CAPITAL BUDGETING WITH INVESTMENT RISKS & RETURNS
CAPITAL BUDGETING
CAPITAL INVESTMENT is the long-term commitment of significant funds to meet certain objectives
such as
acquiring additional plant assets for business expansion. Typical characteristics are as follows:
✓ As to COST: a large sum of money and resources is required
✓ As to COMMITMENT: invested funds are tied up for a long period of time
✓ As to FLEXIBILITY: capital investments are more difficult to reverse than short-term decisions
✓ As to RISK: uncertainties in long-term cash flow projections make capital projects highly risky
INDEPENDENT capital investment projects (meant for SCREENING decisions) are projects that are
evaluated
individually against predetermined corporate standard of acceptability resulting in an accept-or-reject
decision. Common examples: investment in long-term assets such as purchase of property, plant or
equipment, new product development, large-scale advertising campaign.
MUTUALLY EXCLUSIVE capital investment projects (meant for PREFERENCE decisions) are projects that
require choosing from among alternatives and, once chosen, usually preclude the company from
choosing
other competing projects. Common examples: replacement vs. renovation of equipment, lease vs. buy
of
facilities, manual bookkeeping vs. computerized system, preventive maintenance vs periodic overhaul.
CAPITAL BUDGETING is the process of measuring, evaluating, and selecting capital investments.
Six formal stages of capital budgeting: 1) Identification and definition stage 2) Search stage 3)
Informationacquisition stage – both qualitative and quantitative information is considered 4) Selection
stage – choosing projects
after cost-benefit evaluation 5) Financing stage 6) Implementation and Control stage – conduct of post-
audit.
An over-simplified capital budgeting process involves the following steps:
Step 1: Step 2: Step 3:
Nature of Capital Investments FACTORS OF CONSIDERATION
Replacement (Equipment)
Improvement (Products)
Expansion (Facilities) Net Investments Net Returns Costs of Capital
Addition (Technology)
Reduction (Costs)
Non-discounted methods Discounted methods
Payback period Net present value (NPV)
Bail-out payback Profitability index
Accounting rate of return (ARR) Internal rate of return (IRR)
Payback reciprocal Discounted payback
NET INVESTMENTS, primarily computed for decision-making purposes, refer to COSTS (cash outflows)
less
SAVINGS (cash inflows) incidental to the acquisition of the capital investment projects.
✓ COSTS (Cash outflows) include:
➢ Purchase price of the asset, net of any related cash discount
➢ Incidental project-related expenses such as freight, insurance, handling, installation, test-runs
➢ Additional working capital needed to support the operation of the project at the desired level.
(NOTE: At the end of the project’s life, additional working capital shall be recaptured as part of the
project’s terminal cash flow, along with any salvage value of the project)
➢ Market value of existing idle assets to be used in the operation of the proposed capital project.
➢ Training cost, net of related tax
✓ SAVINGS (Cash inflows) include:
➢ Proceeds from sale of an old asset disposed or replaced, net of related tax
➢ Trade-in value of the old asset (in case of replacement)
➢ Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax
NET RETURNS refers to either net income (under accrual basis) or net cash flows (under cash basis),
the
latter may be computed under direct or indirect method:
✓ Direct method: Net cash inflows = cash inflows – cash outflows
✓ Indirect method: Net cash inflows = net income + noncash expenses (e.g., depreciation)
COST of CAPITAL, a.k.a. hurdle rate, minimum acceptable/required rate of return, desired rate, cut-off
rate,
standard rate, is used as a discount rate in discounted capital budgeting techniques like NPV and IRR.
[Cost of Capital is covered in MS-11]
PAYBACK PERIOD measures the length of time required to recover the amount of initial investment.
PAYBACK PERIOD = Net Investment
Net Cash Inflows
RULE: a project is acceptable if its payback period is shorter than the benchmark period used by
management
PROS: simple to compute, easy to understand, useful in evaluating liquidity of the project, a good
surrogate
for risk -- a quick or short payback period indicates a less risky project.
CONS: ignores time value of money, ignores salvage value, ignores cash flows after payback period,
more
emphasis on return OF investment instead of ROI, maximum payback period may be arbitrary
BAIL-OUT PAYBACK PERIOD is payback method wherein cash recoveries include not only the annual
net cash
inflows but also the estimated salvage value realizable at the end of each year of the project life.
