CAPITAL

BUDGETING
Fundamental Concepts on Capital Budgeting Process

Screening Capital Investment Proposals

BUDGETING
Preference Decisions – The Ranking of Investment Projects

TOPICS
Comparing Preference Rates

Inflation and Capital Budgeting

 Fundamental Concepts on Capital Budgeting Process

Screening Capital Investment Proposals

BUDGETING Preference Decisions – The Ranking of Investment Projects

TOPICS
Comparing Preference Rates

Inflation and Capital Budgeting

 QUESTION???
?

When is the right time to cut down

trees that are growing, or when
should we bottle mango juice as it
gets older
A brief DEFINITION

BUDGET CAPITAL BUDGETING/INVESTMENT

APPRAISAL
A plan that details
projected cash flow CAPITAL is a sound procedure to plan, evaluate, compare and to
during some period. determine whether a firm’s long term investments are
Operating assets used economically acceptable and will contribute value to
for production. the firm.
ELEMENTS OF CAPITAL BUDGETING

The amount
of the investment

The operating
cash flows or
Returns from The minimum acceptable
the investment rate of return on
the investment.
ELEMENTS OF CAPITAL BUDGETING

The Theamount
operating
cash flows
The minimum or
acceptable
of the rate investment
Returns from
of return
the investment
on
the investment.
ELEMENTS OF CAPITAL BUDGETING

The operating
cash The
flows
amount
The minimum acceptable
or
of theofinvestment
Returns
rate
from
return on
the investment.

the investment
ELEMENTS OF CAPITAL BUDGETING

The minimum acceptable

The operating
cash flows or
The amount
rateofReturns
ofinvestment
the return
from on
thethe investment
investment.
CHARACTERISTICS OF CAPITAL INVESTMENT
DECISION

Substantia Because of the The effect Plans must Success or

length of time failure of the
l amount of be made well
spanned by a
of funds managerial into an company may
capital
are depend upon a
investment errors will uncertain
decision, the single or
required in be difficult future.
element of relatively few
capital to reverse. investment
uncertainty
projects. becomes more decisions.
critical.
CHARACTERISTICS OF CAPITAL INVESTMENT
DECISION

Substantia
l amount
of funds
are
required in
capital
projects.
CHARACTERISTICS OF CAPITAL INVESTMENT
DECISION

Because of the
length of time
spanned by a
capital
investment
decision, the
element of
uncertainty
becomes more
critical.
CHARACTERISTICS OF CAPITAL INVESTMENT
DECISION

The effect Plans must

of be made well
managerial into an
errors will uncertain
be difficult future.
to reverse.
CHARACTERISTICS OF CAPITAL INVESTMENT
DECISION

Plans must
be made well
into an
uncertain
future.
CHARACTERISTICS OF CAPITAL INVESTMENT
DECISION

Success or
failure of the
company may
depend upon a
single or
relatively few
investment
decisions.
7
PROCESS OF
CAPITAL
BUDGETING
11 Finding Investment Opportunities.
During strategic planning,
companies identify numerous capital
expenditure proposals, which should
be carefully analyzed and evaluated
to ensure long-term profitability.
12
Collect Relevant Information about
Opportunities
To evaluate an investment opportunity, estimate
expected cash flows, determine total outlay,
develop a plan, and gather non-financial
information.
13
Select Discount Rate

To apply the discounted cash flow approach, it

is crucial to establish the discounted cost of
capital before evaluating the cash flow.
14
Financial Analysis of Cash Flows

The second phase's estimated cash flows are

analyzed using capital budgeting techniques.
15
Decision

Many factors, quantitative as well as qualitative

should be given consideration before the final
decision is made as to the selection of a
particular investment.
16
Project Implementation

Once the decision has been made to invest

funds, more detailed plans for making the
project operational are developed.
17
Project Evaluation and Appraisal

This evaluation may be in the form of

continuous monitoring of the project, so that
corrective action can be taken.
IMPORTANCE
OF
CAPITAL
BUDGETING
IMPORTANCE
OF La
CAPITAL Growth
BUDGETING
 Growth

IMPORTANCE
OF Large Amount Irrev
CAPITAL
BUDGETING
 Growth Large Amount

IMPORTANCE
OF Irreversibility
CAPITAL Co
BUDGETING
 Growth Large Amount

IMPORTANCE
OF Complexity
CAPITAL R
BUDGETING

Irreversibility
 Growth Large Amount

IMPORTANCE
OF
Risk
CAPITAL
BUDGETING

Irreversibility Complexity
EVALUATION
TECHNIQUES
 EVALUATION TECHNIQUES
NON DISCOUNTED
DISCOUNTED CASH FLOW
CASH FLOW
 EVALUATION TECHNIQUES
NON DISCOUNTED
DISCOUNTED CASH FLOW
CASH FLOW

