Topic 9 & 10: Capital Budgeting

Capital Budgeting – process of deciding whether or not to commit resources to projects whose costs
and benefits are spread over several time periods.

Characteristics of a Capital Investment Decision:

1. Substantial amount of funds are required in capital projects.
2. Because of the length of time span by a capital investment decision, the element of uncertainty
becomes more critical.
3. The effect of managerial errors will be difficult to reverse.
4. Plans must be made well into an uncertain future.
5. Success or failure of the company may depend upon a single relatively few investment decision.

Two General Types of Capital Investment Projects:

1. Independent Capital Investment Project – results in an Accept or Reject Decision
• Investment in long term assets
• New product development
• Undertaking a large scale advertising campaign
• Corporate acquisition
2. Mutually Exclusive Investment Projects – requirement to choose an alternative and thus automatically
excluding the acceptance of the other
• Replacement against renovation of equipment or facilities
• Rent or lease against ownership of facilities
• Manual bookkeeping system against computerized system
• Preventive maintenance against periodic overhaul of machinery
• Purchase or lease of machinery

There are two main types of capital budgeting decisions:

1. Screening decisions relate to whether a proposed project passes a preset hurdle. For example, a
company may have a policy of accepting projects only if they promise a return of 20% on the
investment.
2. Preference decisions relate to selecting among several competing courses of action. For example, a
company may be considering several different machines to replace an existing machine on the
assembly line.

Three Important Elements of Capital Budgeting

1. Net Amount of Investment
Acquisition Cost
Add: Additional Working Capital Involved
Total
Less: Cash Inflow Arising from Sale of Old Asset Being Replaced (net of taxes)
Avoidable Costs (net of taxes)
Net Investment

2. Operating Cash Flow or Returns from the Investment (Net Returns)

Sources of Cash Inflows:
• Increase revenues over the life of the project
• Reduced operating expenses over the life of the project
• Proceeds from sale of old assets (net of taxes)
• Released working capital at the project’s end
• Salvage value realized from asset disposal at the end of the project
Type of Cash Outflows:
• Acquisition cost
• Additional working capital such as inventories and receivables
• Incremental cash operating costs incurred over the life of the project
• Additional taxes owed on incremental taxable income
Operating Cash Flows may be in the Form of Cash Inflows or Cash Savings:
A. Cash Inflows:
Incremental Revenue
Incremental Cash Operating Costs
Cash Inflows Before Taxes
Less: Incremental Depreciation
Net Income Before Taxes
Less: Income Tax
Net Income After Taxes
Add: Incremental Depreciation
Net Cash Inflow After Tax
 B. Cash Savings:
Cash Operating Costs (Old Asset is Used)
Less Annual Cash Operating Costs (If the New Asset or Method is Used)
Cash Savings Before Taxes
Less: Incremental Depreciation
Increase in Income Before Taxes
Less: Income Taxes
Increase in Income After Taxes
Add: Incremental Depreciation
Net Cash Savings After Taxes

Terminal Cash Flow

Salvage Value of New Asset
Add: Working Capital Recovery
Savings on Loss
Less: Cost to Remove, net of tax
Tax Gain
Terminal Cash Flow

3. Minimum or Lowest Acceptable Rate of Return or Cost of Capital

The interest rate used for evaluating projects can be as follows:
A. Cost of Capital – a weighted average cost of long-term funds (WACC). Only projects that can
earn at least what the firm pays for funds should be accepted.
B. Minimum Acceptable Rate of Return – a particular rate hat is considered to be the lowest
ROR that management will accept.
C. Desired Rate of Return, Target Rate of Return, Required Rate of Return – a rate that reflects
management’s ROR expectations.
D. Hurdle Rate – a level that a project’s ROR must “jump over” or exceed.
E. Cutoff Rate – the rate at which projects with a higher ROR are accepted and those with a
lower ROR are rejected, often the rate where all available capital investment funds are
committed.
Any of the abovementioned rates can be used as discount rate in evaluating capital investment
decisions. Generally, the terms are used loosely to define cost of money or cost of capital.

