Chapter 8: CAPITAL BUDGETING

A capital expenditure is an outlay of funds made in the expectation of receiving future benefits.
Examples of capital expenditures are outlays for buildings, machinery, and research and development.
Capital budgeting, the planning and control of capital expenditures, is an area of decision-making in
which many executives still do not actively participate. In even the largest Philippine corporations,
approaches to capital-budgeting decisions are haphazard, unsystematic and, in not too few instances,
arbitrary.

Nevertheless, there are top executives who want capital-budgeting decisions to be their prerogative.
However, an examination of their methods would reveal that they follow some of the crudest criteria in
making capital-budgeting decisions. Take, for example, the criterion that is exclusively based on the
urgency of the capital outlay. In this method, a replacement or major repair has to be made because the
situation warrants it. There is not doubt that this criterion is valid in cases of destruction wrought by
typhoons, earthquakes, fires, and other fortuitous events.

But a company cannot just live from one emergency to another. Basing capital outlays on degree of
necessity alone is prima facie evidence of the incompetence of top management. It clearly shows that
the top executives are not performing their primary task of looking into the future, of planning to avoid
having to react to necessity, crisis, and urgency.

Pseudocriteria

In some cases, companies try to apply some quantitative measures of profitability in appraising
competing capital outlays. Unfortunately, many of these attempts still fall short of a sound system that
truly optimizes company welfare.

Let us examine two of what we can call “pseudocriteria.”

The first is the very popular payback period criterion. The payback period is defined as the length of time
required for the stream of future incomes Produced by an investment to equal the original cost of the
investment. If the annual net proceed from the investment is a constant amount, the payback period is
easily computed by merely dividing the total original cost by the annual income.

For example:
If the yearly net proceeds are unequal, they must be totalled until they equal the original investment.
The payback period then covers all the years corresponding to the periodic incomes included in this
total. Another example:

Therefore, the payback period is three years since the cumulative income at the end of three years
equals the initial investment.

The payback period criterion can be used in either of two ways. The decision maker could stipulate a
maximum payback period and reject all investment proposals whose payback periods exceed the
maximum. The criterion could also be used to rank various alternative projects: the one with the
shortest period is ranked first and the one with the longest period is ranked last.

The payback period as a capital-budgeting criterion has the following limitations: (l) it exaggerates the
importance of liquidity (ready conversion to cash) as a goal of the capital expenditure program of a firm;
(2) it does not measure profitability because it ignores the income that will be received after the
payback period; and (3) it does not take into consideration the time value of money because it places
incomes received at different times in the future on equal footing.

Despite the above defects, the payback criterion may be valid in some exceptional instances. The first is
a situation in which the firm is faced with great difficulties in generating cash internally and externally. If
liquidity is more important than profitability, it would be logical for the firm to accept only the projects
with a short payback, i.e., two years or less, since its main concern would be a very high “cash turnover.”

Another situation in which the payback period criterion is legitimate is that in which the firm faces an
environment fraught with uncertainties. Is the Government going to take over the firm in the next few
years? Will the firm’s product be completely obsolete soon? If a firm has reasonable grounds for fearing
such uncertain events, then it would be justified to demand the shortest payback period as possible.

Another one of these “pseudocriteria” is the accounting rate of return which is commonly used by
accountants. In equation form,
 P
Accounting Rate of Return =
C
Where P = average yearly net profits and

C = total cost of investment. This is computed by dividing the total estimated earnings of the
project by its expected useful life.

If the “accounting rate of return” is higher than the cost of capital, accept the proposal. If not, reject. In
theory, the cost of capital should be the rate of return that would leave the market price of the firm’s
stock unchanged. Many factors enter into the computation of the cost of capital: the dividends policy of
the firm, expectations of prospective investors regarding the future profitability of the firm, the firm’s
debt-equity ratio. For our purposes, it is sufficient to assume that the prevailing interest rate is the firm’s
cost of capital.

This criterion is at least more forward-looking than the payback period method. But like the payback
period method, it does not take into consideration the time value of money because it places incomes
received at different times in the future on equal footing.

Discounted cash flow

The discounted cash flow method for capital budgeting recognizes the time value of money. A peso
today is worth more than a peso to be received three Years from today because the peso today could be
deposited in a bank and could earn interest for three years. Because the discounted cash-flow method
incorporates the time value of money, it is the preferred method for capital budgeting decisions.

There are two variations of the discounted cash flow method: net present value (NPV) and internal rate
of return (IRR).

