Elements of Capital Budgeting

1. Net Investment – the initial cash outlay that is required to obtain future returns. It is the net
cash flows at time zero (today).

*** if acquisition decision, disregard the old asset.

2. Cash Flows – the expected returns directly attributable to the investment project.

Notes:

 Use cost savings if the

purpose is to reduce cost
or outflows. If for
profitability, use cash
operating income.
 Cash OI: Sales – Var. Costs
– Cash fixed cost (dep.
Should not be included)
 Incremental depreciation:
Dep. of old asset – Dep. of
new asset
 ATCF = Net investment/Payback period
3. Discount Rate – a.k.a minimum required rate of return, the weighted average cost of capital of
long-term funds obtained from different sources. (Used in computing present value)

Techniques in Capital Budgeting

Non-Discounted Techniques

1. Accounting Rate of Return (Book Rate of Return)

ARR = Incremental Net Income / Net Investment
Average investment: Orig. Investment + Salvage
Value / 2
Net investment could be original or average
investment. If the problem is silent, use average
investment.
(ATCF – Dep.)/Initial Investment = ARR

2. Payback Period – the length of time it takes

recover the original cost.
If cash flows are even:
PP = Net Investment / Cash Flows After-tax
If uneven, compute manually.

3. Bail-Out Period – computed manually

Discounted Techniques

1. Discounted Payback Period

 2. Net Present Value – It pertains to the possibility of the investment’s return.

If NPV is negative, discontinue.

IF NPV is 0 or 1, continue.

3. Internal Rate of Return – it is the true rate of return under capital budgeting. The net present
value is zero.
4. Profitability Index