This presentation shows discussion on capital budgeting

1. Capital Budgeting
Maria Cristina P. Obeso CPA, MBA

2. Capital Budgeting
•Process of identifying, evaluating,
planning, and financing capital
investment projects of an
organization.

3. Investment
•Any project for which a firm spends a
certain amount and from which it
expects something in return.

4. Characteristics of Capital Investment Decisions
1.Capital investment decisions usually require
relatively large commitments of resources
2.Most capital investment decisions involve long-
term commitments
3.Capital investment decisions are more difficult
to reverse than short term decisions.
*most capital investment decisions are made by top-level management

5. The Capital Budgeting Process
• Capital expenditure or investment projects can be generally
classified as follows:
1. Replacement
2. Improvement
3. Expansion
• Dependent or contingent projects - acceptance of one
proposal is dependent of the acceptance of one or more
other proposals
• Mutually exclusive projects – acceptance of one proposal
will mean automatic rejection of another proposal

6. Evaluating Capital Investment Projects
Capital Investment Factors
1. Net Investment – cash outflow less cash inflow
2. Net Returns – a. Accounting net income
b. Net cash inflow
3. Cost of capital – cost of using funds
(also known as cut-off-rate, minimum desired rate,
minimum acceptable rate, target rate, standard rate, and
hurdle rate)

7. Evaluating Capital Investment Projects
•Bonds – after tax rate of interest
•Preferred stock – dividend per share
divided by present market price of the stock
•Common stock and retained earnings –
earnings per share (after tax and preferred
dividends) divided by present market price
of stock

8. Commonly Used Evaluation Techniques
A.Methods that do not consider the time value of
money
a. Payback period
b. Payback bailout
c. Accounting rate of return
B.Methods that consider the time value of money
(discounted cash flow method)
a. Net present value
b. Present value index (Profitability index)
c. Present value payback
d. Discounted cash flow rate of return

9. Payback Period
– length of time required by the project
to return the initial cost of investment
Net cost of investment
Annual Net cash inflows
*even and uneven cash flows

10. Payback Period
• Advantages:
1. Payback is simple to compute and easy to understand
2. Payback gives information about liquidity of the project
3. It is a good surrogate for the risk. A quick payback period indicates
a less risky project
• Disadvantages:
1. Payback does not consider the time value of money
2. It gives more emphasis on liquidity rather than on profitability of
the project
3. It does not consider the salvage value of the project
4. it ignores the cash flows that may occur after payback period
The lower the payback period the better

11. Payback Bailout Method
– involves the computation of the bail-out period wherein
cash recoveries include not only the operating net cash
inflows but also the estimated salvage value or proceeds
from sale at the end of each year of the life of the projects

12. Payback Bailout Method
Advantage:
1. Just a refinement of the payback period except that
it attempts to overcome the disadvantage of ignoring the
salvage value of the project

13. ACCOUNTING RATE OF RETURN
-(book value rate of return, financial statement
method, average return on investment, unadjusted
rate of return)
Net Income
Investment

14. ACCOUNTING RATE OF RETURN
• Advantages:
1. The ARR computation closely parallels accounting concepts of income
measurement and investment return
2. It facilitates reevaluation of projects due to the ready availability of data
from the accounting records
3. This method considers income over the entire life of the project
4. It indicates the project’s profitability
• Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not
consider the time value of money
2.With the computation of income and book value based on the historical
cost accounting data, the effect of inflation is ignored

15. ACCOUNTING RATE OF RETURN
With the computation of income and book value
based on the historical cost accounting data, the
effect of inflation is ignored
Accounting rate of return must be higher than cost of capital

16. Discounted Cash Flow Methods
NET PRESENT VALUE METHOD- all cash inflows or outflows related to the
investment project are discounted at a minimum acceptable rate of return
PROFITABILITY INDEX - Ratio of present value of cash inflows to the
present value of cash outflows
NET PRESENT VALUE INDEX - A positive net present value index indicates
that the project is acceptable. A negative net present value is unacceptable
PRESENT VALUE PAYBACK METHOD - the cash flows to be used in
computing the payback period are converted to their present values
TIME ADJUSTED RATE OF RETURN - It refers to the interest or discount
rate that equates the present value of the returns or net cash inflows with
the investment
PAYBACK RECIPROCAL - Payback reciprocal is a reasonable estimate of the
discounted cash flow rate of return

