Construction Accounting and Financial Management

Presenter:
Albert L. Pestaño, CE
MARCH 2023
Professor: Dr. Virgilio Sallentes
GCT 7102
 Learning Outcomes
• Define Capital Budgeting
• Capital Expenditures
• Capital Budgeting tools and decision rules:
• Payback period
• Net Present Value
• Profitability Index
• Internal Rate of Return
• Accounting Rate of Return
 Overview – Capital Budgeting
Capital budgeting is the process of making investment decisions in
capital expenditure. Capital expenditure is an expenditure, the benefits
of which are expected to be received over a period of time exceeding one
year.
What are Capital Expenditures?

Capital expenditures (CapEx) are funds used by a company to acquire, upgrade, and
maintain physical assets such as property, plants, buildings, technology, or
equipment. CapEx is often used to undertake new projects or investments by a
company. Making capital expenditures on fixed assets can include repairing a roof
(if the useful life of the roof is extended), purchasing a piece of equipment, or
building a new factory. This type of financial outlay is made by companies to
increase the scope of their operations or add some future economic benefit to the
operation.

Capital expenditure involves non-flexible long-term commitment of funds. Thus,

capital expenditure decisions are also called long-term investment decisions, and
capital budgeting involves the planning and control of capital expenditure.
Types of CapEx
Many different types of assets can attribute long-term value to a company.
Therefore, there are several types of purchases that may be considered CapEx.

1. Buildings
2. Land
3. Equipment and machinery
4. Computers or servers
5. Software
6. Furniture
7. Vehicles
8. Patents
Formula and Calculation of Capex
CapEx = ΔPP&E + Current Depreciation
where:
CapEx = Capital expenditures
ΔPP&E = Change in property, plant, and equipment

Capital expenditures are also used in calculating free cash flow

to equity (FCFE). FCFE is the amount of cash available to equity
shareholders.

FCFE formula: Alternative formula:

FCFE = EP − (CE − D) × (1 − DR) − ΔC × (1 − DR) FCFE = NI − NCE − ΔC + ND − DR
where: where:
FCFE = Free cash flow to equity NI = Net income
NCE = Net CapEx
EP = Earnings per share
ND = New debt
CE = CapEx
DR = Debt repayment
D = Depreciation
DR = Debt ratio = Total Debts/Total Assets Note: The greater the CapEx for a
ΔC = ΔNet capital, change in net working capital firm, the lower the FCFE.
As part of its 2021 fiscal year end financial statements, Apple, Inc. reported total assets of $351 billion.
Of this, it recorded $39.44 billion of property plant and equipment, net of accumulated depreciation.
Apple, Inc. PPE (2021) Breakdown

The book value of this category of CapEx is valued at $39.4 billion.

Capital Expenditure Decisions:

Since capital expenditure generally involves large amounts, it is

desirable that a proper decision is made in selecting a capital project
from amongst a number of alternative proposals. The main factor to be
considered at the time of making a choice for a suitable project is the
rate of return expected from such a project.
Various other factors to consider before a final choice of the capital
project is made, in addition to the rate of return:

1. The amount and timing of cash inflows and outflows – The shorter is the periods
within which the cost of the project is recovered, the less risky is the project and the
greater is its liquidity.

2. Cost of capital projects – The cost of acquiring the fixed assets, the cash position
and the availability of cash either from within or by borrowing should be considered
before making a choice of a suitable project. It is futile investing borrowed funds in a
capital project if the rate of interest paid on such funds is more than the return
expected from such a project. The working capital required when the project goes
into operation should also be assessed.
3. Product demand – It should be seen whether there will be sufficient demand in
future for the increased production because of additional fixed assets. It is not
worthwhile to purchase a fixed asset having not sufficient demand for the increased
production.

4. The relative importance of the profit – Sometimes, non-profit projects such as

setting up of a hospital or canteen or acquisition of a pollution control device,
though not yielding any return on the amount invested, may be given preference
over profit earning projects on the grounds of their urgency and essentiality.
5. Opportunity cost – Opportunity or alternative cost should be considered while
making a choice of capital expenditure. The return obtainable from the funds, if
utilized somewhere else, should be compared with the return expected from the
proposed project.

6. Cost of production – The ultimate aim of cost accounting is to reduce cost of

production by eliminating all types of wastages. So, the effect of the alternative
capital projects on reduction of future cost of production should be studied. The
project which reduces cost of production should be favored. Cost reduction should
not be at the cost of quality.

