CAPITAL BUDGETING

Capital Budgeting is the process of evaluating and selecting long-term investments that are
consistent with the firm’s goal of maximizing owners’ wealth. Long-term investment results in
benefits to increase the benefits of the company in excess of one year. Some examples of capital
expenditures include expanding or entering into a new line of business, renewing or replacing fixed
assets, construction of new premises, opening a new branch, acquiring machinery and equipment,
etc.

Steps in Capital Budgeting:

1. Investment Proposal. Proposals for capital expenditure come from different levels within a
business organization. These are submitted to the finance team for thorough analysis.
2. Review and Analysis. Financial personnel performs formal reviews and analyses to assess
the benefits and cost of the investment proposals. This personnel makes use of several
financial tools which they see fit in evaluating the project.
3. Decision Making. Companies usually delegate capital expenditure decisions based on
value limits. The analysis is presented to the proper approving body which will, in turn,
decide on whether to push through with the project or not.
4. Implementation. Release of funds and start of the project occurs after approval. Large
expenditures are usually released in phases.
5. Monitoring. Results are monitored, and actual cost and benefits are compared with those
that were expected. Action may be required if deviations from the plan are significant in
amount.

Risk and Return Trade-offs

Financial managers need to note the risk and returns of the projects they enter whenever
making investment decisions. They say the higher the risk, the higher the returns, but if it turned
sour, the higher the losses as well.

When making financial decisions, taking a higher risk allows you to earn higher returns. Low-
risk investments like treasury notes, also called risk-free instruments, offers a low but steady income
flow. In making investment decisions, financial managers ensure that the proposed business will
earn more than the risk-free rate since they need to compensate for the risk the investment will
entail. To calculate an appropriate risk-return tradeoff, investors must consider many factors,
including overall risk tolerance, the potential to replace lost funds and more.

Required Rate of Return is the minimum expected yield investors require to select a
particular investment.

Techniques in Capital Budgeting

A. Payback Method
The payback method is the simplest method to use in capital budgeting. It measures the
amount of time, usually in years, to recover the initial investment. To illustrate this method, let us use
our previous examples for relevant cash flows.

Example:
Mr. Alfonse is deciding on which of the two mutually exclusive projects he should accept.
Project A requires an initial outlay of Php72,000 and is expected to receive Php17,000 annually for
the next five years. On the other hand, Project B requires an investment of Php80,000 but will earn
Php21,000 annually for the next five years. This example shows that the relevant cash flows are the
upfront investment and the annual income from investment.

Payback Method:
For Project A, the initial cash flow is Php72,000. In 4 years, Mr. Alfonse would have generated
a total cash flow of 17,000 × 4 = 68,000. To get the actual period, let us divide the remaining amount
72,000 – 68,000 = 4,000 and divide it by the cash flow for year 5. We get 4,000 ÷ 17,000 = .24, so
the total payback period for Project A is 4 + .24 = 4.24 years.

Conversely, if the cash flows are equal, you may derive the answer by dividing the initial cash
flow by the annuity, 72,000 ÷ 17,000 = 4.24 years. Using the same method for Project B, we get the
payback period of 80,000 ÷ 21,000 = 3.81 years.

In conclusion, for making accept-reject decisions, projects that meet the acceptable payback
period set by managers shall be accepted, and those that are not discarded. It is a popular method
used mainly for small projects due to its simplicity and consideration for the timing of cash flows.
However, the criticism of this method is that it does not consider the time value of money. Also, it
fails to consider the cash flows after the payback period.

B. Net Present Value Method

Net present value is a more sophisticated method used in capital budgeting to analyze the
profitability of a project or investment. It is calculated by taking the difference between the present
value of cash inflows and the present value of cash outflows over time.

The formula for Net Present Value is as follows:

When net cash flows are even, i.e., when all net cash flows are equal:

Where,

R = the estimated periodic net cash flow

r = required rate of return per period, and
n = number of time periods

If analyzing a longer-term project with multiple uneven cash flows, the formula for the net
present value of a project is:
Where,

R = net cash inflow-outflows during a single period t

t

i = required rate of return or discount rate

n = number of time periods

If you are unfamiliar with summation notation, here is an easier way to remember the concept
of NPV:

NPV = PV of Inflows - PV of Outflows

Or
NPV = PV of Future Cash Flows - Initial Investment

If the result is a positive NPV, then the project is accepted. If the NPV is negative, the project
is rejected. And if NPV is zero, then the organization will stay indifferent.

Example:

From our previous example, assuming that the cost of capital is 8%, let us compute for NPV.
NPV Method:

*Note we will be using the PV Annuity formula since we expect equal regular cashflows.

Recall that,

Project A = 17,000 × PVAF(3.993) – 72,000

= 4,119

Project B = 21,000 × PVAF(3.993) – 80,000

= 3,853

C. Internal Rate of Return (IRR)

The internal rate of return (IRR) is a financial metric used to assess the attractiveness of a
particular investment opportunity. IRR is a discount rate that makes the net present value (NPV) of
all cash flows equal to zero.

Generally speaking, the higher an internal rate of return, the more desirable an investment is
to undertake. IRR is uniform for investments of varying types and, as such, can be used to rank
multiple prospective investments or projects on a relatively even basis.

IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the
actual dollar value of the project. It is the annual return that makes the NPV equal to zero.

Example:

You plan to build a branch for your business at Php350,000 and expect to receive Php400,000 in 1
year. First, compute the rate of return (profit/investment).

Rate of return = 50,000 ÷ 350,000

= 0.143 or 14.3%

We compute for the rate of return because the NPV of a project with cost of capital equal to
the rate of return is equal to zero. To illustrate:

NPV = 400,000 ÷ (1 + Rate of Return(0.143)) – 350,000 = 0

Calculating the internal rate of return can be done in three ways:

1. Using the IRR or XIRR function in Excel or other spreadsheet programs

2. Using a financial calculator
3. Using an iterative process where the analyst tries different discount rates until the NPV
equals zero

The general formula used in calculating IRR is as follows

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return-irr/
 The NPV and IRR are interrelated techniques. An IRR greater than the cost of capital equates
to a positive NPV and vice versa. NPV is the better measure on a purely theoretical view since it
measures the actual cash value a project creates for shareholders.