Unit 3: CAPITAL BUDGETING

INTRODUCTION

Businesses look for opportunities that increase their share holders’ value. In
capital budgeting, the managers try to figure out investment opportunities that are worth
more to the business than they cost to acquire. Ideally, firms should peruse all such projects
that have good potential to increase the business worth. Since the available amount of capital
at any given time is limited; therefore, it restricts the management to pick out only certain
projects by using capital budgeting techniques in order to determine which project has
potential to yield the most return over an applicable period of time.

UNIT LEARNING OUTCOMES

By the end of this unit you should be able to:

a) outline the characteristics of capital investments and the reasons for having such;
b) illustrate the capital budgeting process;
c) explain the different cash flows in an investment project;
d) point out the different elements of capital budgeting;
e) apply the discounted and non-discounted techniques in evaluating capital
investments;
f) decide whether an investment project is worth the funding through the firm's
capitalization.

TIMING

Spend at least 3 hours in a day within a week to complete the unit for you to understand
and apply the principles and skills required.

3.1 CAPITAL BUDGETING AND ITS IMPORTANCE

Capital budgeting is the process which enables the management to decide which, when and
where to make long-term investments. With the help of Capital Budgeting Techniques,
management decide whether to accept or reject a particular project by making analysis of
the cash flows generated by the project over a period of time and its cost. Management
decides in favor of project if the value of cash flows generated by the project exceeds the cost
of undertaking that project.

Capital budgeting is a process used to determine whether a firm’s proposed investments or

projects are worth undertaking or not. The process of allocating budget for fixed investment
opportunities is crucial because they are generally long lived and not easily reversed once
they are made. So we can say that this is a strategic asset allocation process and management
needs to use capital budgeting techniques to determine which project will yield more return
over a period of time.

The question arises why capital budgeting decisions are critical? The foremost importance
is that the capital is a limited resource which is true of any form of capital, whether it is raised
through debt or equity. The firms always face the constraint of capital rationing. This may
result in the selection of less profitable investment proposals if the budget allocation and
utilization is the primary consideration. So the management should make a careful decision
whether a particular project is economically acceptable and within the specified limits of the
investments to be made during a specified period of time. In the case of more than one
project, management must identify the combination of investment projects that will
contribute to the value of the firm and profitability. This, in essence, is the basis of capital
budgeting.

Following are the capital budgeting techniques:

 Net Present Value
 Internal Rate of Return
 Profitability Index
 Payback Period
 Bail-out payback method
 Accounting rate of return
 Payback reciprocal method

A Capital Budgeting Decision rules likely to satisfy the following criteria:

a. Must give consideration to all cash flows generated by the project.
b. Must take into account Time Value of Money concept.
c. Must always lead to the correct decision when choosing among mutually
exclusive projects.

Regardless of the specific nature of an investment opportunity under consideration,

management must be concerned not only with how much cash they are expecting to receive,
but also when they expect to receive it and how likely they are to receive it.

Evaluating the size of investment, timing; when to take that investment, and the risk involve
in taking particular investment is the essence of capital budgeting.

3.2 CAPITAL BUDGETING PROCESS

The capital budgeting process consists of five distinct but interrelated steps.

1. Proposal generation. Proposals are made at all levels within a business organization and
are reviewed by finance personnel. Proposals that require large outlays are more carefully
scrutinized than less costly ones.

2. Review and analysis. Formal review and analysis is performed to assess the
appropriateness of proposals and evaluate their economic viability. Once the analysis is
complete, a summary report is submitted to decision makers.

3. Decision making. Firms typically delegate capital expenditure decision making on the
basis of dollar limits. Generally, the board of directors must authorize expenditures beyond
a certain amount. Often plant managers are given authority to make decisions necessary to
keep the production line moving.

4. Implementation. Following approval, expenditures are made and projects implemented.

Expenditures for a large project often occur in phases.

5. Follow-up. Results are monitored and actual costs and benefits are compared with those
that are expected. Action may be required if actual outcomes differ from projected ones.

