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Capital
Capital
Budgeting
Budgeting Decisions

Capital Budgeting Broad Categories of Capital Budgeting Decisions

1. Independent capital investment projects or screening decision.

Used to describe actions relating to the planning
and financing capital outlays for the purposes of:
• purchase of new machinery
• Modernization of plant facilities
• Introduction of new product lines
 An investment concept
Projects which are evaluated individually and reviewed against
predetermined coporate standards of accetability resulting in an “accept” or
“reject” decision.
Examples:
◎ Investment in long-term assets such as PPEs
◎ New product development
◎ Undertaking a large scale advertising campaign
◎ Introduction of a computer

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Broad Categories of Capital Budgeting Decisions Evaluating Capital Investment Proposals

2. Mutually exclusive capital investment projects or Preference decisions The elements or factors to be considered in evaluating capital
investment proposals are:
Projects which require the company to choose from among specific
Examples:
alternatives. The project to be acceptable must pass the criteria of
 The net amount of investment
acceptability set by the company and be better than the other investment
 The operating cash flows or returns from the investment
alternatives.
 The minimum acceptable rate of return on the investment
Examples:
◎ Replacement against renovation of equipment or facilities.
◎ Rent or lease against ownership of facilities.
◎ Manual bookkeeping system against computerized system.
◎ Preventive maintenance against periodic overhaul of machineries

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Net Investment Net Investment

Net investment represent the initial cash outflow that is required to obtain
future returns or the net cash outflow to support a capital investment
project. This may be computed as follows: Purchase price of new asset
Initial cash outlay xxx + Installation and transportation costs
Add: Additional cash outlay related to the asset xxx + Additional net working capital
Additional working capital xxx xxx - Proceeds from sale of old asset
Total xxx +/- Tax effects on disposal of old assets and/or the purchase of new one
Less: Cash inflow asiring form the sale of assets Net Investment
being replaced xxx
Avoidable costs xxx xxx
Net investment xxx

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Net Cash Returns Acceptable Rate of Return

Net operating cash flows or returns are the incremental changes in cash The minimum or lowest acceptable rate of return or opportunity cost may
arising from the cash inflows minus the outflows directly attributed to the equal the average rate of return that the company will earn from
project. Operating cash flows are generally assumed to occur at the end alternative investment opportunities or the cost of capital which is the
of a given year. This is computed as: average rate of return that the firm must pay to attract investment fund.

Annual incremental revenue from the project xxx

Less: Incremental cash operating costs xxx
Annual cash inflow before taxes xxx
Less: Taxes
[tax rate (Annual cash inflow before taxes
- Incremental Depreciation)] xxx
Annual net cash inflow after taxes xxx
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Methods in Evaluating and Screening Alternative

Investment Proposal
The commonly used Capital Budgeting Techniques include the following:
A. Non-discounted cash flow (unadjusted) approach

Project
1. Payback period
2. Bail-out period
3. Accounting rate of return (book value rate of return)

Screening
4. Payback reciprocal
B. Discounted cash flow (time-adjusted) approach
1. Net present value
2. Discounted rate of return or internal rate of return
3. Profitability index
4. Discounted payback period
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Non-discounted Cash Flow (Unadjusted) Approach Non-discounted Cash Flow (Unadjusted) Approach
1. Payback Period Decision Rule:
The length of time required for a project’s cumulative net cash inflows to The desirability of the project is determined by comparing the project’s
equal its net investment. It measures the time required for a project to payback period against the maximum acceptable payback period as
breakeven. This is computed as: predetermined by management. The project with shorter payback period
a. If the annual cash inflows are uniform: than the maximum will be acceptable. Thus:
Payback Period =
If: PB period ≤ Maximum allowed PB period; ACCEPT
If: PB period > Maximum allowed PB period; REJECT
b. If cash inflows are unequal:
Unrecovered cost at the
# of years
Payback start of the year
= prior to full + x 1 year
Period Total Cash flows during
recovery
the last year of recovery
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Non-discounted Cash Flow (Unadjusted) Approach
2. Bail-out Period
In conventional payback computations, investment salvage value is
usually ignored. An approach which incorporates the salvage value in
payback computations is the Bail-out period. This is reached when the
cumulative cash earnings plus the salvage value at the end of a
particular year equals the original investment.
Non-discounted Cash Flow (Unadjusted) Approach
3. Accounting Rate of Return (ARR) or Simple Rate of Return
Also known as the book value rate of return, measures profitability from
the conventional accounting standpoint by relating the required
investment to the future annual net income. This is computed as:
ARR =

