Capital Budgeting by Mrs Belen Apostol Page 1

Capital Budgeting by Mrs. Belen Apostol Page 1

Capital Budgeting Capital Expenditures – substantial outlay of funds for the purpose of which is to lower costs and increase net income for several years in the future. - It covers not only outlays for fixed assets but also expenditures for major research on new products and methods and for advertising that has cumulative effects. Page 2

Capital Expenditures Classes of Capital Expenditures 1. Replacement investments – investments on replacement of worn-out or obsolete facilities. 2. Expansion investments – provide additional facilities to increase the production and distribution capabilities of the firm. Page 3

Capital Expenditures Classes of Capital Expenditures 3. Product-line or New market investments – expenditures on new products or new markets, and on improvement of old products with the combined features of replacement and expansion investments. Page 4

Capital Expenditures Classes of Capital Expenditures 4. Investments in safety and/or environmental projects – expenditures necessary to comply with government orders, labor agreements, or insurance policy terms. These are sometimes called mandatory investments or non-revenue producing projects. Page 5

Capital Expenditures Classes of Capital Expenditures 5. Strategic investments – investments designed to accomplish the overall objectives of the firm. 6. Other investments – this catch-all term includes office buildings, parking lots, executive aircrafts. Page 6

Capital Budgeting - The planning and control of capital expenditures. - It provides systematic evaluation of the firm’s alternatives. - Helps management in choosing an alternative that will provide the best yield for the company. Page 7

The Capital Budgeting Function Capital Budgeting – selecting the best projects in which to invest the firm’s resources Page 8

Capital Budgeting Valuation - The process of determining the proposal’s real worth to the firm. Investment - The firm spends some of its funds for the establishment of a project. Page 9

Capital Budgeting Forms of Investment 1. Initial Investment – amount that has been devoted to a project until it generates cash inflows from operations. 2. Later investments – expenditures made after the first cash inflow. Page 10

Capital Budgeting Objectives of Capital Budgeting 1. Establishing priorities 2. Cash planning 3. Construction planning 4. Eliminating duplication; and 5. Revising plan Page 11

Capital Budgeting Establishing Priorities The resources of the firm is limited and the total number opportunities available cannot all be accommodated. To solve such difficulties, capital budgeting establishes investment priorities. Page 12

Capital Budgeting Cash Planning The objective of the cash planning activities of the firm is to ensure the availability of funds that will be sufficient to meet its cash requirements, including those concerning the acquisition of capital assets. To attain such objectives, the capital budgeting includes a periodic cash expenditure estimate. Page 13

Capital Budgeting Construction Planning The objective of construction planning is to minimize the period expended for the construction or acquisition of a capital asset. The construction plan, a requirement for capital budgeting, will be presented before the capital budget is prepared. This requirement ensures the preparation of such plans. Page 14

Capital Budgeting Eliminating Duplication A centralized capital budgeting activity will help identify efforts undertaken at various levels in a decentralized organization. The duplication of efforts, as a result, will be minimized if not totally eliminated. Page 15

Capital Budgeting Revising Plans Changes in the environmental factors may require appropriate revisions in the authorization of investment projects which include expected profitability, construction costs, and the timing of start-up, where coordination with related activities is essential. Such requirements will be made obvious by a good capital budgeting system. A timely response to such problems, then becomes a possibility. Page 16

The Capital Budgeting System is composed of the following: 1. Preparation and submission of budget requests; 2. Approval of budget 3. Request for appropriation; 4. Submission of progress reports; and post approval reviews. Page 17

The Capital Budgeting System Budget Requests Budget requests are those made to include in the corporate budget capital projects which are felt to be desirable by those in the lower organizational levels. Page 18

The Capital Budgeting System The Budget Request contains the following: 1. Project title 2. Cost, including estimates on: a. fixed capital b. working capital c. non-operating outlays d. others, including opportunity cost Page 19

The Capital Budgeting System The Budget Request contains the following: 3. Priority rating of the project 4. Profitability of the project; 5. Timing or the ability to adhere to a construction schedule; 6. Financing method; 7. Project classification; and 8. Project narrative. Page 20

The Capital Budgeting System Approval of the Budget The approval of the budget is a process which requires the following steps: 1. Budget requests are forwarded to top management 2. Top management decides which projects to recommend to the board of directors 3. Top management sends recommendations to the board of directors Page 21