Net present value

In the net present value method, all cash flows are discounted to present value using the cost of capital
of the firm. As mentioned earlier, the prevailing interest rate is assumed as the firm’s cost of capital. In
equation form:
If the NPV is greater than 0, then the proposal is accepted; if it is less than 0, then it is rejected; and if it
is equal to 0, then the firm is indifferent.

Suppose a businessman is considering the purchase of a machine worth P 100,000 that is expected to be
obsolete in five years. Assume that it has no scrap value at the end of five years. The machine is
expected to bring the following yearly benefits.

The factors used above can be found in any basic book in finance or business mathematics.

The businessman will have to decide not to purchase the machine because its NPV is less than 0. He
would make more money by lending out his P 100,000 at the prevailing rate of interest of 15%.

Internal rate of return

The internal rate of return is the discount rate that equates the present value of the expected cash flows
with the cost of investment. In equation form:
The computed IRR is then compared to the company’s cost of capital. If IRR exceeds the cost of capital,
the project is accepted; if not, it is rejected. Suppose a businessman is considering the purchase of a
machine worth P 10,000 that is expected to be obsolete in four years. Assume also that it has no scrap
value at the end of four years. The machine is expected to bring these yearly benefits.

The equation can be solved by trial and error. Using r = 29% as the first approximation, we compute for
the value of the right-hand side of the equation.

To get a more exact value of r, interpolation can be used

28% P10,015.10

X 10,000.00

29% 9,818.80

Interpolating, we find r = 28.08% Assuming that the cost of capital is 15%, then the businessman should
buy the machine because its IRR (28.08%) is greater that his cost of capital (15.00%).
The ranking process

The firm is often faced with the question of deciding which projects to undertake among different
possible projects. Since the financial resources of a firm is limited, it cannot undertake all the possible
projects that may b? proposed by different managers of the company. Therefore, there is a need to rank
the projects. As long as the projects are mutually exclusive i.e., independent of one another, the
decision of what projects to undertake can readily be made. The projects can be ranked using either
NPV or IRR.

Assuming a cost of capital of 15% the firm should undertake Projects A, B, C, and D since their IRRs are
greater than 15%. If the firm could muster only a total of P 150,000 from retained earnings and debt and
equity financing, then only Projects A and B should be undertaken.

The firm should undertake Projects 1, 2, 3, and 4 since their NPVs are greater than 0. If the firm could
muster only a total of P200,000, then only Projects 1, 2, and 3 should be undertaken.

NVP versus IRR

In evaluating investment proposals, which method (NPV or IRR) should be used? In most cases, the NPV
and the IRR lead to the same acceptance or rejection decision. In some cases, like the evaluation of two
mutually exclusive investment proposals, the NPV and IRR may give conflicting results. The conflict
between these two methods is due to their assumption of the reinvestment rate. NPV assumes that the
cash inflows at the end of the first years of the project can be invested at a rate equivalent to the cost of
capital. IRR, on the other hand, assumes that the cash inflows can be invested at a rate equivalent to the
computed internal rate of return.

Conceptually, the NPV method is considered superior to the IRR method. With the IRR method, the
reinvestment rate depends on the computed IRR, i.e., for projects with high IRR, the reinvestment rate
would be high while for projects with low IRR, the reinvestment rate would be correspondingly low.
With NPV, the reinvestment rate is the same for each proposal. It is the firm’s cost of capital.

However, the IRR method can be modified for two mutually exclusive investment proposals to give the
same decision result as NPV.

Dealing with depreciation

The concept of depreciation is often mind-wracking to a firm manager. At times, he is led to believe that
depreciation charges create a fund that can be used for cash payments. At other times, he gets the
impression that depreciation is merely an accounting device to allocate the original cost of a fixed asset
to the years of the asset’s productive life. Then he also hears the economist saying that the real
economic value of a piece of machinery is the object of depreciation.

To the accountant, depreciation is merely a process of cost allocation. Accounting depreciation follows
the accounting principle of matching cost with revenue. Since an equipment has a finite useful life, the
cost of the equipment must be allocated over its useful life.

To the economist, depreciation must reflect the real economic value of a fixed asset. The depreciation
charge to the economist must represent the real decline in market value of the equipment. If rapid
obsolescence makes the equipment’s market value drop precipitously, the economist would insist on
charging a big chunk of original cost as depreciation expense. If the cost of replacing the equipment has
gone up substantially, the economist would try to estimate the realistic amount that would prevent
erosion of the firm’s capital structure and would charge the corresponding depreciation.