Payback period

Accounting rate of
return
Discounted payback
 EVALUATION TECHNIQUES
NON DISCOUNTED
DISCOUNTED CASH FLOW
CASH FLOW

Payback period Net Present Value

Accounting rate of
return Profitability Index

Discounted payback Internal Rate of Return

Modified Internal Rate of

Return
 EVALUATION TECHNIQUES
NON DISCOUNTED
DISCOUNTED CASH FLOW
CASH FLOW

Payback period Payback period

Accounting rate of Accounting rate of

return return
Discounted payback Discounted payback

Discounted payback
NON DISCOUNTED CASH FLOW

Undiscounted cash flows don't

incorporate the time value of
money
NON DISCOUNTED CASH FLOW

Undiscounted cash flows don't

incorporate the time value of
money
PAYBACK PERIOD

The payback period is the length of time it

takes to recover the cost of an investment or
the length of time an investor needs to reach a
breakeven point.

The shorter the payback period the better the

investment
 PAYBACK PERIOD

To compute the payback period:

FORMULA:
Payback period
= Cost of Project / Return in
Investment
 PAYBACK PERIOD

Ex. 1
Suppose a project costs P100,000 and the expected return on investment
is P43,000 annually. Compute the payback period.

FORMULA: Payback period = Cost of Project / Return in Investment

= P100,000 / P43,860= 2.28 years

PAYBACK PERIOD
Accounting Rate of Return

Also known as book value of return,

it measures profitability from the
conventional accounting standpoint
by relating the required investment
to the future annual net income.
This is calculated as follows:
Decision Rule!

Sol
 Decision Rule!

If ARR ≥ Required rate of return: Accept

If ARR < Required rate of return: Reject

Sol
 Illustrative Problem
Suppose a project costs P195, 000.00 and the book value at the end of its
useful life is P5, 000.00. The company's desired rate of return on any long
term investment is 10% or more. If the projected average annual net
income to be derived from the investment is P12,000.00, is the project
economically acceptable?

ARR = Average Net Income / Average Investment

Average Investment= (BV at beg. of year 1 + BV at end of useful life) /2

ARR = P12, 000.00 / [(P195, 000.00 +P5, 000)/ 2] = 0.12 = 12%

Sol
DISCOUNTED PAYBACK - is a
procedure that discounts the future
cash inflows by the cost of capital .
DISCOUNTED PAYBACK - is a
procedure that discounts the future
cash inflows by the cost of capital .

Let us assume that the prevailing cost of

Capital is 10% per annum. Round off
discounted cash flow figure to tens)
So, the break even is sometime in
rd
the 3 year.

Negative Balance/ CASH Flow From

the Break Even Year = A point of time
in the final year we break even
 LARANA INC.

DISCOUNTED CASH FLOW (DCF)

Is a valuation method used

to estimate the value of an
investment based on its
expected future cash
flows.
 LARANA INC.

Under the discounted cash flow

decision criterion, also frequently
Discounted Cash Flow
called the present-value
Techniques approach, cash outlays and cash
inflows are both discounted back
to the present period using an
appropriate discount rate. The
variations in the DCF techniques
are as follows:
 Discounted Cash Flow Techniques
LARANA INC.
 Discounted Cash Flow Techniques
LARANA INC.

1) Net present value or excess present

method.
2) Discount rate of return or internal rate
of return.
3) Profitability index.

4) Discounted payback period.

NPV:
Net Present Value

It is the difference between the

present value of cash inflows
and the present value of cash
outflows over a period of time

The final amount we get by

adding all the discounted cash
flows.
NPV:
Formula:
Net Present Value

It is the difference between the

present value of cash inflows
and the present value of cash
outflows over a period of time

The final amount we get by

adding all the discounted cash
flows.
LARANA INC.
LARANA INC.
 Profitability index:

Is a measure of a project’s or investment’s

attractiveness.

Also known as profit investment ratio

(PIR) and value investment ratio (VIR) is
the ratio of investment to payoff of a
proposed project. It is a useful tool for
ranking projects because it quantifies the
amount of value created per unit of
investment.
Formula:
Profitable Index = (Net Present Value / Total Investment) + 1
= (149,000 / 870,000) + 1
= 0.172 + 1
= 1.172

Or

Profitability Index = PV of Future Cash Flow

PV of Initial Investment
= P1,019,680 / P870,000
= 1.172
LARANA INC.
 LARANA INC.

