LECTURE NOTES IN CAPITAL BUDGETING

CAPITAL BUDGETING – the process of identifying, evaluating, planning, and financing capital investment projects
of an organization.
CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS
1. Capital investment decisions usually require large commitment of resources (e.g. fixed or non-current
assets)
2. Most capital investment decisions involve long-term commitments. (since once locked in, resources are
committed)
3. Capital investment decisions are more di icult to reverse than short-term decisions.
4. Capital investment decisions involve so much risk and uncertainty. (involves the future)
CAPITAL INVESTMENT FACTORS
1. Net Investment – cost or cash outflows less cash inflows or savings incidental to the acquisition of
investment projects
Cost or cash outflows:
 The initial cash outlay covering all expenditures on the project up to the time when it is ready for use or
operation:
Ex: Purchase price of asset
Incidental project-related costs such as freight, insurance taxes, handling, installation, test-runs,
etc.
 Working Capital Requirement to operate the project at a desired level (increase/decrease in current
assets)
 Market value of an existing, currently idle asset, which will be transferred to or utilized in the operations
of the proposed capital investment project.
Savings or cash inflows:
 Trade-in value of old asset (in case of replacement)
 Proceeds from sale of old asset to be disposed due to the acquisition of the new project (less applicable
tax, in case there is gain on sale, or add tax savings, in case there is loss on sale).
 Avoidable cost of immediate repairs on old asset to be replaced, net of tax.
Net Returns
- Accounting net income
- Net cash inflows
COMMONLY USED METHODS IN EVALUATING CAPITAL INVESTMENT PROJECTS
1. Methods that do not consider the time value of money
a. Payback
b. Bail-out
c. Accounting rate of return
2. Methods that consider the time value of money (discounted cashflow methods)
a. Net present value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return (internal rate of return)
METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY
PAYBACK PERIOD = Net cost of initial investment = The length of time required by
Annual net cash inflows the project to return the initial
cost of investment
Advantages:
1. Payback is simple to compute and easy to understand. There is no need to compute or consider any interest
rate. One just has to answer the question: “How soon will the investment cost be recovered?”
2. Payback gives information about liquidity of the project.
3. It is a good surrogate for risk. A quick payback period indicates less risky project.
Disadvantages
1. Payback does not consider the time value of money. All cash received during the payback period is assumed
to be of equal value in analyzing the project.
 2. It gives more emphasis on liquidity rather than on the profitability of the project. In other words, more
emphasis is given on return of investment rather than the return on investment.
3. It does not consider the salvage value of the project.
4. It ignores the cash flows that may occur after the payback period.
BAILOUT PERIOD – cash recoveries include not only the operating net cash inflows but also the estimated salvage
value or proceeds from sale at the end of each year of the life of the project.
ACCOUNTING RATE OF RETURN – also called book value rate of return, financial method, average return on
investment and unadjusted rate of return.
Accounting rate of = Average annual net income
return Investment
Advantages:
1. The ARR computation closely parallels accounting concepts of income measurement and investment
return.
2. It facilitates re-evaluation of projects due to the ready availability of data from accounting records
3. This method considers income over the entire life of the project.
4. It indicates the project’s profitability.
Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not consider the time value of money.
2. With the computation of income and book value based on the historical cost of accounting data, the e ect
of inflation is ignored.
METHODS THAT CONSIDER THE TIME VALUE OF MONEY (Discounted Cash flow Methods)
NET PRESENT VALUE
Present value of cash inflows
- Present value of cash outflows
Net Present Value
Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as the reinvestment rate
4. Easy to apply
Disadvantages:
1. It requires predetermination of the cost of capital or the discount rate to be used
2. The net present values of di erent competing projects may not be comparable because of di erences in
magnitudes or sizes of the projects
PROFITABILITY INDEX
Total Present Value of cash inflows
Profitability Index =
Total Present Value of cash outflows
DISCOUNTED CASH FLOW RATE OF RETURN – the rate of return which equates the present value (PV) of cash
inflows to PV of cash outflows.
STEPS:
1. Determine the present value factor (PVF) for the discounted cash flow rate of return (DCFRR) with the use of
the following formula:
Net cost of investment
PVF for DCFRR =
Net cash inflows
2. Using the table 2 (present value annuity table), find on line n (economic life) the PVF obtained in step 1. The
corresponding rate is the DCFRR.
Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes the return of project
Disadvantages:
1. Assumes that the IRR is the re-investment rate.
2. When project includes negative earning during the economic life, di erent rates of return may result.
PAYBACK RECIPROCAL - a reasonable estimate of the discounted cash flows rate of return, provided that the
following conditions are met:
1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.
Net cash inflows
Payback Reciprocal =
Investment
1
Payback Reciprocal =
Payback Period