Or, if a cost reduction project is involved, the formula becomes:

ARR =

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Non-discounted Cash Flow (Unadjusted) Approach
Decision Rule:
Under the ARR method, choose the project with the highest rate of
return. Accept the project if the ARR is greater than the cost of capital.
Thus:
Non-discounted Cash Flow (Unadjusted) Approach
4. Payback Reciprocal
Measures the rate of recovery of investment during the payback period.
For projects with even cash flows, the payback reciprocal is computed
as:

If: ARR ≥ Required rate of return; ACCEPT Payback Reciprocal =

If: ARR < Required rate of return; REJECT
The higher the payback period reciprocal, (and, hence, the lower the
payback period) the more worthwhile the project becomes.

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Discounted Cash Flow (Time-Adjusted) Approach
1. Net Present Value (NPV)
The excess of the PV of cash inflows generated by the project over the
amount of the initial investment. This is computed as:
Present value of cash inflows computed based
on minimum desired discount rate
Less: Present Value of investment
Net Present Value
Non-discounted Cash Flow (Unadjusted) Approach
Decision Rule:
For independent project proposal, accept it if the NPV is positive or zero
and reject if the NPV is negative. If the NPV is positive, it means that the
project will earn a return greater than the discount rate also known as
the hurdle rate. If the projects do not meet the hurdle rate, they should
be rejected because the funds that would be invested in them can earn a
xxx
higher rate in some other investment. Thus:
xxx
xxx
If: NPV ≥ 0; ACCEPT
If: NPV < 0; REJECT

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Discounted Cash Flow (Time-Adjusted) Approach
2. Discounted Rate of Return/ Internal Rate of Return
Also known as the Time-Adjusted Rate of Return. The rate which
equates the PV of the future cash inflows with the PV of cost of the
investment which produces them. It is also the equivalent maximum rate
of interest that could be paid each year for the capital employed over the
life of an investment without loss on the project.
Non-discounted Cash Flow (Unadjusted) Approach
Decision Rule:
Accept the proposed investment if the DCR or IRR is equal or greater
than minimum desired rate of return or cost of capital Reject the
proposal if the IRR is lower than the minimum desired rate of return.
Thus:
If: IRR ≥ Required rate of return; ACCEPT
If: IRR < Required rate of return; REJECT

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Discounted Cash Flow (Time-Adjusted) Approach Non-discounted Cash Flow (Unadjusted) Approach
3. Profitability Index Decision Rule:
Also known as the present value index, benefit-cost rate, and desirability The higher the profitability index, the more desirable the project is.
index. The ratio of the total PV of future cash inflows to the initial Projects with the index of less than 1 are rejected Thus:
investment. The index expresses the present value of cash benefits as
to an amount per peso investment in a project and is used as a measure If: PV Index ≥ 1; ACCEPT
of ranking projects in a descending order of desirability. This is If: PV Index < 1; REJECT
computed as:
PV index=

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Discounted Cash Flow (Time-Adjusted) Approach

4. Discounted Payback Period

Equivalent
A method that recognizes the time value of money in a payback context.
The periodic cash flows are discounted using an appropriate cost of
capital rate and accumulated until they equal the amount of investment.

Annual
The length of time required to equalize the discounted cash flows and
investment is the discounted payback period.

