This document discusses key concepts related to capital budgeting and risk analysis. It begins with definitions of capital budgeting as the process of identifying, evaluating, planning, and financing capital investment projects. It describes the main features of capital budgeting projects as having large anticipated benefits, high risk, and a long time period between initial outlay and return. The document then covers various capital budgeting techniques for evaluating projects, including payback period, net present value (NPV), and internal rate of return (IRR). It provides examples of calculating each measure and the criteria for accepting projects. Finally, it discusses risk in capital budgeting, defining it as uncertainty in cash flow forecasts, and methods for measuring risk, such as

1. Present value and Opportunity cost of capital
The Capital Budgeting Decision
Risk and Capital Budgeting

3.  Introduction
 Foundations of the Net PresentValue Rule
 Calculating Present value

4.  The process of identifying, evaluating, planning,
and financing capital investment projects of an
organization.
 Capital budgeting is defined “as the firm’s
formal process for the acquisition and
investment of capital. It involves firm’s decisions
to invest its current funds for addition,
disposition, modification and replacement of
fixed assets”.
 “Capital budgeting is long term planning for
making and financing proposed capital outlays”-
CharlesT. Horngreen.

5.  Capital budgeting involves capital investment
projects which require large sum of outlay and
involve a long period of time – longer than the usual
cut-off of one year or normal operating cycle.
 “Capital budgeting consists in planning
development of available capital for the purpose of
maximizing the long term profitability of the
concern” – Lynch
 The main features of capital budgeting are
 Potentially large anticipated benefits
 A relatively high degree of risk
 Relatively long time period between the initial
outlay and the anticipated return.
- OsterYoung

6.  The success and failure of business mainly depends on
how the available resources are being utilized.
 Main tool of financial management
 All types of capital budgeting decisions are exposed to
risk and uncertainty.
 They are irreversible in nature.
 Capital rationing gives sufficient scope for the
financial manager to evaluate different proposals and
only viable project must be taken up for investments.
 Capital budgeting offers effective control on cost of
capital expenditure projects.
 It helps the management to avoid over investment
and under investments.

7.  Capital investment decisions usually require
relatively large commitments of resources.
 Most capital investment decisions involve
long-term commitments.
 Capital investment decisions are more
difficult to reverse than short-term decisions.

8.  Identification of potential projects
 Process of preparing the master budget plan for a
certain period.
 Generating the proposals for investment.
 Proposals serve as the potential projects that will
be evaluated by top management for inclusion in
the over-all plan for the coming period.

9.  Estimation of costs and benefits
 Project proposal must meet some minimum
criteria set by the firm.
 Estimates of expected costs that the firm would
incur for the project as well as the revenues or
cost savings that may be derived from the project.

10.  Evaluation
 Proposals are evaluated in the light of the
organizational goals and policies.
 Various evaluation methods or analytical
techniques are used to ensure that only the most
desirable projects are accepted.

11.  Development of the capital expenditure
budget
 Consist all capital investment project proposals
that have been approved for the budget period.
 The budget may be a simple listing of the capital
expenditure projects and the amounts of required
investment for each, or it may provide additional
descriptive data about the projects.

12.  Re-evaluation
 Must be reviewed periodically to determine if the
project meets the original expectations.

13.  Replacement
 When an existing capital investment wears out,
becomes obsolete, or suffers an irreparable
damage, such item should be quickly replaced in
kind so as not to unduly interrupt operations.

14.  Improvement
 May consider improvement of a certain product or
process, which may necessitate the acquisition of
capital investment projects.

15.  Expansion
 Involves enlargement of facilities, setting up an
additional business segment and invasion of new
markets.

16.  ProjectTypes and Risk
 Capital projects have increasing risk according to
whether they are replacements, expansion or new
ventures.

