CHAPTER 19- CAPITAL BUDGETING
The operating cash flows or returns from the
Capital budgeting- process of deciding whether or not
to commit resources to projects whose costs and
benefits are spread over several time periods.
- Used to describe actions relating to
the planning and financing capital
outlays for such purposes as the
purchase of new machinery, the
modernization of plant facilities or
introduction of new product lines.
Capital budgeting involves:
1. Preparation of annual budget for capital
investment;
2. Assessment of funding capacities;
3. Allocation of resources to renewal and
expansion projects which most clearly conform
with the company’s priorities.
Capital expenditure- long-term commitments of
resources to realize future benefits and budgeting for
them is one of the most important areas of managerial
decision.
“one of the most difficult steps involved in the
decision-making process relates to the identification of
costs relevant to the problem.”
“the only relevant costs are future costs.”
“historical costs are sunk costs.”
General types of capital investment decisions:
1. Independent capital investment
project/screening decisions
2. Mutually exclusive capital investment
projects/preference decisions
Independent capital investment project/screening
decisions- projects which are evaluated individually and
reviewed against predetermined corporate standards of
acceptability resulting in an “accept” or “reject”
decision.
Mutually exclusive capital investment
projects/preference decisions- projects which require
the company to choose from among specific
alternatives.
Elements of capital budgeting:
1. The net amount of the investment
2.
investment
3. The minimum acceptable rate of return of
investment
net investment- represents the initial cash outlay that is
required to obtain future returns or the net cash
outflow to support a capital investment project.
Net cash returns- inflows of cash expected from a
project reduced by the cash cost that can be directly
attributed to the project.
“the minimum or lowest acceptable rate of return or
opportunity cost may EQUAL the average rate of
return that the company will earn from alternative
investment opportunities or the cost of capital which
is the average rate of return that the firm must pay to
attract investment fund.”
Process of capital budgeting:
1. Finding investment opportunities
2. Collect relevant information about
Opportunities
3. Select discount rate
4. Financial analysis of cash flows
5. Decision
6. Project implementation
7. Project evaluation and appraisal
Major categories of cash flows:
1. Cash inflows:
a. Periodic cash inflows from operations,
net of taxes
b. Investment tax credit
c. Proceeds from sale of old asset being
replaced, net of taxes
d. Avoidable costs, net of taxes
e. Return of some working capital
invested in the project
f. Cash inflow from salvage of the new
long-term asset at the end of its useful
life. This will be net of tax
consequence.
2. Cash outflows:
g. acquisition cost of purchasing and
installing assets
h. additional working capital
i. other cash flows such as severance
payments, relocation costs, restoration
costs and similar costs.
Disinvestment flows- cash flows resulted from the end
of a project’s life.
“to generate positive periodic operating cash flows is
usually the primary reason for acquiring long-term
assets.”
Investment tax credit- allows a credit against a
company’s income tax liability based on the cost of an
acquired asset.
“If an old equipment is to be sold, the proceeds from
such sale is treated as a REDUCTION from cost of
initial investment.”
“the avoidable repairs cost, net of incremental tax will
be treated as a DEDUCTION in computing the cost of
initial investment.”
Most commonly used methods of evaluating capital
investment project:
1. non-discounted cash flow (unadjusted)
approach
a. payback period
b. accounting rate of return
c. payback reciprocal
2. discounted cash flow(time-adjusted) approach
a. net present value
b. discounted rate of return (IRR)
c. profitability index
d. discounted payback period
payback period- (pay-off and payout period) measures
length time required to recover the amount of initial
investment.
- Time interval between time of
initial outlay and the full recovery of the investment.
Decision rule:
If: PBperiod > or = Maximum allowed PBperiod; Accept
If: PBperiod < Maximum allowed PBperiod; Reject
Advantages of payback period method:
1. Easy to compute and understand
2. Used to measure the degree of risk associated
with a project
3. The longer the payback period, the higher the
risk
4. Used to select projects which provide a quick
return of investment funds.
Disadvantages of PBperiod method:
1. Does not recognize the time value of money
2. Ignores the impact of cash inflows after the
PBperiod
3. Does not distinguish between alternatives
having different economic llives
4. Conventional payback computation fails to
consider salvage value, if any
5. Does not measure profitability
6. No necessary relationship bbetween a given
payback and investor wealth maximization so
an investor would not know what an
acceptable payback is.
Bail-out period-approach which incorporates the
salvage value in payback computaions.
Simple rate of return or accounting rate of return-
measures profitability from the conventional accounting
standpoint by relating the required investment to the
future annual net income
Decision rule:
If: ARR > or = Required rate of return; Accept
If: ARR < Required rate of return; Reject
Advantages of ARR:
1. easily understood by investors acquainted
with FS
2. used as a rough preliminary screening device
of investment proposals
Disadvantages of ARR:
1. ignores the time value of money by failing to
discount the future cash inflows and outflows.
2. Does not consider the timing component of
cash inflows
3. Different averaging techniques may yield
inaccurate answers
4. Utilizes the concepts of capital and income
primarily designed for the purposes of FS
preparation and which may not be relevant to
the evaluation of investment proposals
Discounted cash flow techniques- cash outlays and
cash inflows are both discounted back to the present
period using an appropriate discount rate.
Variations of discounted cash flow:
1. Net present value or excess present method
2. Discount rate of return or IRR
3. Profitability index
4. Discounted payback period
Net present value- excess of the present value of cash “the higher the IRR, the more desirable the project.”
inflows generated by the project over the amount of
the initial investment. Net present value method- can be used to rank
competing investment projects if the projects are of
Discounted rate of return- (IRR) rate which equates the equal size, that is, investment funds required are the
present value of the future cash inflows with the cost of same.
the investment which produces them
Economic life- period within which returns are expected
Steps in the computation of the discounted rate of Direct costing- assignment of direct material, DL,
return: variable FOH costs to products
A. Cash inflows are evenly received: Incremental analysis- comparison of cost and revenue
a. Compute the present value factor by data that differ among alternatives
dividing net investment annual cash Average cost of capital- cost of financing the company’s
return activities
b. Trace the pv factor in the table for pv Sales mix analysis- determining the most profitable
of p1 received annually using the life of combination of product sales.
the project as point of reference
c. The column that gives the closest
amount to the PV factor is the
“discounted rate of return”
d. To get the exact discount rate of
return, interpolation applied.
B. Cash inflows are not evenly received:
a. Compute the average annual cash
returns
b. Divided net investment by the average
annual cash returns to get the present
value factor
c. Determine rate
d. Compute present value of annual cash
returns
e. Add the present value of the annual
returns and compare with net
investment
f. Try another rate
g. Interpolate to get exact disc rate of
return

Payback reciprocal-rate of recovery of investment

during payback period

Profitability index- ratio of the total present value of

future cash inflows to the initial investment.

Discounted payback period- method that recognizes

the time value of money in a payback context

Preference decisions- come after screening decisions

and attempt to resove the question of “how the
investment proposals, all of which have been screened
and provide an acceptable rate of return, rank in terms
of predference?”