You are on page 1of 59

The Basics of

Capital
Budgeting

Learning Objectives
1. Define capital budgeting and discuss the characteristics
of capital investment decision. (CO1)
2. Identify the different capital budgeting concepts. (CO1)
3. Evaluate an investment project using the Net Present
Value method. (CO4)
4. Determine the acceptability of an investment project
using the internal rate of return method. (CO4)
5. Evaluate an investment project that has uncertain cash
flows. (CO4)
6. Rank investment projects. (CO4)
7. Compute for simple rate of return on an investment.
(CO4)

Capital Budgeting
the process of determining which

assets to invests in and how much to


invest;
process of planning expenditures for
assets, the returns in which are
expected to continue beyond 1 year.
In summary:
Analysis of potential projects.
Long-term decisions; involves large
expenditures.

Capital Budgeting
Process

1. Identifying longterm goals


2. Screening
3. Evaluation
4. Implementation
5. Control
6. Project audit

2 Broad categories
of capital budgeting
decisions:
1.Screening decision
2.Preference decison

l. Identifying Long-Term
Goals

The firms ultimate objective:


to maximize its stock price and
increase shareholders wealth.
To accomplish this goal, firms
make decisions about 2 types of
investment:
1. strategic investment
2. tactical investment

Strategic Investment
Investments that would change the
very character of the firm.
Examples:
entering a new product market
acquiring or merging with
another company
establishing a major joint venture
expanding overseas

2 Elements of the
Environment
Strategic decisions
must take international

markets into consideration that is, managers


must consider market risk, political risk and
exchange rate risk.

Many proposals cannot be completely evaluated


in terms of only their immediate impact on cash
flows and stock price. Hence, the intangible
benefits that are consistent with the companys
long-term goals should be identified with each
proposal and their benefits and costs analyzed.

Tactical Investment
This involvesProposal
investment that would

affect the firms cash flows and economic


wealth, but not necessarily change the
character of the firm.
Examples:
Replacing a fleet of trucks
Establishing a new facility in an
existing
market to manufacture
products that is
related to the
current product line
Computerizing records

ll. SCREENING
Managers identify how a capital budgeting
proposal will affect the firm.
Proposals can originate in a variety of ways.
Changes in the firms environment that
force the company to take action.
Consumers, competitors or governments
may change the firms product or market
situation, and the firm must respond with
proposals to meet this challenge.
Firms may search out opportunities on
their own initiative.
In this phase, it is useful to categorize
potential proposals as to whether they
reduce the firms cost or expand its
operations.

Types of Investment
Proposals

1. Cost reduction proposal is one


whose primary benefit is that it
will lower the firms operating
costs.
For example the firm may consider
replacing an inefficient old equipment
with a newer version that reduces
waste and consumes less energy.

2. Vertical

revenue expansion proposal


is one that will increase the companys
revenues if its output is increased.

For example, a company that produces


5,000 barrels of formaldehyde
contemplates doubling its output to
10,000 barrels. The potential for
increased economies of scale is very
important, especially for firms that
compete on a multinational scale through
more cost-effective production
techniques.

3. Horizontal revenue expansion

proposal involves investments that are


unrelated to the companys existing
activities.

For example, a small printing company


that considers investing in a restaurant
is considering a horizontal expansion
that should have no effect on its
printing activities.

III. EVALUATION
An economic analysis is conducted using
discounted cash flow analysis to
determine whether the proposal is
economically profitable.
Consists of three distinct activities:
estimating the cash flows from the various
proposals
identifying projects
applying objective criteria before accepting
or rejecting the idea

To understand these activities, we must first


distinguish between proposals and projects.
A proposal is any action under consideration.
For example:
a plan to introduce a new product line
discussions about increasing the advertising
budget
the idea of buying vineyard
to cease credit sales
Of the many proposals a firm may consider,
several may be related to one another in
terms of cash flows.

A project is either a single


proposal or a collection of
dependent proposals that is
economically independent of all
other proposals.