7. Other considerations – Besides cost consideration, there are other non-financial

factors which influence the choice of a capital project. Sometimes, capital
expenditure is incurred to create a favorable image in the minds of the public. For
example, investment may be made in schools, colleges, hospitals, and guest houses.
Need for Capital Budgeting:
Capital budgeting means planning for capital assets.

They are vital decisions to any organization, which include the following:

(a) To decide if funds should be invested in long-term projects such as selling of a

company, purchase of plant and machinery, etc.
(b) To analyze the proposal for expansion or for creation of additional capacities.

(c) To decide for replacements for permanent assets.

(d) To make financial analysis of various investment proposals and to choose the
best out of many alternative proposals.
Process of Capital-Budgeting:
Capital-budgeting decisions involve the following:

(a) Evaluating different proposals on the basis of return expected by the investors of
the firm and the return promised by the proposal, and

(b) Applying different techniques to select an alternative with the objective of

maximization of value of the firm.

Capital budgeting is a complex process as it involves decisions relating to the

investment of current funds for the benefits to be achieved in future; and the future
is always uncertain.
Classification of Capital-Budgeting:
The ultimate objective of capital budgeting is to maximize the profitability of a
firm or the return on investment. It can be achieved by either increasing the
revenues or by reducing the costs.
The decisions in capital budgeting are broadly classified into two categories:
i. Those that increase revenues
ii. Those which reduce costs

The first category includes the decisions to be taken relating to expansion of the
production capacity or size of operation by adding a new product line for increasing
revenue.
The second category includes the decisions to be taken relating to replacement of
obsolete, outmoded, or worn out assets to reduce costs.
Both the categories include the decisions regarding the investment in fixed assets, but
the difference between these two is that increasing revenue investment decisions are
subject to more uncertainty as compared to cost-reducing investment decision.
Capital-budgeting decisions may also be classified as:
1. Accept-reject decisions
2. Mutually exclusive project decisions
3. Capital-rationing decisions

1. Accept-Reject Decision:

When the investment projects do not compete with each other, accept-reject
decisions are taken. Such decisions are compared with a minimum required rate of
return or the cost of capital; the one with the highest rate of return is accepted and
others are rejected. The firm invests only in the accepted proposal.

2. Mutually Exclusive Project Decisions:

When proposals compete with each other, one proposal is accepted at the cost of the
other. For example, a firm intends to replace its machinery, it can either buy a new
machine or buy a used machine or even hire an old machine. Thus, the firm by
deciding on any one option renders other two options/proposals as rejected.
3. Capital-Rationing Decisions:

When the firm has several profitable investment proposals but due to limited funds,
the firm has to ration them.

Rationing implies selection of combination of proposals that will yield the greatest
profitability. The investment proposals are ranked in a descending order as per their
profitability, and the limited funds are distributed so as to earn maximum returns.
 Capital Budgeting tools

• Payback period

• Net Present Value

• Profitability Index

• Internal Rate of Return

• Accounting Rate of Return

Payback Period

A simple method of capital budgeting is the Payback Period. It represents the amount of
time required for the cash flows generated by the investment to repay the cost of the
original investment.
Another definition, payback period refers to the amount of time it takes to recover the cost
of an investment. Simply put, it is the length of time an investment reaches a breakeven
point.

Cost of Investment
Payback Period =
Average Annual Cash Flow

The shorter the payback, the more desirable the investment. Conversely, the longer the
payback, the less desirable it becomes. For example, if solar panels cost $5,000 to install
and the savings are $100 each month, it would take 4.2 years to reach the payback
period. In most cases, this is a pretty good payback period as experts say it can take as
much as eight years for residential homeowners in the United States to break even on
their investment.
Table 1. Payback Period Analysis of Future Cash Flow Payments for Three Capital Projects

PROJECT A PROJECT B PROJECT C

Year Cash Flow Cumulative Year Cash Flow Cumulative Year Cash Flow Cumulative
0 -1000 0 -1000 0 -1000
1 250 250 1 350 350 1 500 500
2 250 500 2 350 700 2 500 1000
3 250 750 3 350 1050 3 350 1500
4 250 1000 4 350 1400
5 250 1250 5 350 1750
6 250 1500
Payback Period Comparison
7 250 1750
Project Payback Period Cumulative
8 250 2000
A 4 yrs. 2500
9 250 2250
B 3 (2.86 yrs.) 1750
10 250 2500
C 2 yrs. 1500
What Is a Good Payback Period?
The best payback period is the shortest one possible. Getting repaid or recovering the
initial cost of a project or investment should be achieved as quickly as it allows.
However, not all projects and investments have the same time horizon, so the shortest
possible payback period needs to be nested within the larger context of that time
horizon. For example, the payback period on a home improvement project can be
decades while the payback period on a construction project may be five years or less.

