CAPITAL

BUDGETIN
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CAPITAL BUDGETING:
AN OVERVIEW
The capital budget is used by management
to plan expenditures on fixed assets. As a
result of the budgets, the company's
management usually determines which
long-term strategies it can invest in to
achieve its growth goals. For instance,
management can decide if it needs to sell
or purchase assets for expansion to
accomplish this.

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GROWTH STRATEGY
WHAT IS CAPITAL BUDGETING?
Capital Budgeting is defined as the process by which a
business determines which fixed asset purchases or project
investments are acceptable and which are not. Using this
approach, each proposed investment is given a quantitative
analysis, allowing rational judgment to be made by the
business owners.

Capital asset management requires a lot of money;

therefore, before making such investments, they must do
capital budgeting to ensure that the investment will procure
profits for the company. The companies must undertake
initiatives that will lead to a growth in their profitability
and also boost their shareholder’s or investor’s wealth.
FEATURES OF CAPITAL BUDGETING
Capital Budgeting is characterized by the following features:

• There is a long duration between the initial investments and the expected returns.
• The organizations usually estimate large profits.
• The process involves high risks.
• It is a fixed investment over the long run.
• Investments made in a project determine the future financial condition of an organization.
• All projects require significant amounts of funding.
• The amount of investment made in the project determines the profitability of a company.
PROCESS OF CAPITAL BUDGETING
IDENTIFYING AND GENERATING
PROJECTS
Investment proposals are the first step in capital
budgeting. Taking up investments in a business
can be motivated by a number of reasons.
SELECTING A PROJECT
Since there is no ‘one-size-fits-all’ factor, there
is no defined technique for selecting a project.
Every business has diverse requirements and
therefore, the approval over a project comes
based on the objectives of the organization.

EVALUATING THE PROJECT

It mainly consists of selecting all criteria
necessary for judging the need for a proposal. In
order to maximize market value, it has to match
the company's mission. It is crucial to consider
the time value of money here.
IMPLEMENTATION
Once the project is implemented, now come the
other critical elements such as completing it in
the stipulated time frame or reduction of costs.

PERFORMANCE REVIEW
This involves the process of analyzing and
assessing the actual results over the estimated
outcomes.

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 OBJECTIVES

CAPITAL SELECTING IDENTIFICATIO

EXPENDITURE PROFITABLE N OF SOURCE
CONTROL PROJECTS OF FUNDS
LIMITATIONS OF CAPITAL BUDGETING
CASH FLOW
It is a simple technique that determines if an enhanced
value of a project justifies the required investment.
The primary reason to implement capital budgeting is
to achieve forecasting revenue a project may possibly
generate. The problem could be the estimate itself.
TIME HORIZON
Usually, capital budgeting as a process works across
for long spans of years. While the shorter duration
forecasts may be estimated, the longer ones are bound
to be miscalculated.
TIME VALUE
The payback period method of capital budgeting holds
a lot of relevance, especially for small businesses. It is
a simple method that only requires the business to
repay in the predecided timeframe.
DISCOUNT RATES
The accounting for the time value of money is done
either by borrowing money, paying interest, or using
one’s own money. The knowledge of discount rates is
essential. The proper estimation and calculation of
which could be a cumbersome task.
TECHNIQUES/METHODS OF CAPITAL
BUDGETING
In addition to the many capital budgeting methods available, the following list outlines a few by which companies can decide
which projects to explore:

NET INTERNAL
PAYBACK PRESENT RATE OF
PERIOD VALUE RETURN
GROWTH STRATEGY
PAYBACK PERIOD
METHOD

It refers to the time taken by a proposed project

to generate enough income to cover the initial
investment. The project with the quickest
payback is chosen by the company.

Formula:

Payback Period = Initial Cash Investment 

Annual Cash Flow

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 ILLUSTRATION
Let us understand the payback period method with a few illustrations.

Apple Limited has a project.

The initial investment in the project is Php 1,000,000.

– Project A has an even inflow of Php 100,000 every year.

Project A:
The formula of payback period when there are even cash flows is:

Payback period= Initial investment/ annual cash inflows

If we use the formula, Initial investment / annual cash inflows

then the payback period computes to –1,000,000/ 100,000 = 10 years
 EXAMPLE:
An enterprise plans to invest $100,000 to enhance its manufacturing process. It has two mutually independent options in front: Product A and Product
B. Product A exhibits a contribution of $25 and Product B of $15. The expansion plan is projected to increase the output by 500 units for Product A
and 1,000 units for Product B.