Different Proposals:
Complementary
proposals

Substitute proposals
Mutually exclusive
proposals

Two proposals are complementary if the


cash flows from adopting them together
exceeds the sum of the cash flows that
would be generated from them individually.
For example, a soft drink manufacturer is
evaluating the development of a line of
snack foods.
If the acceptance of one proposal reduces
the cash flows of another proposal, these
proposals are substitutes.
For example, Pepsi introduced the Pepsi
Maxx for the health-conscious people but
still preferred to take soda pop and the

Proposals are mutually exclusive if


the acceptance of one implies the
rejection of another.
For example: a soft drink
manufacturer is considering replacing
an old warehouse. It can either build a
new warehouse or lease warehouse in
a major business park.
If the acceptance of one proposal has
no effect whatsoever on the cash flows
of another proposal, they are
independent proposals.
For example: a soft drink

IV. IMPLEMENTATION
Here, the company makes the
required arrangements to take
on the new projects. The needed
capital should be made readily
available. The initial start-up
capital is called capital outlay
or net investment.

V. CONTROL
The firm must constantly
monitor the costs and revenues
provided by the project and
assess the extent to which the
actual figures deviate from the
forecasted values used in
capital budgeting decision.

VI. PROJECT AUDIT


This phase provides valuable
information to the firm.
Consistent errors can be rectified,
overlooked areas of concern can
be identified, personnel and
administrative changes may be
required to increase the effect of
future project performance.

Typical Cash OUTFLOWS

Typical Cash INFLOWS

Initial
investment
including
installation costs
Increased
working capital
needs
R&M and
Incremental
operating costs

Incremental
revenues
Reduction in
costs
Salvage value
Release of
working capital

Time Value of Money


Remember that a dollar today is
worth more than a dollar a year from
now.
Projects that promise earlier returns
are preferable over those that
promise later returns.

Methods of Evaluation of
Investment Proposals
Those that do not
consider the time
value of money (nondiscounted method)
Payback period
method
Accounting rate of
return
Bail-out method
Payback reciprocal

Those that consider the


time value of money
(discounted cash
flows method)
Net present value
method
Profitability index
method

Internal rate of return


Present value
Payback method

Basics Consideration in
Capital Budgeting
Generation of investment proposals
Estimate of cash flows for the
proposals
Evaluation of cash flows
Selection of projects based upon an
acceptance criteria
Continued re-evaluation of investment
projects after their acceptance

Typical Capital Budgeting


Decisions
Costs reduction decision
Plant expansion decision
Equipment selection decision
Lease or buy decisions
Equipment replacement
decisions

Steps in Ranking Capital


Investment Proposals
1. Determine the asset cost or net
investment.
The net investment is the net outlay, or
gross cash requirement (outlay), less any
cash recovered from the trade or sale of
existing assets with any necessary
adjustments for applicable tax
consequences.
Includes funds to provide for increases
in working capital such as additional
receivables and inventories.

Steps in Ranking Capital


Investment Proposals
2. Calculate cash flows, period by
period, using the acquired
assets.
3. Relate the cash flow benefits to
their cost by using a method to
evaluate the advantage of
purchasing the asset.
4. Rank the investment

Principles of Estimating
Cash Flows
1. Cash flows should be measured on an
incremental basis.
2. Cash flows should be measured on an after-tax
basis.
3. Changes in net working capital should be
included in the determination of cash flows.
4. All the indirect effects of a project should be
included in the cash flow calculation.
5. Sunk costs should not be considered when
evaluating a project.
6. The value of resources used in a project
should be measured in terms of their
opportunity costs.

Calculating Net
Investment
For new business:
New project cost
Add: Incidental expenses
Investment in initial NWC
Net investment

Replacement of old asset:


New project cost
Add: Incidental expenses
Investment in initial NWC
Less: proceeds from sale of old asset
Add (Deduct): tax effect on gain (loss) of sale of old
asset
Net investment

Calculating Net Cash


Flows

Cash inflows from revenues


Less: operating costs
depreciation expense
Earnings before income tax
Less: income tax
Earnings after tax
Add: depreciation
Cash flow from operations

Criteria for Capital


Budgeting
(Non-Discounted
Payback period refers
to the
Method)
length of time before an
investment is recovered.
It measures the number of years
required to recover the initial
investment.
Also called as simple breakeven
time.

Illustrative Problem
(Uniform Cash Inflow)

Consider a project with an initial investment


of P5,000,000 and expected cash flows of
P1,000,000 per year for ten years.
Payback period = initial investment outlay/
annual cash inflows
= 5 years
Note: For evaluation purpose, the shorter
the payback period the more attractive
the project is.

