CAPITAL BUGETING TECHNIQUES

MSAC-301 FINANCIAL MANAGEMENT

BY: VIDAL W. BADIVAL, JR.

Slide Title Subtitles Notes

1 You Should  Capital is a limited  In the form of either debt or equity, capital is a very limited resource. There is a limit to the volume of credit that
Remember resource the banking system can create in the economy. Commercial banks and other lending institutions have limited
 Capital budgeting is deposits from which they can lend money to individuals, corporations and government. Having limited resources
investment decision- to lend, lending institutions are selective in extending loans to their customers. But even if bank were to extend
making unlimited loans to a company, the management of that company would need to consider the impact that
increasing loans would have on the overall cost of financing.
 In reality, any firm has limited borrowing resources that should be allocated among the best investment
alternative. One might argue that a company can issue an almost unlimited amount of common stock to raise
capital. Increasing the number of shares of company stocks, however will serve only to distribute the same
amount of equity among a greater number of shareholders. In other words, as the number of shares of a
company increases, the company ownership of the individual stockholders may proportionally decrease.
 Faced with limited sources of capital, management should carefully decide whether a particular project is
economically acceptable. In case of more than one project, management must identify the projects that will
contribute most profits and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis of
capital budgeting.
 Capital budgeting is investment decision-making as to whether a project is worth undertaking. Capital budgeting
is basically concerned with the justification of capital expenditures. Current expenditures are short-term and are
completely written-off in the same year that expenses occur. Capital expenditures are long-term and are
amortized over a period of years.
2 Profitability Index =PV of future cash  The profitability index is an index that attempts to identify the relationship between the costs and benefits of a
flows/Initial investment or proposed project through the use of a ratio calculated as: PI=PV of future cash flows over initial investment and
PV of cash inflows/PV of or PV of cash outflows
cash outflows  This method compares the present value of future cash inflows with the initial investment on a relative basis
 If the NPV of a project is positive, the PI will be greater than 1. On the other hand, if the net present value is
negative, the project will have a PI of less than 1. The same conclusion is reached, therefore, whether the NPV
of PI is used. In other words, if the present value of cash flows exceeds the initial investment, there is a positive
NPV and PI greater than 1, indicating that the project is acceptable.
 Advantages:
-Tells whether an investment increases the firm’s value
-Considers all cash flows of the project
-Considers the time value of money

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3 Profitability Index PI Decision Rules
(For Independent
Projects)
 PI > 1 Accept Project
 PI = 1 Indifferent
 PI < 1 Reject Project
4 Profitability Index PI Decision Rules
(For Mutually Exclusive
Projects)
 Take the project with
largest PI, Subject to
PI>1.0
5 Payback Period  The amount of time
required for the cash flow
generated by the by the
investments to repay the
cost of original
investment
 Payback period =
Expected number of
years required to recover
a project’s cost
CAPITAL BUGETING TECHNIQUES
MSAC-301 FINANCIAL MANAGEMENT
BY: VIDAL W. BADIVAL, JR.
-Considers the risk of future cash flows (through the cost of capital)
-Useful in ranking and selecting projects when capital is rationed
 Disadvantages:
-Requires estimate of the cost of capital in order to calculate the PI
-May not give the correct decision when used to compare mutually exclusive projects
 Use:
-It is useful in evaluating capital expenditure projects being a relative measure
 A ratio of 1.0 is logically the lowest acceptable measure on the index, as any value lower than 1.0 would indicate
that the project’s PV is less than the initial investment.
 As values on the profitability index increase, so does the financial attractiveness of the proposed project
 When limited capital is available and projects are mutually exclusive, the project with the highest profitability
index is to be accepted as it indicates the project with the most productive use of limited capital.
 A simple method of capital budgeting
 It provides insight into the liquidity of the investments. However the analysis does not include cash flow payments
beyond the payback period
 The payback period is the traditional method of capital budgeting, it is perhaps, the most widely used quantitative
method for appraising capital expenditure decision.
 Methods to compute:
-The first method can be applied when cash flow is uniform. In such a situation the initial cost of the investment is
divided by the constant annual cash flow.
-The second method is used when a project’s cash flows are not equal. In such a situation PBP is calculated by
the process of cumulating the cash flows till the time when cumulative cash flow becomes equal to the original
investment.
 This technique can be used to compare actual pay back with a standard pay back set up by the management in
terms of the maximum period terms of the maximum period during which the initial investment must be
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 CAPITAL BUGETING TECHNIQUES
MSAC-301 FINANCIAL MANAGEMENT
BY: VIDAL W. BADIVAL, JR.