Interal Rate of Return

The discounted rate of return also known as internal rate

of return, often referred to as the discount rate, is the
interest rate used to determine the present value of future
cash flows or earnings. It's a crucial concept in finance and
investment analysis, particularly in techniques like
discounted cash flow (DCF) analysis.
To determine the IRR, financial calculator is needed,
clear the financial calculator then enter and press the
following:

press CASH,
enter interest rate 10%, press EXE, again press EXE,
enter the cash flows:
870,000.00 press EXE
450,000 press EXE
350,000 press EXE
250,000 press EXE
150,000 press EXE
50,000 press EXE
press ESC,
go to IRR:Solve
press SOLVE.
The answer should be IRR = 18.96%.
LARANA INC.
LARANA INC.

MIRR:
•This assumes that the revenue from a specific
project is not directly invested back into the
project.
•To determine the MIRR, your need to compute
first. This assumes that the revenue from a
specific project is not directly invested back
into the project. of the sum of all cash future
flows, sometimes called the terminal value
LARANA INC.
LARANA INC.

MIRR IRR
LARANA INC.
 LARANA INC.

PREFERENCE DECISIONS
-The Ranking of Investment
Projects
PREFERENCE DECISIONS -The Ranking of
Investment Projects

This is much more difficult to make than screening

decisions because investment funds are usually limited
and that some or many other profitable investment
opportunities may have to be foregone.

Preference decisions come after screening decisions

and attempt to resolve the question of “how do the
investment proposals, all of which have been screened
and provide an acceptable rate or return, rank in
terms of preference?”
PREFERENCE DECISIONS -The Ranking of
Investment Projects

2 methods can be used in making preference decisions

PREFERENCE DECISIONS -The Ranking of
Investment Projects

2 methods can be used in making preference decisions

Net Present Value Method

\
“The higher the profitability
index, the more desirable the
project”

Internal rate of return method

“The higher the internal rate of
return, the more desirable the
project”
 COMPARING
PREFERENCE RULES
OMPARING PREFERENCE RULES
If an independent project is being evaluated, then the NPV and IRR criteria
always lead to the same accept/reject decision.

Net Present Value

The Net Present Value (NPV) is a method that is primarily used
for financial analysis in determining the feasibility of investment
in a project or a business. It is the present value of future cash
flows compared with the initial investments. Let us understand
NPV in detail.
OMPARING PREFERENCE RULES
If an independent project is being evaluated, then the NPV and IRR criteria
always lead to the same accept/reject decision.

Net Present Value If NPV is positive, the investment is

The Net Present Value worthwhile because its rate of return exceeds
(NPV) is a method that is the discount rate.
primarily used for
financial analysis in
determining the
feasibility of investment
in a project or a
business. It is the
present value of future
cash flows compared
with the initial
investments. Let us
understand NPV in
OMPARING PREFERENCE RULES
If an independent project is being evaluated, then the NPV and IRR criteria
always lead to the same accept/reject decision.

Net Present Value If NPV is positive, the investment is

The Net Present Value worthwhile because its rate of return exceeds
(NPV) is a method that is the discount rate.
primarily used for
financial analysis in
determining the
If NPV is negative, the investment is not
feasibility of investment recommended
in a project or a
business. It is the
present value of future
cash flows compared
with the initial
investments. Let us
understand NPV in
OMPARING PREFERENCE RULES
If an independent project is being evaluated, then the NPV and IRR criteria
always lead to the same accept/reject decision.

Net Present Value If NPV is positive, the investment is

The Net Present Value worthwhile because its rate of return exceeds
(NPV) is a method that is the discount rate.
primarily used for
financial analysis in
determining the
If NPV is negative, the investment is not
feasibility of investment recommended
in a project or a
business. It is the
present value of future
cash flows compared
If NPV is zero then the organization
with the initial
will stay indifferent
investments. Let us
understand NPV in
Comparing Preference Rules
 Comparing Preference Rules
Internal Rate of Return
IRR, or internal rate of return, is a metric used in
financial analysis to estimate the profitability of
potential investments. IRR is a discount rate that
makes the net present value (NPV) of all cash flows
equal to zero in a discounted cash flow analysis.
The higher an internal rate of return, the more
desirable an investment is to undertake. IRR is uniform
for investments of varying types and, as such, can be
used to rank multiple prospective investments or
The profitability index is
conceptually superior to the internal
rate of return as method of making
preference decisions. The reason is
that the profitability index will
always give a correct indication as to
the relative desirability of
alternatives, even if the alternatives
have different lives and different
patterns of earnings.
Comparing Preference Rules

