CAPITAL BUDGETING

Finance 319-Financial Management

NAZIL JANE A. NICOR, CPA
 CAPITAL INVESTMENT

• Involves significant commitment of funds to receive a satisfactory return

• Increase in revenue or reduction in costs—over an extended period of time.

Example: Purchase equipment for expansion, replacement of old equipment
 GENERAL CHARACTERISTICS OF
CAPITAL INVESTMENT DECISIONS

• AS TO COST: Usually involves large expenditure of resources, relative to

business size
• AS TO COMMITMENT: Usually funds invested are tied up for a long period of
time
• AS TO FLEXIBILITY: Usually more difficult to reverse than short-term decisions
• AS TO RISK: Usually involves so much risks and uncertainties due to operational
and economic changes over an extended period of time
 CATEGORIES OF CAPITAL
INVESTMENTS

A. Independent capital Investment projects or Screening Decision

Projects which are evaluated individually and reviewed against predetermined
corporate standards of acceptability resulting in an ‘accept’ or ‘reject’ decision.
Examples are:
 Investment in long-term assets such as property, plant and equipment
 New product development
 Undertaking a largescale advertising campaign
 CATEGORIES OF CAPITAL
INVESTMENTS

B. Mutually exclusive capital investment projects or Preference Decisions

 Projects which require the company to choose from among specific alternatives.
Examples are:
 Replacement against renovation of equipment or facilities
 Rent or lease against ownership of facilities
 Manual bookkeeping system against computerized system
 Preventive maintenance against periodic overhauling of machineries
 CAPITAL BUDGETING

• Is the process by which management identifies, evaluates and makes

decision on capital investment projects of an organization. It is the process
of planning expenditures for assets, the return on which are expected to
continue beyond one-year period
 CAPITAL BUDGETING PROCESS
IDENTIFICATION Capital Investment Decisions
• Replacement (Equipment)
• Improvement (Products) Addition (Technology)
• Reduction (Cost) Expansion (Facilities)

EVALUATION Factors of Consideration

• Net Investment
• Net Returns
• Cost of Capital (1) Equity- Dividend, Growth Rate 2) Debt-Interest Payments)

Decision Making Time to Choose

• Reject or Accept
 CAPITAL BUDGETING PROCESS-
Evaluation

• Factors of Consideration Non-discounted Methods Discounted Methods

 Net Investment 1. Payback Period 1. Discounted Payback Period

Net Returns 2. Accounting Rate of Return 2. Net Present Value

Cost of Capital 3. Internal Rate of Return

 Payback Period
• Payback Period (also known as pay off and payout period), measures the
length of time required to recover the amount if initial investment. It is the
time interval between time of the initial outlay and the full recovery of the
investment
Advantages:
 It is easy to compute and understand
 It is used to measure the degree of risk associated with a project

Disadvantages:
 It does not recognize the time value of money
 It ignores the impact of cash inflows after the payback period
 It does not distinguish between alternatives having different economic lives
 Payback Period
• When the periodic cash flows are uniform, payback period is computed as
follows:
Net Investment
Annual Cash Returns

• When the periodic cash flows are not uniform, payback period ic computed
by cumulating the estimated annual cash inflows and determining the point
in time at which they equal the investment outlay
 Payback Period
Decision Rule:

• If: PB Period < Maximum allowed PB period; Accept

• If: PB Period > Maximum allowed PB period; Reject
 Payback Period
ILLUSTRATION: Determination of Payback Period
Assume the following cash inflows for two alternative investment proposals:
 Accounting
Rate of Return
(ARR)
 Accounting
Rate of Return
(ARR)
Accounting Rate of Return
(ARR)
Discounted Payback Period
Net Present Value
Net Present Value- Uniform Cash Inflow
Net Present Value – Uneven Cash Inflow