CAPITAL BUDGETING

CAPITAL BUDGETING – the process of identifying, evaluating, planning, and financing capital
investment projects of an organization.

CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS

1. Capital investment decisions usually require large commitments of resources.
2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short-term decisions.
4. Capital investment decisions involve so much risk and uncertainty.

CAPITAL INVESTMENT FACTORS

1. Net investment 2. Net Returns 3. Cost of Capital

🞵 NET INVESTMENT = costs or cash outflows less cash inflows or savings incidental to the acquisition
of the investment projects
Costs or cash outflows:
1. The initial cash outlay covering all expenditures on the project up to the time when it
is ready for use or operation:
Ex. Purchase price of the asset
Incidental project-related costs such as freight, insurance taxes, handling,
installation, test-runs, etc.
2. Working capital requirement to operate the project at the desired level
3. Market value of an existing, currently idle asset, which will be transferred to or utilized
in the operations of the proposed capital investment project.
Savings or cash inflows:
1. Trade-in value of old asset (in case of replacement).
2. Proceeds from sale of old asset to be disposed due to the acquisition of the new
project (less applicable tax, in case there is gain on sale, or add tax savings, in case
there is loss on sale).
3. Avoidable cost of immediate repairs on old asset to be replaced, net of tax.

🞵 NET RETURNS
1. Accounting net income
2. Net cash inflows

🞵 COST OF CAPITAL
Cost of Capital – the cost of using funds; it is also called hurdle rate, required rate of return, cut-off
rate, opportunity cost of capital.
– the weighted average rate of return the company must pay to its long-term
creditors and shareholders for the use of their funds.

Computation of COST OF CAPITAL

Source Capital Cost of Capital
After-tax rate of interest i (1 –
Creditors Long-term debt TxR)
Stockholders:
Preferred dividends per
share
Preferred Preferred stock
Current market price or
Net issuance price

Common Common stock CAPM or DDM

 1. CAPITAL ASSET PRICING MODEL (CAPM)
R = RF + ß(RM – RF)
where: R = rate of return
RF = risk-free rate determined by government securities
ß = beta coefficient of an individual stock which is the correlation
between the volatility (price variation) of the stock market and
the volatility of the price of the individual stock
Example: If the price of an individual stock rises 10% and
the stock market 15%, the beta is 1.5.
RM = market return
(RM – RF) = market risk premium or the amount above risk-free rate
required to induce average investors to enter the market

2. THE DIVIDEND DISCOUNT MODEL (OR DIVIDEND GROWTH MODEL)

a. Cost of Retained Earnings D1

P0 +G
where: P0 = current price
D1 = next dividend
G = growth rate in dividends per share (it is assumed that the
dividend payout ratio, retention rate, and therefore the EPS
growth rate are constant)

b. Cost of New Common Stock

D1
= P0 (1 – Flotation Cost) + G
Flotation Cost = the cost of issuing new securities

COMMONLY USED METHODS OF EVALUATING CAPITAL INVESTMENT PROJECTS

1. Methods that do not consider the time value of money
a. Payback
b. Bail-out
c. Accounting rate of return
2. Methods that consider the time value of money (discounted cash flow methods)
a. Net present value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return

METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY

Net cost of initial

PAYBACK
investmentPERIOD the length of time required by the
= Annual net cash inflows =
project to return the initial cost of
investment.
Advantages:
1. Payback is simple to compute and easy to understand. There is no need to compute or
consider any interest rate. One just has to answer the question: “How soon will the
investment cost be recovered”?
2. Payback gives information about liquidity of the project.
3. It is a good surrogate for risk. A quick payback period indicates a less risky project.

Disadvantages:
1. Payback does not consider the time value of money. All cash received during the
payback period is assumed to be of equal value in analyzing the project.
2. It gives more emphasis on liquidity rather than on profitability of the project. In other
words, more emphasis is given on return of investment rather than the return on
investment.
3. It does not consider the salvage value of the project.
4. It ignores the cash flows that may occur after the payback period.
 BAIL-OUT PERIOD – cash recoveries include not only the operating net cash inflows but also
the estimated salvage value or proceeds from sale at the end of each year
of the life of the project.

ACCOUNTING RATE OF RETURN – also called book value rate of return, financial statement
method, average return on investment and unadjusted rate of return.
Average annual net income
Accounting Rate of Return = Investment
Advantages:
1. The ARR computation closely parallels accounting concepts of income
measurement and investment return.
2. It facilitates re-evaluation of projects due to the ready availability of data from the
accounting records.
3. This method considers income over the entire life of the project.
4. It indicates the project’s profitability.

Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not consider the time
value of money.
2. With the computation of income and book value based on the historical cost
accounting data, the effect of inflation is ignored.

METHODS THAT CONSIDER THE TIME VALUE OF MONEY (Discounted Cash Flow Methods)
NET PRESENT VALUE
Present value of cash inflows
– Present value of cash
outflows Net Present
Value

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as the reinvestment rate
4. Easy to apply.
Disadvantages:
1. It requires predetermination of the cost of capital or the discount rate to be used.
2. The net present values of different competing projects may not be comparable
because of differences in magnitudes or sizes of the projects.

PROFITABILITY INDEX
Total present value of cash inflows
Profitability Index = Total present value of cash
outflows

DISCOUNTED CASH FLOW RATE OF RETURN – the rate of return which equates the present
value (PV) of cash inflows to PV of cash outflows.

1. Determine the present value factor (PVF) for the discounted cash flow rate of return
(DCFRR) with the use of the following formula:
Net Cost of Investment
PVF for DCFRR =
Net cash inflows
2. Using Table 2 (present value annuity table), find on line n (economic life) the PVF
obtained in Step 1. The corresponding rate is the DCFRR.

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes true return of project
 Disadvantages:
1. Assumes that the IRR is the re-investment rate.
2. When project includes negative earnings during their economic life, different
rates of return may result.

PAYBACK RECIPROCAL – a reasonable estimate of the discounted cash flows rate of return,
provided that the following conditions are met:
1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.

Net cash inflows

Payback Reciprocal = Investment

or
1
Payback Reciprocal =Payback period