7/5/2014

Chapter 1
Capital budgeting: An overview
FPT School of Business
Assessment Scheme
On-going assessment:
- Quizzes (3): 5% each
- Mid-term test: 20%
- Individual Assignment: 15%
- Group Assignment: 20%
- Final Exam: 30%
Completion Criteria: Final Result >=5 & Final
Exam Score >=4

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Main business activities
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Production budgeting
Income statement budgeting
Capital budgeting
Production activity
Selling activity
Investment activity
Production budgeting is about:
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To produce:
What product?
How many?
Production cost?





Income statement budgeting is about:
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To sell:
What product?
At which price?
How much is the profit?
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Should we
build this
plant?
Capital budgeting is about:
Capital budgeting is about:
What to pay to day? (cash outflows)
What to invest?
How much?
When? (year 0 and upgrade)
What to receive in the future? (cash inflows)
What to collect?
How much?
When?
Then compare Net benefit
To answer question:
Can we produce without any
equipment/machine/plant (Fixed assets)?
Capital budgeting is about:
Capital budgeting is the process of identifying,
evaluating, and implementing a firms investment
opportunities.
It seeks to identify investments that will enhance
a firms competitive advantage and increase
shareholder wealth.
Poor capital budgeting decisions can ultimately
result in company bankruptcy.

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What is Capital Budgeting?
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Is long-run planning decisions involving the acquisition of
long-lived assets.
Main goals of capital budgeting investments is to increase the
value of the firm to the shareholders so that select projects
increase the capital (value) of a business.

Requires a large initial cash outflow with the expectation of
future cash inflows
Focuses primarily on projects that span multiple years.
Initial capital outlay Example

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Initial
investment

Y0 ($) Useful life
(years)
Fixed
assets
Land 20,000 forever
Building 10,000 20
Machine 8,000 10
Tools 1,000 2
Structure of Initial capital outlay
Structure of Initial capital outlay could be:
Total Initial capital outlay: 100%
From the Owner equity: 70%
From lenders (Borrowing): 30%, in which:
Original
Term
Interest rate
Payment:
Equal principle
Annuity each year


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Capital Budgeting Within The Firm

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The Position of Capital Budgeting
Capital Budgeting
Long Term Assets Short Term Assets
Investment Decison
Debt/Equity Mix
Financing Decision
Dividend Payout Ratio
Dividend Decision
Financial Goal of the Firm:
Wealth Maximisation
The capital budgeting process
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1. Corporate goal
2. Strategic planning
3. Identification of investment
opportunities
4. Preliminary screening of
projects
5. Financial appraisal of
projects
6. Qualitative factors in project
evaluation
7. The accept/reject decision
8. Project implementation and
monitoring
9. Post-implementation audit
1. Xc nh mc tiu chung
2. Xy dng chin lc
3. Phn tch C hi u t
4. Sng lc s b d n
5. Thm nh ti chnh d n
6. Thm nh yu t nh tnh
7. Ra quyt nh t chi/ph
duyt d n u t
8. Thc hin v gim st d
n
9. Kim tra sau thc hin
The capital budgeting process
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2. Strategic planning
A strategic plan is the grand design of the rm and clearly
identies the business the rm is in and where it intends to
position itself in the future. Strategic planning translates the
rms corporate goal into specic policies and directions.
3. Identification of investment opportunities
To identify investment opportunities that t in with a rms
corporate goals, its vision, mission
and long-term strategic plan.


The capital budgeting process
4. Preliminary screening of projects
There will be many potential investment proposals.
This stage is to isolate the unsound proposals and explore the best
proposals.
5. Financial appraisal of projects
To consider the expected costs and the expected benefits of
alternative capital investments.

The capital budgeting process
6. Qualitative factors in project evaluation
Qualitative factors are those which will have an impact on the
project, but which are virtually impossible to evaluate accurately
in monetary terms. Example:
The societal impact of an increase or decrease in employee
numbers
The environmental impact of the project
7. The accept/reject decision
To choose projects for implementation.