Non-uniform Cash
Inflows

Assume the same information except for


ACIAT
Year 1 P 1,800,000
2
1,200,000
3 1,400,000
4
1,600,000

Year 5
6
7
8

P1,300,000
1,100,000
700,000
900,000

Remaining required amount to fully recover the


investment/ ACIAT in the period in which
investment can be fully recovered.

Sample
Problem:
Firms
desired payback period is 3
years and the investment proposal
requires an initial cash outflow of
P1M. What is
the payback
period?
After-Tax
Free cash
Year 1

Flow
P200,000

Year 2

400,000

Year 3

300,000

Year 4

300,000

Year 5

1,000,000

Consider 2 investment proposals.


Which proposal should be accepted
and why?
Projects
Initial cash
outflow

P1M

P1M

Annual free cash


flows:
Year 1

600,000

500,000

Year 2

400,000

500,000

Year 3

300,000

Year 4

200,000

Proj. A
Year

Discounted Payback
Period
Undiscount PVIFA Discount Cumulat
ed FCF

(1+i)-n

ed FCF

ive
Discount
ed FCF

-1,000,000

1,000,00
0

600,000

.8547

512,820

487,180

400,000

.7305

292,200

194,980

300,000

.6244

187,320

7,660

Assume interest rate of 17% p.a.


4

200,000

.5337

106,740

99,080

Accounting Rate of
TheaccountingReturn
rate of returnis an

alternative evaluative tool that focuses on


accounting income rather than cash flows.
This method divides the average annual
increase in income by the amount of initial
investment.
Also known as financial statement method,
average return on investment, book value
method, or unadjusted rate of return.

Basic formula to compute for


ARR:
SARR = profit/original investment
AARR = profit/ ave. investment

Ave. investment =

(original
investment+residual value)/2

Note: If the problem is silent, ARR is


based on the average investment

Decision rule: accept investment


which exceeds a particular

Assume that Abacus Corporation has the


option to purchase a piece of machinery
with the following details:
Original cost

500,000

Salvage value

20,000

Estimated ANIAT

50,000

Est. economic life

10 years

SARR = 10%
AARR =19.23%
Note: For evaluation purposes, under
the ARR method, the higher the rate the

Bail-out Payback Period


Accounts for the salvage value of the
investment
The same procedure in computing the
payback period are followed whether
the annual cash inflows or savings are
uniform or not except that the
estimated scrap value of the investment
at the end of a given year is added to
the cumulative cash inflow or
savings at the end of each year.

Bail-out Payback Period


It recognizes that the recovery of the
investment outlay can be in the form
of net proceeds from the sale of
capital assets.
The bail-out payback period is
reached when the cumulative cash
operating savings plus the salvage
value at the end of the particular year
equals the original investment.

Sample problem:
Assume the following data:
Investment needed for the project
1,800,000
Est. economic life
years

10

Est. annual cash inflow


500,000
SV at the end of the 1st yr is 700,000;
500,000 for the 2nd yr and 400,000 at the end
of the 3rd year and will decrease by 50,000
thereafter.

Operati Cumulati +
ve ACIAT Salvag
ng
ACIAT
e
Value

Cumulati Bailve
out
Cash
period
Flows

500,000 500,000

700,00
0

1,200,00
0

500,000 1,000,00 500,00


0
0

1,500,00
0

500,000 1,500,00 400,00


0
0

1,900,00
0

.75

At the
end of
year

Total

(1,800,000-1,500,000)/400,000 = .75 years

2.75

Payback Reciprocal
an opposite of the payback method
formula is ACIAT/net investment or
1/payback period.
This method has wide applicability but its
major limitations are the following:
Valid only when the useful life of the
project is at least 2x the payback period.
Assumes that the ACIAT are fixed over the
life of the project.
A better approximator than ARR when the
economic life is long and the time-adjusted
rate is large.

Net Present Value


Determines the cash inflows and outflows at
the same period. (outflows are made at the
start but inflows are to be received in the
future)
It focuses on all cash flows generated by a
project and then capitalizing them at a
market-determined discount rate.
Overcomes all the weaknesses of the payback
period, and accounting rate of return.

Steps in the computation of the


NPV:
Using a minimum acceptable rate of
return, expected annual net cash inflows
from the project are discounted to their
present value.
The present values of expected annual
cash inflows are then totaled.
From the total PV that is determined
above, deduct the amount of the net
investment and the difference is the NPV.

