Capital Budgeting

Jennifer I. Malabrigo, MBA

May 20, 2015
Meaning of Capital Budgeting
Capital budgeting can be defined as the
process of analyzing, evaluating, and deciding
whether resources should be allocated to a
project or not.
Capital budgeting addresses the issue of
strategic long-term investment decisions.
Process of capital budgeting ensure optimal
allocation of resources and helps
management work towards the goal of
shareholder wealth maximization.
Types Capital Budgeting Decisions
Plant expansion

Equipment selection Equipment replacement

Lease or buy Cost reduction

Why Capital Budgeting is Important?
Involve massive investment of
resources
Are not easily reversible
Have long-term implications for the
firm
Involve uncertainty and risk for the
firm
Estimating Cash Flows
Cash basis rather than accounting profits
Initial Capital Expenditure = Initial Cash
Outflow or Net Investment
Determine all Future Cash Flows
Use Incremental Cash Flows
Use After-Tax Cash Flows
Do Not use Sunk Costs
Consider Salvage Value
Cash Outflows
Repairs and
maintenance

Increased Initial
Working investment
Capital
Needs
Incremental
operating
costs
Cash Inflows Salvage
value

Release of
Reduction
working
of costs
capital

Incremental
revenues
Time Value of Money
A dollar today is worth
more than a dollar a
year from now.
Therefore, investments
that promise earlier
returns are preferable
to those that promise
later returns.
The Payback Method
The payback period is the length of time
that it takes to recover your investment.

Accept if Payback Period is

less than or equal to the
specified maximum period .
Investment required
Payback period =
Net annual cash inflow
Techniques of Capital Budgeting
Analysis
Payback Period Approach
Simple and Discounted Payback
Net Present Value Approach
Internal Rate of Return
Profitability Index
Which Technique should we follow?
A technique that helps us in selecting projects
that are consistent with the principle of
shareholder wealth maximization.
A technique is considered consistent with
wealth maximization if
It is based on cash flows
Considers all the cash flows
Considers time value of money
Is unbiased in selecting projects
The Payback Method Example
Purchasing a new equipment
1. Initial Investment 140,000 and has a 8-8-year life.
2. It will generate net annual cash inflows of 35,000
Management requires a payback period of 5 years or less
on all investments.
Payback Period = 140,000/35,000 = 4 yrs

Assume that this new equipment has the following cash

inflow :
Year 1 Year 2 Year 3 Year 4 Year 5
45,,000
45 40,000
40, 35,000
35, 30,000
30, 25,000
25,
Cash Flow: Assume that the Machine has the following cash inflow :
Year 1 =45000, 2 =40000, 3 =35000, 4 = 30000, 5 =25,000

Year Cash Flow Running Total

0 -140,000 -140,000
1 45,000 -95,000
2 40,000 -55,000
3 35,000 -20,000
4 30,000 10,000

Computation of the final year (20,000/30,000)

The year to recover investment is = 3.66 yrs.
Discounted Payback Period
Similar to payback period approach with one
difference that it considers time value of
money
The amount of time needed to recover initial
investment given the present value of cash
inflows
Keep adding the discounted cash flows till the
sum equals initial investment
All other drawbacks of the payback period
remains in this approach
Not consistent with wealth maximization
Discounted Payback Method Example
Purchasing a new equipment
1. Costs $140,000 and has a 8-
8-year life.
2. Assume the Cost of Capital is 5%
Management requires a payback period of 5 years or less
on all investments.

Assume that this new equipment has the following cash

inflow :
Year 1 Year 2 Year 3 Year 4 Year 5
45,000 40,000 35,000 30,000 25,000
Present value of $1 (PVIF)
Periods 1% 2% 3% 4% 6% 8% 10%

1 .. . . . 0.990 0.980 0.971 0.962 0.943 0.926 0.909

2 .. . . . 0.980 0.961 0.943 0.925 0.890 0.857 0.826
3 .. . . . 0.971 0.942 0.915 0.889 0.840 0.794 0.751
4 .. . . . 0.961 0.924 0.888 0.855 0.792 0.735 0.683
5 .. . . . 0.951 0.906 0.863 0.822 0.747 0.681 0.621
10 .. . . . 0.905 0.820 0.744 0.676 0.558 0.463 0.386
20 .. . . . 0.820 0.673 0.554 0.456 0.312 0.215 0.149
Discounted Payback: Assume the cost of Capital is 5% (Present Value)

Discounted
Year Cash Flow Running Total
Cash Flow
0 -140,000 -140,000 -140,000
1 45,000 (.952) 42,840 -97,160
2 40,000(.907) 36,280 -60,880
3 35,000(.864) 30,240 -30,640
4 30,000(.823) 24,690 -5,950
5 25,000(.784) 19,600 13,650

Computation of the final year (5950/19600)

The year to recover investment is = 4.30 yrs.
Evaluation of Payback Method

Advantages Disadvantages

Simple to Compute It Suffers from drawbacks

Cost Effective Ignores Cash Flaw
Short Term Effect Ignores Time Value of
Risk Shield Money
Liquidity Ignores the risk of future
cash flaws
Net Present Value
Present value of the stream of net operating cash flows
from the project minus the projects net investment.
Also called the discounted cash flow (DCF).
NPV used to decide weather or not to invest in a project
by looking at projected cash inflows and outflows

accept if NPV is > 0 or a

project with highest NPV > 0.
The Net Present Value Method
Purchasing a new equipment
1. Costs $140,000 and has a 8-
8-year life.
2. Assume the Cost of Capital is 5%
Management requires a payback period of 5 years or less
on all investments.

