MODULE 6– CAPITAL BUDGETING TECHNIQUES 1

MODULE 6 – CAPITAL BUDGETING TECHNIQUES

INTRODUCTION

Capital budgeting is the process most companies use to authorize capital spending on long‐
term projects and on other projects requiring significant investments of capital. Because capital
is usually limited in its availability, capital projects are individually evaluated using both
quantitative analysis and qualitative information. Most capital budgeting analysis uses cash
inflows and cash outflows rather than net income calculated using the accrual basis. Some
companies simplify the cash flow calculation to net income plus depreciation and amortization.
Others look more specifically at estimated cash inflows from customers, reduced costs, and
proceeds from the sale of assets and salvage value, and cash outflows for the capital
investment, operating costs, interest, and future repairs or overhauls of equipment.

LEARNING OUTCOMES:

After reading this module, the learner should be able to:

1. Explain the significance of Capital Budgeting Techniques

2. Compute using the different methods used for capital budgeting and explain
results

TIME:

The time allotted for this module is six (3) hours.

LEARNER DESCRIPTION

The participants in this module are 3rd year BSBA students

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MODULE CONTENTS:

Lesson 6.1: Capital Budgeting and its Significance

Significance of Capital Budgeting?

 Capital budgeting is an essential tool in financial management.

 It provides a wide scope for financial managers to evaluate different projects in
terms of their viability to be taken up for investments and helps in exposing the
risk and uncertainty of different projects.
 It also keeps a check on over or under investments
 The management is provided with an effective control on cost of capital
expenditure projects.
 Ultimately the fate of a business is decided on how optimally the available
resources are used

Example of Capital Budgeting:

Capital Budgeting for a small scale expansion involves three steps: recording the
investment’s cost, projecting the investment’s cash flows and comparing the projected
earnings with inflation rates and the time value of the investment.

For example:
An equipment that costs P15,000 and generates a P5,000 annual return would
appear to “pay back” on the investment in 3 years. However, if economists expect
inflation to rise 30 percent annually, then the estimated return value at the end of the 1st
year (P20,000) is actually worth P15,385 when you account for inflation (20,000 divided
by 1.3 equals P15,385). The investment generates only P385 in real value after the first
year.

Importance of Capital Budgeting

1. Long term investments involve risks: Capital expenditures are long term investments
which involve more financial risks. That is why proper planning through capital
budgeting is needed.

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2. Huge investments and irreversible ones: As the investments are huge but the funds
are limited, proper planning through capital expenditure is a pre-requisite. Also, the
capital investments are irreversible in nature, i.e, once a permanent asset is purchased
its disposal shall incur losses.
3. Long run in the business: Capital budgeting reduces the costs as well as brings
changes in the profitability of the company. It helps avoid over or under investments.
Proper planning and analysis of the projects helps in the long run.

Lesson 6.2: Payback Period Method

What is payback period method?

 As the name suggests, the method refers to the period in which the proposal will
generate cash to recover the initial investment made
 It purely emphasizes on the cash inflows, economic life of the project and the
investment made in the project, with no consideration to time value of money
 Through this method, selection of a proposal is based on the earning capacity of
the project
 With simple calculations, selection or rejection of the project can be done, with
results that will help gauge the risks involved.
 However, as the method is based on thumb rule, it does not consider the
importance of time value of money and so the relevant dimensions of profitability

PAYBACK PERIOD = Cash outlay (investment) / Annual Cash Inflow

Example:
Project A Project B
Cost 100,000 100,000
Expected Future Cash
Flows
Year 1 50,000 100,000
Year 2 50,000 5,000
Year 3 110,000 5,000
Year 4 None None
TOTAL 210,000 110,000
Payback 2 years 1 year

Note: Payback period of Project B is shorter than A, but project A provides higher returns. Hence,
project A is superior to Project B.

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Lesson 6.3: ACCOUNTING RATE OF RETURN METHOD (ARR)

What is ARR?
 This method helps to overcome the disadvantages of the payback period
method. The rate or return is expressed as a percentage of the earnings of the
investment in a particular project.
 It works on the criteria that any project having ARR higher than the minimum rate
established by the management will be considered and those below the
predetermined rate are rejected
 This method takes into account the entire economic life of a project providing
better means of comparison
 It also ensures compensation of expected profitability or projects through the
concept of net earnings
 However, this method also ignores the time value of money and does not
consider the length of life of the projects.
 Also, it is not consistent with the firm’s objective of maximizing the market value
of shares

ARR = Average Income / Average Investment

Lesson 6.4: NET PRESENT VALUE METHOD

What is NPV?
 It is the widely used methods for evaluating capital investment proposals.
 In this technique the cash inflow that is expected at different periods of time is
discounted at a particular rate
 The present values of the cash inflow are compared to the original investment. If
the difference between them is positive (+) then it is accepted or otherwise
rejected
 This method considers the time value of money and is consistent with the
objective of maximizing profits for the owners.

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The equation for the net present value, assuming all the cash outflows are made in the
initial year, will be:

Where “R” represents cash inflows/outflows, “i” is the firm’s cost of capital, t is the
time period. The result shall be deducted to the initial cash outlay or investment. If the
result is positive, accept the project, otherwise, reject.

Lesson 6.5: INTERNAL RATE OF RETURN

What is IRR?

 This is defined as the rate at which the net present value of the investment is
zero. The discounted cash inflow is equal to the discounted cash outflow.
 This method also considers the time value of money
 It tries to arrive to a rate of interest at which funds invested in the project could be
repaid out of the cash inflows. However, computation of IRR is a tedious task
 It is called internal rate because it depends solely on the outlay and proceeds
associated with the project and not any rate determined outside the investment.

If IRR > WACC then project is profitable

If IRR > k = ACCEPT
If IRR < k = REJECT

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Lesson 6.6: PROFITABILITY INDEX

 It is the ratio of the present value of future cash benefits, at the required rate of
return to the initial cash outflow of the investment
 It may be gross or net, net being simply gross minus one.
 The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as
follows:

PI = PV cash inflows/ Initial cash outlay A

PI = NPV (benefits) / NPV (costs)

All projects with PI > 1.0 is accepted.

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