Cost of Capital – weighted average cost of long-term funds (WACC)

A. Cost of Debt → Interest Rate (1 – Corporate Tax Rate)
B. Cost of Preferred Stocks → Dividends Per Share / MV Per Share of Preferred Stock or
Dividend Yield
C. Cost of Common Stocks / Cost of Retained Earnings:
i. Gordon’s Growth Model / Constant Growth Model
𝐶𝑎𝑠ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 (𝑁𝑒𝑥𝑡 𝑃𝑒𝑟𝑖𝑜𝑑)
+ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 𝑜𝑓 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘
𝐷1
+𝑔 where 𝐷1 = Dividend to be received after one period
𝑃0
𝑃0 = Current Market Value of Common Stock

*For New Common Stock Issuance

𝐶𝑎𝑠ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 (𝑁𝑒𝑥𝑡 𝑃𝑒𝑟𝑖𝑜𝑑)
+ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝑃𝑒𝑟 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘 (1 − 𝐹𝑙𝑜𝑎𝑡𝑎𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡)
𝐷1
+ 𝑔 where 𝐷1 = Dividend to be received after one period
𝑃0 (1−𝑓)
𝑃0 = Current Market Value of Common Stock
𝑓 = Floatation Cost

ii. Capital Asset Pricing Model

𝐾𝑟𝑓 + 𝑏(𝐾𝑚 − 𝐾𝑟𝑓)
𝑏(𝐾𝑚 − 𝐾𝑟𝑓) = 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
Where Krf → cost of money that is risk free (usually treasury bill rate is used)
Km → expected rate of return based on market prices
b → BETA which is an index of the stock’s risk in relation to a portfolio
(slope); the higher the beta, the higher the risk of the stock

Note: Among the sources of capital, the following preference of priority is followed based
on cost to the firm:
a. Debt – because interest is a form of tax savings
b. Preferred Stock – because it has a fixed return represented by dividends
c. Retained Earnings – it is an imputed cost and at the same time an opportunity
cost if there is available alternative investment opportunity or source of funding
 d. New Common Stock Issuance – usually issued only after the exhaustion of the
Retained Earnings

Project Evaluation Techniques

• Project investments are evaluated on their liquidity or profitability.
• Net cash inflow is used to measure liquidity while net income is used to measure profitability.
• Evaluating proposed investments may or may not consider time value of money.
• Project evaluation techniques may be classified as ―non-discounted or traditional models‖
or ―discounted models. Traditional models do not consider the time value of money, while
discounted models consider time value of money.

Time value of money

• The time value of money concept recognizes that a dollar today is worth more than a dollar a year
from now. Therefore, projects that promise earlier returns are preferable to those that promise later
returns.
• The capital budgeting techniques that best recognize the time value of money are those that involve
discounted cash flows. Therefore, projects that promise earlier returns are preferable to those that
promise later returns.
• Capital budgeting techniques that recognize the time value of money involve discounting cash flows.

Basic assumptions used in the project evaluation techniques:

1. The cost of investment is made at the beginning of the period.
2. Cash inflows and net income are to be received at the end of each operating year.
3. The residual value is to be received at the end of the project’s terminal life.
4. The working capital is to be recovered at the end of the project’s terminal life.
5. Annual cash inflows may either be even or uneven; even (ie. Annuity) when annual cash inflows are
the same from one year to another.
6. Annual cash inflows are reinvested to the business and would earn a corresponding rate of return.
7. For net present value, profitability index, NPV index and discounted payback period the discount rate
used is the cost of capital (WACC).
8. The discount rate used for internal rate is the internal rate of return itself.

Discounted Cashflow Techniques

Methods that consider time value of money.
Advantages:
• It is more reliable because the time value of money is taken into account.
• Income over the entire life of the project is considered.
• It is more objective and relevant because it focuses on cash flows.
Disadvantages:
• It is not easily understood.
• It is more complex and difficult to apply.
• It required detailed long-term forecasts of incremental cashflow data.
• It required the pre-determination of the cost of capital or discounted rate to be used.

1. Net Present Value

Present Value of Cash Inflows (Annual Cash Flows and Terminal Cash Flows)
Less: Initial Investment
Net Present Value
Decision Rule: If NPV ≥ 0; Accept
If NPV < 0; Reject
If uniform Cash Inflows: Cash Inflows X PVAIF
If Cash Inflows not Equal: Cahs Inflow Year 1 X PVIF 1 + Cash Inflow Year 2 X PVIF 2 + …

2. Internal Rate of Return

• It is also known as discounted cash flow rate of return or time adjusted rate of return. IRR is
defined as the rate of return generated by the investment as represented by the Cash Flows
from the project. Converting the cash flows (returns in absolute amounts) into a percentage (or
rate) will give the IRR of the project.
• It is interesting to note that NPV of the cash flow discounted using the IRR is equal to 0. Simply
put, at NPV = 0, the cost of capital is the same as the IRR rate.