Assume that this new equipment has the following cash

inflow :
Year 1 Year 2 Year 3 Year 4 Year 5
45,000 40,000 35,000 30,000 25,000
Present value of $1 (PVIF)
Periods 1% 2% 3% 4% 6% 8% 10%

1 .. . . . 0.990 0.980 0.971 0.962 0.943 0.926 0.909

2 .. . . . 0.980 0.961 0.943 0.925 0.890 0.857 0.826
3 .. . . . 0.971 0.942 0.915 0.889 0.840 0.794 0.751
4 .. . . . 0.961 0.924 0.888 0.855 0.792 0.735 0.683
5 .. . . . 0.951 0.906 0.863 0.822 0.747 0.681 0.621
10 .. . . . 0.905 0.820 0.744 0.676 0.558 0.463 0.386
20 .. . . . 0.820 0.673 0.554 0.456 0.312 0.215 0.149
Net Present Value: Assume the cost of Capital is 5% (Present Value)

Net Cash Present Value NPV of Net Total PV of Net

Year
Inflows 5% Cash Inflows Cash Inflows

1 45,000 .952 42,840 42,840

2 40,000 .907 36,280 79,120
3 35,000 .864 30,240 109,360
4 30,000 .823 24,690 134,050
5 25,000 .784 19,600 153,650

Net Present Value = 153,650 140,000 = 13,650 at 5% PV within 5 years

Net Present Value Example
The company is considering another investment.
Initial investment is $135,000. Investment in working capital is $5,000.
Working capital will be recovered. Useful life is five years.
Estimated residual value is $4,000. Net cash savings is $30,000 per year.
Expected return is 5%.

Net Cash NPV of Net

Years 5% PV Inflows Cash Inflows
1-5 4.329 30,000 129,870
5 0.784 9,000 7,056
Total PV of net cash inflows 136,926
Net initial investment 140,000
Net present value of project ( 3,074)
Evaluation of Net Present Value
Advantages Disadvantages
It recognizes the time Cash Flow Estimation-
value of money. Difficult to obtain the
It considers the cash estimates of cash flows
inflow of the entire due to uncertainty
project. Discount Rate Difficult
It estimates the present to measure
value of their cash Mutually Exclusive
inflows by using a Projects- in alternative
discount rate equal to projects with unequal
the cost of capital. lives
It is consistent with the Ranking of Projects-not
objective of maximizing independent at the
the welfare of owners. discount rate
Internal Rate of Return
Define as the discount rate that equates the
PV of the net cash flows from a project with
the PV of the Net Investment.

Accept a project if IRR is

> Cost of Capital
The higher the internal rate of return, the
more desirable the project

Investment required
IRR=
Net annual cash inflow
The Internal Rate of Return Method
Example
Purchasing a new equipment
Initial Investment is 140,000
Net cash inflows is 35,000 per year
Useful life is 8 years.

140,000/35,000 = 4.00 (PV Annuity Factor)

IRR = 18% (from the table, eight -period line)

Internal Rate of Return

Advantages Disadvantages

It takes into account Multiple Rates

the time value of Mutually Exclusive Projects
money Value Additively
Acceptance Rule-
same as NPV
Shareholder Value-
Wealth Maximization
The Profitability Index [PI]
The Profitability Index is the ratio of the present value of
cash inflows, at the required rate of return, to the initial
cash outflow of the investment. Profitability index is
another time adjusted method of evaluating the
investment proposals. It is consistent with NPV.

Accept a project if PI is = or > 1.0

The Higher the PI is better

Present Value of cash inflows

Profitability Index =
Initial Investment
Ranking Investment Projects
Investment
A B
Present value of cash inflows 153,650 16,000
Investment required 140,000 14,000
Profitability index 1.10 1.14

The higher the profitability index, the

more desirable the project
Profitability Index

Advantages Disadvantages

It uses time value of Similar to the IRR, it may

money. It is similar to give the wrong decision
the NPV, and, is easy when choosing between
to interpret mutually exclusive projects
Value Maximization
Relative Profitability
Project Decision Analysis. Making
Go/No-Go Project Decision
Focus on cash flows, not profits
Focus on incremental cash flows
Account for time. Time is Money.
Account for Risk
End of my presentation

Thank you
and
God bless us all