17. Net Present Value Method
All cash inflows or outflows related to the
investment project are discounted at a minimum
acceptable rate of return
Present value of Cash inflows – Present value of cash
outflows
OR
Present value of Cash inflows – Cost of investment
The project is acceptable if the present value of cash
inflows is greater than the present value of cash outflows

18. Net Present Value Method
Advantages:
1. It considers the time value of money and the
timing of cash flows in evaluating the project
Disadvantages:
1. Computations involved are quite difficult
2. Computations of present values of cash inflows
to the present value of cash outflows

19. Profitability Index
(aka present value index, desirability
index and total present value index)
- Ratio of present value of cash inflows to
the present value of cash outflows

20. Profitability Index
Present value of cash inflows
Present value of cash outflows
OR
Present value of cash inflows
Cost of investment
The purpose of profitability index is to provide a basis for
comparison between or among projects of different sizes
A profitability index of 1.0 or greater is acceptable while less
than 1.0 is not acceptable

21. Net Present Value Index
NPV Index = Net Present Value
Investment
A positive net present value index indicates
that the project is acceptable. A negative net
present value is unacceptable

22. Present Value Payback Method
The cash flows to be used in
computing the payback period
are converted to their present
values

23. Time Adjusted Rate of Return
(also known as adjusted rate of return, internal rate of
return, discounted rate of return , discounted cash flow
rate of return)
• It refers to the interest or discount rate that
equates the present value of the returns or net
cash inflows with the investment
When the DCFRR is used, the PV of cash inflows = cost of
investment

24. Time Adjusted Rate of Return
Procedure: (FOR EVEN CASH FLOWS)
1. Determine the present value factor for the discounted cash flow
rate of return (DCFRR)
PVF for DCFRR = Net cost of investment
Net cash inflows
2. Using Present Value Annuity Table, find on line n (economic life)
the PVF obtained in step 1. The corresponding rate is the DCFRR
3. If exact rate is desired, the following interpolation should be
used:
DCFRR = LR + [ (HR-LR) x PVF (Ir) – PVF ( dcfrr) ]
PVF (Ir) – PVF (hr)

25. Time Adjusted Rate of Return
FOR UNEVEN CASH FLOWS:
Use trial and error
If exact rate is desired:
DCFRR = LR + [(HR-LR) x NPV (Ir) – 0
NPV (Ir) – NPV (hr)
If the DCFRR is higher than the cost of capital or minimum
desired rate of return then the projects is acceptable

26. Time Adjusted Rate of Return
Advantages:
1. DCFRR method considers the time value of money and the timing of cash
flows
2. It provides a measure of profitability that can be compared with a minimum
acceptable rate of return
3. It can be used to evaluate alternative proposals that require different initial
cash outlays and have unequal economic lives by logically ranking such projects
based on their respected DCFRR
Disadvantages:
1. Difficult to use and understand
2. When negative cash flow exist, the proposals yields questionable DCFRR’s
3. Method assumes that the cash inflows are reinvested at the internal rate of
return of the project, which is not at all times realistic

27. Payback Reciprocal
Payback reciprocal is a reasonable estimate of the discontinued cash flow
rate of return, provided that the following conditions are met:
1. The economic life of the project is at least twice the payback period
2. The net cash inflows are constant (uniform) throughout the life of the
project
Payback reciprocal = Net cash inflows
Investment
Or
1/ Payback period

28. Payback Reciprocal
Advantage:
The payback reciprocal is easy to compute
and provides a reasonable estimate of the DCFRR
provided some conditions are met

29. Comparison of the Evaluation Methods
Discounted Cash flow methods are
considered conceptually superior than
those that do not consider the time
value of money

30. Ranking Investment Projects
If problem in ranking arise due to conflicting results
shown by the evaluation methods, the results shown by
the DCF methods must be given more weight. However, if
ranking problems still exist despite the use of the DCF
methods, the result shown by the Net Present Value
method or better still by the Profitability index should be
preferred. The final decision however should be based on
the result shown by the profitability index.

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