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Capital Budgeting

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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

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

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

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

must consider market risk, political risk and

exchange rate risk.

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

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

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

is one that will increase the companys

revenues if its output is increased.

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.

unrelated to the companys existing

activities.

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

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.

proposal or a collection of

dependent proposals that is

economically independent of all

other proposals.

Different Proposals:

Complementary

proposals

Substitute proposals

Mutually exclusive

proposals

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

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.

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.

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

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

time value of money

(discounted cash

flows method)

Net present value

method

Profitability index

method

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

Decisions

Costs reduction decision

Plant expansion decision

Equipment selection decision

Lease or buy decisions

Equipment replacement

decisions

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.

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

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

Flows

Less: operating costs

depreciation expense

Earnings before income tax

Less: income tax

Earnings after tax

Add: depreciation

Cash flow from operations

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)

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

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

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

Which proposal should be accepted

and why?

Projects

Initial cash

outflow

P1M

P1M

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

4

200,000

.5337

106,740

99,080

Accounting Rate of

TheaccountingReturn

rate of returnis an

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.

ARR:

SARR = profit/original investment

AARR = profit/ ave. investment

Ave. investment =

(original

investment+residual value)/2

based on the average investment

which exceeds a particular

option to purchase a piece of machinery

with the following details:

Original cost

500,000

Salvage value

20,000

Estimated ANIAT

50,000

10 years

SARR = 10%

AARR =19.23%

Note: For evaluation purposes, under

the ARR method, the higher the rate the

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.

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

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

0

0

1,500,00

0

0

0

1,900,00

0

.75

At the

end of

year

Total

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.

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.

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.

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%

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.

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

Is a discounted(IRR)

rate of return measure

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.

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

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

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

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

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