CAPITAL BUDGETING

WHAT IS CAPITAL BUDGETING?

-the process of planning for purchases of assets whose returns are expected to continue beyond one year.
-also called as Investment Appraisal

CAPITAL EXPENDITURE VS. REVENUE EXPENDITURE

-is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than one year.

-is expenditure which results in maintaining the existing earning capacity of noncurrent assets.

CAPITAL EXPENDITURE VS. REVENUE EXPENDITURE

temporary effect.

have long term effect.

value of an asset increased as a result of this expenditure value of an asset does not increase.

non-recurring
has physical existence

recurring and regular

no physical existence

CAPITAL EXPENDITURE VS. REVENUE EXPENDITURE

Purchase costs Installation costs Replacement costs

Repair costs Maintenance costs

CAPITAL EXPENDITURE VS. REVENUE EXPENDITURE

Journal Entries:

Fixed assets

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Expense

xx

Cash/Accounts Payable

xx

Cash/Accounts Payable

xx

EXAMPLES OF CAPITAL INVESTMENT PROJECTS

Purchase of new equipment Replacement of an existing capital asset Expansion of existing products Merger

IMPORTANCE OF CAPITAL BUDGETING

used to determine whether an organizations long term investments are worth funding. require sizable cash outlay. have a long-range impact on the firms performance. risky and uncertain.

KEY TERMS IN CAPITAL BUDGETING

How Projects are Classified?

Independent Projects Mutually Exclusive Projects Contingent Projects

CLASSIFICATION OF PROJECTS

Independent Projects

- one whose acceptance or rejection does not directly eliminate other project from consideration.

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CLASSIFICATION OF PROJECTS

Mutually Exclusive Projects

-one whose acceptance or rejection precludes the acceptance of one or more alternative proposals.

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CLASSIFICATION OF PROJECTS

Contingent Projects
-one whose acceptance is dependent on the adaptation of one or more other projects.

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KEY TERMS IN CAPITAL BUDGETING

Capital Rationing
-setting limits or restrictions on the amount of new investments or projects undertaken by a company.

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Strategic Planning

CAPITAL BUDGETING PROCESS

Investment Opportunities Preliminary Screening

Financial Appraisal

Project Evaluation

Post- Implementation Audit

Implementation and monitoring

Decision

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CAPITAL BUDGETING PROCESS

Strategic Planning

-translates the firms corporate goals into specific policies and directions, sets priorities, specifies the structural, strategic and tactical areas of business development , and guides the planning process in the pursuit of solid objectives.

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CAPITAL BUDGETING PROCESS

Identification of Investment Opportunities

-the process of identifying potential projects that can benefit the firm.

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CAPITAL BUDGETING PROCESS

Preliminary Screening
-identified investment opportunities have to be subjected to a preliminary screening process by management to isolate the marginal and unsound proposals.

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CAPITAL BUDGETING PROCESS

Financial Appraisal (Quantitative Analysis)

-management analyze expected future cash flows of the project, evaluate the risk associated with those cash flows, develop alternative cash flow forecast and examine the sensitivity of the results to possible changes in the predicted cash flows.

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CAPITAL BUDGETING PROCESS

Project Evaluation -when a project passes through quantitative analysis test, it has to be further evaluated taking into consideration qualitative factors.

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CAPITAL BUDGETING PROCESS

Qualitative factors are those which will have an impact on the project, and which are virtually impossible to evaluate accurately in monetary terms.

Example: Environmental impact of the project Societal impact of the project Legal requirements Health & Safety standards

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CAPITAL BUDGETING PROCESS

Decision (Accept/Reject)

-management chooses whether to accept or reject the project. -Combination of quantitative analysis and qualitative factors to form the basis of decision support information.

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CAPITAL BUDGETING PROCESS

Project Implementation and Monitoring

-projects are being realized and executed. The integral part of project implementation is the constant monitoring of project progress with a view of identifying potential bottlenecks to take corrective actions when needed.

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CAPITAL BUDGETING PROCESS

Post Implementation Audit

-deals with a examination of the performance of the projects already implemented. An evaluation of the performance of pastdecisions, however can contribute greatly to the improvement of current investment decision-making by analyzing the past rights and wrongs

TIME VALUE OF MONEY

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TIME VALUE OF MONEY

-an amount of money received today is worth more than the same dollar amount it would be if it were received a year from now.

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Interest

TIME VALUE OF MONEY

-a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money or money earned by deposited funds
- the amount of money borrowed or invested. -the percentage on the principal that the borrower pays the lender per time period as compensation for forgoing other investment or consumption opportunities.

Principal Rate of interest

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Simple Interest

INTEREST

-the interest paid (in the case of borrowed money) or earned (in the case of invested money) on the principal only.

I= PV x i x n

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SIMPLE INTEREST (example)

If Mr. X bought a land and borrowed $30,000 at a 10% annual interest rate, what would be his first months interest payment?

I= $30,000 x 10% x 1/12 = $250

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COMPOUND INTEREST

Compound Interest

-interest that is paid not only on the principal but also on any interest earned but not withdrawn during earlier periods.

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COMPOUND INTEREST (example)

If Mr. Cool Lukoy deposits $1000 in a savings account paying 6 percent interest compounded annually, what is the future (compound) value of his account at the end of one year.

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INTEREST (example)

FV1= PV0 (1+i) =1000 (1 + 0.06) =1,060

0 t (Year) 1

1,000

FV1

1,060

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TIME VALUE OF MONEY

If Mr. Cool Lukoy leaves the $1,000 plus the accumulated interest in the account for another year, its worth at the end of the second year is as follows: FV2= FV1 (1+i) =$1,060 (1+ o.06) =$1,123.60
0 2 3

1,000

1,060

1,123.60

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TIME VALUE OF MONEY

If Mr. Lukoy makes no withdrawals from the account for another year, it will total the following at the end of third year:

FV= FV2 (1+i) =$1,123.60 (1+0.06) =$1,191.02

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P R E S E N T V A L U E 1,210

TIME VALUE OF MONEY

FV3=$1,191.02 1,180 Compound interest (year 3)

FV2= $1,123.60
1,120 FV=$ 1,060 1,060 Simple Interest 1,000 YEAR 1 YEAR 2 YEAR 3

Compound interest (year 2)

PRINCIPAL

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TIME VALUE OF MONEY

Nominal Interest Rate
.the periodic interest rate multiplied by the number of periods per year.

FV=PV0 1+

i nom
m

mn

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TIME VALUE OF MONEY

Determine the future value if present value worth $1,000 compounded semiannually at a 10% nominal interest per year.

FV=$1,000 1+ =$ 1,102.50

0.10

2x1

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Initial amount
$1,000 1,000 1,000

TIME VALUE OF MONEY

Compounding frequency
Yearly Semiannually Quarterly

Future value (end of year 1)

$ 1,1oo 1,102.50 1,103.81

1,000

monthly

1,104.71

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Effective interest

EFFECTIVE INTEREST

In contrast to nominal interest, is the actual rate of interest earned by the lender.
i nom
m

i eff= 1+

) -1

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EFFECTIVE INTEREST

Suppose a bank offers you a loan at an annual nominal interest rate of 12% compounded quarterly. What is the effective annual interest rate is the bank charging you?

i eff

(1+ )
4

0.12

-1

=o.1255 = 12.55 %

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COMPOUNDING vs DISCOUNTING -employing formulas to find the present value of a future dollar amount.

-determines the future value of a present dollar amount by using a compound-interest rate formula.

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COMPOUNDING vs. DISCOUNTING