CAPITAL BUDGETING

Capital budgeting is used to describe how managers
plan significant investments in projects that have longterm implications such as the purchase of new
equipment or the introduction of new product.
d. Lease or buy decision
e. Equipment replacement decision
2
CATEGORIES
OF
CAPITAL
BUDGETING
DECISION
1. Screening decision


Managers must carefully select a project which
generate the highest future return.
Any decision that involves a cash outlay now to obtain a
future return is a capital budgeting decision.
FOUR METHODS FOR MAKING CAPITAL BUDGETING DECISIONS

Relate to whether a proposed project is
acceptable – whether it passes a preset hurdle.
2. Preference decision

Relate to selecting from among the several
acceptable alternatives
1. Payback method
TYPES OF CASH FLOWS IN CAPITAL BUDGETING
2. Net-present value method
a. Cash Outflows
3. Internal rate of return method

Initial investment of equipment, other assets,
and installation costs

Salvage value realized from the sale of old
equipment can be recognized as a reduction in
the initial investment or as a cash inflow.
b. Expansion decisions

Working capital required
c. Equipment selection decision

Periodic outlays for repairs and maintenance
and additional operating costs
4. Simple rate of return method
TYPICAL BUDGETING DECISIONS
a. Cost reduction decision

Projects that promise earlier returns are preferable than
those that promise later returns.

Since the money received today is worth more than the
money received in the future, cash flows that are
received at different times must be valued differently.
b. Cash Inflows

Increase in revenue or reduction in cost (savings
in operating costs/incremental revenue less
cash receipts)

Salvage value of new asset at the end of the
asset’s life

Release of working capital at the end of the
asset’s life

BASIC TERMS TO REMEMBER REGARDING THE TIME VALUE OF
MONEY
1. Annuity

A series of identical cash flow
Depreciation tax shield
2. Compound interest
TIME VALUE OF MONEY


The time value of money recognizes that a dollar today
is worth more than a dollar a year from now if for no
other reason than you could put the dollar in a bank
today and have more than a dollar a year from now.

The process of paying interest on interest in an
investment
3. Discount rate

Payback method does not recognize time value of
money
The rate of return that is used to find the present
value of a future cash flow
4. Discounting

Net present value and internal rate of return does not
only focus on cash flows, but they also recognize time
value of those cash flows. They use discounting cash
flows.

The process of finding the present value of a
future cash flow
5. Present value

The value now of an amount that will be
received in some future period
INTERNAL RATE OF RETURN

The internal rate of return is the rate of return of an
investment project over its useful life

The internal rate of return is computed by finding the
discount rate that equates the present value of its cash
outflows with the present value of its cash inflows

The internal rate of return is the discount rate that
results in a net present value of zero
NET PRESENT VALUE METHOD

The difference between the present value of
cash flows, called the net present value,
determines whether or not a project is an
acceptable investment.

Managers assume that all cash flows other than
initial investment occurs at the end of the
period.
COST OF CAPITAL AS A SCREENING TOOL


Managers assume that all cash flows generated
by an investment project are immediately
reinvested at the rate of return equal to the rate
used to discount the future cash flows, also
known as discount rate.
The company’s cost of capital is usually regarded
as its minimum required rate of return.
a. The net present value method

The cost of capital is used as the discount rate
when computing the NPV of the project

Any project with negative NPV is rejected
b. The internal rate of return

Cost of capital is the average rate of return that
the company must pay to its long-term creditors
and its shareholders for the use of their funds.

The cost of capital is used as the hurdle rate that
a project must clear for acceptance

It is compared to the IRR of a project

Any project whose IRR is less than the cost of
capital is rejected
PAYBACK PERIOD
RANKING OF COMPETING PROJECTS

The payback period is the length of time it takes
for a project to recover its initial cost from the
net cash inflows that it generates
The NPV of one project cannot be directly
compared to the NPV of another project unless
the initial investments are equal

Sometimes referred to as time it takes for an
investment to pay for itself

There is a need to use the profitability index


The higher the profitability index, the more
desirable the project
The basic premise of the payback period is that
the more quickly the cost of an investment can
be recovered, the more desirable is the
investment.
a. Using NPV to rank competing projects

b. Using IRR to rank competing projects

The higher the IRR, the more desirable the
project
CAPITAL BUDGETING TECHNIQUES THAT IGNORE THE TIME
VALUE OF MONEY
CRITICISMS OF THE PAYBACK PERIOD METHOD

Not a true measure of profitability of the investment. It
only tells how many years are required to recover the
original investment

A shorter payback period does not always mean one
investment is more desirable than the other

It ignores all cash flows that occur after the payback
period

It does not consider the time value of money – a cash
inflow to be received several years in the future is
weighed the same as a cash inflow received right now
1. Payback period
2. Simple rate of return / Accounting rate of return /
unadjusted rate of return
SIMPLE RATE OF RETURN
DETERMINING RELEVANT CASH FLOWS

Evaluate cash flows on an incremental basis, net of
applicable taxes

Disregard sunk costs

Include opportunity costs

Include working capital requirements in outflow, and
release of working capital in inflows

Consider the terminal value or salvage value at the end
of the projects life