NPV Index = NPV/COI

Uniform ACIAT
Assume an asset costs 150,000 and will
generate an annual net cash inflows after tax
of 50,000 per year for 5 years with a SV of
15,000 at the end of the 5th year. The
companys cost of capital is 20%.
PV of an
PV of cash
Year
ACIAT
annuity of
P1 at 20%

inflows at
20%

149,530.5
0

0-5

50,000

2.99061

15,000

.40188

Total

6,028.20
155,558.7
0

To compute for PV of
annuity
1 - (1+i)-n or

(1+i) / / =

i
Using scientific
calculator:
Value = (1+i)-n
PV = (1-value)/i

NPV (Uneven
ACIAT)
Assume the following information:
Est. net investment
100,000
Est. life 5 years
Salvage value
20,000
Est annual net cash inflows after tax:
Year 1 70,000
Year 2 50,000
Year 3 20,000
Year 4 15,000
Year 5 10,000
Desired rate of return
20%

The NPV is then computed as follows:


Year

ACIAT

PV of an annuity
of P1 at 20%

0-1

70,000

.83333

1-2

50,000

.69444

2-3

20,000

.57870

3-4

15,000

.48225

4-5

30,000**

.40188

PV of
**10,000 Total
+20,000
=
ACIAT

PV of ACIAT

58,333.00
34,722.00
11,574.00
7,233.75
12,056.40

Profitability Index
Also known as desirability index, present
value index, and benefit cost ratio
Provides a common basis of ranking
alternatives which require different amounts
of investment.
Determined by dividing the total present value
of ACIAT by the net investment
Projects are ranked starting with the project
with the highest index.
Only those with more than or equal to 1.00
will be eligible for further consideration since
those less than zero will not yield the desired
rate of return.

To illustrate this method, consider the


following investment proposals:
Project A
Project B
Est. net investment
580,000
ACIAT- Yr. 1

575,000

220,000
2

420,000

200,000

325,000
3

450,000

200,000

Year
1
2
3
Total PV

ACIAT x
PVF
ACIAT x .
833
ACIAT x .
694
ACIAT x .
579

Project A Project B
183,260

349,860

138,800

225,550

260,550

115,800

582,610

691,210

PI (A) = 582,610/575,000 =
1.013

5. Internal Rate of Return


Is a discounted(IRR)
rate of return measure

derived directly from knowledge of a


projects cash flow pattern.
A project is accepted or rejected by
comparing its IRR with its required rate
of return, which is the opportunity cost
of capital. It is the rate at which the
sum of the PV of the ACIAT = the sum
of the PV of the investment.
The IRR rule is to accept a project if
IRR > RRR.

If the cash inflows are uniform,


the IRR is determined as follows:
Determine the ratio of the initial cost of
investment by the net cash inflows generated
by the investment. Ratio is computed using the
same formula in solving for the payback period.
Using a table giving the PV of an annuity of P1,
locate the line for the number of periods
corresponding to the useful life of the asset and
read across to find the ratio determined in step
1. This ratio will be located in the interest
column representing the rate of return. If the
ratio is not = to the factor, take the closest
value and determine the appropriate rate of
return by interpolation.

Net investment w/ no SV
P300,000
Estimated life
years

Est. annual net cash inflow


120,000
PVFA = 300,000/120,000 = 2.5
Period
24%

18%

2.690

20%

22%
2.589

Model

Concept of Focus of
Recovery measurem
ent

Decision
Criteria

Traditional Models (those that do not consider the time


value of money)
Payback
period

Net cash
inflows

liquidity

the shorter,
the better

Payback
reciprocal

Net cash
inflows

liquidity

the higher,
the better

Payback
bailout

Net cash
inflows

liquidity

the shorter,
the better

profit

profitability

the higher,
the better

Accounting
rate of
return

Model

Concept of Focus of
Recovery measurem
ent

Decision
Criteria

Discounted Models (those that consider the time value


of money)
Net present
value

Net cash
inflows

liquidity

Positive =
accept
Negative =
reject

Profitability
index

Net cash
inflows

liquidity

> 1 = accept
< 1 = reject

Discounted
payback
method

Net cash
inflows

liquidity

the shorter,
the better

Internal rate
of return

Net cash
inflows

liquidity

the higher,
the better