MODULE 5

CAPITAL BUDGETING

LEARNING OUTCOME:

At the end of this module the students would be able to:

1. Learn the different meaning or definitions of capital and budget.

2. Explain the meaning of capital and budget and importance in the business investment

3. Comprehend with solving problems about the types or methods of evaluating prjects.

INTRODUCTION

The word Capital refers to be the total investment of a company of firm in money, tangible
and intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said to
be the art of building budgets.
Budgets are a blue print of a plan and action expressed in quantities and manners. The
examples of capital expenditure:
1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc.
2. The expenditure relating to addition, expansion, improvement and alteration to the fixed
assets.
3. The replacement of fixed assets.
4. Research and development project.

DEFINITIONS
According to the definition of Charles T. Hrongreen, “capital budgeting is a long-term
planning for making and financing proposed capital out lays.

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 According to the definition of G.C. Philippatos, “capital budgeting is concerned with the
allocation of the firms source financial resources among the available opportunities. The
consideration of investment opportunities involves the comparison of the expected future streams
of earnings from a project with the immediate and subsequent streams of earning from a project,
with the immediate and subsequent streams of expenditure”.
According to the definition of Richard and Green law, “capital budgeting is acquiring
inputs with long-term return”.
According to the definition of Lyrich, “capital budgeting consists in planning
development of available capital for the purpose of maximizing the long-term profitability of the
concern”.

It is clearly explained in the above definitions that a firm’s scarce financial resources are
utilizing the available opportunities. The overall objectives of the company from is to maximize
the profits and minimize the expenditure of cost.

NEED AND IMPORTANCE OF CAPITAL BUDGETING

1. Huge Investments: Capital budgeting requires huge investments of funds, but the
available funds are limited, therefore the firm before investing projects, plan are control its capital
expenditure.
2. Long-Term: Capital expenditure is long-term in nature or permanent in nature.
Therefore financial risks involved in the investment decision are more. If higher risks are involved,
it needs careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed back.
Once the decision is taken for purchasing a permanent asset, it is very difficult to dispose off those
assets without involving huge losses.
4. Long-term Effect: Capital budgeting not only reduces the cost but also increases the
revenue in long-term and will bring significant changes in the profit of the company by avoiding
over or more investment or under investment.
Over investments leads to be unable to utilize assets or over utilization of fixed assets.
Therefore before making the investment, it is required carefully planning and analysis of the
project thoroughly.

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PRINCIPLES OF CAPITAL INVESTMENTS
Capital budgeting is a difficult process to the investment of available funds. The benefit
will be attained only in the near future but, the future is uncertain.

SUCCESSFUL ADMINISTRATION OF CAPITAL INVESTMENTS:

1. Generation of Investment Proposals
2. Estimation of Cash Flows for the Proposals
3. Evaluation of Cash Flows
4. Selection of Projects based on the Acceptance Criterion
5. Continual Reevaluation of Investment Projects after the Acceptance

CLASSIFICATIONS OF PROJECT CATEGORIES

1. New Products or Expansion of an Existing Product
2. Replacement an Equipment of a Building
3. Research and Development
4. Exploration
5. Others

HIERARCHY OF AUTHORITY FOR A PROJECT PROPOSAL ORIGINATING IN THE

PRODUCTION AREA
1. Section Chiefs 4. Committee under the Financial Manager
2. Plant Managers 5. The President
3. VP for Operation 6. Board of Directors

CASH FLOW FORECAST

Future Cash Flow is one of the most important tasks in capital budgeting. The final results
obtained are only as good as the accuracy of our estimates.

PRINCIPLES OF REPLACEMENT DECISION AND DEPRECIATION

Replacement Decision involves taxes and that we are considering the purchase of a new
machine or equipment to replace an old one, and we need to obtain cash flow information in order
to evaluate the attractiveness of the project.

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 Depreciation is the portion of the cost or other basic value of a tangible capital asset
allocated or charged as an expense during an accounting period.
It can also be defined as an expense which may be part of the cost of goods sold
manufactured or an operating expense.

