Capital Budgeting Financing decision - involves choices regarding the method of raising capital to fund an investment.

Investment decision - is a judgment about which assets to acquire to accomplish an entity's mission.
Capital asset - is a long-term asset that is used in the production of goods or services. These assets
are typically significant investments for a company and are expected to provide benefits over an Cash flows from a capital project are received and paid at different points in time over the project's
extended period. Organizations invests in capital assets and these assets can be classified as tangible life. Some cash flows occur at the beginning of a period, some during the period, and others at the
or intangible assets. end.

Tangible assets - such as machineries, buildings, inventories, supplies and raw materials, and Sample Cash Flow Illustration
intangible assets - such as capital lease or renting of an asset for temporary use
Assume that various capital projects are being considered by Family One Stop, a retail chain selling
Capital budgeting is a systematic approach that businesses use to evaluate, select, and manage consumer goods in 55 locations throughout the Midwest. One investment being considered by the
future capital investment projects. Managers and accountants apply quantitative and qualitative firm is the acquisition of photovoltaic power technology to light all parking lots owned by the chain.
criteria to evaluate the feasibility of alternative projects. These are: In addition to long-term cost savings, this investment would reduce the company's carbon footprint.

Quantitative Criteria Qualitative Criteria The expected cost to purchase and install the technology as well as the operating cost
savings appear in the table below. This detailed information can be simplified to a net cash flow for
1. Accounting rate of return 1. Employee morale
each year. For Family One Stop, the project generates a net negative flow in the first year and net
2. Payback period 2. Employee safety positive cash flows thereafter. This cash flow information can be illustrated using a time line.

3. Discounted payback period 3. Employee responsibility Cash Outflow Cash Inflows

4. Net present value 4. Corporate image Year 0 $13,500,000 Electricity cost savings:

5. Internal rate of return 5. Social responsibility Year 1 500,000 Year 1 $2,700,000

6. Profitability index 6. Market share Year 2 300,000 Year 2 2,900,000

7. Growth Year 3 3,200,000

8. Strategic planning Year 4 3,900,000

9. Sustainability Year 5 4,200,000

Cash flows Year 6 2,100,000

Capital budgeting investment decisions can be based on a variety of quantitative techniques. All Year 7 1,000,000
these methods except internal rate of return focus on cash flows.
Time Lines
Operating cash flows - represent the cash generated or used by a company's primary business
A time line virtually illustrates the points in time when projected cash flows are received or
activities, such as sales of goods and services.
paid, making it a helpful tool for analyzing cash flows of a capital investment proposal. On a time
Financing cash flows - represent the cash transactions related to a company's financing activities. line, cash inflows are shown as positive amounts and cash outflows are shown as negative amounts.
These cash flows involve raising capital from investors.
 The following time line represents the cash flows associated with Family One Stop's potential At the end of the fourth year, all but $1,600,000 of the initial $13,500,000 investment had been
photovoltaic technology investment: covered. The $4,200,000 inflow in the fifth year is assumed to occur evenly throughout the year.
Therefore, it should take approximately 38 percent ($1,600,000 ÷ $4,200,000) of the fifth year to
cover the balance of the original investment, giving a payback period for this project of 4.38 years (or
End of period 0 1 2 3 4 5 6 7 4 years and 4.6 months).

When equal periodic cash flows are generated from a project (an annuity), the payback
Inflows $0 $2,700 $2,900 $3,200 $3,900 $4,200 $2,100 $1,000
period is determined as follows:
Outflows $ (13,500) (500) (300) (0) (0) (0) (0) (0)
Payback period = Investment ÷ Annuity amount
Net cash flow $(13,500) $2,200 $2,600 $3,200 $3,900 $4,200 $2,100 $1,000
Discounting future cash flows

A time value is associated with money because interest is paid or received on money. For example,
Payback Period $1 received today has more value than $1 received one year from today because money received
today can be invested to generate a return that will cause it to accumulate to more than $1 over
Information on the timing of net cash flows is an input to a simple and often used capital budgeting
time; this effect is referred to as the time value of money
technique called payback period
Discounting means reducing future cash flows by removing the portion of the future values
A project's payback is complete when the organization has recouped its investment.
representing interest
The payback period for a project having unequal cash inflows is determined by accumulating cash
Discount rate, is used to determine the imputed interest portion of the future cash flows. The
flows until the original investment is recovered. Thus, using the information shown in Exhibit 15.2
discount rate should equal or exceed the company's cost of capital (COC)
and the time line presented earlier, the photovoltaic technology investment payback period is
calculated using a yearly cumulative total of inflows (in thousands) as follows: Return of capital is the recovery of the original investment (or the return of principal)

Year Annual Cash Flow Cumulative Total Return on capital is income and equals the discount rate multiplied by the investment amount.