3.3 INDEPENDENT AND MUTUALLY EXCLUSIVE PROJECTS

Understanding of classification of capital budgeting projects plays a crucial role while

analyzing viability of projects.
A Project whose cash flows have no impact on the acceptance or rejection of other projects
is termed as Independent Project. Thus, all such Projects which meet this criterion should
be accepted.

A set of projects from which at most one will be accepted is termed as Mutually Exclusive
Projects. In mutually exclusive projects, cash flows of one project can be adversely affected
by the acceptance of the other project. In mutually exclusive projects, all projects are to
accomplish the same task. Therefore, such projects cannot be undertaken simultaneously.
Hence, while choosing among Mutually Exclusive Projects, more than one project may satisfy
the Capital Budgeting criterion. However, only one project can be accepted. Which project
should be accepted depends on different factors like initial investment, time period required
for completion, strategic importance of the project, etc. usually the project which adds more
value to the business in the long run will be selected.

Capital budgeting techniques give same acceptance or rejection decisions regarding

independent projects but conflict may arise in case of mutually exclusive projects. If conflicts
arise while making decision regarding mutually exclusive projects, the Net Present Value
method should be given priority due to its more conservative or realistic reinvestment rate
assumption. The Net Present Value and Internal Rate of Return, both methods are superior
to the payback period, but Net present Value is superior to even Internal Rate of Return.

3.4 CASH FLOWS

Success of any business can be determined through its capacity to generate positive cash
flows. Therefore, Cash inflow and outflow is considered as one of the most essential elements
which gives us as idea about the continued existence of a business in future. Therefore, the
stake-holders focus on two things while investing in business: first, how does business
generate funds and second, where does business invest those funds for generating more.

Objectives of a cash flow statement:

The main objective of a cash flow statement is to assist users:

 in assessing the business’s ability to generate positive cash flow.
 in assessing business’s ability to bridge the gap between out flow and inflow of funds.
 in assessing its ability to meet its short and long term obligations
 in assessing the rationale of differences between reported and related cash flows
 in assessing the effect on finances of major projects during the year.

The statement of cash flow, therefore; shows increase and decrease in cash and cash
equivalents rather than working capital.

3.5 CAPITAL STRUCTURE AND CASH FLOWS

On one hand, operations of the company may help in forecasting of future cash flows but in
addition to this, future cash inflows and out flows can also be accessed through company
capital structure. A corporation may use different combinations of equity, debt, or mixture
of securities to finance its assets which is termed as Capital Structure. Company’s capital
structure is basically the composition of its liabilities i.e. how much the company owes to its
shareholders and how much to its creditors.

Stake holders can easily judge the management’s mind-set, strategy of running business and
business’s future prospects. A company’s value is affected by the capital structure it employs,
therefore; while deciding capital structure, management has to consider different important
factors like bankruptcy costs, agency costs, taxes, and information asymmetry.

For example, if a company sells P100 billion in equity and P300 billion in debt, it is said to be
25% equity-financed and 75% debt-financed. The Company’s ratio of debt to total financing,
75% in this example is referred to as the company’s leverage. Capital structure may be highly
complex and may include other sources of finances like short term loans, coalition etc.
3.6 FACTORS TO CONSIDER IN CAPITAL BUDGETING

3.6.1 Net Investments

The company’s net investments refer to the following:
a. Costs less savings incidental to the acquisition of the capital investment
projects.
b. Cash outflows less cash inflows incidental to the acquisition of the capital
investment
projects.

Costs or cash outflows

1. Purchase price of the asset, net of related discount
2. Incidental project-related expenses such as freight, insurance, handling,
installation, test- runs,etc.

Consider also the following if any:

o Additional working capital needed to support the operation of the project at
the desired level.
o Market value of existing idle assets to be used in the operation of the proposed
capital project.
o Training cost, net of related tax.

Savings or cash inflows

1. Proceeds from sale of old asset disposed, net of related tax

Consider also the following if any:

o Trade in value of old asset.
o Avoidable cost of immediate repairs on the old asset to be replaced, net of
related tax.

3.6.2 Net Returns

Net returns of the company will depend on whether it is accrual or cash basis.

