Capital Budgeting (Long Term Investment) Decisions Chap.12 Dr.

Kiani
A. What is capital budgeting?
Capital budgeting is the series of long term planning decisions by individual
economic units as to how much and where resources will obtained and expended
for future use, particularly in the production of future goods and services.

B. The scope of capital budgeting encompasses:

1. How money is acquired and from what sources?
Sources are:
a. Internal= Retained earnings and depreciation
b. External= Issue bonds, debt financing, issue stocks(common &
preferred)
2. How individual capital project alternatives are identified and evaluated?
3. How minimum requirements of acceptability are set?
---- cost of capital
------ weighted average cost of capital
Sources % Specific cost of Capital WACOC
RE $3,000,000 .3 .10 .030
DEBT 2,000,000 .20 .15 .030
C/S 4,000,000 .40 .09 .036
P/S 1,000,000 .10 .08 .008
----------------------------------------------------------------------------------------
10,000,000 1.00 10.40%
======================================================
4. How final project selections are made?
5. How post mortem are conducted?

C. Capital Investments Decisions:

a. Expansion decisions
b. Replacement decisions
c. New product decisions

D. Data requirements for capital budgeting projects

a. Expected revenues and expenditures
b. Expected useful life
c. Expected salvage value
d. Expected tax benefits
e. Expected cost of capital
f. Actual cost of investment
E. Techniques of Capital Budgeting :
a. Payback period
b. Payback reciprocal
c. Accounting Rate of Return (AROR)
d. Net Present Value (NPV)
e. Net Profitability Index(NPI) or Net Present Value Index (NPVI)

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 f. Adjusted Rate of Return or Internal Rate of Return (IRR)
1. What is Payback Period?
Number of years required to retain the original investment. That is how long it
takes to recover the original investment.
Major advantages: Simplicity and liquidity
Major disadvantages:
a. It ignores time value of money
b. It ignores income which may be produced beyond the payback
period.
Rank projects using payback period by lowest payback period to highest payback
period.
Payback Period = (Investment)/ (Net Cash Inflows)
Net cash Inflows = Net Operating Income + Depreciation Expense
Cash inflows:
• Incremental Revenues
• Reduction in Costs
• Salvage Value
• Release of Working Capital …Working capital means ( Cash, accounts
receivables, and inventory)
Cash Outflows:
• Initial Investment ( Including installation costs)
• Increased in Working Capital needs
• Repairs and Maintenance
• Incremental Operating Costs

2. ACCOUNTING RATE OF RETURN (AROR)

=
(NET OPERATING INCOME)/ (INITIAL INVESTMENT)
Major advantage: a. Data are readily available from accounting records.
b. Easy to understand and use
c. Ties in with Income Statement and Performance Evaluation
Major disadvantages: it ignores time of money.
Rank projects according to highest AROR to lowest AROR provided that lowest is
at least equal to the cost of capital.

3. NET PRESENT VALUE (NPV) :

NPV =Present Value of Cash Inflows – Present Value of Cash Outflows

Decision Rule:
a. If NPV>0, then accept the project
b. If NPV=0, then indifference position, go no go situation
c. If NPV< 0, then reject the project

Rank projects according to highest NPV to lowest NPV, provided that lowest
NPV=0.
Major advantages:

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 a. Emphasizes Cash Flows
b. Recognizes Time Value of Money
c. Assume Discount Rate is Reinvestment Rate
d. Easy to Apply
Major Disadvantages:
a. Favors Larger, Longer Project
b. Assumes No Changes in Required Rate of Return.

F = P (1+i%)n
Where :
F = future sum
P = Principal
i% = interest Rate
n = # of years or period
PV= Present Value
PV factor= discount factor = 1/(1+i%)n
So: PV = F/(1+i%)n

4. Profitability Index (PI) or Present Value Index (PVI)

=
( Present Value of Cash Inflows)/ ( Present Value of Cash Outflows)

Decision Rule:
a. If PVI > 1 , then accept the project
b. If PVI = 1, then indifference position
c. If PVI < 1, then reject the project
Ranking project according to highest PVI to lowest PVI ( at least = 1).

5. INTERNAL RATE OF RETURN = (IRR)

IRR is an interest rate which equates the present value of cash inflows to present
value of cash outflows, and makes NPV=0.

Calculation: a: trial and error approach or b: mathematical equation

Decision Rule:
a. IF IRR > Cost of Capital (COC), then accept the project
b. IF IRR = COC, then indifference position
c. IF IRR <COC, then reject the project
Major advantages:
a. Emphasizes Cash Flows
b. Recognizes Time Value of Money
c. Computes True Return of Projects
Major disadvantages:
a. Assume IRR is the reinvestment rate
b. Favors shorter projects.

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