Capital Budgeting
- Capital Budgeting is the process of
identifying, evaluating, planning and financing
capital investment projects of an organization
Project Classification
1. Replacement: Maintenance of Business
2. Replacement: Cost Reduction
3. Expansion of Existing Products or Markets
4. Safety and Environmental Projects
5. Other Projects (Office Buildings, Parking Lots,
Executive Aircraft)
Capital Investment Projects
1. Large commitments of resources
2. Long-term commitments
3. More difficult to reverse than short-term decisions
4. Involve so much risk and uncertainty
Factors affecting Long term decisions
1. Estimated Cash Flows
a. Net Investments
b. Cash Returns
c. Terminal Value
2. Cost of Capital (another topic)
3. Acceptance Criteria
Computing Net Investment
1. Costs or Cash Outflows
a. Initial cash outlay covering all expenditures
b. Working capital requirement to operate the
project at the desired level
c. Market value of an existing, currently idle
asset, which will be transferred to or utilized
on the operations
2. Savings or Cash Inflows
a. Trade-in value of old asset (in case of
replacement)
b. Proceeds from sale of old asset to be
disposed (less tax, if there is gain, add tax
savings, if there is loss on sale)
c. Avoidable cost of immediate repairs on old
asset to be replaced, net of tax
Net Investment = Costs – Savings or
Net Investment = Cash Outflows - Cash Inflows
Cash Returns vs Net Returns
Sales.
Expenses (COGS + OPEX)*
Operating Income.
Income Taxes*
Net Income
Depreciation Expenses
Cash Returns
Common Evaluation Techniques
Methods that do not consider the time value of
money:
1. Payback (PB)
2. Bailout (BO)
3. Accounting Rate of Return (ARR)
Methods that consider time value of money:
1. Net Present Value (NPV) - nile-less ang
investment
2. Profitability Index (PI) - PV of cash return
divided by investment
3. Discounted Payback (DPB) -
4. Discounted Cash Flow Rate of Return or
Internal Rate of Return (IRR)
Payback Period (PB)
Advantages
1. Simple to compute and easy to understand.
2. Gives information about liquidity of the project
3. It is a good surrogate for risk.
Disadvantages
1. Does not consider the time value of money.
2. 2 Gives more emphasis on liquidity rather than
on profitability of the project. (return of
investment vs return on investment)
3. Does not consider the salvage value of the
project
4. Ignores the cash flows that may occur after the
payback period
Accounting Rate of Return
Advantages
1. Closely parallels accounting concepts of
income measurement and investment
2. Facilitates re-evaluation of projects due to the
ready availability of data from the accounting
records
3. Considers income over the entire life of the
project
4. It indicates the project's profitability
Disadvantages
1. Does not consider the time value of money
2. The effect of inflation is ignored
Net Present Value (NPV)
Advantages
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as the reinvestment rate
4. East to apply
Disadvantages

1. Requires predetermination of the cost of

capital or the discount rate to be used
2. Different competing projects may not be
comparable because of differences in
magnitudes or sizes of the projects.
Discounted Cash Flow Rate of Return or Internal
Rate of Return (IRR)m
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.