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CAPITAL BUDGETING 2.

Proceeds from sale of old asset to be disposed due to the


The process of identifying, evaluating, planning, and financing capital acquisition of new project (less applicable tax, in case there is gain
investment projects of an organization. on sale, or add tax savings, in case there is loss on sale)
3. Avoidable cost of immediate repairs on old asset to be replaced,
Investment Decision judgment about which assets to acquire to net of tax.
achieve the companys stated objectives
Cost of Capital the cost of using funds; it is also called the hurdle
Financing Decision judgment regarding the method of raising capital rate of return the company must pay to its long term creditors and
to fund an investment shareholders for the use of their funds.

Characteristics of Capital Investment Decisions Net Returns


1. Capital investment decisions usually require large commitments of 1. Accounting net income
resources. 2. Net cash inflows
2. Most capital investment decisions involve long-term commitments. Economic life the period of time during which the asset can
3. Capital investment decisions are more difficult to reverse than provide economic benefits or positive cash inflows
short term decisions. Depreciable life the period used for accounting and tax
4. Capital investment decisions involve so much risk and uncertainty. purposes over which the depreciable assets cost is systematically
and rationally allocated.
Stages in the Capital Budgeting Process Terminal Value (End-of-life Recovery Value) net cash
1. Identification and definition proceeds expected to be realized at the end of the projects life.
2. Search for potential investment projects
3. Information gathering both quantitative and qualitative Commonly Used Methods of Evaluating Capital Investment
information Projects
4. Selection choosing the investment projects after evaluating their 1. Methods that do not consider the time value of money
projected costs and benefits a. Payback
5. Financing b. Bail-out
6. Implementation and monitoring c. Accounting rate of return
2. Methods that consider the time value of money (discounted cash
Types of Capital Investment Projects flow methods)
1. Replacement a. Net present value
2. Improvement b. Present value index
3. Expansion c. Present value payback
d. Discounted cash flow rate of return
Capital Investment Factors
1. Net Investment METHODS THAT DO NOT CONSIDER TIME VALUE OF MONEY
2. Cost of capital Payback Method
3. Net returns Payback Period = Net cost of initial investment
Annual net cash inflows
Net investment cost or cash outflows less cash inflows or savings *Payback period is the length of time required by the project to return the initial cost of
investment
incidental to the acquisition of the investment projects
Advantages:
Cost or Cash Outflows:
1. Payback is simple to compute and easy to understand. There is no
1. The initial cash outlay covering all expenditures on the project up
need to compute or consider any interest rate. One just has to
to the time when it is ready for use or operation:
answer the question: How soon will the investment cost be
Ex. Purchase price of the asset
recovered?
Incidental project-related cost such as freight, insurance,
2. Payback gives information about the projects liquidity.
taxes, handling, installation, test-runs, etc.
3. It is good surrogate for risk. A quick payback period indicates a
2. Working capital requirement to operate the project at the desired
less risky project.
level
Disadvantages:
3. Market value of an existing, currently idle asset, which will be
1. Payback does not consider the time value of money. All cash
transferred to or utilized in the operations of the proposed capital
receive during the payback period is assumed to be equal value in
investment project.
analyzing the project.
2. It gives more emphasis on liquidity rather than on profitability of the
Savings or Cash Inflows:
project. In other words, more emphasis is given on return of
1. Trade-in value of old assets (in case of replacement)
investment than the return on investment.
3. It ignores the cash flows that may occur after the payback period. 3. Present value of cash inflows
- Cost of investment
Bail-out Period Net Present Value
Cash recoveries include not only the operating net cash inflows but
also the estimated salvage value or proceeds from sale at the end Advantages:
of each year of the life of the project. 1. Emphasizes cash flows
2. Recognizes the time value of money
Accounting Rate of Return 3. Assumes discount rate as the reinvestment rate
Also called book value rate of return, financial accounting rate of 4. Easy to apply.
return, average return on investment and unadjusted rate of return.
Disadvantages
Accounting Rate of Return = Average annual net income 1. It requires predetermination of the cost of capital or the discount
Investment rate to be used.
2. The net present values of different competing projects may not be
Advantages: comparable because of different magnitudes or sizes of the
1. The ARR computation closely parallels accounting concepts of projects.
income measurement and records.
2. It facilitates re-evaluation of projects due to the ready availability of Profitability Index
data from the accounting records.
3. This method considers income over the entire life of the project. Profitability Index = Total present value of cash inflows
4. It indicates the projects profitability. Total present value of cash outflows

Disadvantages: If the cost of investment is the only cash outflow:


1. Like the payback and bail-out methods, the ARR method does not
consider the time value of money. Profitability Index = Total present value of cash inflows
2. With the computation of income and book value based on the Cost of investment
historical cost accounting data the effect of inflation is ignored.
Net Present Value Index = Net present value
METHODS THAT CONSIDER TIME VALUE OF MONEY Investment
Present Value (PV) of an amount is the value now on some future cash
flow. Internal Rate of Return
- The rate of return which equates the present value (PV) of cash
PV of P1 or PV Factor (PVF) = 1 where: i = discount rate inflows to PV of cash outflows. It is the rate of return where NPV
(1+i)n n = number of periods = 0.

PV of future cash flows = Future cash flows x PVF When the cash flows are uniform, the IRR can be determined as
follows:
Future Value (FV) of an amount available at a specified future time 1. Determine the present value factor (PVF) for the internal rate of
based on a single investment (or deposit now) return (IRR) with the use of the following formula:
FV of P1 or FV Factor = (1+i)n PVF for IRR = Net cost of investment
FV of Present Cash Flows = Present cash flows x FVF Net cash inflows
2. Using the present value annuity table, find on line n (economic life)
Annuities a series of equal payments at equal intervals of time the PVF obtained in step 1. The corresponding rate is the IRR.
Ordinary Annuity (Annuity in Arrears) cash flows occur at the end
of the periods involved. When the cash flows are not uniform, the IRR is determined using trial-
Annuity Due (Annuity in advance) cash flows occur at the and-error method.
beginning of the periods involved.
Advantage:
Net Present Value 1. Emphasizes cash flows
1. Present value of cash inflows 2. Recognizes the time value of money
- Present value of cash outflows 3. Computes the true return of the project
Net Present Value
Disadvantages:
2. Present value of cash inflows 1. Assumes that IRR is the reinvestment rate.
- Present value of cost of investment 2. When project includes negative earnings during their economic
Net Present Value life, different rates of return may result.
Payback Reciprocal
- A reasonable estimate of the internal rate of return,
Provided that the following conditions are met:
1. The economic life of the project is at least twice the payback
period.
2. The net cash inflows are constant (uniform) throughout the
life of the project.
Payback reciprocal = Net cash inflows
Investment
Or

Payback reciprocal = 1_____


Payback period

Discounted Payback or Break-even Time


- The period required for the discounted cumulative cash inflows on
a project to equal the discounted cumulative cash outflows (usually
the initial cost).