CAPITAL BUDGETING AND SINKING FUNDS

Capital Budgeting – the process of planning expenditures on

assets with cash flows that are expected to extend beyond
one year. This refers to investment decisions involving fixed
assets. It is the whole process of analyzing projects and
deciding which one to include in the capital budget. In capital
budgeting, set of cash flows are forecasted, find the present
value of those flows, and make investment only if the PV of
inflows exceed the investment cost.
CAPITAL BUDGETING AND SINKING FUNDS

Capital budget includes the following projects:

Replacement of worn-out and damaged equipment
Expansion of existing products or markets – increasing outputs
Expansion to new products or markets
Safety and/or environmental projects – compliance to gov’t. policy
Other projects – Buildings, parking lots, new machine, etc
Merger – buying another firm resulting to merger
Capital Budgeting Process

Capital budgeting is a multi-step process business use to

determine how worthwhile a project an investment would be.
A company might use capital budgeting to figure out if it
should expand its warehouse facilities, invest in new
equipment, or spend money on specialized employee training.
Capital Budgeting Process

Capital budgeting process consist of five steps:

1. Identify and evaluate potential opportunities.

The process begin by exploring available opportunities. For many given initiative, a
company will probably have multiple options to consider, for example: seeking new
location for larger space, expand warehousing. Once the most feasible opportunity is
identified, the company should determine the right time to pursue.

2. Estimate the operating and implementation cost – (need internal and external research)

3. Estimate Cash flow or benefit – (how much income would it generate)

4. Assess risk – estimating the degree of risk (determine the cost and benefits)

5. Implement – (need implementation plan) (sources: The Motley Pool)

METHODS OF RANKING INVESTMENT PROPOSALS
In accepting or reject new projects, procedures must be established. The following criteria
or methods will be helpful:

1. Net present value (NPV) – a method of ranking investment proposals using NPV, which
is equal to the present value of the project’s free cash flows discounted at the cost of
capital.

The Net Present Value tells us how much a project contributes to shareholder’s wealth –
the larger the NPV, the more the project adds; and added value means a higher stock
price. Thus, NPV is the best selection criterion.
 
METHODS OF RANKING INVESTMENT PROPOSALS

For example: for r = 10%

NPVs = -P1,000 + P500 + P400 + P300 + P100
(1.10)ˡ (1.10)² (1.10)ᵌ (1.10)⁴
Or one may use Excel’s NPV function
A B C D E F G
WACC for both project S and L
13 10%
14 Initial Cost After Tax, End-of-Year Cash Inflows, CFT
15 Year 1 2 3 4
16 Project S -P1000 500 400 300 100 P1,300
17 Project L -P1000 100 300 400 675 P1,475
METHODS OF RANKING INVESTMENT PROPOSALS
Finding the NPV for Project S & L

A B C D E F
22 Project S 0 1 2 3 4
23
24 -1000 500 400 300 100
25 454.55
26 330.58
27 225.39
28 68.30
29 NPVs 78.82 Sum = NPVs for Project S
30
NPVL = P100.40 = NPV(.10,100,300,400,675)+-1000
METHODS OF RANKING INVESTMENT PROPOSALS

Before using these NPVs in the decision process, we need to know whether
Project S and L are independent or mutually exclusive. Independent Projects
are projects whose cash flows are not affected by one another. On the other
hand, Mutually Exclusive Projects are projects wherein if one project is
accepted, the other must be rejected. Choosing mutually exclusive projects, the
larger positive NPVs, the more it would be accepted.

 Since Both Project S and L are having positive NPVs, both are acceptable
projects. However if both Project S and L are Mutually Exclusive Projects, then
Project S has the tendency to be rejected.
METHODS OF RANKING INVESTMENT PROPOSALS

Internal rate of return (IRR) - the discount rate that forces a project’s NPV to
equal zero. A project’s IRR is the discount rate that forces the PV of its inflows
to equal its cost. This is equivalent to forcing the NPV to equal zero. The IRR
is an estimate of the project’s rate of return, and it is comparable to the YTM
on a bond.
METHODS OF RANKING INVESTMENT PROPOSALS

