CAPITAL

BUDGETING
Compiled by Gwizu
 LECTURE OBJECTIVES
 By the end of this lecture you should be able:

1. Describe the stages in capital budgeting.

2. Evaluate and use non-discounted cash flow methods

to choose between alternative projects i.e.
Accounting Rate of Return
(ARR) and Payback
method.

3. Explain the concept of relevant cash flows, giving practical

examples and calculate relevant cash flows in given capital
investment decision scenarios.
LECTURE OBJECTIVES (CONT)
4. Evaluate and use discounted cash flow methods to
choose between alternative projects
 INTRODUCTI
ON
 Also referred to Investment Appraisal.

 Is the process in which an organization evaluate whether it is

worthwhile to pursue long term investment.
 Investments can be in the form of acquisition of additional assets
replacements and modifications of activities and expansion of plant.
 Investments is any expenditure incurred in anticipation of
future benefits to flow to the entity
 Investments are categorized into two
1. Capital expenditure.
2. Revenue Expenditure.
 Capital expenditure focuses on
purchase of non current asset or
improving the earning capacity of a non
current asset.
 Revenue expenditure focuses on the day
to day running expenses of the business.
 Before an organization commits its scarce
resources and valuable capital resources to
fixed productive assets ,it needs to be
assured of the profitability as well as an
acceptable return.
 Every project therefore must go under the
capital budgeting process.
STAGES IN CAPITAL BUDGETING
PROCESS

1.Identification of
investment projects.
2. Project Screening
3. Analysis and acceptance
4. Monitoring and review
IDENTIFICATION OF INVESTMENT
PROJECTS.

At this stage, original ideas comes from

departments or form environmental scanning.
Top management also plays key role in
proposing new projects that needs
investments.
 PROJECT SCREENING

 Potential projects are selected based on non financial

data.
 At this stage , Qualitative characteristics must be
considered for each projects.
1. how does the project fit into long term vision of the
org
2. What are the legal requirements if it is implemented.
3. Does it put the organization at risk. e.g. going concern.
4. Do we have the expertise to complete the project
 ANALYSIS AND ACCEPTANCE
 The project is then evaluated based on financial
information.
 Expected costs of the investment and expected cash
inflows are produced.
 potential projects which meet the organizations
minimum criteria for investment are accepted using
one or more investment appraisal techniques to be
discussed later.
 ANALYSIS AND ACCEPTANCE
(CONT)
 The projects is accepted based on predetermined
criteria.
 At this stage, qualitative factors are also considered.

1. Its adverse effect on staff morale

2. Effect on company image

3. Further investment requirements

4. The ability of the org to react to technology changes.

 MONITORINGAND
REVIEW
 At this stage the focus is on monitoring the progress
of the project.
 Controls should be in place so that the desired results
are achieved.
1. capital expenditure does not exceed authorized

2. Targets are met so that the project is not delayed.

 INVESTMENT APPRAISAL
TECHNIQUES
 These are methods that are used to evaluate a
project based on financial grounds.
 These techniques can be grouped into two i.e

1. Non discounted cash flow technique

2. Discounted cash flow technique

 NON DISCOUNTED CASH
FLOW TECHNIQUES

1. ACCOUNTING RATE OF
RETURN
 Also called simple rate of return.
 It is an approach that takes into uses accounting
profits when evaluating a project.
 It is a ratio of average profits after depreciation to
capital invested.
 Profits may be before or after tax but normally the
latter is used.
 Accounting rate of return =
average annual net income after taxes x 100
initial investment
or
average annual net income after taxes x 100
average initial investment

average initial investment= initial investment/2

A PROJECT SHOULD BE ACCEPTED IF ITS

ARR IS HIGHER THAN THE TARGETED ARR
 ACTIVITY
 A firm1
is considering three projects each with a initial with an
investment of 5000 and a life of 5 years. the detailed
estimated profits are as follows
year A B C

1 500 1000 200

2 500 900 200

3 500 600 200

4 500 600 900

5 500 800 1000

 REQIRED
 calculate accounting rate of return for each project
if the company requires an accounting rate of return
of 25%(use average investments in your calculations)
 Advice the company which project to undertake.
 ACTIVITY 2
 Information relating to a proposed investment 1 whose
initial cost is $80 000 is as follows
Year Net cash flows
1 35 000
2 30 000
3 25 000
4 (10 000)
5 5000
Depreciation is estimated to be 10% on cost.
 REQIRED
 calculate accounting rate of for each
return project if the company accounting
requires
rate anof 25% and advice the company
of return
THE PAYBACK PERIOD
Is the length of time it takes for a
project to recoup its initial cost out of
cash receipts that it generates.
or the time it takes for an investment

to pay for itself.

The quicker the recoupment time the

more desirable the investment is.

 When the annual cash inflows
are the same every year use the
following formula to calculate
payback:
 Payback period = investment
required
 net cash inflows
ACTIVITY 3
A company need a new machine .
The company is considering two machines
, machine A and machine B .

Machine A costs $15000 and will reduce
operating costs by $5000 annually.
Machine B costs only $12000 but will
reduce operating costs by $5000 per year.
Which machine should the company
purchase?
 Example 2
 An ice cream vending company Dairy board
ltd is considering removing and installing
equipment to dispense soft ice cream.

 The equipment would cost $80000 and have an

eight year useful life.

Incremental annual revenues and costs
associated with the sale of ice cream would

be as follows: $
Sales 150 000
less cost of ingredients‘ 90 000
 contribution margin 60 000
less fixed expenses
salaries 27000
maintenance 3000
depreciation 10000 (40
000)
n et income 20 000
 The vending machine can be sold for
$5000 scrap value.
 The company requires a payback of 3years
or less.
 Should the equipment be purchased?
ACTIVITY 4 (UNEVEN CASH FLOW)

 P= A+B/C
Where P- payback period
A- number of years immediately proceeding the year
of final recovery.
B- the balance amount still to be recovered
C- cash flow during the year of final recovery
 EXAMPLE
 A company has the following cash inflows:
 Initial outlay 700
 Cash flow year 1 400
 2 200
 3 200
 4 200
 5 100
 ACTIVITY 5
 A company has the following cash inflows. Cal the
pay back period
Year investment Cash inflow
1 4000 1000
2 0
3 2000
4 2000 1000
5 500
6 3000
7 2000
8 2000
 THE END