The Firm’s investing Decisions:
CAPITAL BUDGETING
TECHNIQUES
Presented by: Padios, Pamela L.
CAPITAL BUDGETING PROCESS
1.
Proposal for projects
2.
Review and analysis of projects
3.
Decision making about proposals
4.
Selection and implementation
5.
Follow-up and review process
TYPES OF CAPITAL BUDGETING DECISIONS
• Independent projects (Accept-Reject criterion)
• Mutually exclusive projects
• Capital rationing decisions
METHODS OF CAPITAL BUDGETING
Bail-out Period
Capital Budgeting
Techniques
Accounting Rate of Return
Net Present Value
Internal Rate of Return
CAPITAL BUDGETING TECHNIQUES
1.
Pay Back Period Method (PBP)
-the amount of time required for a firm to recover its initial
investment in a project, as calculated from cash inflows.
Decision criteria:
Determination of the length of the maximum acceptable payback
period.
If the calculated payback period of a project is less than the
maximum acceptable payback period, accept the project.
If the payback period of the project is greater than the maximum
acceptable payback period, reject the project.
1. PAY BACK PERIOD METHOD (PBP)
Company B
Company A
• Initial Investment = $1,000,000
• Initial Investment = $200,000
• Annual Cash Flow = $250,000
• Annual Cash Flow = $100,000
• Payback Period = $1,000,000 / $250,000 = 4 years
• Payback Period = $200,000 / $100,000 = 2 years
• So, the first project has a payback period of 4 years
• The second project has a payback period of 2 years.
.
METHODS OF CAPITAL BUDGETING
Pay Back Period
Capital Budgeting
Techniques
Accounting Rate of Return
Net Present Value
Internal Rate of Return
2. BAIL-OUT PERIOD METHOD
• The bailout payback method shows the length of time required to repay the
total initial investment cash flows combined with salvage value. The shorter the
payback period, the more attractive the company is.
1.
Payback Period=20,000/5,000= 4
2.
2. Bailout Payback
METHODS OF CAPITAL BUDGETING
Pay Back Period
Bail-out Period
Capital Budgeting
Techniques
Net Present Value
Internal Rate of Return
3. AVERAGE RATE OF RETURN OR ACCOUNTING RATE
OF RETURN (ARR)
-a financial metric used to evaluate the profitability of an
investment or project. It is calculated by dividing the average annual
accounting profit by the initial investment cost and is expressed as a
percentage.
3. AVERAGE RATE OF RETURN OR ACCOUNTING RATE
OF RETURN (ARR)
Given Data:
• Initial Investment: $250,000
• Expected Annual Revenue: $70,000
• Time Frame: 5 years
METHODS OF CAPITAL BUDGETING
Pay Back Period
Bail-out Period
Capital Budgeting
Techniques
Accounting Rate of Return
Internal Rate of Return
4. NET PRESENT VALUE
-a crucial financial metric used in capital budgeting to
evaluate the profitability of an investment or project. It assesses
the difference between the present value of expected cash
inflows (such as revenue or income) and the present value of
cash outflows (like costs or expenses) over a specified time
frame. In essence, NPV quantifies the current worth of all future
cash flows associated with an investment, and then it deducts the
initial investment cost. A positive NPV indicates that the
investment is expected to generate profit, while a negative NPV
suggests potential losses.
METHODS OF CAPITAL BUDGETING
Pay Back Period
Bail-out Period
Capital Budgeting
Techniques
Accounting Rate of Return
Net Present Value
5. INTERNAL RATE OF RETURN
• The internal rate of return (IRR) 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.
• IRR calculations rely on the same formula as NPV does. Keep in mind
that IRR is not the actual dollar value of the project. It is the annual
return that makes the NPV equal to zero.
5. INTERNAL RATE OF RETURN
where: Ct=Net cash inflow during the period t
C0=Total initial investment costs
IRR=The internal rate of return
t=The number of time periods
5. INTERNAL RATE OF RETURN
• Project A
• Project B
Project A
Initial Outlay = $5,000
Initial Outlay = $2,000
Year one = $1,700
Year one = $400
$0 = (−$5,000) + $1,700 ÷ (1 + IRR)1 + $1,900 ÷ (1 + IRR)2 + $1,600 ÷ (1 + IRR)3 +
$1,500 ÷ (1 + IRR)4 + $700 ÷ (1 + IRR)5
Year two = $1,900
Year three = $1,600
Year four = $1,500
Year five = $700
Year two = $700
Year three = $500
Year four = $400
Year five = $300
IRR Project A = 16.61 %
Project B
$0 = (−$2,000) + $400 ÷ (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 + IRR)3 + $400 ÷
(1 + IRR)4 + $300 ÷ (1 + IRR)5
IRR Project B = 5.23 %
REFERENCES
• https://www.investopedia.com/terms/p/paybackperiod.asp#toc-what-isthe-payback-period
• https://theproreaders.com/bailout-payback-period/
• https://www.investopedia.com/terms/a/arr.asp#:~:text=The%20accountin
g%20rate%20of%20return%20(ARR)%20formula%20is%20helpful%20in,of
%20return%20from%20each%20project.
Thank you
very much!