The Capital Budgeting System Approval of the Budget The approval of the budget is a process which requires the following steps: 4. The board of directors approves or disapproves the recommendations; and 5. Top management informs projects sponsors of the action taken on their projects. Page 22

The Capital Budgeting System Request for Appropriation After the approval of the budget, the next step is getting an appropriation request approved. The managers and officers of a corporation are usually given the authority to approve appropriations requests up to certain established limits. Page 23

The Capital Budgeting System Request for Appropriation The appropriations request usually contains the following: 1. The request and authority section – serves to identify the originator of the project. 2. The narrative section – details the requesting entity’s justification for undertaking the proposal Page 24

The Capital Budgeting System Request for Appropriation The narrative section normally includes the following: 1. Proposal 2. Objectives 3. Conceptual framework 4. Alternatives; and 5. Sensitivity and risk. Page 25

The Capital Budgeting System 3. Supporting documentation section – contains cost estimates and the results of market studies and financial analysis. Page 26

The Capital Budgeting System Submission of Progress Reports Progress reports are submitted at regular intervals for the following purposes: 1. To review the accuracy of the expenditures forecasts; 2. To provide updated expenditures forecasts; and 3. To verify the assumptions and economics underlying the acceptance of individual projects. Page 27

The Capital Budgeting System Post Approval Reviews Post approval reviews are required to achieve the following objectives: 1. To provide management with a standard method of evaluating the abilities and judgment of project sponsors; 2. To identify errors or patterns of error in judgment which can be avoided in future similar situations; 3. To help ensure that the quality and accuracy of information attains the highest feasible Page 28 standards.

EVALUATION OF PROPOSED CAPITAL EXPENDITURES Proposed capital expenditures should be scrutinized since they involve large outlay of funds. A number of primary factors should be considered by management Page 29

EVALUATION OF PROPOSED CAPITAL EXPENDITURES Primary Factors: 1. Urgency – Decision should be made quickly as possible for requirements that are urgent 2. Repairs – management should consider the availability of spare parts and maintenance experts. When these are critical and they are not available, the concerned proposal should be ruled out. Page 30

EVALUATION OF PROPOSED CAPITAL EXPENDITURES Primary Factors: 3. Credit – this factor should be considered in the sense that some credit terms may be highly favorable to the company. 4. Non-economic factors – refer to social considerations, and other non-economic persuasions and preferences. Page 31

EVALUATION OF PROPOSED CAPITAL EXPENDITURES Primary Factors: 5. Investment Worth – refers to the economic evaluation of a certain proposal. 6. Risk involved – refers to the uncertainty of an expected return. Page 32

Methods of Economic Evaluation Three basic methods of evaluating proposals: 1. Payback method 2. Average Rate of Return methods 3. Discounted cash flow method Page 33

A Sample Investment Proposal for the purchase of a machine Acquisition cost P 10, 000 Economic life 10 years Salvage Value 100, 000 Earnings & cost per year Income 5, 000 Expenses - 2, 000 Net Income before tax & depreciation 3, 000 less: Depreciation (straight line) 990, 000 Net Income before tax 2, 010, 000 less: Income tax 623, 100 Average Net Annual Earnings 1, 386, 900 Cash Inflows per year = Net Earnings + Depreciation Page 34 1, 386, 900 + 990, 000 = 2, 376, 900

The Payback Method The payback method determines the number of years required to recover the cash investment made on a project. The recovery of cash comes from the cash inflows generated from the project. The formula used is as follows: Cost Payback Period --------------Annual Cash Inflow Page 35

The Payback Method Substituting data, the payback period is presented as: P 10, 000 Payback Period = -----------2, 376, 900 = 4. 2 years The cost of machinery is expected to be recovered in full after 4. 2 years. Page 36

The Payback Method The payback method is simple and easy to understand. When the firm does not favor exposure of its own investments for longer periods, the proposal is rejected. This decision can be made quickly with the use of the payback method. Page 37

The Payback Method Disadvantages: 1. It does not consider the time value of money 2. The accept- reject criterion is stated in terms of years rather than at a discount rate; 3. The firm’s attention is focused on cash flow rather than on rate of return; 4. Careful projection of the timing of the investment outlays and the year by year projection of cash inflows over the entire life of the proposal are not encouraged; 5. The salvage value of the proposal is Page 38 not considered.