* ACCRUAL BASIS: Accounting net income after tax

* CASH BASIS: Net cash inflows

> Direct Method
Net cash inflows = cash inflows – cash outflows

> Indirect Method

Net cash inflows = Net income after tax + noncash expenses (ex. Depreciation
expense)

3.6.3 Cost of capital

The cost of capital used in capital budgeting is the Weighted Average Cost of Capital
(WACC). These are specific costs of using long-term funds obtained from the different
sources: borrowed (debt) and invested (equity) capital.

3.7 CAPITAL BUDGETING TECHNIQUES IN EVALUATING PROJECTS

When firms have developed relevant cash flows, they analyze them to assess whether a
project is acceptable or to rank projects. A number of techniques are available for performing
such analyses. The preferred approaches integrate time value procedures, risk and return
considerations, and valuation concepts to select capital expenditures that are consistent with
the firm’s goal of maximizing owner’s wealth.
Capital budgeting techniques can be discounted method (considers the time value of
money) or non-discounted (methods that do not consider the time value of money).

Non-discounted methods include the following:

1. Payback period method
2. Bail-out payback method
3. Accounting rate of return
4. Payback reciprocal method

Discounted methods include the following:

1. Net present value method
2. Profitability index method
3. Internal rate of return method
4. Present value payback method

3.8 NON-DISCOUNTED TECHNIQUES: DO NOT CONSIDER TIME VALUE OF MONEY

3.8.1 PAYBACK PERIOD

Payback period is the first formal and basic capital budgeting technique used to assess the
viability of the project. It is defined as the time period required for the investment’s returns
to cover its cost. Payback period is easy to apply and easy to understand technique; therefore,
widely used by investors.

The formula for payback period is computed as follows:

Net initial cost of investment

Payback Period =
Annual net after-tax cash inflows

For example, an investment of P5,000 which returns P1000 per year will have a five year
payback period. Shorter payback periods are more desirable for the investors than longer
payback periods.

It is considered as a method of analysis with serious limitations and qualifications for its use.
Because it does not properly account for the time value of money, risk and other important
considerations such as opportunity cost.

Decision guideline: The shorter the payback period, the more attractive the investment.

Advantages of payback period:

1. Payback is simple to compute and easy to understand.
2. Payback gives information about the liquidity of the project.
3. It is a good surrogate for risk. A quick or short payback period indicates a less risky
project.

Disadvantages of payback period:

1. Payback does not consider the time value of money. All cash received during the payback
period is assumed to be of equal value of in analyzing the project.
2. It gives more emphasis on liquidity rather than on profitability of the project. In other
words, more emphasis is given on return of investment rather than return on investment.
3. It does not consider the salvage value of the project.
4. It ignores cash flows that may occur after the payback period (short-sighted).

3.8.2 BAIL OUT PAYBACK PERIOD

Bail-out payback period is a modified payback method wherein cash recoveries include the
estimated salvage value at the end of each year of the project life.
For example:
ABC Company invested for an equipment amounting to P1,000,000 and is expected to have
a net cash inflow and salvage value for each year as:

YEAR CASH INFLOW SALVAGE YEAR CASH INFLOW SALVAGE

VALUE VALUE

1 300,000 200,000 3 200,000 50,000

2 400,000 100,000 4 150,000 20,000

To compute for the bail-out payback period:

BAILOUT PAYBACK

3.8.3 ACCOUNTING RATE OF RETURN

The accounting rate of return is based directly on accrual accounting data rather than on
cash flows. It indicates the profitability of a capital expenditure by dividing expected annual
net income by the average investment. Accounting rate of return is also called annual rate
of return. The formula is computed as follows:

Annual rate of return = Expected annual net income ÷ Average investment

Decision guideline: A project is acceptable if its rate of return is greater than management’s
required rate of return.

For example:

ABC Company is planning to invest for an equipment of P5,000,000 with useful life of 10
years with salvage value of P500,000. The said equipment will provide the following items,
annually:

Sales 7,500,000
Operating expenses 3,500,000
Taxes 30%

To compute for the accounting rate of return:

Sales 7,500,000 Simple ARR = 2,485,000/5,000,000

Less: Op. Expenses 3,500,000 = 49.70%
Dep. Exp. 450,000 Average ARR
Income before Tax 3,550,000 =2,485,000/((5,000,000+500,000)/2)
Tax Exp. 1,065,000 =2,485,000/2,750,000
Net Income after Tax 2,485,000 =90.36%

Note: The average accounting rate is more appropriate, if the problem is silent.
Advantages of ARR:
1. The ARR closely parallels accounting concepts of income measurement and
investment return.
2. It facilitates re-evaluation of projects due to ready availability of data from the
accounting records.
3. This method considers income over the entire life of the project.
4. It indicates and emphasizes the project’s profitability.