SALVAGE VALUE AND TAXES

Salvage Value is also called scrap value. It is the amount that can be recovered from the
sale of an asset after its estimated useful life. Note that a salvage value can be added net of tax to
the net cash inflow during the last year if period is two or more years.
Taxes are government levies or charges on personal and business undertakings.
Income Taxes are levies on the annual net income of business firms and individuals.

EVALUATION METHODS USED IN CAPITAL BUDGETING

1. Payback Period refers to the length of time it takes to recoup the cost of a project from
the earnings it generates.

This is a technique whereby one calculates the length of time the firm will be able to
recover investment in the project.

Payback Period (PP) = Initial Investment

Annual Cash Inflows

Point of Analysis: Accept/Reject Criteria

If the Payback Period is less than the estimated useful life of the machine, or
equipment or life of the product, Accept the Project; if not it is to be rejected.

2. Accounting or Average Rate of Return this method shows the relationship between the
average earnings after taxes and the cash outflow of the project.

This represents the ratio of the average annual profit after taxes to the investment in the
project.

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 Average Rate of Return (ARR) = Annual Income after Taxes
Initial Investment

Accept/Reject Criteria: If the actual accounting rate of return is more than the
predetermined required rate of return, the project would be accepted. If not it would be
rejected.

3. Net Present Value is the discount rate that equates the present value of the expected cash
outflows with the present value of the expected inflows.
Net present value describes as the summation of the present value of cash inflow and
present value of cash outflow.
Net present value is the difference between the total present value of future cash inflows
and the total present value of future cash outflows.

Net Present Value (NPV) = Present Value of Net Cash Inflow – Initial Investment

Present Value of Cash Inflow (Annuity) or P = F x 1

n

(1 + r)

or F = P (1 +r)n* *power n
PV = CF (IF)

Where: P = Present Value of the principal sum CF = Cash Inflow

F = Future Value IF = Interest Factor or Discount
r = Interest Rate Rate
n = Number of years

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 Accept/Reject Criteria: If the present value of cash inflows is more than the present value
of cash outflows, it would be accepted. If not, it would be rejected.

If NPV is Positive (that is PV > Initial Investment), Accept the Project

If NPV is Negative (that is PV < Initial Investment), Reject the Project

4. Internal Rate of Return (IRR) refers to the discount rate that equates the present value
of the expected cash outflows with the present value of the expected inflows.

Internal Rate of Return is time adjusted technique and covers the disadvantages of the
traditional techniques. In other words, it is a rate at which discount cash flows to zero.

Steps to be followed:

Step 1. Find out Factor

Step 2. Find out positive net present value
Step 3. Find out negative net present value
Step 4. Find out formula net present value

Note: The solution will be through the use of Interpolation Principle using the table.

Accept/Reject Criteria: If the present value of the sum total of the compounded
reinvested cash flows is greater than the present value of the outflows, the proposed project
is accepted. If not it would be rejected.
If IRR > Cost of Capital = Accept the Project
If IRR < Cost of Capital = Reject the Project

5. Profitability Index is the ratio of the total present value of the net cash inflow and the
initial cash outlay.

Profitability Index (PI) = Present Value of the Cash Inflows*

Initial Cash Outlay (Initial Investment)

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 The *Present Value of the Net Cash Inflows is already determined in the NPV solution,
therefore, the same value will be used in the PI formula; while the Investment is normally
given in the problem.

Accept/Reject Criteria: If PI > or = 1 Accept the Project

If PI < 1 Reject the Project

Illustrative Problem:

The Mariveles Apparel Company is considering the acquisition of a new machine of which
price is Ᵽ 18,500 and it will require an additional Ᵽ 1,500 to install, bringing the total cost to
Ᵽ 20,000.
The old machine can be sold for its depreciated book value at Ᵽ 2,000. The new machine
should cut labor and maintenance costs and effect other cash savings totaling Ᵽ 7,100 a year before
taxes for each of the next five (5) years, after which it will not probably provide any savings, nor
will it have a salvage value. Assume a tax rate of 40% and the cost of capital at 10%.
Evaluate the project using the five methods of capital budgeting.

