CAPITAL BUDGETING

Capital Budgeting

• It is the process of evaluating and selecting

long-term investments that are consistent with
the firm’s goal of maximizing owners’ wealth.
• Long-term investment results in benefits to
accrue to the company in excess of one year
while operating expenses benefits the company
only within the operating period.
Examples of capital expenditure
• • Expand or enter into a new line of business
• • Replace or renew fixed assets
• • Construct new premises
• • Opening a new branch
• • Acquisition of machineries and equipment
 Steps in Capital Budgeting
• 1. Investment Proposal. Proposals for capital expenditure come from different levels
within a business organization. These are submitted to the finance team for thorough
analysis.
• 2. Review and Analysis. Financial personnel perform formal review and analysis to assess
the benefits and cost of the investment proposals. These personnel make use of several
financial tools which they see fit in evaluating the project.
• 3. Decision Making. Companies usually delegate capital expenditure decisions on the
basis of value limits. The analysis is presented to the proper approving body who will in
turn make the decision on whether to push through with the project or not.
• 4. Implementation. Release of funds and start of the project occurs after approval. Large
expenditures are usually released in phases.
• 5. Monitoring. Results are monitored and actual cost and benefits are compared with
those that were expected. Action may be required if deviations from the plan are
significant in amount.
• In making investment decisions, financial
managers take note of the risk and returns of
the projects they are entering.
• Taking a higher risk gives you the opportunity
to earn higher returns. Low risk investments
like treasury notes, also called risk-free
instruments, earn a low and steady income
flow. In making investment decisions, financial
managers ensure that the proposed business
will earn more than the risk-free rate since
they need to compensate for the risk the
investment will entail. This introduces us to the
Required Rate of Return. It is the minimum
expected yield investors require in order to
select a particular investment.
Basic terminologies related to capital
budgeting.
• Independent vs. Mutually Exclusive Investments • Independent
Projects are those whose cash flows are independent of one
another. The acceptance of one project does not eliminate the
others from further consideration. Mutually exclusive projects,
on the other hand, are projects which serve the same function
and therefore compete with one another. The acceptance of
one eliminates all other proposals that serve a similar function
from further consideration.
Basic terminologies related to capital
budgeting.
• Unlimited Funds vs. Capital Rationing •
• The amount and availability of funds affects the company’s
decisions in capital outlays. If the company has unlimited funds,
then all projects which pass the risk-return criteria will be
accepted and implemented. Otherwise, firms will operate
under capital rationing and will accept only projects which
provide the best opportunity to increase shareholder wealth.
Basic terminologies related to capital
budgeting.
• Accept-Reject vs. Ranking Approaches •
• The Accept-Reject approach is usually done for mutually
exclusive projects where one project is favored over the others.
The approach accepts projects which pass a certain criteria.
Ranking is done when there are several projects passing the
criteria and the company is only able to fund so much. The
highest-ranking projects will be selected for implementation.
Different techniques in capital budgeting

•Payback Method
•Net Present Value (NPV)
•Internal Rate of Return (IRR)
Different techniques in capital budgeting

• Before proceeding with discussion of techniques, let us first

introduce the concept of relevant cash flows. Relevant cash
flows include the initial investment, cash inflows from income
from the project, and the expected terminal value of the
project, if any. These are the cash flows considered in analyzing
whether an investment adds value to the firm. Cash flows
should be net of tax. However, to simplify our discussion, we
shall not include tax in our consideration.
• For example, Mr. Alfonse is deciding on which of the 2
mutually exclusive projects he should accept. Project A requires
an initial outlay of PHP72,000 and is expected to receive
PHP17,000 annually for the next 5 years. Project B, on the other
hand, requires an investment of PHP80,000 but will earn
PHP21,000 annually for the next 5 years. In this example, we
can see that the relevant cash flows are the upfront investment
and the annual income from investment.
•