If Cash Inflows are Even: Compute the PV Factor = Net Investment / Annual Cash Returns
Trace the PVAIF Factor in the table.

If Cash Inflows are Uneven: Compute the PV Factor = Net Investment / Average Annal Cash Returns
Trace the PVAIF Factor in the table.
Compute the PV using the PVIF table.
 Interpolate to get the exact IRR.
(𝑃𝑉𝐴𝐼𝐹𝑥−𝑃𝑉 𝐹𝑎𝑐𝑡𝑜𝑟)
Interpolation Formula: 𝑋% + (𝑦% − 𝑥%)
(𝑃𝑉𝐴𝐼𝐹𝑥−𝑃𝑉𝐴𝐼𝐹𝑦)
x% PVAIFx
? PV Factor
y% PVAIFy

3. Modified Internal Rate of Return

• The discount rate at which the present value of a project’s cost is equal to the present value of its
terminal value where the terminal value is found as the sum of the future values of the cash
inflows, compounded at the firm’s cost of capital.
Formula: PV of Outflows = PV of Terminal Value
Terminal Value → Future Value of All Cash Inflows compounded at cost of capital
Outflows = Investment + Additional Outflows discounted at cost of capital
To compute MIRR, we follow the same procedures as that in computing IRR.

4. Multiple IRR - Multiple IRRs happen when a project has irregular material cash outflows during its
economic life. In this case, the changes in the cash flows, positives and negatives, may be balanced
over the years resulting to two or more internal rates of return.

5. Profitability Index
• This technique is the ratio of the total present value of future cash inflows to the initial investment.
• The best use of the profitability index is to rank projects particularly those with varying amounts of
investments.
𝑃𝑉 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
Formula:
𝑃𝑉 𝑜𝑓 𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Decision Rule: If PV Index ≥ 1; Accept
If PV Index < 1; Reject

6. Discounted Payback Period / Breakeven Time Period

• The same principle applies with conventional payback period; however, payback period is
computed using the discounted cashflow values rather than actual cash flows.
Formula: Annual Cash Flow X PVIF Factor = PV of Cahs Flow

7. Fischer Rate / Crossover Rate

• Discount rate at which the NPV profiles of two projects cross and thus, at which the projects’
NPV are equal.
Formula: NPV Project 1 = NPV Project 2
Step 1: Compute for the difference in Investments and Cashflows
Step 2: Compute the NPV using assumed rates (One Rate for Positive NPV and One Rate for
Negative NPV)
Step 3: Interpolate
Step 4: Determine the Crossover Rate
Step 5: Verify

Non-Discounted Cashflow Techniques

1. Payback Period
• This technique is also known as payoff and payout period. It measures the length of time
required to recover the amount of initial investment and it takes into account liquidity rather than
profitability of an investment.
Formula:
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
a. Assume that cash inflows are uniform:
𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
b. If cash inflows are not uniform, payback period is computed by cumulating the estimated
annual cash inflows and determine the point in time at which they equal the investment
outlay.
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑡𝑠𝑚𝑒𝑛𝑡 − 𝐶𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑜𝑓 𝑡ℎ𝑒 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟
Decision Rule: If PB Period ≤ Maximum Allowed PB Period; Accept
If PB Period > Maximum Allowed PB Period; Reject
Advantages:
• It is easy to compute and understand.
• It is used to measure the degree of risk associated with a project. Generally, the longer the
payback period, the higher the risk.
• It is used to select projects which provide quick returns of invested funds.
Disadvantages:
• It does not recognize the time value of money.
• It ignores the impact of cash inflows after the payback period.
• It does not distinguish between alternatives having different economic lives.
 • The conventional payback computation fails to consider salvage value if any.
• It does not measure profitability – only relative liquidity of the investment.

2. Payback Reciprocal
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 1
Formula: 𝑜𝑟
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑
Uses:
• A project with an infinite life would have a discounted rate of return exactly equal to its payback
reciprocal.
• When a project life is at least twice the payback period and the annual cash flows are
approximately equal, the payback reciprocal may be used to estimate the discounted rate of
return or internal rate of return.