0 $(13,500) (13,500) Three discounted cash flow techniques are the net present value method, the profitability index,
and the internal rate of return. Each of these methods is defined and illustrated in the following
1 2,200 (11,300)
sections.
2 2,600 (8,700)

3 3,200 (5,500)

4 3,900 (1,600)

5 4,200 2,600

6 2,100 4,700

7 1,000 5,700
 2. Cashflows – these are the expected returns directly attributable to the investment project.
Cashflows could be OPERATING CASHFLOWS AFTER TAX or END OF LIFE CASHFLOWS.
Time Value of Money – discounting is mostly used in capital budgeting. The question is when to use
OPERATING CASH FLOWS AFTER TAX – the incremental changes in cash arising from
present value factors.
cashflows and cash outflows directly attributable to the project. These cashflows are
 Present value of 1 (PV of 1) – used if the cashflows flow on a lump-sum basis. assumed to occur at the end of the year.
Incremental – comparison of old new asset.
1 SOLUTION GUIDE
Present Value of P1 = n
(1+r ) Cost Savings xxx
Incremental Depreciation (xxx)
 Present value of ordinary annuity – used if the cashflows flow evenly on an annual basis.
Cashflow before Tax xxx
1 Incremental tax (xxx)
1−
Present Value of Ordinary Annuity of P1 = (1+r )
n Incremental Net Income xxx
r Add back Incremental Dept. xxx
OPERATING CASHFLOWS AFTER TAX xxx
1− present value of P 1 NOTE: Cash operating income is used if the purpose of the capital project is to increase net
Or
r cashflows. On the other
hand, cost savings is used if the purpose of the capital project is reducing the operating cost.
ELEMENTS OF CAPITAL BUDGETING

These are the factors of capital budgeting used in evaluating capital investment proposal. End of Life Cashflows
These are the net cashflows occurring at the end of the investment projects life.
1. Net Investment – represent the initial cash outlay that is required to obtain future returns or
SOLUTION GUIDE
the net cash outflows to support a capital project.
Operating Cashflows After Tax xxx
Simply stated, net investment is net cashflows at time zero.
Salvage Value xxx
SOLUTION GUIDE Return to Increase in Working Capital xxx
Return of Decrease in Working Capital xxx
To compute net investment, let us divide in into three (3) parts
END OF LIFE CASHFLOWS xxx
OLD ASSETS NEW ASSET WORKING CAPITAL
Trade in value (-) Acquisition costs Increase in working 3. Discount Rate – A.K.A minimum required rate of return or cut-off rate or target rate. This is
(+) capital (+) the weighted average cost of capital of long term funds obtained from different sources.
Proceeds from sale (-) Other direct costs Decrease in working CAPITAL BUDGETING TECHNIQUES
(+) capital (-) NON-DISCOUNTED TECHNIQUES
Tax on gain on sale (+) 1. ACCOUNTING RATE OF RETURN (ARR) – A.K.A Book rate of return (BRR). This is a
Tax on loss on sale (-) conventional or traditional technique of measuring profitability by relating the required
Avoidable repairs, net investment to its incremental net income.
of tax (+)
NOTE: If the decision in an acquisition decision, computation of ne investment is limited only to new
ADVANTAGES DISADVANTAGES
asset and working capital section. If it is a replacement, the three sections are complete.
 ARR closely parallels Ignores time value money 2. INTERNAL RATE OF RETURN - this is the rate which equates the present value of cash
accounting concepts of income inflows to present value of cash outflows. Simply stated, it is the rate where present value is
measurement and investment zero.
return. Guidelines in determining IRR:
It facilities re-evaluation of With the computation of a) Determining the present value factor of IRR with the use of the formula below:
projects due to the ready income and book value based net investment
availability of data from the on the historical cost IRR =
operating cash flow after −tax
accounting records. accounting data, the effect of
b) Using the present value annuity table, find the line “n” (economic life) the factor
inflation is ignored.
computed in the corresponding rate is the IRR.
ARR considers income over the
entire life of the project. 3. PROFITABILITY INDEX – is designed to provide a common basis of ranking alternatives that
require differences amounts of investment.
ARR emphasizes profitability SOLUTION GUIDELINES
rather than liquidity
SOLUTION GUIDE present value of cash inflows
Profitability Index =
present value of cash outflows
average annual net income
ARR =
net investment NPV
Profitability Index = +1
NOTE: Net investment could be based on original investment or average investment. Average net investment
investment is computed as original investment plus salvage value divided by two.
PV factor discount rate
2. PAYBACK PERIOD – it is the measurement of time project to break even. With that, Profitability Index =
PV factor IRR
PAYBACK PERIOD is a measurement of LIQUIDITY rather than PROFITABILITY.
INVESTMENT DECISION
The solution below is a guide only if the operating cash flow after tax are even. Otherwise,
payback period computation is done manually. Management must identify the best asset to acquire for fulfilling the company’s goals and objectives.

net investment Screening Decisions - determines whether a capital project is desirable based on some previously
Payback Period = established minimum criteria. A project that does not meet the minimum standard is excluded from
operating cashflow after−tax
further consideration.
DISCOUNTED TECHNIQUES
Preference Decision – ranks project according to their impact on the achievement of company
1. NET PRESENT VALUE – NVP is the excess of the present value of cash inflows over present objectives.
value of cash outflows generated by the project throughout its life.
SOLUTION GUIDE JUDGEMENT METHOD – the judgement method of risk adjustments allows decision makers to use
Present Value of Cash Inflows xxx logic and reasoning when deciding whether a project provides rate of return in relation to its risks.
Present Value of Cash Outflows (xxx) RISK ADJUSTED DISCOUNT RATE METHOD – the decision maker increases the rate used for
NET PRESENT VALUE xxx discounting future cash inflows and decrease the rate used for discounting future cash outflows to
compensate for increased risks.