17.  Stand-Alone and Mutually Exclusive Projects
 Stand-alone project has no competing
alternatives
 Mutually exclusive projects involve selecting one
project from among two or more alternatives

18.  The Cost of Capital
 The average rate a firm pays investors for use of
its long term money

19.  Net Investment
 Net Returns
 Cost of Capital

20.  Availability of funds
 Structure of capital
 Taxation policy
 Government policy
 Lending policies of
financial institutions
 Immediate need of
the project
 Earnings
 Capital return
 Economic value of
the project
 Working capital
 Accounting practice
 Trend of earning

21.  Payback
 Net PresentValue
 Internal Rate of Return

22. NET PRESENTVALUE RULE
 NPV = PV-C0
 The difference between the PresentValue of the
investment (future net cash flows, i.e., benefits and its
initial cost).
 Ideas:
 An investment is worth undertaking if it creates value
for its owners
 An investment creates value if it worth more than the
costs within the time value of many framework.

23.  If NPV >= 0, accept the project
 If NPV <= 0, reject the project

24. PRESENTVALUE
- Amount of money today

25. PV = FV (1+i)-n
or
PV= FV x [1/(1+i)n]
or
PV= FV / (1+i)n

26. Let's assume we are to receive $100 at the end
of two years. How do we calculate the present
value of the amount, assuming the interest rate
is 8% per year compounded annually?
PV= FV / (1+i)n

27. Where;
FV= $100
i=8%
N=2
PV= FV / (1+i)n
PV= 100/ (1.08)2
PV= 100/ 1.1664
PV= $ 85.73

28. Suppose you are depositing an amount today in
an account that earns 5% interest, compounded
annually. If your goal is to have Php. 5,000 in the
account at the end of six years, how much must
you deposit in the account today?
PV= FV / (1+i)n

29. Where;
FV= Php. 5,000
i= 5%
N=6
PV= 5,000/(1.05)6
PV=5,000/(1.3401)
PV=Php. 3,731.08

31.  Payback Method
 Net PresentValue Method
 Internal Rate of Return

32. “Payout method”
 Involves computation of the payback period.
 PAYBACK PERIOD
▪ Length of time required by the project to return the
initial cost of time.

33. According to this method, the project that
promises a quick recovery of initial
investment is considered desirable.
Example:
If a company wants to recoup the cost of a
machine within 5 years of purchase, the
maximum desired payback period of the
company would be 5 years.

35. ADVANTAGES
1. Payback is simple to compute and easy to
understand.
2. Payback gives information about liquidity of
the project.
3. Payback period reduces risk of loss.

36. DISADVANTAGES
1. Payback does not consider the time value of
money.
2. It gives more emphasis on liquidity rather
than profitability of the project.
3. It does not consider salvage value of the
project.
4. It ignores the cash flows that may occur after
the payback period.

38. Due to increased demand, the management of Rani
Beverage Company is considering to purchase a new
equipment to increase the production and revenues.
The useful life of the equipment is 10 years and the
company’s maximum desired payback period is 4
years. The inflow and outflow of cash associated with
the new equipment is given below:

39. The initial cost of equipment $37,500
Annual cash inflow:
Sales $75,000
Annual cash outflow:
Cost of ingredients $45,000
Salaries expenses $13,500
Maintenance expenses $1,500
Non cash expenses:
Depreciation $5,000
 Required: Should Rani BeverageCompany
purchase the new equipment? Use payback
method for your answer.

40. Computation of net annual cash inflow:
$75,000 – ($45,000 + $13,500 + $1,500)
= $15,000
= $37,500/$15,000
=2.5 years

41. The management of Health Supplement Inc.
wants to reduce its labor cost by installing a new
machine.Two types of machines are available in
the market – machine X and machineY. Machine
X would cost $18,000 where as machineY would
cost $15,000. Both the machines can reduce
annual labor cost by $3,000.
Required: Which is the best machine to
purchase according to payback method?

42. Machine X MachineY
Cost of machine
(a)
$18,000 $15,000
Annual cost
saving (b)
$3,000 $3,000
Payback period
(a)/(b)
6 years 5 years

43. An investment of $200,000 is expected to
generate the following cash flows in six years:
Year Net cash flow
1 $30,000
2 $40,000
3 $60,000
4 $70,000
5 $55,000
6 $45,000
Required: Compute payback
period of the investment.
Should the investment be
made if management wants
to recover the initial
investment in 3 years or less?

44. (1). Because the cash inflow is uneven, the payback
period formula cannot be used to compute the
payback period.We can compute the payback period
by computing the cumulative net cash flow as follows:
Year Net cash flow
Cumulative
net cash
inflow
1 $30,000 $30,000
2 $40,000 $70,000
3 $60,000 $130,000
4 $70,000 $200,000
5 $55,000 $255,000
6 $45,000 $300,000

45. (2). As the payback period is longer than the
maximum desired payback period of the
management (3 years), the investment should
not be made.

