Chapter 13

• Capital Budgetting 


  Decision whether or not to commit resources to project whose cost and benefits spread over specified time period
• Capital Budgeting 


  Investment concept, involves commitment of fund to receive some desired return in future in form of ADDITIONAL cash INFLOWS or REDUCED cash OUTFLOW
• Capital Budgetting involves:

  1. Preparation of annual budget for capital investment
  2. Assessment of funding capacities
  3. Allocation or resources to renewal an expansion projects
• Capital expenditures

  • Long term commitment of resources to realize future benefits and budgeting .

  It is most important areas of managerial decision:

  1. Substantial amount of funds required
  2. Length of time spanned by capital investment, element of uncertainty is critical
  3. Effect of managerial error is difficult to reverse
  4. Plan must made week into uncertain future
  5. Success or failure depend on single or relatively few investment decision
• Identification of cost related to problem

  • One of the most difficult step in decision making as this involves future Cost.
  • Historical Cost = Sunk cost, it doesn't affect future alternative
  • in choosing future alternative it evaluate

  > Monetary advantage of alternative

  > Effect of it to employee, company image and realtion to other company
• Categories of Capital Investment

  1. Independent Capital Investment projects / screening decision- Evaluate individually and review against the predetermined company standard of acceptability; Accept or reject
  2. Mutually exclusive capital investment project / preference decision- Choose specific alternative then it's should pass criteria of acceptability then must be better than other alternative
• Element of Capital Budgeting

  • Net amount of the investment; NET INVESTMENT it represent that Initial CASH OUTLAY ( required to obtain future return) or NET CASH OUTFLOW ( Support capital investment project)
  • Operating cash flow or return on investment; NET CASH RETURN- inflows of cash expected from project reduced by cash cost directly attributed to project
  • 1. Minimum or lowest acceptable rate of return on investment - Average rate of return company EARN from alternative investment/ 2. Cost of Capital - Average rate of return company PAY to attract investment funds
• Process of Capital Budgetting

  1. Finding investment opportunities
  2. Collect Relevant information about opportunities
  3. Select discount rate
  4. Financial analysis of cash flows
  5. Decision
  6. Project Implementation
  7. Project Evaluation and Appraisal
• Process of Capital Budgeting

  1. Finding Investment Opportunities - company goal is long term profitability depends on nature and quality of capital Investment, investment opportunity should carefully analyze and evaluated
  2. Collect Relevant Information about Opportunities - a effectively investment include EXPECTED CASH FLOWS must be estimated, Total Cash Outlay place in investment must be determined.
  3. Select Discount Rate - Before cash flow evaluated, if discounted cash flow approach is use this must be established first.
• Process of Capital Budgeting 


  4. Financial Analysis of Cash Flows - applied on expected cash outflows developed in second phase

  5. Decision - consider quantitative as well as qualitative before final selection of investment.

  6. Project Implementation - after decision on investment, detailed plan for making project operational developed

  7. Project Evaluation and Appraisal - Assessment how effective investment actually is. Form of continuous monitoring so corrective action can be taken but overall decision making process should also be appraised for possible improvement.
• Major categories of Cash flows


  • Cash Inflows
  • Cash Outflows
• Cash Inflows


  • Periodic net cash return or cash Inflows from operations, net taxes
  • Investment-Tax Credit - allow credit against company income tax liability based on cost acquired asset
  • Proceeds from sale of old asset being replaced, net of taxes
  • Sold at gain - tax is deducted from proceed
  • Sold at Loss - Tax saving is added to the proceeds
  • Avoidable cost, net of taxes - in tax it will be treated as deduction in computing cost of initial investment
  • Return of working capital - when project end leftover inventory if freed to use elsewhere and treated as cash inflow
  • Cash Inflow from salvage value of new long term assets at the end of it's useful life - any net outflows from disposal of assets become TAX DEDUCTION in the year of disposal
• Cash outflows

  • Acquisition cost of purchasing and installing assets - primary outflows for lost capital investment, listed as outflows when they are INCURRED.
  • additional working capital - project require fund for working capital needs, cash flow occur before project is in operation
• Payback period ( payout)

  • Length of time required to recover amount of initial investment
  • From initial outlay and full recovery of investment
• Decision rule 