(72,000) 17,000 17,000 17,000 17,000 17,000

(80,000) 21,000 21,000 21,000 21,000 21,000

Payback Method
• This is the simplest method used in capital budgeting. It measures the
amount of time, usually in years, to recover the initial investment.
• For Project A, the initial cash flow is PHP72,000. In 4 years, Mr. Alfonse
would have generated a total cash flow of PHP68,000. To get the actual
time period, let us divide the remaining amount (4,000)* and divide it by
the cash flow for year 5. We get .24, so the total payback period for
Project A is 4 + .24 = 4.24 years. Conversely, if the cash flows are equal,
you may derive the answer by dividing the initial cash flow by the annuity,
• Project A =72,000/17,000 = 4.24 years.
• Project B = 80,000/21,000 = 3.81 years.
Payback Method
Let us also illustrate an example of computing the payback period for
uneven cash flows.
Initial Investment = 15,000
Year 1 = 7,000
Year 2 = 4,000
Year 3 = 6,000
Year 4 = 3,000
For years 1 and 2, we have already recovered 11,000 of our investment. We
need 4,000 more to reach 15,000 thus for the third year, we have
4,000/6,000 = 0.67. The payback period is 2.67 years. Notice that the cash
flow for year 4 is already ignored.
Payback Method
Year Managers usually set an acceptable payback period for projects. For
making accept-reject decisions, projects which meet the set acceptable
payback period shall be accepted and those which not are discarded. It is a
popular method used especially for small projects due to its simplicity and
consideration for the timing of cash flows. The criticism of this method,
however, it that it does not consider the time value of money. Also, it fails to
consider the cash flows after the payback period. For instance, in our
previous example, we can see that Project B is better compared to Project A
due to the quick recovery of the investment. If Project A has a cash flow of,
let’s say PHP50,000 at year 5, we can easily deduce that Project A is more
profitable. However, the payback method only recognizes the gains during
the payback period.
Net Present Value (NPV)
This method is more sophisticated than the payback method
since it considers the time value of money and it considers all the
cash flows during the life of the project including the terminal
value. The NPV can be computed by comparing the present
value of cash inflows against the present value of cash outflows.
Cash flows are discounted using the firm’s cost of capital (cost of
acquiring funding needs) to get the present values.
Net Present Value (NPV)
NPV = Present value of cash inflows – present value of cash outflows
• If the NPV of a project is zero or positive, it should be accepted. In finance,
if these projected cash flows are realized, the NPV of the project should be
equivalent to the increase in total shareholder’s value.
• Assuming that the cost of capital is 8%, let us compute the NPV for our
previous example.
Project A = 17,000 x PVAF(3.993) – 72,000 = 67,881 – 72,000 = (4,119)
Project B = 21,000 x PVAF(3.993) – 80,000 = 83,853 – 80,000 = 3,853
We can see that Project A’s NPV is negative and Project B’s NPV is positive,
thus, we only accept project B.
Internal Rate of Return (IRR)
The IRR is one of the most widely used techniques in capital
budgeting. It is defined as the discount rate that equates the
NPV of an investment to zero. If this method is used for capital
budgeting analysis, the project’s IRR is compared to the
company’s cost of capital. If the IRR is greater than the cost of
capital, the project should be accepted otherwise, it should be
rejected. Manual computation of the IRR involves trial and error,
however, this IRR computation is a lot easier using computation
applications like MS Excel.
Internal Rate of Return (IRR)
For example, you are planning to build a branch for your business at PHP350,000
and expect to receive PHP400,000 in 1 year. First, compute for the rate of return
(profit/investment).
Rate of return = 50,000/350,000 = 14.3%
We compute for the rate of return because the NPV of a project with cost of capital
equal to the rate of return is equal to zero. To illustrate:
NPV = 400,000/(1+0.143) – 350,000 = 0
• The IRR can easily be computed using MS Excel using the IRR function.
• The NPV and IRR are interrelated techniques. An IRR greater than the cost of
capital equates to a positive NPV and vice versa. On a purely theoretical view, NPV
is the better measure since it measures the actual cash value a project creates for
shareholders. However, IRR is also a widely used tool since financial managers
usually like to think in terms of ratios and percentages.