46.  - is the excess of the present value s of the
projects cash inflow over the amount of the
initial investment.
 It provides an absolute measure of a projects
worth because it measure the total present value
of peso return. It also works equally well for
independent projects as it does for choosing
among mutually exclusive projects.
 Estimate CFs (inflows & outflows).
 Assess riskiness of CF’s.
 Determine the appropriate cost of capital.

47.  Accept the project if it’s NPV is equal or
greater than zero; otherwise, the project is
rejected.This means that the firm will earn a
return equal to or greater than its cost of
capital. If the NPV is negative, it means the
project does not meet the hurdle rate and it
should be rejected as the funds that would be
invested in it could earn a higher rate in some
other investments.

48. Project A has a net investment of P 120,000 and
annual net cash inflows of P 50,000 for five
years. Management wants to calculate Project
A’s net present value using a 16% discount.

49. Present value of cash inflows (P 50,000 x 3.274) P 163,700
Less: Net Investment 120,000
Net Present value P 43,700
Therefore, Project A should be accepted because it
could earn more than the desired minimum rate of
return as indicated by the positive net present value.

50. Agila Corp. plans to invest in a four-year project that will cost
P 750,000. Agila’s cost of capital is 8%. Additional
information on the project is as follows:
Cash flow from Present value
Year operations, net of taxes of P1 at 8%
1 P 200,000 0.926
2 220,000 0.857
3 240,000 0.794
4 260,000 0.735
Required:
Using the net present value method, determine whether the
project is accepted or not.

51. Present value of cash inflows at 8%:
Cash Inflows
Year Amount PV factor PV
1 P 200,000 0.926 P 185,200
2 220,000 0.857 188,540
3 240,000 0.794 190,560
4 260,000 0.735 191,100
Total P 755,400
Less: Present value of net investment 750,000
Excess or net present value P 5,400

52.  Rate of return – it measure the speed that
money comes back to you after you invest.
It is written in % per year/per annum.

53.  Also known as discounted rate of return and
time-adjusted rate of return.
It is the rate which equates the present
value of the future cash inflows with the cost of
the investment which produces them. It is also
the equivalent maximum rate of interest that
could be paid each year for the capital
employed over the life of an investment
without loss on the project.

54. Accept Project if IRR > Cost of Capital
Reject Project if IRR < Cost of Capital

55. An investment of P 50,000 will yield an average
annual cash return of P 7,500 a year for a period
of 10 years.What is the discounted rate of
return?

56. 1. PV Factor= Net Investment/AnnualCash
Returns
= 50,000/7,500
= 6.6667
2. Referring to the table for Present value of P1
received annually for 10 years, the column that
gives the nearest value to 6.6667 is the column
for 8 %.

57. 3.To get the exact rate of return, interpolate
between 8% and 10%.
8% - 6.710
=0.043
? - 6.667 =0.565
=0.522
10% - 6.145
Exact discounted rate of return = 8% +
(0.043/0.565 x 2%)
= 8% + 0.15%
= 8.15%

58. An investment amounting to P 100,000 is
expected to yield cash returns as follows:
Year Amount
1 P 40,000
2 50,000
3 60,000
Required: Compute the discounted rate of
return.

59. 1. Average cash return = P 150,000/3
= P 50,000
2. PV Factor = P 100,000/ 50,000
= 2
3. Referring to the table for PresentValue of P1
received annually period 3, the column that will
give the nearest value of 2 is the column for
22%.