Is the Payback Period the Same Thing As the Break-Even Point?

While the two terms are related, they are not the same. The breakeven point is the
price or value that an investment or project must rise to cover the initial costs or
outlay. The payback period refers to how long it takes to reach that breakeven.

Is a Higher Payback Period Better Than a Lower Payback Period?

A higher payback period means it will take longer for a company to cover its initial
investment. All else being equal, it's usually better for a company to have a lower
payback period as this typically represents a less risky investment. The quicker a
company can recoup its initial investment, the less exposure the company has to a
potential loss on the endeavor.
What Are Some of the Downsides of Using the Payback Period?
As the equation above shows, the payback period calculation is a simple one. It does not
account for the time value of money, the effects of inflation, or the complexity of
investments that may have unequal cash flow over time.
The discounted payback period is often used to better account for some of the
shortcomings, such as using the present value of future cash flows. For this reason, the
simple payback period may be favorable, while the discounted payback period might
indicate an unfavorable investment.
When Would a Company Use the Payback Period for Capital Budgeting?
The payback period is favored when a company is under liquidity constraints because it can
show how long it should take to recover the money laid out for the project. If short-term
cash flows are a concern, a short payback period may be more attractive than a longer-term
investment that has a higher NPV.
The Bottom Line
Payback period is the amount of time it takes to break even on an investment. The
appropriate timeframe for an investment will vary depending on the type of project or
investment and the expectations of those undertaking it. Investors may use payback in
conjunction with return on investment (ROI) to determine whether or not to invest or enter
a trade. Corporations and business managers also use the payback period to evaluate the
relative favorability of potential projects in conjunction with tools like IRR or NPV.
Discounted Payback Period
The Payback Period analysis does not take into Table 2. Discounting a Series Future
account the time value of money. To correct for this Cash Flows (10% Discount Rate)
deficiency, the Discounted Payback Period method
was created. PROJECT B
Year Cash Flow Present Value of
The discounted cash flows for Project B in Table 1 are Cash Flows
shown in Table 2. Assuming a 10 percent discount 0
rate, the $350 cash flow in year one has a present
1 350 318
value of $318 (350/1.10) because it is only discounted
over one year. Conversely, the $350 cash flow in year 2 350 289
five has a present value of only $217 3 350 263
(350/1.10/1.10/1.10/1.10/1.10) because it is discounted 4 350 239
over five years. The nominal value of the stream of
five years of cash flows is $1,750 but the present value 5 350 217
of the cash flow stream is only $1,326. Total 1,750 1,326
What Is Net Present Value (NPV)?
Net present value (NPV) is the difference between the present value of cash inflows and
the present value of cash outflows over a period of time. NPV is used in capital budgeting
and investment planning to analyze the profitability of a projected investment or project.

NPV is the result of calculations that find the current value of a future stream of
payments, using the proper discount rate. In general, projects with a positive NPV are
worth undertaking while those with a negative NPV are not.
Net Present Value (NPV) Formula
If there’s one cash flow from a project that will be paid one year from now, then the
calculation for the NPV of the project is as follows:

Cash flow
NPV = 𝒕 − initial investment
𝟏+𝒊

Where:
i – required return or discount rate
t – number of time periods
Table 2. Net Present Value Analysis (5% and 10% Discount Rates)
Assume:
Capital Expenditure = 10,000
Useful life of expenditure = 5 years
Annual return from expenditure = 2,000
Value of investment at the end of the analysis period = 3,000
Discount rate = 5% and 10%

Capital Present Value of Cash Flows

Year Investment Annual Return Net Cash Flows
& Ending Value 5% Discount 10% Discount
0 -10,000 -10,000 -10,000 -10,000
1 2,000 2,000 1,905 1,818
2 2,000 2,000 1,814 1,653
3 2,000 2,000 1,728 1,503
4 2,000 2,000 1,645 1,366
5 3,000 2,000 5,000 3,918 3,105
Total 1,010 -555