The Average Rate of Return Methods The Average rate of return methods consists of the following: 1. The average return on investment; and 2. The average return on average investment Page 39

The Average Rate of Return Methods 1. The average return on investment shows the ratio of the average cash inflow to the investment. The formula is as follows: Annual Cash Inflow Average return on investment = -----------Investment Outlay Substituting data: 2, 376, 900 Average return on investment = ---------= 24% 10, 000 Page 40

The Average Rate of Return Methods Advantage: 1. easy to compute 2. the available accounting data may be readily used Disadvantage: 1. does not take into account the time value of money Page 41

The Average Rate of Return Methods 2. The average return on average investment – similar to the average return on investment method except that the effect of the depreciation charge on the investment is taken into consideration. The formula is as follows: Average return on Annual cash inflow Average investment = ----------------Investment / 2 Page 42

The Average Rate of Return Methods Substituting data Average return on 2, 376, 900 Average investment = ------------ = 48% 10, 000 / 2 The initial investment outlay is divided by two to derive the average balance of the investment as it is decreased periodically by the depreciation charge. Advantage: easy and simple to compute Disadvantage: the true rate of return is overstated : does not consider time value of Page 43 money

The Discounted Cash Flow Methods The time value of money is recognized under the discounted cash flow method. Two approaches 1. The net present value method/ and 2. The internal rate of return method. Under these approaches, all future values of proposal are discounted and compared to the values of other proposals. The discounting factor makes these two methods preferred by users in evaluating capital expenditure proposals. Page 44

The Net Present Value Method A desired rate of return is used for discounting purposes Discounting – synonymous to the calculation of the present value of a future value. The present value concept is applied to the cash flows of a proposal and are discounted at the desired rate of return for the periods involved. The sum of the present values of the outflows (the cost of the machine) is compared with the sum of the present values of the inflows (net income plus depreciation) Page 45

The Net Present Value Method If the discounted cash inflows are larger than the discounted cash outflows, the project will earn more than the desired rate of return. The proposal is accepted. If the discounted cash outflows are larger than the discounted cash inflows, the project will not be able to generate the desired minimum rate of return. The proposal is rejected Page 46

The Net Present Value Method The following formula shows the computation of the NPV = PVCO – PVCI Where NPV – net present value (also the net value after deducting the discounted cash outflow from the discounted cash inflow) PVCI – discounted value of the anticipated cash inflows PVCO – discounted value of the anticipated cash outflows. Page 47

The Net Present Value Method The formula for finding the present value of an expected cash inflow is as follows A PV = -----------(1 + r ) n Where A = expected cash inflow R = desired rate of return N = number of years the cash inflow is expected Page 48

The Net Present Value Method If the desired rate of return in the example is 25%, the cash inflows for the ten year period may be computed to determine the present value for each year. For example, the present value of the cash inflow for the second year is computed as follows: 2, 376, 900 Present Value = ----------Of cash inflow, year 2 (1+. 25) 2 = 1, 521, 216 Page 49

The Net Present Value Method Applying the present Value formula, the present values of the cash flows appear as follows Cash Flow Outflow Inflows 1 2 3 4 5 6 7 8 9 10 10 th year salvage value Total Future Value 2, 376, 900 2, 376, 900 2, 376, 900 100, 000 23, 869, 000 Present Value 10, 000. 00 1, 901, 520. 00 1, 521, 216. 00 1, 216, 972. 80 973, 578. 24 778, 862. 59 623, 090. 07 498, 472. 06 398, 777. 65 319, 022. 12 255, 217. 69 10, 737. 42 8, 497, 467 Page 50

The Net Present Value Method To find out the net present value of the proposal NPV = PVCO - PVCI = 10, 000 - 8, 497, 467 = 1, 502, 533 The computation shows a negative net present value indicating that the sum of the discounted cash outflow is greater than the sum of the discounted cash inflows. The proposal is rejected Page 51

Internal Rate of Return method This method make use of the discount rate as a factor. For the internal rate of return, the discount rate is not given The discount rate will yield a net present value equal to zero. The present value of the cash inflows is equal to the present value of the cash outflows. The correct discount rate may be determined by trial and error. Page 52

Internal Rate of Return method The acceptability of the proposal will depend on the prevailing rates as compared with the computed correct discount rate. If the prevailing rate is higher, the proposal is rejected. If the prevailing rate is lower, the proposal is accepted. Page 53

Internal Rate of Return method In the net present value method, a net present value of P 1, 502, 533 was shown. Since the discount rate of 25% was used, an attempt to find the correct discount rate will be made using one which is lower than 25%. Page 54