Disadvantages of ARR:
1. Like traditional payback methods, the ARR does not consider the time value of
money.
2. With the computation of income and book value based on historical cost accounting
data, the effect of inflation is ignored.

There are a lot of terms used to denote the ARR some of them are as follows:
 Book value rate of return
 Unadjusted rate of return
 Simple rate of return
 Approximate rate of return method
 Financial statement rate of return method
 Average return on investment

3.8.4 PAYBACK RECIPROCAL

Payback reciprocal is a reasonable estimate of the discounted cash flow rate of return (a.k.a
IRR) provided the following conditions are met:
1. The economic life of the project is at least twice payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.

Payback reciprocal is computed as follows:

Net cash inflows 1

Payback Reciprocal = =
Investment Payback period

3.9 DISCOUNTED TECHNIQUES: CONSIDER TIME VALUE OF MONEY

The time value of money is an opportunity cost concept. A peso on hand today is worth more
than a peso to be received tomorrow because of interests a peso could earn by putting it in a
savings account or placing it in investment that earns income. The time value of money is
usually measured by using a discount rate that is simplified to be the interest foregone by
receiving funds at a later time.

3.9.1 NET PRESENT VALUE

Net Present Value measures the difference between present value of future cash inflows
generated by a project and cash outflows during a specific period of time. With a help of net
present value we can figure out an investment that is expected to generate positive cash
flows.

In order to calculate net present value (NPV), we first estimate the expected future cash flows
from a project under consideration. The next step is to calculate the present value of these
cash flows by applying the discounted cash flow (DCF) valuation procedures. Once we have
the estimated figures then we will estimate NPV as the difference between present value of
cash inflows and the cost of investment computed as follows:

NPV=Present Value of Future Cash Inflows – Cash Outflows (Investment Cost)

Cash inflows include cash infused by the capital investment project on a regular basis (e.g.,
annual cash inflow) and cash realizable at the end of the capital investment project. (e.g.,
salvage value, return of working capital requirements). The net investment cost required at
the inception of the project usually represents the present value of the cash outflows.

For example:

The management of Fine Electronics Company is considering to purchase an equipment to

be attached with the main manufacturing machine. The equipment will cost $6,000 and will
increase annual cash inflow by $2,200. The useful life of the equipment is 6 years. After 6
years it will have no salvage value. The management wants a 20% return on all investments.

Computation of net present value:

*Value from “present value of an annuity of $1 in arrears“.

Advantages of NPV:
1. NPV emphasizes cash flows.
2. NPV recognizes the time value of money.
3. NPV assumes discount rate as reinvestment rate.

Disadvantages of NPV:
1. NPV requires determination of the costs of capital or the discount rate to be used.
2. The NPV of different values of different competing projects may not be comparable
because of differences in magnitude or sizes of the projects.

Decision Rule:
A prospective investment should be accepted if its Net Present Value is positive and rejected
if it is negative.

3.9.2 PROFITABILITY INDEX

Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful
capital budgeting technique for grading projects because it measures the value created by
per unit of investment made by the investor.

This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value
investment ratio (VIR).

The ratio is calculated as follows:

Present value of cash inflows

Profitability Index =
Present value of cash outflows

Using the example in the computation of net present value, the profitablity index will the
qoutient of 7,317 over 6,000.
The profitability index method is designed to provide a common basis of ranking alternatives
that require different amounts of investment.

If project has positive NPV, then the PV of future cash flows must be higher than the initial
investment. Thus the Profitability Index for a project with positive NPV is greater than 1 and
less than 1 for a project with negative NPV. This technique may be useful when available
capital is limited and we can allocate funds to projects with the highest PIs.