3. Payback Bailout
• This evaluation technique applies the same concept as conventional payback period. The
difference lies on the fact that we include the estimated salvage value at the end of the year in
the computation of cash flow in additional to the operating cash flow generated by the project.
• Bailout period is achieved when the cumulative cash earnings plus the salvage value at the end
of a particular year equals the original investment.
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−(𝐶𝑢𝑚𝑢𝑙𝑎𝑡𝑖𝑣𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑜𝑓 𝐿𝑎𝑠𝑡 𝑌𝑒𝑎𝑟+𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐶𝑢𝑟𝑟𝑛𝑒𝑡 𝑌𝑒𝑎𝑟)
Formula:
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠

4. Accounting Rate of Return

• This technique measures profitability from the conventional accounting standpoint by relating the
required investment to the future annual net income.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
Formula:
𝐼𝑛𝑣𝑒𝑡𝑠𝑚𝑒𝑛𝑡
a. Original Investment
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡+𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒
b. Average Investment =
2
Decision Rule: If ARR ≥ Required Rate of Return; Accept
If ARR < Required Rate of Return; Reject
Advantages:
• It is easily understood by investors acquainted with the financial statements.
• It is used as a rough preliminary screening device of investment proposals.
Disadvantages:
• It ignores the time value of money by failing to discount the future cash inflows and outflows.
• T does not consider the timing component of cash inflows.
• Different averaging techniques may yield inaccurate answers.
• It utilizes the concepts of capital and income primarily designed for the purpose of financial
statements preparation and which may not be relevant to the evaluation.

Mutually Exclusive Projects Analysis

• The discussion earlier focused on the purchase of a investment in an independent project. The
succeeding discussed an analysis technique in case we are faced with a mutually exclusive scenario
particularly a replacement situation.
• We take into account the following:
1. Net investment of the project
2. Net cash flows rom operations – including tax savings
3. Terminal cash flows
• All the cash flows in the future period will have to be discontinued to the present to determine the
present value of the project and from there determine if it is worth pursuing or not.
• In cases where on must choose between mutually exclusive investments, the NPV and IRR methods
may give decisions that contradict each other. The conditions under which contradictory rankings can
occur are:
a. Projects have different expected lives.
b. Projects have different size of investment
c. Timing of the projects’ cash flows differ
• The contradiction results from different assumptions with respect to the investment rate on cash flows
released from the projects.
a. The NPV method discounts all cash flows at the cost of capital, thus implicitly assuming that
these cash flows can be reinvested at this rate.
b. The IRR method implies a reinvestment rate at IRR. Thus the implied reinvestment rate will
differ from project to project.
• In situation like this, the NPV will prove to be superior over IRR since the cost of capital is a more
realistic reinvestment rate. However, in practice, IRR computation remains to be favored technique.
Sensitivity Analysis
• One basic approach to evaluating cash flow and NPV estimates involves asking “what if” questions.
Sensitivity analysis is the process of changing one or more variables to determine how sensitive a
project’s returns are to these changes.
• By asking “what if” questions, the decision maker is able to identify relevant variables affecting the
final outcome. Once these variables are identified, the decision maker can investigate the variables
more carefully in order to improve his/her ability to predict them.
• Percentage change in NPV resulting from a given percentage change in an input variable, other
things held constant.
• The basic idea with a sensitivity analysis is to freeze all the variables except one and then see how
sensitive our estimate of NPV is to changes in that one variable (ceteris paribus).
• If the NPV estimate turns out to be very sensitive to relatively small changes in the projected value of
some component of project cash flow, then the forecasting risk associated with that variable is high.
• Sensitivity analysis is useful for pointing out where forecasting errors will do the most damage but
does not tell us what to do about possible errors.

Scenario Analysis
• It is a risk analysis technique in which “bad” and “good” sets of financial circumstances are compared
with a most likely or based case situation. It considers both the sensitivity of NPV to changes in key
variables and the likely range of variable values.
a. Worst Case Scenario – an analysis in which all of the input variable are set at their worst
reasonably forecasted values. This defines the lower bound of the analysis.
b. Best Case Scenario – an analysis in which all of the input variable are set at their best reasonably
forecasted values. This defines the upper bound of the analysis.
c. Base Case Scenario – an analysis in which all of the input variable are set at their most likely
values.
• To adopt an expected NPV from this analysis, probabilities are assigned to each type of scenario and
adding all probabilities and further defined by he project’s coefficient of variation and standard
deviation.