The capital budgeting process
8. Project implementation and monitoring
To get projects underway and monitor their performance.
9. Post-implementation audit
The post-implementation audit is somewhat like a lessons learned
activity in that it provides great information to use on future
project engagements, but its more of an evaluation of the
projects goals and activity achievement as measured against the
project plan, budget, time deadlines, quality of deliverables,
specifications, and client satisfaction.
Project Classification
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According to risk:
Expansion projects
Replacement projects


According to dependence on other projects:
Independent projects
Mutually exclusive projects
Contingent projects

Indipendent projects

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Is one that the acceptance or rejection of which does not
directly eliminate other projects. A company can select
one, or the other, or bothso long as they meet minimum
profitability thresholds.
Example:
Introduce a new product line - product A (Project 1)
Replace a machine is currently producing - product B
(Project 2)
Project 1and Project 2 are Indipendent projects

Mutually exclusive projects
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Is one that the acceptance of one prevents the
acceptance of the alternative proposal. A firm can
select one or another but not both.

Example:
A firm may own a block of land which is large
enough to establish:
A shoe manufacturing plant (Project A)
A steel manufacturing plant (Project B)
A and B are Mutually exclusive projects

Contigent projects
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Is one that the acceptance or rejection of which is
dependent on the decision to accept or reject
other project. A company can select one, or the
other, or bothdepends on the decision had
made.
Contigent projects is divided into two types:
Complementary: ei: pharmacy project and doctors
surgery project.
Substitutes: ei: Chinese restaurant project and
Thai restaurant project.


Evaluation of investment projects
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Can be evaluated independently
to select the project provided
adds value to the firm. May
chose 1 proposal or all the
proposal.
Can be evaluated independently
to select the one which yields the
highest NPV to the firm. Chose
only1 proposal and must reject
other.
Can be evaluated in the
interaction of all the projects.
Indipendent projects





Mutually exclusive projects





Contigent projects
Asset expansion project and Asset
replacement projects
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Asset expansion project: is one that proposes
to invest inaditional assets
To expand an existing product
To launch a new product line
Asset replacement project: is one involves
retiring one asset and replacing it with a more
efficienct asset.



Point of views in project evaluation
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TIPV: Total investment point of view (Tng vn u t)

EPV: Equity point of view (Vn ch s hu)


Point of views in project evaluation
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TIPV :
How much the owner and the lenders invest in the project
today?
How much the owner and the lenders may collect from
exploring the project in the future?
Evaluate the NET BENEFIT of both sides. It means NET
CASH FLOWS for both sides.
EPV:
How much the owner in the project today?
How much the owner may collect from exploring the
project in the future?
Evaluate the NET BENEFIT of the owner only.

Now, doing exercise
Preparing loan payment schedule
Equal principle payment
Annuity payment
Preparing an Income statement with different
cost classification.
List of costs
Variable costs and fixed costs
Production costs and Non-production costs
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Example 1: Preparing loan payment schedule
Equal principle payment
Original loan 10,000 year 0 (2009)
Interest rate 10% per year
Payment period 5 year
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Loan payment schedule
(Equal principle payment)
2009 2010 2011 2012 2013 2014
Year 0 1 2 3 4 5
Beginning
balance of
the loan 10,000 8,000 6,000 4,000 2,000
Interest
expense 1,000 800 600 400 200

Principle 2,000 2,000 2,000 2,000 2,000
Step 1: Principle = Orginal loan / Number of periods
Step 2: Beginning balance = Beginning balance of previous year
Principle of previous year.
Step 3: Interest expense = Beginning balance * Interest rate
Example 2: Preparing loan payment schedule
(Annuity payment)
Original loan 10,000 year 0 (2009)
Interest rate 10% per year
Payment period 5 year
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Loan payment schedule
(Annuity payment)
2009 2010 2011 2012 2013 2014

Year 0 1 2 3 4 5
Beginning
balance of
the loan 10,000 8,362 6,560 4,578 2,398
Annuity
2,638 2,638 2,638 2,638 2,638
Interest
expense 1,000 836 656 458 240
Principle 1,638 1,802 1,982 2,180 2,398

Step 1: Annuity = -PMT(rate, total periods, orginal loan)
Step 2: Interest expense = Beginning balance * Interest rate
Step 3: Principle = Annuity - Interest expense
Example 3: Preparing Income Statement
Project life time is 3 years.
A new machine purchased to day (t=0) costs of $150,000.
The useful life of new machine is 6 year (straight-line
method).
The project will increase annual revenues by $800,000 and
operating expenses (exclude depreciation) by $400,000 in
each year, for years 1 through 3. in which:
Rent expense: $ 200,000
Salary expense: $ 100,000
Insurance expense: $ 60,000
Office supplies expense: $ 40,000

