BULLET NOTES ON CAPITAL BUDGETING
Capital Budgeting Evaluation Process
 The process of making capital expenditure decisions in business is referred to as
capital budgeting.
 Capital budgeting involves choosing among various projects to find the one(s) that will
maximize a company’s return on its financial investment.
 The capital budgeting evaluation process generally has the following steps:
1. Project proposals are requested from departments, plants, and authorized
personnel.
2. Proposals are screened by a capital budget committee.
3. Officers determine which projects are worthy of funding.
4. Board of directors approves capital budget.
Cash Flow Information
 While accrual accounting has advantages over cash accounting in many contexts, for
purposes of capital budgeting, estimated cash inflows and outflows are preferred for
inputs into the capital budgeting decision tools.
 Sometimes cash flow information is not available, in which case adjustments can be
made to accrual accounting numbers to estimate cash flows.
 The capital budgeting decision, under any technique, depends in part on a variety of
considerations:
o The availability of funds.
o Relationships among proposed projects.
o The company’s basic decision-making approach.
o The risk associated with a particular project.
Commonly Used Methods of Evaluating Capital Investment Projects

Methods that do not consider the time value of money
o Payback Period
o Accounting rate of return

Methods that consider the time value of money (discounted cash flow methods)
o Net present value (NPV)
o Profitability Index (PI)
o Internal Rate of Return (IRR)

Payback Period
 The formula when net annual cash flows are equal is:
Payback Period = Cost of Capital Investment ÷ Net Annual Cash
Flow
 The shorter the payback period, the more attractive the
investment.
 The cash payback technique recognizes that:
 The earlier the investment is recovered, the sooner
the company can use the cash funds for other
purposes.
 The risk of loss from obsolescence and changed
economic conditions is less in a shorter payback
period.
 Net annual cash flow is computed by adding back depreciation
expense to net Depreciation expense is added back because it is an
expense that does not require an outflow of cash.
 In the case of uneven net annual cash flows, the company
determines the cash payback period when the cumulative net cash
flows from the investment equal the cost of the investment.
 The cash payback technique is relatively easy to compute and
understand.
BULLET NOTES – CAPITAL BUDGETING
Compiled by Vhin
 It should not ordinarily be the only basis for the capital budgeting
decision because it ignores the expected profitability of the
project.
 Bail-out Payback Period is a modified payback period method
wherein cash recoveries include not only the net cash inflows
from operations but also the estimated salvage value realizable at
the end of each year of the project life.

Accounting Rate of Return
 The annual rate of return method is based directly on accounting
data rather than on cash flows.
 The annual rate of return method indicates the profitability of a
capital expenditure and its formula is:
Expected Annual Net Income ÷ Average Investment
 Management compares the annual rate of return with its
required rate of return for investments of similar risk.
 The required rate of return is generally based on the company’s
cost of capital.
 The decision rule is: A project is acceptable if its rate of return is
greater than management’s required rate of return. It is
unacceptable when the reverse is true.
 The higher the rate of return for a given risk, the more attractive
the investment.
 The principal advantages of this method are the simplicity of its
calculation and management’s familiarity with the accounting
terms used in the computation.
 A major limitation of this method is that it does not consider the
time value of money.

Net Present Value
 Discounted cash flow techniques are generally recognized as the
most informative and best conceptual approaches to making
capital budgeting decisions.
 These techniques consider both the time value of money and the
estimated net cash flow from the investment.
 The primary discounted cash flow technique is the net present
value method.
 The net present value method in values discounting net cash
flows to their present value and then comparing that present
value with the capital outlay required by the investment. The
difference between these two amounts is referred to as net present
value (NPV).
 Company management determines what interest rate to
use in discounting the future net cash flows. This rate is
often referred to as the discount rate or required rate of
return.
 A proposal is acceptable when net present value is
positive, because this means the rate of return on the
investment equals or exceeds the discount rate (required
rate of return).
 The higher the positive net present value, the more attractive
the investment.
 The discount rate used by most companies is its cost of
capital—that is, the rate that the company must pay to obtain
funds from creditors and stockholders.
 The net present value method demonstrated in the text requires the
following assumptions:
 All cash flows come at the end of each year.
 All cash flows are immediately reinvested in another
project that has a similar return.
 All cash flows can be predicted with certainty.
BULLET NOTES – CAPITAL BUDGETING