Here, the incremental cash flow will be calculated as:

(25*500) = 12,500 for Product A

Now, the Payback Period for Product B is calculated as:
(15*1000) = 15,000 for Product B
1
The Payback Period for Product A is calculated as:

2 Initial Cash Investment $100,000

1
3 Incremental Cash Flow $15,000

4 Payback Period of Product B (Years) 6.7

2 Initial Cash Investment $100,000

3 Incremental Cash Flow $12,500

4 Payback Period of Product A 8

(Years) Product B = 100,000 / 15,000 = 6.7 years

Product A = 100,000 / 12,500 = 8 years

This brings the enterprise to conclude that Product B has a shorter
payback period and therefore, it will invest in Product B.
Despite being an easy and time-efficient method, the Payback Period cannot be called optimum as

it does not consider the time value of money. The cash flows at the earlier stages are better than

the ones coming in at later stages. The company may encounter two projections with the same

payback period, where one depicts higher cash flows in the earlier stages/years. In such as case,

the Payback Period may not be appropriate.

NET PRESENT VALUE METHOD (NPV)
Evaluating capital investment projects is what the NPV method helps the companies with. There
may be inconsistencies in the cash flows created over time. The cost of capital is used to discount
it. An evaluation is done based on the investment made. Whether a project is accepted or rejected
depends on the value of inflows over current outflows.

This method considers the time value of money and attributes it to the company's objective, which
is to maximize profits for its owners. The capital cost factors in the cash flow during the entire
lifespan of the product and the risks associated with such a cash flow. Then, the capital cost is
calculated with the help of an estimate.

Formula:

Net Present Value (NPV) = Rt 

(1+i)t

t = time of cash flow

i = discount rate

Rt  = net cash flow

 ILLUSTRATION
Let us say Nice Ltd. wants to expand its business and so it is willing to invest Php 1,000,000. The investment is said to bring an inflow of Php 100,000 in
first year, 250,000 in the second year, 350,000 in third year, 265,000 in fourth year and 415,000 in fifth year. Assuming the discount rate to be 9%. Let us
calculate NPV using the formula.

Year Flow Computation Present value

0 -1,000,000 – – – -1,000,000
1 100,000 100,000 100,000 100,000 91,743
(1+.09)1 (1.09)1 1.09
2 250,000 250,000 250,000 250,000 210,419
(1+.09)2 (1.09)2 1.1881
3 350,000 350,000 350,000 350,000 270,264
(1+.09)3 (1.09)3 1.295029
4 265,000 265,000 265,000 265,000 187,732
(1+.09)4 (1.09)4 1.411582
5 415,000 415,000 415,000 415,000 269,721 -1,000,000
(1+.09)5 (1.09)5 1.538624 1,029,879
29,879 = NPV
TOTA 1,029,879
L
 EXAMPLE:
Example of Net Present Value (with 9% Discount Rate):
Year Flow Calculation Present Value
For a company, let’s assume the following conditions:
0 ($10,000) -  - - ($10,000)

Capital investment = $10,000 1 1,000 1,000/(1+ .09)1 1,000/(1.09)1 1,000/1.09 9,174

Expected Inflow in First Year = $1,000 2 2,500 2,500/(1+ .09)2 2,500/(1.09)2 2,500/1.1881 2,104

3 3,500 3,500/(1+ .09)3 3,500/(1.09)3 3,500/1.295029 2,692

Expected Inflow in Second Year = $2,500
4 2,650 2,600/(1+ .09)4 2,600/(1.09)4 2,600/1.411582 1,892
Expected Inflow in Third Year = $3,500
5 4,150 4,000/(1+ .09)5 4,000/(1.09)5 4,000/1.538624 2,767

Expected Inflow in Fourth Year = $2,650

Total         $18,629

Expected Inflow in Fifth Year = $4,150

Discount Rate = 9%
Net Present Value achieved at the end of the calculation is:
-10,000
18,629 With 9% Discount Rate = $18,629
8,629 = NPV
This indicates that if the NPV comes out to be positive and indicates
profit. Therefore, the company shall move ahead with the project.
ADVANTAGES LIMITATIONS

• Time value of money • Discounting rate

• Comprehensive tool • Different projects are not
• Value of investment comparable
• Multiple Assumptions
INTERNAL RATE OF
RETURN (IRR) IRR refers to the method where the NPV is zero. In such as
condition, the cash inflow rate equals the cash outflow rate.
Although it considers the time value of money, it is one of the
complicated methods.