Comparing Projects with Unequal Lives

if we were deciding between two mutually exclusive alternatives with

significantly different lives, an adjustment would be necessary. This
problem may be dealt using any one of these procedures,

1. The placement chain method and

2. The equivalent annual annuity method (EAA)
Replacement Chain (Common Life) Approach
Replacement Chain (Common Life) Approach

This method compares project of unequal lines

which assumes that each project can be repeated as
many times as necessary to reach a common life
span. The Net Present Values (NPVs) over this life
span are then compared, and the project with higher
common life NPV is chosen.
Replacement Chain (Common Life) Approach

This method compares project of unequal lines

which assumes that each project can be repeated as
many times as necessary to reach a common life
span. The Net Present Values (NPVs) over this life
span are then compared, and the project with higher
common life NPV is chosen.

To illustrate the application of this method we shall

assume the following data on mutually exclusive
projects, Project N and Project M.
Replacement Chain (Common Life) Approach
Replacement Chain (Common Life) Approach
Observations and Analysis
a. Based on the NPV, Project N appears to the better
project. This analysis is, however, incomplete and the
decision to choose it, may not be correct.
 Replacement Chain (Common Life) Approach
Observations and
Analysis
a. Based on the
NPV, Project N
appears to the
better project. This b. If Project M is chosen, there will be an opportunity to
analysis is, make a similar investment in 3 years and if cost and
however, revenue conditions continue, this investment will also
incomplete and be profitable. If Project N is chosen, there is no second
the decision to investment opportunity.
choose it, may not
be correct.
Replacement Chain (Common Life) Approach

c. To make a proper comparison of Project M and Project

N, the replacement chain (common life) approach could
be applied.
b. If
•For Project M, add in a second project to extend the Project
overall life of the combined project to 6 years. M is
chosen,
•Assuming that Project M’s investment cost and annual there will
cash inflows will not change if the project is repeated in be an
3 years (Year 1: P70,000, Year 2: P130,000, and Year 3: opportun
P120,000) cost of capital will remain at 12%. The new ity to
NPV of this project will be P88,240 and IRR will be make a
25.2%. similar
investme
nt in 3
 Replacement Chain (Common Life) Approach

c. To make
a proper
compariso d. Since the P88,240
n of extended NPV of Project
Project M
and
M over the common life
Project N, of 6 years is greater than
the the P64,910 NPV of
replaceme Project N, Project M
nt chain
should be selected.
(common
life)
approach
could be
applied.
EQUIVALENT ANNUAL ANNUITY (EAA)
APPROACH
EQUIVALENT ANNUAL ANNUITY (EAA)
APPROACH
Equivalent Annual Annuity (EAA) Method is a method which calculates the
annual payments a project would provide if it were an annuity. Generally, when
comparing projects of unequal lives, the one with higher equivalent annual
annuity should be chosen.

To illustrate how this procedure is applied, let us assume the same data for
the two projects, Project M and Project N.
EQUIVALENT ANNUAL ANNUITY (EAA)
APPROACH
1
It is noted that
Project M’s NPV =
P51,550
Project N’s NPV =
P64,910
The Expected Net Cash
Flows for Project N
and M are computed as
follows:

Project M and Project

N
EQUIVALENT ANNUAL ANNUITY (EAA)
APPROACH
1
It is noted that
Project M’s NPV =
P51,550
Project N’s NPV =
P64,910
The Expected Net Cash
Flows for Project N
and M are computed as
follows:

Project M and Project

N
EQUIVALENT ANNUAL ANNUITY (EAA)
APPROACH
2
To find the value
of EAA for Project
M use the equation

51,550 = EAA (PV

of an ordinary
annuity for 3
periods at 12%)

51,550 = EAA x
2.40183
EAA - P21,463
EQUIVALENT ANNUAL ANNUITY (EAA)
APPROACH
3
To find the value of
EAA for Project n,
the equation will
be:
69,910 = EAA (PV of
an ordinary annuity
for 6 periods at
12%)

EAA = 64,910
4.11
EAA = P15,793
 GROUP 4

Mastering The Art Of

 GROUP 4

Mastering The Art Of

INFLATION
and Capital
Budgeting
 and Capital Budgeting
Mastering The Art Of

I. TERMS AND DEFINITION

A. WHAT IS INFLATION?

Inflation is the INCREASE in the general level of prices for all

goods and services in an economy.

