Capital Budgeting
Capital Budgeting is the process of identifying, evaluating , planning and financing capital
investment projects of an organization.
Financing Decision- judgement regarding the method of raising capital to fund an investment.
Investment Decision- judgement about which assets to acquire to achieve the company’s stated
objectives.
Elements of Capital Budgeting
1) Net amount of the investment- this represents costs or cash outflows or savings incidental to the
acquisition of the investment project.
Cost or cash outflows include:
a) The initial cash outlay covering all expenditures on the project up to the time when it is
ready for use or operation.
b) Working capital requirements to operate the project at the desired level
c) Market value of an existing, idle asset which will be transferred to or utilized in the
operations of the proposed capital investment project.
Savings or cash inflows:
a) Trade in value of old asset (in case of replacement)
b) Proceeds from sale of old assets 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)
c) Avoidable costs of immediate repairs on old asset to be replaced, net of tax.
2) Cost of Capital –
a) the cost of using the funds. It is also called hurdle rate, required rate of return, cut off rate.
b) The weighted average rate of return the company must pay to long term creditors and
shareholders for the use of their funds.
3) Net returns-
a. Accounting income
b. Net cash inflows
Terms to remember
1) Economic Life- the period of time during which the asset can provide economic benefits or positive
cash inflows
2) Depreciable life- the period used for accounting and tax purposes over which the depreciable asset’s
cost is systematically and rationally allocated.
3) Terminal value (or end-of-life recovery value)- net cash proceeds expected to be realized at the end
of the project’s life.
Commonly used methods of evaluating capital investment proposals
1) Methods that do not consider the time value of money
a) Payback period - refers to the amount of time it takes to recover the cost of an investment or the
length of time an investor needs to reach a break-even .
Payback period= Net cost of initial investment
Annual net cash inflows
b) Bail out payback 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.
c) Accounting rate of return (ARR)- also called book value rate of return, financial accounting rate of
return, average return on investment and unadjusted rate of return.
ARR = Average annual net income
Net investment
2) Methods that consider the time value of money
a)Net present value computed as:
Present value of cash inflows xx
Less Present value of cash outflows xx
Net present value xx
==
Or Present value of cash inflows xx
Less Present value of cost of investment xx
Net present value xx
==
Or Present value of cash inflows xx
Less cost of investment xx
Net present value xx
==
b)Profitability index = Total present value of cash inflows
Total present value of cash outflows
Or : if the cost of investment is the only cash outflow,
Profitability index = Total present value of cash inflows
Cost of investment
Net present value index = Net present value
Investment
c)Internal rate of return (IRR)- the rate of return which equates the present value of cash inflows to
present value of cash outflows. It is the rate of return where NPV = 0. When the cash inflows are
uniform, the IRR can be determined as follows:
1) Determine the present value factor (PVF) for the IRR, using the following formula:
PVF for IRR = Net cost of investment
Net cash inflows
2) Using the PV annuity table, find on line N (economic life) the PVF obtained in Step 1. The
corresponding rate is the IRR.
When the cash inflows are not uniform, the IRR is determined using trial and error method.
d)Payback reciprocal- a reasonable estimate of the internal 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.
Payback reciprocal = Net cash inflow
Investment
Or Payback reciprocal = 1______
Payback period
e)Discounted payback period- a method that recognizes the time value of money in a payback
context. This is used to compute the payback in terms of discounted cash flows received in the
future.
Illustration of discounted payback period:
SK Manufacturing Company uses discounted payback period to evaluate investments in capital
assets. The company expects the following annual cash flows from an investment of P3,500,000:
Year Cash Inflows
0 (P3,500,000)
1 900,000
2 900,000
3 900,000
4 900,000
5 900,000
6 900,000
7 900,000
8 900,000
No salvage/residual value is expected. The company’s cost of capital is 12%.
Required:
1. Compute discounted payback period of the investment.
2. Is the investment desirable if the required payback period is 4 years or less.
Solution:
In order to compute the discounted payback period, we need to compute the present value of each year’s
cash flow.
Year Cash Inflow PV Factor PV of cash Cumulative
(12%) inflows cash inflow
1 900,000 0.893 803,700 803,700
2 900,000 0.797 717,300 1,521,000
3 900,000 0.712 640,800 2,161,800
4 900,000 0.636 572,400 2,734,200
5 900,000 0.567 510,300 3,244,500
6 900,000 0.507 456,300 3,700,800
7 900,000 0.452 406,800 4,107,600
8 900,000 0.404 363,600 4,471,200
Discounted payback period = Years before full recovery + (Unrecovered cost at start of the year/Cash flow
during the year)
= 5 + (255,500/456,300)
= 5 + 0.56