The corporate tax rate is 30%. No ending inventory.
REQUIRE: Prepare Income statement from year 1 to
year 3.
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Cost classification:
List of costs
Total costs are divided into:
Operating cost (exclude Depreciation): $400,000
Rent expense: $ 200,000
Salary expense: $ 100,000
Insurance expense: $ 60,000
Office supplies expense: $ 40,000
Depreciation expense
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Depreciation
Year Cost of asset Depreciation
expense/year
Book value
0 150,000
1 $25,000 125,000
2 $25,000 100,000
3 $25,000 75,000
4 $25,000 50,000
5 $25,000 25,000
6 $25,000 0
Y1 Y2 Y3
Sales $800,000 $800,000 $800,000
Operating expense
(Exclude D.)
$400,000 $400,000 $400,000
Depreciation $25,000 $25,000 $25,000
EBIT $375,000 $375,000 $375,000
Interest expense 0 0 0
EBT $375,000 $375,000 $375,000
Taxes (30%) $112,500 $112,500 $112,500
Net income $262,500 $262,500

$262,500

Income statement
Example 4: Preparing Income Statement
Background information:
Project life time is 3 years.
A new machine purchased to day (t=0) costs of $150,000.
The useful life of new machine is 6 year (straight-line
method).
Sales of 10,000 units/year; selling price is $50/unit.
Variable cost per unit is $30.
Other Fixed costs (Exclude Depreciation) are $50,000 per
year.
The tax rate is 30%. No ending inventory.
REQUIRE: Prepare Income statement from year 1 to
year 3.
Cost classification:
Variable costs and fixed costs
Total costs are divided into:
Operating cost (exclude Depreciation)
Total Variable costs
Other Fixed costs
Depreciation expense
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Depreciation
Year Cost of asset Depreciation
expense/year
Book value
0 150,000
1 $25,000 125,000
2 $25,000 100,000
3 $25,000 75,000
4 $25,000 50,000
5 $25,000 25,000
6 $25,000 0
Y1 Y2 Y3
Sales $500,000 $500,000 $500,000
Unit sales 10,000 10,000 10,000
Selling price $50,000 $50,000 $50,000
Operating cost(Excl.D) $350,000 $350,000 $350,000
Total Variable costs $300,000 $300,000 $300,000
Variable costs/unit $30 $30 $30
Unit produced 10,000 10,000 10,000
Other Fixed costs $50,000 $50,000 $50,000
Depreciation $25,000 $25,000 $25,000
EBIT $125,000 $125,000 $125,000
Interest expense 0 0 0
EBT $125,000 $125,000 $125,000
Taxes (30%) $37,500 $37,500 $37,500
Net income $87,500 $87,500 $87,500
Example 5: Preparing Income Statement
Invested in a new machine purchased to day (t=0) costs of $150,000. The
useful life of new machine is 6 year (straight-line method). Project life is 3
years.
Sales:
10,000 units/year;
selling price is $50/unit.
Production costs (Exclude depreciation) include:
Direct material cost is $20/unit
Direct labor cost is $10/unit
Overhead costs are $30,000 per year
Non - Production costs (Exclude depreciation) include:
Selling costs are $15,000 per year.
Administrative costs are $5,000 per year.
Other information:
The tax rate is 30%. No ending inventory.
REQUIRE: Prepare Income statement from year 1 to year 3.
Cost classification:
Production costs and Non-production cost
Total costs are divided into:
Operating cost (exclude Depreciation)
Production cost
Cost of goods sold
Non production cost
Selling costs
Administrative costs
Depreciation expense
If Production volume = Sales volume,then
COSG = Production cost




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In which, Production cost:
+ Direct material cost
+ Direct labor cost
+ Overhead cost
Depreciation
Year Cost of asset Depreciation
expense/year
Book value
0 150,000
1 $25,000 125,000
2 $25,000 100,000
3 $25,000 75,000
4 $25,000 50,000
5 $25,000 25,000
6 $25,000 0
Y1 Y2 Y3
Sales $500,000 $500,000 $500,000
Operating cost (Exc.D)
$355,000 $355,000 $355,000
COGS=Production cost $330,000 $330,000 $330,000
Total D.M cost $200,000 $200,000 $200,000
Total D.L cost $100,000 $100,000 $100,000
Overhead costs $30,000 $30,000 $30,000
Selling costs $15,000 $15,000 $15,000
Administrative costs $10,000 $10,000 $10,000
Depreciation $25,000 $25,000 $25,000
EBIT $125,000 $125,000 $125,000
Interest expense 0 0 0
EBT $125,000 $125,000 $125,000
Taxes (30%) $37,500 $37,500 $37,500
Net income $87,500 $87,500 $87,500
End of chapter 1

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Thank you!