A B C D E F
37 Project S 0 1 2 3 4
38 r = 14.489%
39 -1000 500 400 300 100
40 436.72
41 305.16
42 199.91
43 58.20
44 NPVs P0.00 NPV at a discount rate of P14.489%. Since NPV is zero,
45 14.489% must be the IRR
46 IRRs = 14.49% IRR(B39:F39) 14.49%
47
METHODS OF RANKING INVESTMENT PROPOSALS

This illustrates the process of finding the IRR of Project S. Three procedures can be used:

Trial and Error – this is done by trying various rates and see if equation solves to zero

Calculate Solutions

IRRs = 14.489%

IRRL = 13.549%

Excel Solution – the use IRR function in Excel’s spreadsheet

To find the rate that would solve the cost of capital to zero connotes YTM in Bonds

 
METHODS OF RANKING INVESTMENT PROPOSALS

Modified Internal rate of return (MIRR) – the discount rate at which the
present value of a project’s cost is equal to the present value of its
terminal value, where the terminal value is found as a sum of the future
values of the cash inflows, compounded at the firm’s cost of capital
 Because reinvestment at the IRR is generally presumed not correct, the
MRR is a better indicator of a projects true profitability which also
eliminates multiple IRR trial in error problem.
METHODS OF RANKING INVESTMENT PROPOSALS

A B C D E F
113 WACC = 10%
114
115 Project S 0 1 2 3 4
116
117 -1000 500 400 300 100
118 ₱330.00
119 ₱484.00
120 ₱665.50
121 PV (cost) = 1,000-1000 P1,579.5
122 N=4; PV = 1,000; PMT= 0; FV = 1,579.50
123 Press 1/YR to sol ve for MIRR 12.11%
124 Excel , RATE function =RATE(F115,0,B121,F121) 12.11% 12.11%
METHODS OF RANKING INVESTMENT PROPOSALS

Payback Period – The length of time required for an investment’s

cash flows to cover its cost. It is the number of years required to
recover the funds invested in a project from its cash flows.
Project S Years 0 1 2 3 4

Cash Flow -1000 500 400 300 100

Discounted Cash Flow -1000 455 -100 200 300

Payback S = 2+ 100/300 = 2.33

0 1 2 3 4
Project L
Cash Flow -1000 100 300 400 675
Discounted Cash Flow -1000 -900 -600 -200 475

Payback L = 3+200/675 = 3.3

METHODS OF RANKING INVESTMENT PROPOSALS

Payback = Number of years prior to recovery+ (unrecovered cost

at the start of the year /Cash flow during recovery year)

 The shorter the payback, the better the project. Therefore, if the
firm requires a payback of three years or less, S would be
accepted, but L would be rejected. If the project is mutually
exclusive, S would rank over L because of its shorter payback
METHODS OF RANKING INVESTMENT PROPOSALS

Discounted payback – the length of time required for an

investment’s cash flows, discounted at the investment’s cost of
capital, to cover its cost.
Project S Years 0 1 2 3 4

Cash Flow -1000 500 400 300 100

Discounted Cash Flow -1000 455 331 225 68
Cumulative Discounted Cash Flow -1000 -545 -215 11 79

Discounted Payback S =2+215/225 2.94

0 1 2 3 4
Project L
Cash Flow -1000 100 300 400 675
Discounted Cash Flow -1000 91 248 301 461
Cumulative Discounted Cash Flow -1000 -909 -661 -361 100

Discounted Payback L = 3+361/461 = 3.78

METHODS OF RANKING INVESTMENT PROPOSALS

Assuming both Project S & L have 10% cost of capital, each inflow
is divided (1+r)ͭ = (1.10)ͭ where “t” is the year in which the cash
flow occurs and r is the project’s cost of capital; and those PVs are
used to find the payback. Project S’s discounted payback is 2.95,
while L’s 3.78
FREE CASH FLOW VS. OPERATING CASH FLOW

Free cash flow is the cash that a company generates from its
normal business operations after subtracting any money spent on
capital expenditures. Capital expenditures or CAPEX for short, are
purchases of long-term fixed assets, such as property, plant, and
equipment. 
On the other hand, operating cash flow is the cash that's
generated from normal business operations or activities.
Operating cash flow shows whether a company generates enough
positive cash flow to run its business and grow its operations.
ACCOUNTING INCOME VS CASH FLOW

