Capital Budgeting - Importance
1. Long-term planning
● Investment opportunities should align with the organization's strategic goals =
long-term (more than 3 years)
● Accept or reject investment.
● Timing - capital assets must be ready at the time they are needed.
○ Time for evaluation and meet the standards.
○ Payback period (based on the cash flows - gaano katagal bago
marecover?)
○ Company policy.
2. Risk management
● Capital budgeting involves a thorough analysis of potential risks associated with
each investment opportunity.
● For long-term = what will be the potential risks?
● Ex. Sa una (Small cash inflows, eventually malaki na)
3. Resource allocation
● Connected to economics.
● It aids in efficient allocation of financial resources.
a. The amount/cost is substantial.
b. Unavailable funds (working capital, may require financing agreements =
hindi nagagawa over time)
c. Cash inflow (recovery) takes a long period of time
d. Risks involved are greater as well as its uncertainties (compare cost vs.
benefits)
e. The effect of unwise decision is severe and difficult to correct.
Project Classification
● Master time value of money.
1. Replacement
a. Maintenance of business (damaged equipment)
b. Cost reduction (replace obsolete equipment)
2. Expansion if existing products or markets (Increase output of existing products)
3. Expansion of new product of markets (R&D)
4. Safety and environmental projects (comply government orders, terms, etc)
Objectives
1. Primary
● Utilize of funds
2. Secondary
● Maximize present value of resources investment to obtain as high return as
possible without undue risks
Process of Capital Budgeting
● Determines the allocation of funds in order of priority.
1. Potential projects
2. Cost and benefits
3. Riskiness
Factors affecting capital budgeting decisions
● Read only.
○ The company should have a company policy.
○ Ex. Rate of return should be 10%
Concepts
1. Costs avoided
2. Proceeds from disposal of old asset
3. Income tax effect on disposal.
Problems:
● Project A = 42k
● Project B = 45k
Payback Period
● Payback method = simply measures how long it takes to recover the initial investment
(months or years).
○ Ex. Add per year (Project A)
○ 14k + 14k = 28k + 14k = 32k
● The maximum acceptable payback period is determined by management.
○ Ex. Sinet ni MGMT is 2 years pero yung Project A ay 3 years.
● If the PP is less than the Maximum PP = Accept the project.
● If the PP is greater than the Maximum PP = Reject.
Pros and Cons
● Simple, intuitive, and considers cash flows rather than accounting profits.
● Weakness: No time value of money.
○ Ex. Iba na value ng 14,000.
○ Fails to consider maximization of wealth.
Examples:
● Just add the inflows to come up with the payback period.
Formula:
● Payback period = Net initial investment / Annual net cash inflow
Net Present Value: 2nd Capital Budgeting Technique
● Formula:
● PV of after-tax inflows - PV of After-tax outflows
Decisions:
● If computed NPV > 0 = Accept
● NPV < 0 = Reject
● NPV = 0 = Technically indifferent
Examples
● Even equal payments = PV of Ordinary Annuity
● Cash outflow = Initial investment (42k) (Ayun na rin PV niya)
● Cash inflows = With PV na. Ex. 14k etc.
Time value if money
● Six questions
● If unequal payment each year = No need to deduct 1.
Internal Rate of Return
● Discounted.
● Discount rate that will equate the PV of the outflows with the present value of the inflows.
● The IRR is the project's intrinsic rate of return.
● Decisions:
○ IRR > k (10%) = Accept
○ IRR < k = Reject
○ IRR = k) Technically indifferent
Example:
● Trial and error.
● PV of cash inflows = 53,071
● Cost of capital = 10%
● Dapat mapababa siya into 42,000
● Tataasan yung cost of capital.
Among the three:
● IRR is the best method.
● Payback period just gives the idea.
Included in the exam:
● Above discussion.
● Basic terms and definitions.
● Page 208
● Six problems for each topic in the Final Term.
● Payback Period, NPV, IRR (No uneven payments)
Take down note:
● IRR = Other reference material.
● Compute first the PV factor.
● Initial investment/Annual cash inflow = PV factor to find out IRR.
Annual rate of return/Accounting Rate of Return
● Very straightforward.
● Net income after tax/net investment.
● Lalabas din 'to.
Profitability Index
● Included.
● Take note of the formula.
● Page 208.
Next week:
● Check chapters 8,9,10,11.
● Long quiz (CH 8-11)
● Group Activity (Take home) = Problem Solving
Chapter 10: Long-Term Financing
Leverage
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