  Accepted: PB ≤ Max. allowed PB

  Reject: PB > Max. allowed PB
• Advantage of Payback period method

  • Easy to compute and understand
  • Measure degree of risk associated with project
  • Longer payback period,higher risk
  • Help select project that provide quick return of investment
• Disadvantage of Payback period method

  • Does not recognize time value of money
  • Ignores impact of cash inflow after PB period
  • Fails to consider salvage value
  • Does not measure profitability
  • No necessary relationship between payback and investor wealth maximization
• Bail out period

  • It incorporate salvage value in payback computation
  • Reached when:

  Cumulative cash earning + salvage value = original investment
• • Accounting Rate of Return or Some Rate Return ( Book Value rete of return)
  • Measures profitability by relating required investment to future annual net income

  $AAR =$$Average annual net income/ initial investment$
• Accounting Rate of Return or Some Rate Return ( Book Value rete of return)

  • Measures profitability by relating required investment to future annual net income


  Computation:

  AAR =AVERAGE ANNUAL NET INCOME/INITIAL INVESTMENT

  If cost reduction involve

  AAR= COST SAVING-DEPRECIATION OF NEW EQUIPMENT/ INITIAL INVESTMENT
• Decision Rule in AAR

  Accepted: AAR ≥ (larger) Required rate of return

  Reject: AAR < Required rate of return
• Discounted cash flow technique

  Known as present value approach, cash outflows and cash inflow are both discounted back to present period using appropriate discount rate
• Variation of DCF


  1.NET CASH PRESENT VALUE (NPV)

  • Excess of PV of cash inflows generate by project over amount of initial investment
  • DR:

  NPV is zero or positive = ACCEPT

  NPV is negative = REJECT
• Variation of DCF


  2. DISCOUNTED RATE OF RETURN ( INTERNAL RATE OF RETURN -IRR)

  • Equates PV of future cash inflows with cost of investment produces them.
  • Equivalent max. rate of interest paid each year for capital employed over life of investment w/o loss on project

  Steps in computation read on book. Page 434
• Decision Rule of IRR

  • ACCEPT: IRR ≥ rate of return
  • REJECT: IRR < rate of return
• Payback reciprocal

  • Rate of recovery of investment during payback period
  • Use to estimate discounted rate of return of payback period at least twice and annual cash flows approximate equal.
• Probability Index

  • Known as PV of Index, Benefit Cost Rate and Desirability Index
  • Ratio of total PV of future cash inflows to initial investment.
  • Express PV of cash benefits to amount per peso of investment and measure ranking project in descending order of desirability
• Decision Rule of Profitability Index

  • ACCEPT: PV index ≥ 1
  • REJECT: PV index < 1
• Discounted Payback Period

  • Method recognize time value of money in payback content that computed in terms of discounted cash flows received
• Preference Decision 


  Attempt to resolve question of " how do investment proposal, all of which have been screened and provide an acceptable rate of return, rank in terms of preference?
• Preference Decisions 


  More difficult to screening decision, as investment fund usually limited and profitable of investment opportunities may have foregone
• Preference Decision 2 methods:

  1.Internal Rate of Return method

  higher IRR, more desirable the project

  Use in 2 main reason:

  1. No additional computation
  2. Rank data that easily understood by management

  2. Net present Value Method

  • Used in ran compering investment if project are equal size and investment fund required the same.

  3. Profitability Index - used if competing project require diff amount of funding

  • Higher probability Index, more desirable the project
• Comparing Preference Rates

  NPV is superior to IRR

  • NPV focus on reinvestment to FIRM COST CAPITAL while IRR is on PROJECT CAPITAL

  Probability Index superior to IRR

  • PI always give correct indication despite different lives and pattern
  • If unequal lives, IRR is used
• Replacement Chain (Common Life) Approach 


  Compare unequal lines assumes each product can repeat until reach the necessary common life span
• Replacement Chain

  • NPV is being compare over lifespan
  • choose higher common life of NPV
• EQUIVALENT ANNUAL ANNUITY (EAA)


  used for mutually exclusive project with different lives
• EQUIVALENT ANNUAL ANNUITY APPROACH

  • Calculates annual payment project provided the annuity
  • Unequal lives, choose higher EAA
• EAA is easier to apply than Replacement Chain
• Potential serious weakness inherent to unequal lives analysis

  • Inflation is effective, static condition built be valid
  • Replacement might change cash flow
  • Estimate lines of series is different and only speculation
• Inflation had significant affect on the number of capital budgeting used in analysis but not on its result