MABINI COLLEGES, INC.

Daet, Camarines Norte

COLLEGE OF BUSINESS ADMINISTRATION

And ACCOUNTANCY
1st Sem., S.Y.2022-2023

GEC Elect 2 – Business Finance

MODULE 5
Title: CAPITAL BUDGETING

Name of Student:
Course/ year:
Class Schedule:
Date Submitted:

Module Overview:

In Module 5, you will learn about the Capital Budgeting. The topic aims to present capital budgeting
as an important segment of business finance. Among those included are the relevant concepts
pertaining to investment, valuation, risk, and uncertainty.

Learning Outcomes

After completing this module, students must have:

● Know the basic terms and objectives of capital budgeting
● Understand the Capital Budgeting System
● Learn the evaluation of Proposed Capital Expenditures
● Know the Methods of Economic Valuation
● Understand risk, uncertainty and sensitivity

LECTURE NOTES
Read this…

CAPITAL BUDGETING
A. BASIC TERMS IN CAPITAL BUDGETING

For a better understanding of capital budgeting concepts, the following terms are defined
and explained: capital expenditures, capital budgeting, valuation, and investments.
1. Capital Expenditures

The term capital expenditure refers to substantial outlay of funds the purpose of which is to
lower costs and increase net income for several years in the future. It includes expenditures that tie
up capital inflexibility for long periods. It covers not only outlays for fixed assets but also
expenditures for major research on new products and methods and for advertising that has
cumulative effects.

Classes of Capital Expenditures. Capital expenditures may be classified into the following:

1. replacement investments – this refers to investments on replacement of worn-out or obsolete

facilities;

2. expansion investments – this type of expenditure will provide additional facilities to increase the
production and/ or distribution capabilities of the firm;

3. product-line or new market investments – this refers to expenditures on new products or new
markets, and on improvement of old products with the combined features of replacement and
expansion investments.

4. investments in safety and/or environmental projects – these are expenditures necessary to

comply with government orders, labor agreements, or insurance policy terms. These are sometimes
called mandatory investments or non-revenue producing projects.

5. strategic investments – these are investments designed to accomplish the overall objectives of
the firm.

6. other investments – this catch-all term includes office buildings, parking lots, executive aircraft.

2. Capital Budgeting

The planning and control of capital expenditures is referred to as capital budgeting. This activity is
essential because it provides a systematic evaluation of the firm’s alternative. It helps management
in choosing an alternative that will provide the best yield for the company.

3. Valuation

Management is, at times, confronted with the problem of evaluating a proposal. When the
proposal’s real worth to the firm is determined, the process is called valuation.

4. Investment

An investment is made when a firm spends some of its funds for the establishment of a project. By
doing so, the opportunity to use the same funds in other possible projects is lost.

Investments take two forms: (1) initial; and (2) later. Initial investment refers to the
amount that has been devoted to a project until it generates cash inflows from operations.
Expenditures made after the first cash inflow is called later investments.

B. OBJECTIVES OF CAPITAL BUDGETING

The objectives of capital budgeting are the following:

1. establishing priorities;

2. cash planning;

3. construction planning;

4. eliminating duplication; and

5. revising plans.

1. Establishing Priorities

The resources of the firm are said to be limited. The total number of opportunities available for
investment cannot all be accommodated by the firm. Capital budgeting will help to solve this
difficulty. This is possible because investment priorities are established in capital budgeting.

2. Cash Planning

The objectives of the cash planning activities of the firm is to ensure the availability of funds that will
be sufficient to meet its cash requirements, including those concerning the acquisition of capital
assets. A periodic cash expenditures estimate included in the capital budget helps to attain such
objective.

3. Construction Planning

The objective of construction planning is to minimize the period expended for the construction or
acquisition of a capital asset. The construction plan, a requirement for capital budgeting, will be
presented before the capital budget is prepared. This requirement ensures the preparation of such
plans.

4. Eliminating Duplication

A centralized capital budgeting activity will help identify efforts undertaken at various levels
in a decentralized organization. The duplication of efforts, as a result, will be minimized if not totally
eliminated.

5. Revising Plans

Changes in the environmental factors may require appropriate revisions in the authorization
of investments projects which include expected profitability, construction cost, and the timing of
start-up, where coordination with related activities is essential. Such requirements will be made
obvious by a good capital budgeting system. A timely response to such problems, then becomes a
possibility.

