THE CAPITAL BUDGETING PROCESS

Present value and Opportunity cost of capitalThe Capital Budgeting DecisionRisk and Capital Budgeting

I. Present value and Opportunity cost of capital

Introduction Foundations of the Net Present Value

Rule Calculating Present value

CAPITAL BUDGETING 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”- Charles T. Horngreen.

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. - Oster Young

SIGNIFICANCE OF CAPITAL BUDGETING 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.

CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS

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.

THE CAPITAL BUDGETING PROCESS 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.

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.

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.

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.

Re-evaluation Must be reviewed periodically to

determine if the project meets the original expectations.

TYPES OF CAPITAL INVESTMENT PROJECTS 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.

Improvement May consider improvement of a certain

product or process, which may necessitate the acquisition of capital investment projects.

Expansion Involves enlargement of facilities,

setting up an additional business segment and invasion of new markets.

CHARACTERISTICS OF BUSINESS PROJECTS Project Types and Risk

Capital projects have increasing risk according to whether they are replacements, expansion or new ventures.

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

The Cost of Capital The average rate a firm pays investors

for use of its long term money

CAPITAL BUDGETING FACTORS

Net Investment Net Returns Cost of Capital

FACTORS INFLUENCING CAPITAL BUDGETING 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

CAPITAL BUDGETING TECHNIQUES Payback Net Present Value Internal Rate of Return

Foundations of Net Present Value Rule

NET PRESENT VALUE RULE NPV = PV-C0

The difference between the Present Value 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.

DECISION RULE

If NPV >= 0, accept the project

If NPV <= 0, reject the project

Calculating Present Values

PRESENT VALUE- Amount of money today

FORMULA

PV = FV (1+i) -nor

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

PV= FV / (1+i)n

EXAMPLE

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

SOLUTION

Where;FV= $100i=8%N=2

PV= FV / (1+i)n

PV= 100/ (1.08) 2

PV= 100/ 1.1664

PV= $ 85.73

EXAMPLE

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

SOLUTION

Where;FV= Php. 5,000i= 5%N=6

PV= 5,000/(1.05)6

PV=5,000/(1.3401)PV=Php. 3,731.08

II. The Capital Budgeting Decision

Payback Method Net Present Value Method Internal Rate of Return

PAYBACK METHOD

“Payout method” Involves computation of the payback

period. PAYBACK PERIOD▪ Length of time required by the project to

return the initial cost of time.

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.

Formula

CHARACTERISTICS OF THE PAYBACK METHOD

ADVANTAGES1. 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.

DISADVANTAGES1. 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.

EXAMPLE

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:

The initial cost of equipment $37,500Annual cash inflow:Sales $75,000Annual cash outflow:Cost of ingredients $45,000Salaries expenses $13,500Maintenance expenses $1,500Non cash expenses:Depreciation $5,000Required: Should Rani Beverage

Company purchase the new equipment? Use payback method for your answer.

Solution

Computation of net annual cash inflow:$75,000 – ($45,000 + $13,500 +

$1,500)= $15,000

= $37,500/$15,000=2.5 years

EXAMPLE

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 machine Y. Machine X would cost $18,000 where as machine Y 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?

SOLUTIONMachine X Machine Y

Cost of machine (a) $18,000 $15,000

Annual cost saving (b) $3,000 $3,000

Payback period (a)/(b)

6 years 5 years

EXAMPLEAn investment of $200,000 is expected to generate the following cash flows in six years:Yea

r Net cash flow

1 $30,0002 $40,0003 $60,0004 $70,0005 $55,0006 $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?

SOLUTION(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

inflow1 $30,000 $30,0002 $40,000 $70,0003 $60,000 $130,0004 $70,000 $200,0005 $55,000 $255,0006 $45,000 $300,000

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

NET PRESENT VALUE - 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.

Decision Rule:

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.

Illustrative CaseNPV Application: Uniform Cash InflowsProject 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.

SOLUTIONPresent 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.

Illustrative Case. NPV Application: Uneven Cash Inflows

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 valueYear 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.

SOLUTIONPresent 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 0.735 191,100Total P 755,400

Less: Present value of net investment 750,000Excess or net present value P 5,400  

INTERNAL RATE OF RETURN Rate of return – it measure the speed

that money comes back to you after you invest.

It is written in % per year/per annum.

Internal Rate of Return

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.

Decision Rule

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

Cost of Capital

Illustrative Case 29-4. Calculation of Internal Rate of Return: Uniform Cash flow

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?

Solution

1. PV Factor= Net Investment/Annual Cash Returns = 50,000/7,500 = 6.66672. 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 %.

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%

Illustrative Case. Calculation of Internal Rate of Return; Uneven Cash Flows

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.

SOLUTION

1. Average cash return = P 150,000/3 = P 50,000

2. PV Factor = P 100,000/ 50,000 = 23. Referring to the table for Present Value of P1 received annually period 3, the column that will give the nearest value of 2 is the column for 22%.

4. Using the table for Present Value of P1, column 22%, the cash returns are discounted as follows:

For trial at 22% Amount of Cash PV of

CashYear 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

For Trial 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

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=2,76020% - 102,760 Discounted rate of return = 22% - (540/3,300 x 2%) = 22% - 0.30 % = 21.70%

III. Risk and Capital Budgeting

Definition of Risk The concept of Risk Averse Measurement of Risk

CAPITAL BUDGETING RISK

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.

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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.

RISK AVERSION 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.

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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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RISK AVERSION

METHODS OF ESTIMATING AND MEASURING RISK

1. SCENARIO ANALYSIS2. SENSITIVITY ANALYSIS3. SIMULATION ANALYSIS-4. BETA ESTIMATION ANALYSIS

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SCENARIO ANALYSIS 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.

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SENSITIVITY ANALYSIS 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.

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SENSITIVITY ANALYSIS 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)

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Sensitivity Analysis: Pros and Cons 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.

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Sensitivity Analysis: Pros and Cons

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.

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SIMULATION ANALYSIS 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.

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BETA ANALYSIS 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.  

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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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BETA ANALYSIS

Capital Budgeting Process

END

JANINE FERNANDEZAILEEN MAE DOROJA

ANA LIZA CORTINACARLENA ABRERA