2.3 Capital Budgeting PDF

Capital Budgeting
Techniques
Chapter 10
Capital Budgeting
• Definition: The process of evaluating and
selecting long-term investments that are
consistent with the firm’s goal of maximizing
owner’s wealth
• Types of Capital Investment Projects:

1. Revenue-enhancing investments (e.g. expansion)
2. Cost-reduction investments (e.g. new
equipment)
3. Mandatory investments that are a result of
government mandates (required specifications)
Capital Budgeting
• Preferred or ideal traits of a technique:
1. Easy application (simple calculations)
2. Considers cash flow
3. Recognizes time value of money
4. Fully accounts for expected risk and return;
and
5. Leads to higher stock prices (maximization
of shareholder’s wealth)
Capital Budgeting Techniques
• Non-discounted Cash Flow Techniques (Simple
methods)
1. Accounting Rate of Return
2. Payback Period
3. Payback Reciprocal Rate
4. Bailout Payback Period
• Discounted Cash Flow Techniques (Complex
methods)
5. Discounted Payback Period
6. Net Present Value
7. Profitability/ Present Value Index
8. Internal Rate of Return (IRR)
9. Modified IRR (MIRR)
methods)
2. Payback Period
methods)
Accounting Rate of Return (ARR)
• Calculation of a hurdle rate by dividing contribution to
net income by the book value of investment, either on
a year-by-year basis or by taking an average over the
project’s life.
• Contribution to net income are estimated by

subtracting annual depreciation from the annual
operating cash inflows.
• Decision rule: accept if equal or above the minimum
ARR set
ARR (cont’d)
• Example: A piece of equipment costs P1.2M. The
equipment has a useful life of 4 years. In each of
the four years, the investment generates a cash
inflow of P500,000. The impact of the investment
project on net income is derived by subtracting
depreciation from cash flow each year.
1. Assume the equipment is depreciated on a straight-
line basis over 4 years, what is the annual
contribution to net income?
2. Accounting rate of return for the 1st, 2nd, 3rd and 4th
year?
3. What is the average accounting rate of return?
methods)
2. Payback Period
methods)
Payback Period (PP)
• Number of years of future cash flows needed to recover
the initial investment in a proposed project
• For mixed stream, use cumulative cash flow to

determine the no. of years to recover and the year of
recovery
• Decision rule: accept if equal or less than maximum

acceptable payback period
methods)
2. Payback Period
methods)
Payback Reciprocal Rate
(PRR)
• A variation of the payback period, stated in percentage,
which gives a quick estimate of the internal rate of
return on an investment
• Decision rule: accept if equal or greater than hurdle

rate or cost of capital
• Accurate only when (a) project life is more than twice

the payback period and (b) cash inflows are uniform
methods)
2. Payback Period
methods)
Bailout Payback Period (BPP)
• A variation of the payback period incorporating the
salvage value of the asset in the calculation
• Applicable salvage value is combined with cash inflow
to determine the payback period
• Use cumulative cash flow to determine no. of years to
recover and the year of recovery
• Decision rule: accept if equal or less than maximum

acceptable payback period
methods)
2. Payback Period
methods)
payback period (DPP)
• The number of years required for a project’s
discounted cash flows to recover the initial
cash outlay for an investment
• Use cumulative cash flow to determine no. of
years to recover and the year of recovery
• Decision rule: accept if equal or less than

maximum acceptable payback period
PP, Reciprocal, Bailout and Discounted
• Example: UR Company has a new project with
initial after tax cost is P5,000,000 and is expected
to provide after-tax operating cash inflows of
P1,800,000 in year 1, P1,900,000 in year 2,
P700,000 in year 3 and P1,800,000 in year 4. The
salvage value of the project for year 1-4 as a
percentage of its cost are: 60%, 40%, 25%, 10%,
respectively. Compute for:
1. Payback period
2. Payback reciprocal rate
3. Bailout payback period
4. Discounted payback period, using 10% cost of capital
PP, Reciprocal, Bailout and Discounted
Compute for the PP, PRR, BPP and DPP of the 10-
year investment proposal below:
Initial investment P8,000,000
Annual Cash inflow 1,800,000
Salvage value as % of initial 75% at year 1 then decreases
investment (year 1-9) by 5% for succeeding years
Cost of capital 10%
methods)
2. Payback Period
methods)
Net Present Value
• Difference in the present value of an
investment proposal’s future cash flows and the
initial cash outlay. This difference is the
expected increase in value of the firm due to
the acceptance of the project
• Discounted at rate consistent with the project’s
risk.
• Decision rule: accept if equal or greater than

P0 (nil)
NPV Rule and Shareholder
Wealth
• If we apply NPV logic to our valuation topics
previously, we can create a connection
between stock prices and NPV
methods)
2. Payback Period
methods)
5. Discounted Payback PerioD
Profitability Index (PI)
• A variation of the NPV stated in percentage
• The ratio of the present value of the expected
future cash flows for an investment proposal
(discounted using the required rate of return for
the project) divided by the initial investment in
the project
• Decision rule: accept if equal or greater than 1.0

methods)
2. Payback Period
methods)
Internal Rate of Return (IRR)
• The compound annual rate of return earned by an
investment
• Can be calculated using a financial calculator,
spreadsheet, graph or trial and error approach
The rate wherein, Initial investment = PV of

cashflows
• Is the discount rate wherein NPV = 0

• Decision rule: accept if equal or greater than hurdle
rate or cost of capital
NPV-IRR relationship
• NPV Profile- Graph that depicts a project’s
NPVs for various discount rates.
NPV, PI and IRR
• NCF Semiconductors is evaluating a new etching
tool. The equipment costs P1M and will generate
after-tax cash inflows of P400,000 per year for six
years. Assume the firm has a 15% cost of capital.
What’s the NPV, PI and IRR (30-35%) of the
investment?
• What is the NPV, PI and IRR (11-15%) for the

following project if its cost of capital is 0% and its
initial after tax cost is P5M and it is expected to
provide after-tax operating cash inflows of P1.8M
in year 1, P1.9M in year 2, P1.7M in year 3 and
P1.3M in year 4?

2.3 Capital Budgeting PDF

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2.3 Capital Budgeting PDF

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Capital Budgeting

• Types of Capital Investment Projects:

• Contribution to net income are estimated by

• For mixed stream, use cumulative cash flow to

• Decision rule: accept if equal or less than maximum

• Decision rule: accept if equal or greater than hurdle

• Accurate only when (a) project life is more than twice

• Decision rule: accept if equal or less than maximum

• Decision rule: accept if equal or less than

• Decision rule: accept if equal or greater than

• Decision rule: accept if equal or greater than 1.0

The rate wherein, Initial investment = PV of

• Is the discount rate wherein NPV = 0

• What is the NPV, PI and IRR (11-15%) for the

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