C. THE CAPITAL BUDGETING SYSTEM

The capital budgeting system is composed of the following:

1. preparation and submission of budget requests;

2. approval of budget;

3. request of appropriation;

4. submission of progress reports; and

5. post approval reviews.

1. Budget Requests

Budget requests are those made to include in the corporate budget capital projects which
are felt to be desirable by those in the lower organization levels.

The budget request contains the following:

1. project title;

2. cost; including estimates on:

a. fixed capital

b. working capital

c. non-operating outlays

d. others, including opportunity costs;

3. priority rating of the project;

4. profitability of the project;

5. timing or the ability to adhere to a construction schedule;

6. financing method;

7. project classification; and

8. project narrative.

2. Approval of the Budget

The approval of the budget is a process which requires the following steps;

1. budget request are forwarded to top management;

2. top management decides which projects to recommend to the board of directors;

3. top management sends recommendations to the board of directors;

4. the board of directors approves or disapproves the recommendations; and

5. top management informs projects sponsors of the action taken on their projects.

3. Request for Appropriation

After the approval of the budget, the next step undertaken is getting an appropriations
request approved. The officers and managers of a corporation are usually given the authority to
approve appropriations requests up to certain established limits.

The appropriations request usually contains the following:

1. the request and authority section – this serves to identify the originator and the project;
2. the narrative section – this details the requesting entity’s justification for undertaking the
proposal. This section normally includes the following:

a. proposal;

b. objectives;

c. conceptual framework;

d. alternatives; and

e. sensitivity and risk.

3. supporting documentation section – this contains cost estimates and the results of market studies
and financial analysis.

4. Submission of Progress Reports

Progress reports are submitted at regular intervals for the following purposes:

1. to review the accuracy of the expenditures forecasts;

2. to provide updated expenditures forecasts; and

3. to verify the assumptions and economics underlying the acceptance of individual projects.

5. Post Approval Reviews

Post approval reviews are required to satisfy the following objectives:

1. to provide management with a standard method of evaluating the abilities and judgment of
project sponsors;

2. to identify errors or patterns of error in judgment which can be avoided in future similar
situations; and

3. to help ensure that the quality and accuracy of information attains the highest feasible standards.

D. EVALUATION OF PROPOSED CAPITAL EXPENDITURES

Proposed capital expenditures should be scrutinized since they involve large outlays of funds. A
number of primary factors should be considered by management. These are the following:

1. Urgency. Decisions should be made as quickly as possible for requirements that are urgent.

2. Repairs. Management should consider the availability of spare parts and maintenance experts.
When these are critical and they are not available, the concerned proposal should be ruled out.

3. Credit. This factor should be considered in the sense that some credit terms may be highly
favorable to the company.
4. Non-Economic Factors. These refer to social considerations, and other non-economic persuasions
and preferences.

5. Investment Worth. This refers to the economic evaluation of a certain proposal.

6. Risk Involved. This refers to the uncertainty of an expected return.

E. METHODS OF ECONOMIC EVALUATION

Since the primary objective of the firm is to make profits, every business activity should be directed
towards achieving this end. Capital investments are not exempted from this requirement. It is,
therefore, a requirement that investment proposals should be analyzed and a determination of their
economic value to the firm should be made.

There are three basic methods of evaluating proposals. These are composed of the following: (1) the
payback method; (2) the average of return methods; and (3) the discounted cash flow methods.
These methods will be discussed using data indicated in Exhibit 3.

Exhibit 3

A SAMPLE INVESTMENT PROPOSAL

FOR THE PURCHASE OF A MACHINE
Acquisition Cost P 10,000,000
Economic Life 10 years
Salvage Value P 100,000
Earnings and Costs per
Income 5,000,000
Expenses - 2,000,000
Net Income before fax ond depreciation 3,000,000

Less: Depreciation (Straight line) 1,000,000

Net Income Before Tax 2,000,000

Less: Income Tax 620,000
Average Net Annual Earnings 1, 380,000

Cash Inflows Per Year = Net Earnings + Depreciation = P2,380,000

1. The Payback Method

The payback method determines the number of years required to recover the cash investment made
on a project. The recovery of cash comes from the cash inflows generated from the project. The
formula used is as follows:

Payback period = Cost

Annual Cash Inflow

Substituting data from Exhibit 3, the payback period is presented as:

Poybock period = P 10,000,000

 = 4.2 years
P 2,380,000

The cost of the machinery is expected to be recovered in full after 4.2 years. The payback method is
simple and easy to understand. When the firm does not favor exposure of its own investments for
longer periods, the proposal is rejected. This decision can be made quickly with the use of the
payback method.