The DECREASE in purchasing value of money ( due to

increasing prices).

Inflation is an important fact of economic life and must be

considered in capital budgeting.
 and Capital Budgetin
I. TERMS AND DEFINITION

B. NOMINAL VALUE VS REAL VALUE

Nominal Value- The nominal value represents the stated or current value of
a variable or asset without adjusting for inflation or other factors affecting
purchasing power. It is the face value or unadjusted value of an economic
quantity.

For Example: Suppose a company's revenue for a particular year is $1,000,000.

This $1,000,000 represents the nominal value of the company's revenue for
that year. However, without considering inflation, this nominal value does not
provide insight into the real purchasing power or the actual increase in wealth
over time.
 and Capital Budgetin
I. TERMS AND DEFINITION

B. NOMINAL VALUE VS REAL VALUE

Nominal Value- The nominal value represents the stated or current value of a variable or asset without
adjusting for inflation or other factors affecting purchasing power. It is the face value or unadjusted value of
an economic quantity.

Real Value- The real value represents the adjusted value of a variable or
asset after accounting for changes in purchasing power due to inflation
or deflation. It reflects the value of an economic quantity in terms of
constant, inflation-adjusted dollars.
 and Capital Budgetin
I. TERMS AND DEFINITION

B. NOMINAL VALUE VS REAL VALUE

Nominal Value- The nominal value represents the stated or current value of a variable or asset without
adjusting for inflation or other factors affecting purchasing power. It is the face value or unadjusted value of
an economic quantity.

For Example: Continuing with the previous

Real Value- The real
value represents the example, suppose the inflation rate for the year
adjusted value of a
variable or asset after was 3%. To calculate the real value of the
accounting for changes
in purchasing power
company's revenue, we would adjust the nominal
due to inflation or
deflation. It reflects the
value of $1,000,000 by subtracting the effect of
value of an economic inflation. If we determine that the real value of
quantity in terms of
constant, the revenue after adjusting for inflation is
inflation-adjusted
dollars. $970,873, this represents the real purchasing
power or the actual increase in wealth accounting
for changes in the general price level.
D. MARKET-BASED COST OF CAPITAL VS.
REAL COST OF CAPITAL
D. MARKET-BASED COST OF CAPITAL VS.
REAL COST OF CAPITAL
Market-Based Cost of Capital - The
market-based cost of capital represents the
rate of return required by investors to
compensate them for the risk of investing in a
particular asset or project.
Adjusting Cash Flows for Inflation:

When discounting cash flows using a

market-based cost of capital, it's crucial to
adjust the cash flows upwards to maintain their
real value.
D. MARKET-BASED COST OF CAPITAL VS.
REAL COST OF CAPITAL
Real Cost of Capital - The real cost of
capital is adjusted for inflation, meaning
that it already incorporates the effects of
inflation into the discount rate.

No need to adjust Cash Flows Upward:

When discounting cash flows using the
real cost of capital, the discount rate
automatically adjusts for changes in
purchasing power.
III. Solution A: Inflation not IV. Solution A: Inflation
considered considered
(Real Cost of Capital) (Market-Based Cost
Capital)
III. Solution A: Inflation not
considered
(Real Cost of Capital)
IV. Solution A: Inflation
considered
(Market-Based Cost
Capital)
profitability.

II. EFFECTS OF INFLATION

ON CAPITAL BUDGETING
 profitability.
Does Inflation affect Capital Budgeting?
II. EFFECTS OF INFLATION
ON CAPITAL BUDGETING

Cash Flow Projections: Inflation

can distort cash flow projections
by affecting both revenues and
expenses.
 profitability.
Does Inflation affect Capital Budgeting?
II. EFFECTS OF INFLATION
ON CAPITAL BUDGETING

Discount Rates: Inflation affects the discount

rates used to evaluate investment
opportunities. Higher discount rates decrease
the present value of future cash flows, making
long-term investments less attractive.
Therefore, failing to adjust discount rates for
inflation can lead to incorrect investment
evaluations.
 profitability.
Does Inflation affect Capital Budgeting?
II. EFFECTS OF INFLATION
ON CAPITAL BUDGETING

Purchasing Power Risk:

Inflation erodes the
purchasing power of
money over time, leading
to a decrease in the real
value of future cash
flows.
Does Inflation affect Capital Budgeting?
II. EFFECTS OF INFLATION
ON CAPITAL BUDGETING

Strategic Considerations:

Inflation can impact the strategic

considerations underlying capital
budgeting decisions.
THANK YOU!
GROUP 4