Annuity (EAA)
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Equivalent Annual Annuity (EAA) Approach Equivalent Annual Annuity (EAA) Approach
EAA approach is a method which calculates the annual payments a For example:
project would provide if it were an annuity. X Company is contemplating on investing in a new machine costing
P200,000 with the following expected cash returns:
The EAA method involves the followinf basic steps. These are:
Year 1 P 70,000
1. Find the project’s NPV over its initial life. Year 2 130,000
2. Find the value of EAA. Year 3 120,000
The cost of capital is 10%.

What is the EAA for this project?

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Equivalent Annual Annuity (EAA) Approach Equivalent Annual Annuity (EAA) Approach
Step 1: Compute for the NPV Step 2: Compute for the EAA

Initial investment (P200,000*1) (200,000.00)

Annual Cash Returns 51,555 = EAA x (PV of an annuity of 1 for 3 years @ 12%)
Year 1 (70,000*0.8929) 62,503.00 51,555 = EAA (2.4018)
Year 2 (130,000*0.7972) 103,636.00 EAA = 51,555 / 2.4018
Year 3 (120,000*0.7118) 85,416.00 EAA = P21,465
Net Present Value 51,555.00

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Equivalent Annual Annuity (EAA) Approach

Investment
Step 3: Analysis

This analysis is useful when comparing mutually exclusively objects with

Project Ranking/
different lives.

The project with the higher EAA will always have the higher NPV when

Prerence
extended out to any common life. Hence, the project with a higher EAA
should be chosen.

Decision
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Methods used in making Preference Decisions
Preference decisions come after screening decisions and attempt to
resolve the question of “How do the investment proposal, all of which
have been screened and provide an acceptable rate of return, rank in
terms of preference?”.
Basically, either the internal rate of return method or the net present
value method can be used in making preferences.
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Net Present Value Method
The net present volume method can be used to rank competing
investment projects if the projects are of equal size, that is, investment
funds required are the same. If competing projects require different
amount of funding, it may be necessary to compute the profitability
index. Profitability index is computed by dividing the present value of
cash flows by the investment required.
The preference rule to rank competing investment projects using the
profitability index is:
“The higher the profitability index, the more desirable is the project.”
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Internal Rate of Return Method
The preference rule when using the internal rate of return method to run
competing investment project is:
“The higher the internal rate of return, the more desirable is the project.”
This method, despite the use for two mainly reasons, namely:
1. No additional computation need to be made beyond those already
performed in making initial screening decisions.
2. The ranking data are recently understood by management.
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Comparing the Preference Rates
• If an independent project is being evaluated, then the NPV and the
IRR criteria always lead to the same accept/reject decision.
• For mutually exclusive projects (among acceptable alternative)
especially those that differ in scale (project size) and/or timing of
conflict may arise.
• The IRR method may favor one alternative over another, while the
NPV method may indicate otherwise. It conflicts arise, the NPV
method should be used.
• The NPV method assumes that the cash flows will be reinvested at
the firm’s cost of capital, while the IRR method assumes reinvestment
at the project’s IRR.
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Comparing the Preference Rates

• Because of reinvestment at the cost of capital is generally a better
(closer to reality) assumption, the NPV is superior to the IRR.
• 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 alternatives have different
Capital
lives and different pattern of earnings. On the other hand, if lives are
unequal, the internal rate of return method can lead the manager to
make incorrect decision.
Rationing
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Capital Rationing Types of Capital Rationing

• A situation in which management places a constraint on the total size
of the firm’s capital budget during a particular period.
• It is also described as the selection of investment proposals in a
situation of constraint on availability of capital funds to maximize the
wealth of a company by selecting those projects which will maximize
overall net present value of the firm.
• Soft rationing occurs when different units in a business are allocated
some fixed amount of money each year for capital spending. It is
done as a means of controlling and keeping track of overall spending,
in spite of the fact that the business firm is not short of capital and
funds can be raised on ordinary terms if management so desires.
• Hard rationing occurs when a business cannot raise financing for a
project under any circumstances. This can occur when a business
experience is financial distress, meaning that bankruptcy is a
possibility.

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