The payback method, however, has some disadvantages. These are the following:

1. it does not consider the time value of money;

2. the accept-reject criterion is stated in terms of years rather than at a discount rate;

3. the firm's attention is focused on cash flow rather than on rate of return;

4. careful projection of the timing of the investment outlays and the year-by-year projection of cash
inflows over the entire life of the proposal are not encouraged; and

5. the salvage value of the proposal is not considered.

2. The Average Rate of Return Methods

The average rate of return methods consists of the following: (1) the average return on investment;
and (2) the average return on average investment.

a) Average Return on Investment. This method is simple and is easy to compute. It shows the ratio
of the average cash inflow to the investment. The formula is as follows:

Average return on investment = Annual cash Inflows

Investment Outlay

Substituting data from Exhibit 3, we have

Average return on investment = P 2,380,000

= 24%
P10,000,000
The advantage of this method is that it is very easy to compute and the available accounting data
may be readily used. Its main a disadvantage, however, is that it does not take into account the time
value of money.

b) Average Return on Average Investment. This method is similar to the average return on
investment method except that the effect of the depreciation charge on the investment is taken into
consideration. The formula is as follows:
 Average return = Annual Cash Inflow
On Average Investment Investment/2

Substituting data from Exhibit 3, the computation is shown as follows:

Average Return P 2, 380, 000

on Average = = 48%
Investment P 10, 000, 000

Under this method, the initial investment outlay is divided by two to derive the average balance of
the investment as it is decreased periodically by the depreciation charge. This method is also simple
and easy to compute. The true rate of return is, however, overstated Moreover, it does not also
consider the time value of money.

3. Discounted Cash Flow Methods

The time value of money is recognized under the discounted cash flow methods. There are
two approaches available: (1) the net present value method; and (2) the internal rate of return
method.
Under these approaches, all future values of a proposal are discounted and compared to the values
of other proposals. The discounting factor makes these two methods preferred by users in
evaluating capital expenditure proposals.

a) Net Present Value Method. Under this method, a desired rate of return is used tor discounting
purposes. The term discounting is synonymous to the calculation of the present worth of a future
value as presented in Module 3. The present value concept is applied to the cash flows of a proposal
and are discounted at the desired rate of return for the periods involved. The sum of the present
values of the outflows (i.e, the cost of the machine in Exhibit 3) is compared with the sum of the
present values of the inflows (i.e. net income plus depreciation).

If the discounted cash inflows are larger than the discounted cash outflows, the project will earn
more than the desired rate of return. The proposal is accepted.

Conversely, if the discounted cash outflows are larger than the discounted cash inflows, the project
will not be able to generate the desired minimum rate of return. The proposal is, then, rejected. To
illustrate, the following formula and computation are presented as follows:

NPV = PVCI -PVCO

where NPV = net present value (also the net value derived after deducting the discounted cash
outflow from the discounted cash inflow)

PVCI = discounted value of the anticipated cash inflows

PVCO = discounted value of the anticipated cash outflows

The formula for finding the present value of an expected cash inflow is as follows:
PV = A
(1 + R)n
 where: A = expected cash inflow

R= desired rate of return

n = number of years the cash inflow is expected

If the desired rate of return in Exhibit 3 is 25%%, the cash inflows for the ten-year period may be
computed to determine the present value for each year. For example, the present value of the cash
inflow for the second year is computed as follows:

PV of cash inflow, P2, 380, 000 P2, 380, 000

Year 2 = =
(1 + .25)2 (1.25)2
 
= P 1,523, 200

Applying the present value formula, the present values of the cash flows indicated in Exhibit 3 will
appear as follows:

Cash Flow Future Value Present Value

Outflows - P10, 000, 000
Inflows

1st year P 2, 380, 000 P 1, 904, 000

2nd year 2, 380, 000 1, 523, 000
3rd year 2, 380, 000 1, 218, 560
4th year 2, 380, 000 972, 840
5th year 2, 380, 000 779, 870
6th year 2, 380, 000 623, 900
7th year 2, 380, 000 499, 120
8th year 2, 380, 000 399, 290
9th year 2, 380, 000 319, 430
10th year 2, 380, 000 255, 550
10th year (salvage value) 100, 000 10, 730

TOTAL P 23, 900, 000 P 8, 508, 490

To find out the net present value of the proposal presented in Exhibit 3, the formula earlier stated is
applied as follows:

NPV = PVCI – PVCO

= P8, 508, 490 - P 10,000, 000
= - (P1,491, 510)

The computation shows a negative net present value indicating that the sum of the discounted
cash outflow is greater than the sum of the discounted cash flows. On this basis, the proposal is
rejected.

b. Internal Rate of Return Method. This method and the net present value method use the discount
rate as a factor. The difference , however, is that under the internal rate of return method, the
discount rate is not given. Rather, it becomes the object of computation. The discount rate which
will yield a net present value of zero or one approximating zero is the correct discount rate. This
means that the present value of the cash inflows is equal to the present value of the cash outflows.
The correct discount rate may be determined by trial and error.

The acceptability of the proposal will depend on the prevailing interest rates as compared
with the computed correct discount rate. If the prevailing rate is higher, the proposal is rejected, and
conversely, if it is lower, the proposal is accepted.

In our computation of the preceding method, a negative net present value of P1, 491, 510
was shown. Since the discount rate of 25% was used, an attempt to find the correct discount rate
will be made using one which is lower than 25%. Computations using various discount rates
applicable to the example shown in the preceding method are shown below.

Computations at Various Discount Rates

Cash Flow Future Flow Present Value

Outflow (at 22%) (21%)

(at 20%)
Inflow P10, 000, 000 P10, 000,
000 P10, 000, 000
1st year P 2, 380, 000 P 1, 950, 000 P 1,966, 694
P 1, 983, 330
2nd year 2, 380, 000 1, 599, 030 1, 625, 570
1, 652, 570
3rd year 2, 380, 000 1, 310, 680 1, 343,
440 1, 377, 310
4th year 2, 380, 000 1, 074, 320 1, 110, 280
1, 147, 760
5th year 2, 380, 000 885, 090 917, 590
956, 460
6th year 2, 380, 000 721, 780 758, 340
797, 050
7th year 2, 380, 000 591, 640 626, 720
664, 210
8th year 2, 380, 000 484, 950 517, 950
553, 510
9th year 2, 380, 000 397, 500 428, 060
461, 250
10th year 2, 380, 000 325, 820 353, 770
384, 380
Salvage Value 100, 000 13, 680 14,
860 16, 150
Total Inflows P 9, 350, 800 P9, 663,
520 P9, 994, 180

The net present values at different discount rates may now be computed as follows:
 a. NPV at 22% discount rate = PVCI – PVCO
= P 9, 350, 800 – P 10, 000, 000
= - (P649, 200)

b. NPV at 21% discount rate = PVCI – PVCO

= P 9,603, 520 – P 10,000, 000
= - (P 396, 480)

c. NPV at 20% discount rate = PVCI – PVCO

= P9, 994, 080 – P10, 000, 000
= - (P5,920)

The results of the computation show net present values a different discount rates.
Obviously, the discount rate which yield the net present value nearest to zero is 20%. If the standard
interest rate is below 20%, the proposal is acceptable.

F. RISK, UNCERTAINTY, AND SENSITIVITY

Among the primary factors considered in the evaluation of proposed capital expenditures, the
uncertainty of expected returns pose a challenge to one who manages the firm's finances. In the
preceding discussion of the methods of economic evaluation, it is assumed that the returns are
certain. This is misleading because one can never be fully certain about the results that will be
obtained from an investment.

Meaning of Risk, Uncertainty, and Sensitivity

Risk is defined in Module 3 as the uncertainty concerning loss. Uncertainty, as a term is

synonymous to risk, and as such, they will be used interchangeably in the discussions that will
follow. At this point, however, it is worth mentioning their similarity and difference. Uncertainty and
risk both refer to variations of actual values from average or expected values. They differ, however,
in the cause of the variations. The variations referred to in risks is caused by chance, while the
variations referred to in uncertainty is caused by errors in estimating.

Sensitivity refers to the effect on investment of changes in some factors, which were not previously
determined with certainty.

Factors Affecting Risk

There are four (4) primary factors involved in the evaluation of risks pertaining to capital
expenditures. These are the following: (1) possible inaccuracy of the figures used in the evaluation;
(2) type of business involved; 3) type of physical plant and equipment involved; and (4)
the length of time that must pass before all the conditions of the evaluation become fulfilled.

Estimates could be wrong or inaccurate at times. Accuracy however, depends on how the
figures were obtained. Estimates can be made either by scientific methods or by plain guesswork. A
certain degree of reliability can be assigned to the former and none to the latter method.