Analysis: The savings represent the net savings to the firm if it replaces the old machine with the
new one. In other words, we are concerned with the difference between the cash flows resulting
from the two alternatives as follows:
1. Continuing with the old machine
2. Replacing it with the new one.

Let us determine first the incremental impact of the project by getting the depreciation charges of
both machines, with the remaining useful life for the old and the estimated useful life of the new
one.
Using the Straight-Line Method of Depreciation, it is equal to:

Depreciation of new machine = Ᵽ 20,000 = Ᵽ 4,000 per year

5 yrs.

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 Annual Depreciation of old machine = Ᵽ 2,000 = Ᵽ 400 per year
5 yrs.
Therefore, we subtract depreciation on the old machine from depreciation charges on the new
machine to obtain the incremental depreciation charges associated with the project.

To reconcile the Book Account and the Cash Flow Account, this solution follows:

Book Account Cash Flow Account

Annual Cash Savings Ᵽ 7,100 Ᵽ 7,100
Less: Depreciation of new machine 4,000
Less: Dep. of old machine 400 3,600 -0-
Income before taxes 3,500 7,100
Less: Income tax (40%) 1,400 1,400
Net Income after taxes 2,100 * 5,700
Add: Depreciation 3,600 -0-
ANNUAL NET CASH FLOWS Ᵽ 5,700 Ᵽ 5,700

Note: This is patterned from the typical format of preparing an Income Statement, where we
obtained Net Income of Ᵽ 2,100*

The Net Cash Flow is considered as the pre-requisite in order to solve for the five required methods
to evaluate the viability of the project. Therefore, using the given formulas, solutions are as
follows:

1. Payback Period = Ᵽ 20,000 = 3.51 years or 3 yrs., 6 months & 3 days

5,700

Decision Rule: Since the 3.51 is less than the 5 year-period for the life of the machine, the
project is acceptable.

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2. ARR = Ᵽ 2,100 ÷ 20,000 = 0.105 or 10.50%

Decision Rule: Since the ARR is greater than the required ROR, project can be accepted
( 10.50% > 10%)

3. @ 10% the value of the interest factor or discount rate from table A-2 at a period of 5 years
is 3.7908, therefore solve for the Present Value (PV), then deduct the initial investment:

NPV = Ᵽ 5,700 ( 3.7908) - Ᵽ 20,000

= 21,608 - 20,000

= Ᵽ 1,608
=======
Decision Rule: Since net present value is positive, accept the project.

4. In solving for the IRR, we need to determine first the rate that can give us negative NPV.
Take note that, at the given rate of 10%, NPV is positive at Ᵽ 1,608 therefore we need to
try a rate that can give us negative NPV.

Notice that in the Table for PV of an Annuity, the higher the rate the lower the value of the
interest factor; and the lower the rate the higher the interest factor. It means that the rate to
be tried must be above or higher than 10%.

Let us try at 14 % where at 14% the value of IF is 3.4331

NPV = Ᵽ 5,700 ( 3.4331) - Ᵽ 20,000

= 19,569 - 20,000

NPV = (Ᵽ 431)
=====
Now, since we found the negative NPV at 14%, it means that the internal rate of return
we are looking for is in between 10% and 14%. Hence, it is higher than 10% but lower
than 14%.

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 Whereas, through this table of interpolation we can solve the IRR as:

Rate Net Present Value

10% 1,608 1,608

True NPV 0

14% (431)

Difference 4% 2,039 1,608

IRR = 10% + 1,608 x 4%

2,039

= 10 % + 0.78862 x 0.04

= 10 % + 3.15 %

IRR = 13.15%
=======
Decision Rule: Since IRR is greater than the required ROR or cost of capital, accept the
project (13.15% > 10 %)

5. Profitability Index = Ᵽ 21,608 ÷ Ᵽ 20,000

PI = 1.0804 X or 108.04 %

Decision Rule: Since the PI obtained is greater than 1, accept the project. This means
the ratio of profitability is 1: 1.08 or for every Ᵽ 1 of investment, it earns
Ᵽ 1.08, therefore the project is profitable.

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