CAPITAL BUDGETING

DECISION MAKING PROCESS

Group 2 (B2C)

BABIDA, PRIME DOMINIC

ESPIRITU, GABRIEL
Kate Ortencio
Chris Baltazar
OVERVIEW OF CAPITAL BUDGETING
Capital Budgeting
• The process of evaluating and selecting long-term investments that are consistent with the firm’s goal of
maximizing owner’s wealth.

 Long-term Investments
 - assets that a company intends to hold for more than a year.
 - represent sizeable outlays of funds that commit a firm to some course of action.
 - Fixed assets - Land, plant, buildings and equipment (earning assets).

• The process involves analyzing a project’s cash inflows and outflows to determine whether the
expected return meets a set benchmark.  

• “Firms treat capital budgeting (investment) and financing decisions separately”

MOTIVES FOR CAPITAL EXPENDITURE
Capital Expenditure
• An outlay of funds by the firm that is expected to produce benefits over a period of time
greater that greater than 1 year.
• Known as CAPEX or capital expenses

• Include the purchase of items such as new equipment, machinery, land, plant, buildings

or warehouses, furniture and fixtures, business vehicles, software, or intangible

assets such as a patent or license.

Operating Expenditure
• An outlay of funds by the firm resulting in benefits received within 1 year.
• Known as operating expense (OPEX)
• An expense required for the day-to-day functioning of a business. 
WHAT IS CAPITAL BUDGETING PROCESS?

•  It is the total investment of the company and firms’ budgeting

process done when there are possible projects, it is the art of
building budgets.

STEPS IN THE PROCESS:

The capital budgeting process consists of five distinct but
interrelated steps:
STEPS IN CAPITAL BUDGETING PROCESS

1. Proposal generation
2. Review and analysis
3. Decision making
4. Implementation
5. Follow-up
 INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS
Most investments can be placed into one of two categories:

1. Independent Projects
 Independent (sometimes called stand-alone) projects are any set of projects in
which choosing one has no impact on our decision to choose another project from
that set.
 Taking one project does not influence the other, so they are independent.
 For example, McBurger Inc. may have the following capital budgeting projects to
consider. The first is a new deep frying system for their french fries. The second is a
new order placement system for the drive-thru. McBurger could choose to take the
new deep fryer or the new order placement, or it could choose both.
2. Mutually Exclusive Projects
 The acceptance of one eliminates from further consideration all other
projects that serve a similar function.
 This means two or more events that cannot happen simultaneously. It is
commonly used to describe a situation where the occurrence of one
outcome supersedes the other.
 The time value of money (TVM) is often considered when deciding between
two mutually exclusive choices.
For example, assume a company has a budget of $50,000 for expansion projects. If
available Projects A and B each cost $40,000 and Project C costs only $10,000, then
Projects A and B are mutually exclusive. If the company pursues A, it cannot also
afford to pursue B and vice versa. Project C may be considered independent.
Regardless of which other project is pursued, the company can still afford to pursue C
as well. 

Project Cost

A $40,000
MUTUALLY EXCLUSIVE
B $40,000

C $10,000
INDEPENDENT
 UNLIMITED FUNDS VS. CAPITAL RATIONING
•Unlimited Funds
▫ It is the financial situation in which a firm or a company is able to accept all
independent projects that provide an acceptable return.
▫ All independent projects that will provide an acceptable return can be accepted.
•Capital Rationing
▫ It is the act of placing restrictions on the amount of new investments or projects
undertaken by a company. This is accomplished by imposing a higher cost of
capital for investment consideration or by setting a ceiling on specific portions of a
budget.
▫ The goal of capital rationing is to ensure that money is allocated to its best use
and to ensure that the enterprise will not run short of cash.
Note: The availability of funds for capital expenditures affects the firm’s decisions.
 ACCEPT-REJECT VS. RANKING APPROACHES
There are two basic approaches to capital budgeting decisions:
1. Accept-Reject Approach
▫ A determination is made as to whether or not a project meets some minimum
acceptance criteria. If so, if is accepted; if not, it is rejected. In these cases, only
acceptable projects should be considered.
▫ This approach can be used when the firm has unlimited funds, as a preliminary step
when evaluating mutually exclusive projects, or in a situation in which capital must
be rationed.
2. Ranking Approach
▫ The ranking approach involves ranking projects on the basis of some predetermined
measure, such as the rate of return.
▫ Here we list projects' rates of return from highest to lowest, then determine as to
which projects make the "cut."  Here an independent or mutually exclusive
situation must be considered.
Capital budgeting techniques under certainty:

 Capital budgeting techniques (Investment appraisal criteria) under certainty

can also be divided into following two groups:

• Non-Discounted Cash Flow Criteria: -

▫ Pay Back Period (PBP)

• Discounted Cash Flow Criteria:

▫ Net Present Value (NPV)
▫ Internal Rate of Return (IRR)
Capital Budgeting Technique
• Payback Period (PBP)
▫ The amount of time required for a firm to recover its initial investment
in a project, as calculated from cash inflows.

• If the payback period is less than the maximum acceptable payback period, accept
the project.
• If the payback period is greater than the maximum acceptable payback period,
reject the project.

Note: The length of the maximum acceptable payback period is determined by management.
 PAYBACK PERIOD (PBP)
• ANNUITY - the payback period
can be found by dividing the
initial investment by the annual
cash inflow.

PBP =INITIAL INVESTMENT /

ANNUAL CASH INFLOW

• MIXEDSTREAMS - the yearly

cash inflows must be
accumulated until the initial
investment is recovered.