60. For trial at 22%
Amount of Cash PV of Cash
Year Returns PV Factor Returns
1 P 40,000 0.820 P 32,800
2 50,000 0.672 33,600
3 60,000 0.551 33,060
P 99,460

61. ForTrial at 20 %
1 P 40,000 0.833 P 33,320
2 50,000 0.694 34,700
3 60,000 0.579 34,740
P 102,760

62. Discounted rate of return is 22%. If the exact discount
rate of return is required, interpolation may be
necessary. Computation will be:
22% - 99,460
=540
? - 100,000 =3,300
=2,760
20% - 102,760
Discounted rate of return = 22% - (540/3,300 x 2%)
= 22% - 0.30 %
= 21.70%

64.  Definition of Risk
 The concept of Risk Averse
 Measurement of Risk

65.  Risk exists because of the inability of the decision-maker to make perfect
forecasts.
 Risk is referred to a situation where the probability distribution of the
cash flow of an investment proposal is known.
65
FORECASTING RISK OR
ESTIMATION RISK Is the possibility that a bad decision will be made because
errors in the projected cash flows.
 There is a danger that will conclude a project has a positive
NPV.
 Risk should be considered in evaluating capital budgeting
projects in both informal and formal ways.

66.  is a concept that addresses how people will
react to a situation with uncertain outcomes.
 It attempts to measure the tolerance for risk
and uncertainty.
 Risk aversion is the reluctance of a person to
accept a bargain with an uncertain payoff
rather than another bargain with a more
certain, but possibly lower, expected payoff.
66

67.  Aversion is also a concept that addresses
how people will react to a situation with
uncertain outcomes. It attempts to measure
the tolerance for risk and uncertainty.
 In the realm of finance and economics, Risk
Aversion is a concept that addresses how
people will react to a situation with uncertain
outcomes.
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68. 1. SCENARIO ANALYSIS
2. SENSITIVITY ANALYSIS
3. SIMULATION ANALYSIS-
4. BETA ESTIMATION ANALYSIS
68

69.  The basic form of “what-if” analysis.
 One way to examine the risk of investment is to
analyse the impact of alternative combinations of
variables, called scenarios, on the project’s NPV (or
IRR).
 The decision-maker can develop some plausible
scenarios for this purpose.
69

70.  This is also known as a “what if analysis”.
 This is calculated in terms of NPV, or net present
value.
 Sensitivity analysis allows to see the impact of the
change in the behaviour of critical variables on the
project profitability.
 Conservative forecasts include using short payback
or higher discount rate for discounting cash flows.
70

71.  Except a very few companies most companies do not use
the statistical and other sophisticated techniques for
analysing risk in investment decisions.
 Identification of all those variables, which have an
influence on the project’s NPV (or IRR).
 Sensitivity analysis is a way of analysing change in the
project’s NPV (or IRR) for a given change in one of the
variables.
 The decision maker, while performing sensitivity
analysis, computes the project’s NPV (or IRR)
71

72.  It compels the decision-maker to identify the variables,
which affect the cash flow forecasts. This helps him in
understanding the investment project in totality.
 It indicates the critical variables for which additional
information may be obtained. The decision-maker can
consider actions, which may help in strengthening the ‘weak
spots’ in the project.
 It helps to expose inappropriate forecasts, and thus guides
the decision-maker to concentrate on relevant variables.
72

73. It does not provide clear-cut results. The terms
‘optimistic’ and ‘pessimistic’ could mean different
things to different persons in an organisation. Thus,
the range of values suggested may be inconsistent.
It fails to focus on the interrelationship between
variables.
73

74.  Considers the interactions among variables and
probabilities of the change in variables. It computes the
probability distribution of NPV.
 The simulation analysis involves the following steps:
 First, you should identify variables that influence cash inflows and
outflows.
 Second, specify the formula that relate variables.
 Third, indicate the probability distribution for each variable.
 Fourth, develop a computer programme that randomly selects
one value from the probability distribution of each variable and
uses these values to calculate the project’s NPV.
74

75.  Beta is a measure firms can use in order to
determine an investment's return sensitivity
in relation to overall market risk.
 Beta describes the correlated volatility of an
asset in relation to the volatility of the
benchmark that said asset is being compared
to.
75

76.  Beta is also referred to as financial elasticity or
correlated relative volatility, and can be referred
to as a measure of the sensitivity of the asset's
returns to market returns, its non-diversifiable
risk, its systematic risk, or market risk.
 Higher-beta investments tend to be more
volatile and therefore riskier, but provide the
potential for higher returns. Lower-beta
investments pose less risk, but generally offer
lower returns.
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77. END
JANINE FERNANDEZ
AILEEN MAE DOROJA
ANA LIZA CORTINA
CARLENAABRERA