recovered. The standard PBP is determined by the management subjectively on the basis of a number of factors
such as type of project, the perceived risk of the project and etc. PBP can be even used for ranking mutually
exclusive projects. The projects may be ranked according to the length of PBP and the project with shortest PBP
will be selected.
 Advantages:
-simple to compute
-Provide some information on the risk of the investment
-Provide a crude measure of liquidity. It emphasizes selecting a project with the early recovery of the investment
-It is a cost effective method which does not require much of the time of the finance executives as well as the use
of computers
-It is a method for dealing risk. It favors projects which generates substantial cash inflows in earlier years and
discriminates against projects which brings substantial inflows in later years. Thus PBP method is useful in
weeding out risky projects
 Disadvantages:
-Ignores the time value of money. Cash inflows are simply added without discounting. This violates the most
basic principle of the financial analysis that stipulates the cash flows occurring at different points of time can be
added or subtracted only after suitable compounding or discounting
-Ignores cash flows occurring after the payback period
-No concrete decision criteria to indicate whether an investment increases the firm’s value.
-Ignores the risk of future cash flows
-It is a measure of projects capital recovery, not profitability so this cannot be used as the only method of
accepting or rejecting a project.
-The projects are not getting preference as per their cash flow pattern. It gives equal weight to the projects with
the same PBP but fails to recognize cash flow pattern.
 Uses:
-The PBP method may be useful for firms having troubles with liquidity
-It is very useful for those firms which emphasizes on short term earning performance rather than its long term
growth
6 Payback Period Decision rule  Decision rule:
-If the PBP is less than the maximum acceptable payback period, accept the project
-If the PBP is greater than the maximum acceptable payback period, reject the project
7 Discounted The number of years  One of the major limitations of PBP method is that it ignores time value of money. This problem can be solved if
Payback Period taken in recovering the we discount the cash flows and then calculate the PBP. Thus, discounted payback period is the number of years
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 CAPITAL BUGETING TECHNIQUES
MSAC-301 FINANCIAL MANAGEMENT
BY: VIDAL W. BADIVAL, JR.

investment outlay on the taken in recovering the investment outlay on the present value basis.
present value basis  Advantages:
-Considers the time value of money
-Considers the riskiness of the project’s cash flow (through the cost of capital)
 Disadvantages:
-No concrete decision criteria that indicate whether the investment increases the firm’s value
-Requires an estimate of the cost of capital in order to calculate the payback
-Ignores cash flows beyond the discounted payback period
8 Accounting/Average ARR=(Average Annual  It uses accounting information rather than cash flow.
Rate of Return Profit after tax divided by  It is the ratio of the average after tax profit divided by the average investment.
(ARR) average investment)  Decision rule:
multiply by 100 -If the ARR is higher than the minimum rate established by the management, accept the project
Also known as ROI or -If the ARR is less than the minimum rate established by the management, reject the project
Return on capital  The ranking method can also be used to select or reject the proposal using ARR. It will rank a project number one
employed if it has highest ARR and lowest rank would be given to the project with lowest ARR.
 Advantages:
-It is simple to calculate
-It is based on accounting information which is readily available and familiar to businessman
-It considers benefit over the entire life of the project
 Disadvantages:
-It is based upon accounting profit, not cash flow in evaluating projects
-It does not take into consideration time value of money so benefits in the earlier years or later years cannot be
valued at par.
-This method does not take into consideration any benefits which can accrue to the firm from the sale or
abandonment of equipment which is replaced by a new investment. ARR does not make any adjustment in this
regard to determine the level of average investments
-It takes into account all years income but it is averaging out the profit
-The firm compares any project’s ARR with the one which is arbitrarily decided by the management generally
based on the firm’s current return on assets.
 Use:
-The ARR can better be used as performance evaluation measure and control devise but it is not advisable to be
used as a decision making criterion for capital expenditures of the firm as it is not using cash flow information

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 CAPITAL BUGETING TECHNIQUES
MSAC-301 FINANCIAL MANAGEMENT
BY: VIDAL W. BADIVAL, JR.

9 Project Decision Making go/no-go project  Focus on cash flows, not profits. One wants to get as close as possible to the economic reality of the project,
Analysis decision Accounting profits contain many kinds of economic fiction. Flow of cash, on the other hand, is economic facts.
Focus on cash flows, not  Focus on incremental cash flows. The point of the whole analytical exercise is to judge whether the firm will be
profits better off or worse off if it undertakes the project. Thus one wants to focus on the changes in cash flows caused
Focus on incremental by the project. The analysis may require some careful thought: a project decision identified as a simple go/no-go
cash flows question may hide a subtle substitution or choice among alternatives. For instance: Will the machine expand
Account for time capacity (and thus permit to exploit demand beyond your current limits)? Will the machine reduce costs (at the
Account for risk current level of demand) and thus permit us to operate more efficiently than before we had a machine? Will the
machine create other benefits (e.g., higher quality, more operational flexibility) The key economic question asked
should be “How will things change (i.e., be better or worse) if we undertake the project?”
 Account for time. Time is money. We prefer to receive cash sooner rather than later.
 Account for risk. Not all projects present the same level of risk. One wants to be compensated with higher return
for taking more risk. The way to control for variations in risk from project to project is to use a discount rate to
value a flow of cash that is consistent to the risk of that flow
10 End of presentation References:  http://www.exinfm.com/training/s_course_desc.html
 IOWA State University-Extension and Outreach-www. Extension.iastate.edu/agdm
 Journal of economics and finance education –volume 11
 Proceedings in Manufacturing Systems, Volume 7, Issue 1, 2012
 http://accountingexplained.com
 http://investopia.com
 Article prepared by Pamela Peterson-Drake, Florida Atlantic University
 Pandey I M, Financial Management