What is the difference between accounting income and cash

flow? Which do we need to use when making
decisions? Accounting income is purely revenue - expenses
= income; Cash flow is when cash is actually changing hands,
either coming in or leaving. We need to use cash flow since it is
more current. In determining Net Income, non-cash expense items
are deducted from generated sales or revenue such as
depreciation and depletion, if applicable. Whereas in the
preparation of cash flow analysis, all non-cash items deduction
from gross revenue are added back to determine actual cash
balance at the end of the period.
CAPITAL BUDGETING DECISION RULES

Noting the five Capital Budgeting Decision Criteria, NPV, IRR,

MIRR, Payback and Discounted Payback, when we compared
these methods with one another and highlight their strength and
weaknesses, we may have created the impression that
“sophisticated” firms should use only one method, the NPV.
However, virtually all capital budgeting decisions are analyzed by
computer, so it is easy to calculate all five decision criteria. In
making the accept/reject decision, large sophisticated firms
generally calculate and consider all five measures because each
provides a somewhat different piece of information about
decision.
ESTIMATING PROJECT CASH FLOWS

Estimating project cash flows is generally the most important, but

also the most difficult step in the capital budgeting process.
Methodology, such as the use of NPV versus IRR, is important, but
less so than obtaining reasonably accurate estimate of project’s
cash flows. This is so because net income is not equal to the cash
flow available for distribution to investors. For capital budgeting
purposes, it is the project’s net cash flow, not its accounting
income that is relevant.
ESTIMATING PROJECT CASH FLOWS

Cash flow is the amount of money going in and out of your

business. ... A cash flow projection estimates the money you
expect to flow in and out of your business, including all of your
income and expenses. Typically, most businesses' cash flow
projections cover a 12-month period
ESTIMATING PROJECT CASH FLOWS

Advantages of projecting cash flow

Projecting cash flows has many advantages. Some pros of creating a cash
flow projection include being able to:

Predict cash shortages and surpluses

See and compare business expenses and income for periods
Estimate effects of business change (e.g., hiring an
employee) Prove to lenders your ability to repay on time
Determine if you need to make adjustments (e.g., cutting
expenses) Cash flow projection isn’t for every business. Your projected
cash flow analysis can be time-consuming and costly if done wrong.
ESTIMATING PROJECT CASH FLOWS

How to calculate projected cash flow

If you’re ready to start calculating projected cash flow for your
business, start gathering some historical accounting data.
You need to get reports detailing your business’s income and
expenses from your accountant, books, or accounting software.
Depending on the timeframe you want to predict, you might need
to gather additional information.
Want to learn how to calculate cash flow projections? Use the
projected cash flows steps next slides.
ESTIMATING PROJECT CASH FLOWS
1. Find your business’s cash for the beginning of the period

2. Estimate incoming cash for next period

3. Estimate expenses for next period
4. Subtract estimated expenses from income
5. Add cash flow to opening balance
To complete the next period’s projected cash flow, repeat the
steps from above.
ESTIMATING PROJECT CASH FLOWS
SINKING FUNDS

A sinking fund is an account containing money set aside to pay

off a debt or bond. A company that issues debt will need to pay
that debt off in the future, and the sinking fund helps to soften
the hardship of a large outlay of revenue. A sinking fund is
established so the company can contribute to the fund in years
leading up to the bond’s maturity. Example
Bond: 10M for 10 year period at 10% interest
Cash flow as a sinking fund may be even in 10 years that is 1M per
year
SINKING FUNDS

Without Cash flow - only interest is paid by the issuer every year
and the whole principal amount will be paid at the end of 10 years
This sinking fund is not directly paid by the issuer but at a
separate investment unless specified in the bond that payment be
made by the issuer to the holder in a periodic payment.
Take note that the bond issuer is the debtor and the bond holder
is the creditor
Thank You and
God bless Good Luck to your
everyone! Midterm Exam

(Click the arrow when in Slide Show mode)