It follows the rule that if the IRR is more than the average cost of
the capital, then the company accepts the project, or else it rejects
the project. If the company faces a situation with multiple projects,
then the project offering the highest IRR is selected by them.

Internal Rate of Return = Discount rate that makes NPV=0; 

implies discounted cash inflows are equal to

discounted cash outflows

Internal Rate of Return Rule = Accept investments if IRR greater than Threshold Rate of
Return,

else reject.
 ILLUSTRATION
Year Cash flows Discounted Computation
Let us say a company has an option to replace its machinery.
cash flows
The cost and return are as follows: 0 -500,000 -500,000 (500,000 * 1)
Initial investment = Php 500,000 1 200,000 176,991 200,000 * (1/1.13)1
Incremental increase per year = Php 200,000
2 200,000 156,229 200,000 * (1/1.13)2
Replacement value = Php 45,270
Life of asset = 3 years 3 200,000 138,610 200,000 * (1/1.13)3
If we assume IRR to be 13%, the computation will be as follows. 4 45,270 27,765 45,270 * (1/1.13)4

The total of the column Discounted Cash Flows approximately sums up to zero making the NPV equal to Zero. Hence, this discounted rate is the best rate. As
can be seen from the above, using the rate of 13%, the cash flows, both positive and negative become minimum.

Hence, it is the best rate of return on investment. The cost of capital of the company is 10%. Since the IRR is higher than the cost of capital, the project can be
selected.

If the company has another opportunity to invest the money in a project that gives a 12% return, the company will still go in for the machinery replacement
since it gives the highest IRR.
 EXAMPLE:
Internal Rate of Return
So, the Internal Rate of Return is the interest rate that makes the Net Present Value zero.

And that "guess and check" method is the common way to find it (though in that simple case it could have been worked out directly).

Let's try a bigger example:

Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500 in the 3rd year.

Let us try 10% interest:

Now: PV = -$2,000
Year 1: PV = $100 / 1.10 = $90.91
Year 2: PV = $100 / 1.102= $82.64
Year 3: PV = $100 / 1.103 = $75.13
Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29

Adding those up gets:

NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29 = $126.97
 EXAMPLE:
Example: (continued) at 12% interest rate

Now: PV = -$2,000
Year 1: PV = $100 / 1.12 = $89.29
Year 2: PV = $100 / 1.122 = $79.72
Year 3: PV = $100 / 1.123 = $71.18
Year 3 (final payment): PV = $2,500 / 1.123 = $1,779.45

Adding those up gets:

NPV = -$2,000 + $89.29 + $79.72 + $71.18 + $1,779.45 = $19.64

Example: (continued) at 12.4% interest rate

Now: PV = -$2,000
Year 1: PV = $100 / 1.124 = $88.97
Year 2: PV = $100 / 1.1242 = $79.15
Year 3: PV = $100 / 1.1243 = $70.42
Year 3 (final payment): PV = $2,500 / 1.1243 = $1,760.52

Adding those up gets:

NPV = -$2,000 + $88.97 + $79.15 + $70.42 + $1,760.52 = -$0.94
WHAT ARE THE SHORTCOMINGS OF
THE METHOD?

As mentioned earlier, IRR is widely used and adopted by many companies in

combination with other techniques for capital budgeting. However, this
method has some shortcomings.

• IRR does not take into consideration the duration of the project.
• IRR assumes that the cash flows are reinvested at the same rate as the
project, instead of the cost of capital.

Given the shortcomings of the method, analysts are using the Modified
Internal Rate of Return. It assumes that the positive cash flows are reinvested
at the cost of capital and not IRR.
 SUMMARY

It is of prime importance for a company when dealing with capital budgeting

decisions that it determines whether or not the project will be profitable.

It might seem like an ideal capital budgeting approach would be one that
would result in positive answers for all three metrics, but often these
approaches will produce contradictory results. Some approaches will be
preferred over others based on the requirement of the business and the
selection criteria of the management. Despite this, these widely used
valuation methods have both benefits and drawbacks.
THANK YOU
Aira Coleen R. Orbegoso
BA604
Managerial Accounting