Net Present Value PVCF (5%) = 2000/1.05 = 1,905

5% Discount Rates = $1,010 PVCF (10%) = 2000/1.10 = 1,818
10% Discount Rates = -$555 PVCF ending=5000/(1.05)5 =3,918
Profitability Index (PI)

Another measure to determine the acceptability of a capital investment is the

Profitability Index (PI). The Profitability Index is computed by dividing the present value
of cash inflows of the capital investment by the present value of cash outflows of the
capital investment. If the Profitability Index is greater than one, the capital investment is
accepted. If it is less than one, the capital investment is rejected.
A higher PI means that a project will be considered more attractive.

Present Value of Cash Inflows

Profitability Index =
Present Value of Cash Outflows
Profitability Index Rule = Accept investments if the
Profitability Index is greater than one and reject
investments if the Profitability Index is less than
one.
Table 3. Profitability Index Comparison Analysis
(5% and 10% Discount Rate)
PROJECT B
Present Value of Cash Flows
Year Cash Flow
5% Discount 10% Discount
0 -10,000 -10,000 -10,000
1 2,000 1,905 1,818
2 2,000 1,814 1,653
3 2,000 1,728 1,503
4 2,000 1,645 1,366
5 5,000 3,918 3,105
Total 1,010 -555

11,010
Profitability Index (5%) = = 1.101
10,000
9,445
Profitability Index (10%) = = 0.9445
10,000
The Profitability Index is positive (greater than one) with the five percent discount rate.
The Profitability Index is negative (less than one) with 10 percent discount rate. If the
Profitability Index is greater than one, the investment is accepted. If it is less than one, it
is rejected.
Internal Rate of Return (IRR)
Table 4. Internal Rates of Return Analysis
Another method of analyzing capital Cash Flows
investments is the Internal Rate of Return Year
(IRR). The Internal Rate of Return is the rate Project A Project B
of return from the capital investment. In other 0 -10,000 -10,000
words, the Internal Rate of Return is the 1 2,500 3,000
discount rate that makes the Net Present
Value equal to zero. As with the Net Present 2 2,500 3,000
Value analysis, the Internal Rate of Return can 3 2,500 3,000
be compared to a Threshold Rate of Return to 4 2,500 3,000
determine if the investment should move
5 2,500 3,000
forward.
Total 12,500 15,000

IRR 7.9% 15.2%

Table 4. Internal Rates of Return Analysis

Cash Flows
Year
Project A Project B
0 -10,000 -10,000
1 2,500 3,000
2 2,500 3,000
3 2,500 3,000
4 2,500 3,000
5 2,500 3,000
Total 12,500 15,000

IRR 7.9% 15.2%

Accounting Rate of Return

The term accounting rate of return (ARR) is a formula that reflects the percentage rate of
return expected on an investment or asset, compared to the initial investment's cost. The
ARR formula divides an asset's average revenue by the company's initial investment to
derive the ratio or return that one may expect over the lifetime of an asset or project. ARR
does not consider the time value of money or cash flows, which can be an integral part of
maintaining a business.

Average Annual Profit

ARR =
Initial Investment
Example, a business is considering a project that has an initial investment
of $250,000 and forecasts that it would generate revenue for the next five years.
Calculate the ARR:

Initial investment: $250,000

Expected revenue per year: $70,000
Time frame: 5 years
ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
ARR = 0.28 or 28%

How to Calculate the Accounting Rate of Return (ARR)

• Calculate the annual net profit from the investment, which could include revenue minus any annual
costs or expenses of implementing the project or investment.
• If the investment is a fixed asset such as property, plant, and equipment (PP&E), subtract any
depreciation expense from the annual revenue to achieve the annual net profit.
• Divide the annual net profit by the initial cost of the asset or investment. The result of the calculation
will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.
 References
• https://www.extension.iastate.edu/agdm/vdoperations.html
• https://www.toptal.com/finance/budgeting/capital-budgeting-process
• https://www.accountingnotes.net/financial-management/capital-budgeting/capital-budgeting-
meaning-need-process-and-classification-firms-economics/17293
• EcoWatch. "How Long Will Your Solar Panel Payback Period Be? https://www.ecowatch.com/solar -
panel-payback-period-2655204475.html”
Thank you for listening!!!