Compiled by Vhin
Profitability Index
 In theory, all projects with positive NPVs should be accepted.
However, companies rarely are able to adopt all positive-NPV
proposals because:
 The proposals are mutually exclusive (if the company
adopts one proposal, it would be impossible to also adopt the
other proposal).
 Companies have limited resources.
 Proposals are often mutually exclusive—if the company adopts
one proposal, it would be impossible to also adopt the other
proposal.
 In choosing between two projects, one method that takes into
account both the size of the original investment and the
discounted cash flows is the profitability index.
 The profitability index is a method that compares the relative
merits of alternative capital investment projects.
 It is computed by dividing the present value of net cash flows by the
initial investment.
Profitability Index = Present Value of Future Cash Flows
÷
Initial Investment
 The higher the profitability index, the more desirable the
project.
 The project with the greater profitability index should be
the one chosen.

Internal Rate of Return
 The internal rate of return method differs from the net present
value method in that it finds the interest yield of the potential
investment.
 The internal rate of return is the interest rate that will cause the
present value of the proposed capital expenditure to equal the
present value of the expected net annual cash flows.
 Determining the internal rate of return can be done with a financial
(business) calculator, computerized spreadsheet, or by employing
a trial-and-error procedure.
 Determine the present value factor (PVF) for the internal rate of
return (IRR) with the use of the following formula:
PVF for IRR = Net investment cost ÷ Net cash inflows
Once managers know the internal rate, of return, they compare
it to the company’s required rate of return (the discount rate).
 The decision rule is: Accept the project when the internal rate of
return is equal to or greater than the required rate of return.
Reject the project when the internal rate of return is less than
the required rate.
Intangible Benefits
 Intangible benefits, such as increased quality, improved safety, or enhanced employee
loyalty, are difficult to quantify, and thus often are ignored in capital budgeting
decisions.
 To avoid rejecting projects that should actually be accepted, managers can either:
o Calculate the net present value (NPV) ignoring intangible benefits, and if the
resulting NPV is negative, evaluate whether the intangible benefits are worth
at least the amount of the negative NPV.
o Incorporate intangible benefits into the NPV calculation by projecting rough,
conservative estimates of their value. If, after using conservative estimates, the
net present value is positive, the project should be accepted.
BULLET NOTES – CAPITAL BUDGETING
Compiled by Vhin
Sensitivity Analysis
 Another consideration made by financial analysts is uncertainty or One approach for
dealing with uncertainty is sensitivity analysis.
 Sensitivity analysis uses a number of outcome estimates to get a sense of the
variability among potential returns. In general, a higher risk project should be
evaluated using a higher discount rate.
Post-Audit of Investment Projects
 A post-audit is a thorough evaluation of how well a project’s actual performance
matches the projections made when the project was proposed.
 Performing a post-audit is important for several reasons.
o Since managers know that their results will be evaluated, there is an incentive
for them to make accurate estimates rather than presenting overly optimistic
estimates in an effort to get projects approved.
o A post-audit provides a formal mechanism for determining whether existing
projects should be continued, expanded, or terminated.
o Post-audits improve future investment proposals because managers improve
their estimation techniques by evaluating past successes and failures.
 A post-audit involves the same evaluation techniques that were used in making the
original capital budgeting decision—for example, use of the net present value method.
The difference is that, in the post-audit, actual figures are inserted where known, and
estimation of future amounts is revised based on new information.
COST OF CAPITAL
Source
Capital
Creditors
Long-term debt
Cost of Capital
After-tax rate of interest
I * ( 1 – tax rate)
Stockholders:
Preferred
Preferred stock
Common
Common stock
Preferred dividends per share ÷
Current market price or Net issuance price
CAPM or DDM
1. CAPITAL ASSET PRICING MODEL (CAPM)
R = RF = β(RM – RF)
where:
R = rate of return
RF = risk-free rate determined by government securities
β = beta coefficient of an individual stock which is the correlation between the volatility
(price variation) of the stock market and the volatility of the price of the individual stock.
2. THE DIVIDEND DISCOUNT MODEL (OR DIVIDEND GROWTH MODEL)
a. Cost of Retained Earnings
(D1 ÷ P0) + G
where:
P0 = current price
D1 = next dividend
G = growth rate in dividends per share (it is assumed that the dividend payout ratio,
retention rate, and therefore the EPS growth rate are constant)
b. Cost of New Common Stock
D1 ÷ P0 (1 – Flotation Cost) + G
Flotation Cost = the cost of issuing new securities.