It is interesting to note that in some firms, the accountants follow the economist’s depreciation concept
for internal reporting purposes.

The replacement problem

A clear understanding of depreciation charges is. Crucial to certain capital budgeting decisions. One of
these is the problem of whether to replace a machine that is still useful with a new improved model. A
machine that is still useful normally has a value corresponding to the non-depreciated part of its original
cost. What should be done with the book value? Does it enter into the capital budgeting calculations?

Let us look into a simpler but related decision a firm has to make. Suppose a firm has to choose between
two models that produce identical products or render identical services. One model is more costly than
the other, but its operating cost is lower. Assume that the two machines have identical useful lives.
Machine A is worth P75,000 while Machine B costs P50,000. Machine A will save the company P 15,000
a year in operating costs while Machine B will save the company P 10,000 a year. Both machines have
productive lives of 10 years.

The decision would rest on the firm’s cost of capital. If the firm’s cost of capital is 15%, then Machine A
should be preferred because the NPV of the above equation using a 15% discounting rate is P94.

NPV = 5,000 (5.0188) – 25,000 = 94

The factor used above is obtained from any basic book in finance or business mathematics showing the
cumulative present value of PI .00 received at different periods in the future at varying interest rates.
This table is convenient to use when the net inflows through the years are uniform.

However, if the firm’s cost of capital is 16%, then Machine B should be preferred over Machine A
because the NPV of the above equation using a 16% discounting rate is P834.

It must be noted that depreciation is not included in the calculations. It should be recalled that
depreciation, whether of the accounting or economic variety, does not involve an actual cash outlay. In
comparing the costs of operations for the two machines, only costs requiring actual cash outlay should
be included. Depreciation is relevant only when taxes are considered. Since depreciation is an expense
included in the calculation of net income, it would affect the net profits of the firm and therefore the
amount of tax to be paid by the firm.
The problem becomes complicated if one machine has already been acquired and currently being used
and the other is still to be bought. Should the purchase price of the new machine be compared to the
book or non depreciated value of the old one? Again, we have to remember that the undepreciated cost
has already been spent, i.e., it is already sunk cost. Of course, the old machine can be traded in or can be
sold as scrap. What is relevant to the replacement criterion is hot the book value of the old machine but
its current trade-in or scrap value.

How then should the firm decide about replacing an old machine with a new and better model? The
savings in operating costs should once more be determined. In this case, however, it would not be
realistic to assume the same years of life for the two machines. The new one will undoubtedly outlive
the old one. Thus, after the estimated life of the old machine is over, the net income (not only cost
savings) from the newer model should be included in the computation. The resulting criterion will be:

Where S = cost savings

P = net profit from the new machine after the life of the old one is over

n = remaining life of the old machine

m= total life of new machine

r = cost of capital

T = scrap or trade-in-value of the old machine

C = cost of the new machine

It is assumed in the above formula that neither the new nor the old machine has a scrap value after its
useful life is over.

HIGHLIGHTS

1. Capital budgeting is the planning and control of capital expenditures - which are outlays of funds
made in the expectation of receiving future benefits.

2. An examination of the criteria that top executives use in making capital budgeting decisions
reveal that crude methods are usually employed. Two of these are called “pseudocriteria.” The
first is the very popular payback period criterion—the length of time required for the stream of
future incomes produced by an investment to equal the original cost of the investment. Another
one is the accounting rate of return which is commonly used by accountants. Neither of these
two methods take into consideration the time value of money since they lead the decision
maker to place incomes received at different times in the future on equal footing.
3. On the other hand, there are more preferable methods for better capital budgeting decisions.
There is the discounted cash flow method which recognizes the time value of money.

In the net present value method, all cash flows are discounted to the present at a rate equal to
the cost of capital of the firm.

4. The internal rate of return is the discount rate that equates the present value of the expected
cash flows with the cost of investment. Since financial resources of a firm is limited, it cannot
undertake all the possible projects that may be proposed by different managers of the company;
hence, the need to rank the projects. As long as the projects are independent of one another,
the decision on what projects to undertake can readily be made by using either the net present
value or the internal rate of return.

5. The concept of depreciation is one crucial aspect of capital-budgeting decisions, especially in

machine replacement problems. It must be recalled that depreciation, whether of the
accounting or economic variety, does not involve an actual cash outlay and is relevant only
when taxes are considered.