Every type of business has its own degree of risk that is peculiar to itself. One line may be
more stable in terms of demand than the others. The demand for food, for instance, is more stable
than the demand to specialized consumer items like hair dyes. Also, more risk is involved in the
operations of a new venture than a business with a successful record of past performance.

Physical plants and equipment are also subject to risks. Some may become obsolete before
their economic life expires. The demand for special equipment, like that tor DVD players, may
diminish
without warning

Finally, estimates involving longer periods are usually more prone to inaccuracies than
those involving shorter periods. This is true because, most often, changes in the environment
happen sooner
than expected.

Sensitivity Analysis

The expected returns on investment may change as changes in some relevant factors
happen. Capacity utilization at various levels, for instance, may yield various rates of return on
investment. As
capacity utilization depends mostly on some relevant factors like the availability of raw materials, it
is important that an analysis of the expected returns be made on various utilization levels. This is
actually finding the sensitivity of an investment to various changes.

Sensitivity analysis is applicable to capital expenditures useful involving the purchase or construction
of a plant. It is useful for management to know the expected returns that will be generated by the
various capacity utilization in the operation of the plant. Consider the following example:

Effect of Various Capacity Operation

on Rate of Return Pertaining to a Plant

Capacity Operation
100% 75% 50%

Annual Revenue P10, 000,000 P 7, 500, 000

P5, 000, 000
Annual Expenses 7, 000, 000 5, 500, 000 4,
000,000
Net Income 3, 000, 000 2, 000, 000
1, 000, 000
Rate of Return 43% 36%
25%

The example cited above indicates that by using the plant at full capacity, the return will
be at its highest level, which is 43%. However, if because of some factors, this is not possible, the
expected
return will still be 36% at 75%o capacity operation, and 25% at 50% capacity operation. If the
prevailing interest rate is below 25%, the proposal should be accepted.
 Focus Questions
Thinking to Learning
Thoroughly
Discuss your answers on the following questions briefly:
(If means of learning and teaching is done online, the following questions will be asked to students
during video conference or be posted by the teacher in the Google Class Stream/ Wall as a discussion
point.)

1. What is capital budgeting? Explain the reasons why this activity cannot be disregarded by
management.
2. Cite examples of the different classes of capital expenditures.

3. Cite specific examples applicable to each of the six primary factors that must be considered
by management in the evaluation of proposed capital expenditures.

4. Why must risk, uncertainty, and sensitivity be included as factors in the evaluation of
proposed capital expenditures?

5. Discuss the importance of obsolescence as a risk factor.

Learning Activities
Enriching What Have You
Learned

A firm is considering the purchase of a forty-year old building. The following pertinent data
were provided:

Acquisition Cost P12,000,000

Economic Life (remaining) 10 years

Salvage value P200,000

Annual Rental Income P5,000,000

Annual Expenses P3,000,000

Net Income before Tax and Depreciation P2,000,000

Depreciation (straight line method) P1,000,000

Net Income before Tax P1,000,000

Income Tax (withheld by lessors) P50,000

Average net Annual Earnings P950,000

Required: Evaluate the proposal using the three basic methods.

Assessment
Testing How Far Have You
Learned
(In Google Classroom, this will be posted as a written task. There will be a deadline to be set for the
submission of answers)

True or False. Write I like to if the statement is True and Move it if the statement is False.

_____________ 1. Capital budgeting is an important segment of business finance. It includes

relevant aspects of investment, valuation, risk, and uncertainty.
_____________ 2. The substantial outlay of funds for the purpose of lowering costs and increasing
net income for several years in the future is called capital expenditure.
_____________ 3. The planning and control of capital expenditure is called valuation.
____________ 4. When the real worth to the firm of any proposal for capital expenditure is
determined, the process is called valuation.
_____________ 5. Sensitivity refers to the effect on investment of changes in some factors, which
were not previously determined with certainty.

_____________ 6. Under the discounted cash flow method, a desired rate of return is used tor
discounting purposes.
_____________ 7. Credit as a factor should be considered in the sense that some credit terms may
be highly favorable to the company.

_____________ 8. The payback method determines the number of years required to recover the
cash investment made on a project.
_____________ 9. This Average Return on Average Investment method is similar to the average
return on investment method except that the effect of the depreciation charge on the investment is
taken into consideration.

_____________ 10. Risk is defined as the uncertainty concerning loss.