inflows include the operating cash flows-after tax, salvage value or net proceeds
from sale and the return of working capital from original investment. Simply stated,
these are the end of life cash flows. Just remember to multiply them to their appropriate
present value factors.
(b) Cash outflows are represented by the initial cost of the investment or the net
investment. Since it occurred at time zero, it is NOT DISCOUNTED.
ADVANTAGES DISADVANTAGES
(1) It requires predetermination of
(1) Emphasizes cash flows rather
the cost of capital or the discount
than net income
rate to be used.
(2) The net present value of
different competing projects may
(2) Recognizes the time value of not be comparable
money because of differences in
magnitudes or sizes of the
projects.
(3) Assumes discount rate as the
reinvestment rate
(c) Fisher rate is the rate where the projects will generate the same net present value.

(2) INTERNAL RATE OF RETURN

A.K.A. Discounted cash flow rate of return, time-adjusted rate of return or sophisticated
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.

Guidelines in determining IRR:

(a) Determining the present value factor of IRR with the use of the below formula:

IRR factor = Operating Cash Flow AfterNet

Investment -tax

NOTE: The above formula is the same as payback reciprocal, so, it can also be used if
the cash flows aftertax are even and the cash inflows consist only cash-flows after tax.
(If there are salvage value and return of working capital the formula cannot be used)

(b) Using the present value annuity table, find on line “n” (economic life) the factor
computed in (a). The corresponding rate is the IRR. If the exact rate is not found
on the table, interpolation process may be necessary.

(3)
PROFITA
BILITY
INDEX
A.K.A.

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA

 Laguna State Polytechnic University- Los Baños Laguna (LSPU-LBC)
BSBA 3A

Material No. 3 : CAPITAL BUDGETING

NPV
index.
Profitability index is designed to provide a common basis of ranking alternatives that
require difference amounts of investment.
SOLUTION GUIDES
Present Value of Cash Inflows
Profitability Index = Present Value of Cash Outflows

NPV Net
Profitability Index = + 1
Investment

PV factor Discount Rate PV

Profitability Index = factor IRR

(4) 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 the initial cost). It is the same concept
as payback period except that cash flows should be discounted.

INVESTMENT DECISIONS
For independent projects:
Accept Reject Indifferent
NPV + - 0
IRR > DR < DR = DR
PI >1 <1 =1
Payback > ½ of Life < ½ of Life = ½ of Life
ARR > DR < DR = DR
For mutually exclusive projects:
If same size – basis would be NPV.
If different size – basis would be PI

CAPITAL RATIONING
Capital rationing is a situation in which management places a constraint on the total size of
the firm’s capital budget during a particular period. It is also described as the selection of the
investment proposals in a situation of constraint on availability of capital funds to maximize
the wealth of the company by selecting those projects which will maximize overall NPV.

STEPS IN CAPITAL RATIONING

(1) Rank the projects according to their profitability index
(2) Choose the combination of projects with the highest total NPV.

Special Topics in Financial Management by Nicole S.A Parducho,CTT,MRITax,MBA