Profitability index method is also known as desirability index, present value index and benefit
cost ratio.

Decision Rule:
Rules for the selection or rejection of a proposed project:
If Profit Index is greater than 1, then project should be accepted.
If Profit Index is less than 1, then reject the project.

3.9.3 INTERNAL RATE OF RETURN

Internal Rate of Return is another important technique used in Capital Budgeting Analysis to
access the viability of an investment proposal. This is considered to be most important
alternative to Net Present Value (NPV). IRR is “The Discount rate at which the costs of
investment equal to the benefits of the investment. Or in other words IRR is the Required
Rate that equates the NPV of an investment zero.

In other words, IRR is the rate of return that equates the present value of cash inflows to
present value of cash outflows. It is also known as discounted cash flow rate of return, time-
adjusted rate of return or sophisticated rate of return.

NPV and IRR methods will always result identical accept/reject decisions for independent
projects. The reason is that whenever NPV is positive, IRR must exceed Cost of Capital.
However this is not true in case of mutually exclusive projects.

The problem with IRR comes about when Cash Flows are non-conventional or when we are
looking for two projects which are mutually exclusive. Under such circumstances IRR can be
misleading.

Suppose we have to evaluate two mutually exclusive projects. One of the projects requires a
higher initial investment than the second project; the first project may have a lower IRR
value, but a higher NPV and should thus be accepted over the second project (assuming no
capital rationing constraint).

Guidelines in determining IRR:

1. Determine the present value factor for the internal rate of return with the use of he
following formula:

Net investment Cost

PVF for IRR =
Net cash inflows

2. Using the present value annuinity table, find on “n” (economic life) the PVF obtained in
No. 1. The corresponding rate is the IRR. If the exact rate is not found on the PVF table,
‘interpolation’ process may be necessary.

For example:

The management of VGA Textile Company is considering to replace an old machine with a
new one. The new machine will be capable of performing some tasks much faster than the
old one. The installation of machine will cost $8,475 and will reduce the annual labor cost by
$1,500. The useful life of the machine will be 10 years with no salvage value. The minimum
required rate of return is 15%.

In our example, the required investment is $8,475 and the net annual cost saving is $1,500.
The cost saving is equivalent to revenue and would, therefore, be treated as net cash inflow.
Using this information, the internal rate of return factor can be computed as follows:

Internal rate of return factor = $8,475 /$1,500

= 5.650

After computing the internal rate of return factor, the next step is to locate this discount
factor in “present value of an annuity of $1 in arrears “. Since the useful life of the machine is
10 years, the factor would be found in 10-period line or row. After finding this factor, see the
rate of return written at the top of the column in which factor 5.650 is written. It is 12%. It
means the internal rate of return promised by the project is 12%. The final step is to compare
it with the minimum required rate of return of the VGA Textile Company. That is 15%.

Advantages of IRR:
1. IRR emphasizes cash flows.
2. IRR recognizes the time value of money.
3. IRR computes the true return of project.

Disadvantages of IRR:
1. Assumes that IRR is the re-investment rate.
2. When project includes negative earnings during its life, different rates of return may result.

Decision Rule:
If Internal Rate of Return exceeds the required rate of Return, the investment should be
accepted or should be rejected otherwise.

3.9.3 PRESENT VALUE PAYBACK PERIOD/DISCOUNT PAYBACK PERIOD

One of the limitations in using payback period is that it does not take into account the time
value of money. Thus, future cash inflows are not discounted or adjusted for debt/equity
used to undertake the project, inflation, etc. However, the discounted payback period solves
this problem. It considers the time value of money, it shows the breakeven after covering such
costs. This technique is somewhat similar to payback period except that the expected future
cash flows are discounted for computing payback period.

Discounted payback period is how long an investment’s cash flows, discounted at project’s
cost of capital, will take to cover the initial cost of the project. In this approach, the PV of
future cash inflows are cumulated up to time they cover the initial cost of the project.
Discounted payback period is generally higher than payback period because it is money you
will get in the future and will be less valuable than money today.

Decision Rule of Discounted Payback:

If discounted payback period is smaller than some pre-determined number of years then an
investment is worth undertaking.