Internal Rate of Return method Cash Flow Outflow Inflows 1 2 3 4 5 6 7 8 9 10 10 th year salvage value Total Future Value 2, 376, 900 2, 376, 900 2, 376, 900 100, 000 22% 10, 000. 00 Present Value 21% 10, 000. 00 20% 10, 000. 00 1, 948, 278. 69 1, 596, 949. 74 1, 308, 975. 20 1, 072, 930. 49 879, 451. 22 720, 861. 66 590, 870. 21 484, 319. 85 396, 983. 48 325, 396. 30 13, 689. 94 1, 964, 380. 17 1, 623, 454. 68 1, 341, 698. 08 1, 108, 841. 39 916, 397. 84 757, 353. 59 625, 912. 06 517, 282. 69 427, 506. 36 353, 311. 04 14, 864. 36 1, 980, 750. 00 1, 650, 625. 00 1, 375, 520. 83 1, 146, 267. 36 955, 222. 80 796, 019. 00 663, 349. 17 552, 790. 97 460, 659. 14 383, 882. 62 16, 150. 56 9, 338, 707 9, 651, 002 9, 981, 237 Page 55

Internal Rate of Return method The net present values of different discount rates may now be computed as follows: a. NPV at 22% discount rate = PVCI – PVCO = 9, 338, 707 – 10, 000 = 661, 293 b. NPV at 21% discount rate = PVCI – PVCO = 9, 651, 002 - 10, 000 = 348, 998 c. NPV at 20% discount rate = PVCI – PVCO = 9, 981, 237 - 10, 000 = 18, 763 Page 56

Internal Rate of Return method The results of the computation show net present values at different discount rates. Obviously, the discount rate which yields the net present value nearest to zero is 20%. If the standard interest rate is below 20%, the proposal is acceptable. Page 57

RISK, UNCERTAINTY, & SENSITIVITY Among the primary factors considered in the evaluation of proposed capital expenditures, the uncertainty of expected returns pose a challenge to one who manages the firm’s finances. In the methods of economic evaluation, it is assumed that returns are certain, but one can never be fully certain about the results that will be obtained from an investment. Page 58

Meaning of Risk, Uncertainty and Sensitivity Risk is the uncertainty concerning loss. Uncertainty is synonymous to risk. Uncertainty and risk refer to variations of actual values from average or expected values. They differ, however, in the cause of variations. Variations referred to in risk is caused by chance, while the variations referred to in uncertainty is caused by errors in estimating. Sensitivity – refers to the effect on investment of changes in some factors, which were not previously determined with Page 59 certainty.

Factors Affecting Risk Four primary factors involved in the evaluation of risks pertaining to capital expenditures: 1. Possible inaccuracy of figures used in the evaluation; 2. Type of business involved 3. Type of physical plant and equipment involved; and 4. The length of time that must pass before all the conditions of the evaluation become fulfilled. Page 60

Factors Affecting Risk 1. Possible inaccuracy of figures used in the evaluation; Estimates could be wrong or inaccurate at times. Accuracy depends on how figures were obtained. Estimates can be made by scientific method or by plain guesswork. In scientific method, there is a certain degree of reliability while none to plain guesswork Page 61

Factors Affecting Risk 2. Type of business involved Every type of business has its own degree of risk that is peculiar to itself. One line may be stable in terms of demand than the others. Also, more risk is involved in the operations of a new venture than a business with a successful record of past performance. Page 62

Factors Affecting Risk 3. Type of physical plant and equipment involved; and Physical plants and equipment may become obsolete before their economic life. The demand for special equipment may diminish without warning. Page 63

Factors Affecting Risk 4. The length of time that must pass before all the conditions of the evaluation become fulfilled. Estimates involving longer periods are usually more prone to inaccuracies than those involving shorter periods. This is true because, most often, changes in the environment happen sooner than expected. Page 64

Sensitivity Analysis The expected returns on investment may change as changes in some relevant factors happen. Capacity utilization at various levels, for instance, may yield various rates of return on investment. As capacity utilization depends mostly on some relevant factors like the availability of raw materials, it is important that an analysis of the expected returns be made on various utilization levels. This is finding the sensitivity of investment to various changes. Page 65

Sensitivity Analysis The sensitivity analysis is applicable to capital expenditures involving the purchase or construction of a plant. It is useful form management to know the expected returns that will be generated by the various capacity utilization in the operation of the plant. Page 66