OUR LADY OF THE PILLAR COLLEGE – CAUAYAN

Cauayan City, Isabela

Financial Management – Capital Budgetig/ Capital Investment

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 commitments of resources.

2. Most capital investment decisions involve long – term commitments.
3. Capital investment decisions are more difficult to reverse than short – term decisions.
4. Capital investment decisions involve so much risk and uncertainty.

The Capital Budgeting Process

1. Identification of potential projects

2. Estimation of costs and benefits
3. Evaluation
4. Development of the capital budget
5. Re - evaluation

Types of Capital Investment Projects

1. Replacement
2. Improvement
3. Expansion

Capital Investment Factors

1. Net investment
2. Net returns
3. Cost of capital

☻ Net Investment » costs or cash outflows less cash inflows or savings incidental to the acquisition of the
investment projects

Cost or cash outflows:

1. The initial cash outlay covering all expenditures on the project up to the time when it is ready for
use or operation, e.g. purchase price of the asset, incidental project – related costs such as freight,
insurance taxes, handling, installation, test – runs, etc.

2. Working capital requirement to operate the project at the desired level

3. 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:

1. Trade – in value of old asset (in case of replacement)

2. 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)

3. Avoidable cost of immediate repairs on old asset to be replaced, net of tax

☻ Net Returns

1. Accounting net income 2. Net cash inflows

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 ☻ Cost of Capital » cost of using funds
» also called cut – off rate, minimum desired rate, minimum acceptable rate, target rate, desired
rate of return, standard rate, and hurdle rate.

Computation:
Source Cost of Capital

Bonds After – tax rate of interest

Preferred stock Dividends per share divided by the present market

price of the preferred stock.

Common stock and retained earnings Earnings per share (after – tax and preferred
dividends) divided by the current, market price of the
common stock.

Economic life – the period of time during which the asset can provide economic benefits or positive
cash inflows.

Terminal value (or end – of – life recovery value) – net cash proceeds expected to be realized at the
end of the project’s economic life.

Commonly Used Methods of Evaluating Capital Investment Projects

1. Methods that do not consider the time value of money

a. Payback period
b. Bail – out period
c. Accounting rate of return

2. Methods that do not consider the time value of money

a. Net present value

b. Present value index
c. Present value payback
d. Discounted cash flow rate of return

☻ Methods that Do not Consider the Time Value of Money

► Payback Period = Net Cost of Initial Investment / Annual Net Cash Inflows

» the length of time required by 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 a 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 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.

► Bail – Out 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.

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 ► Accounting Rate of Return = Average Annual Net Income / Investment

» also called book value rate of return, financial statement method,

average return on investment and unadjusted rate of return.
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 the 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 pay – back 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 accounting data, the effect of
inflation is ignored.

☻ Methods that Consider the Time Value of Money (Discounted Cash Flow Methods)

► Net Present Value (NPV)

1. Net Present Value = (Present Value of Cash Inflows – Present Value of Cash Inflows)

OR

2. Net Present Value = (Present Value of Cash Inflows – Present Value of the Cost of Investment)

OR

3. Net Present Value = (Present Value of Cash Inflows – Cost of Investment)

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 different competing projects may not be comparable because of differences in
magnitudes or sizes of the projects.

► Profitability Index

1. 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:

2. Profitability Index = Total Present Value of Cash Inflows / Cost of Investment

3. Net Present Value Index = Net Present Value / Investment

► Discounted Cash Flow Rate of Return (DCFRR) » the rate of return which equates the present value
(PV) of cash inflows to PV of cash outflows.

Procedure:

1. Determine the present value factor (PVF) for the discounted cash flow rate of return
(DCFRR) with the use of the following formula:

PVF for DCFRR = Net Cost of Investment / Net Cash Inflows

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 2. Using the table of present value annuity, 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 true return of project

Disadvantages:

1. Assumes that the IRR is the re – investment rate

2. When project includes negative earnings during their economic life, different 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.

Payback Reciprocal = Net Cash Inflows / Investment

OR

Payback Reciprocal = 1 / Payback period