The Capital Budgeting Process

The Capital Budgeting Process
Group IV
Leader: Vera Christine N. Dadula
Members: Rey R. Lor
Francis V. Agustin
Jowee Gesilva
Richard P. Gedalanga
What is Capital Budgeting?
Is an investment decision-making as to whether or not a

project is worth undertaking. It is basically concerned
with the justification of capital expenditures
The Capital Budgeting Process Ref. Foundations

21/03/2011 of Financial Management 11th Edition 2
Time Value of Money
Prepared by: Vera Christine N. Dadula
Which would you rather have -- $1,000 today or
$1,000 in 5 years?
Obviously, $1,000 today.
Money received sooner rather than later allows

one to use the funds for investment or
consumption purposes. This concept is referred to
as the TIME VALUE OF MONEY!!

Why TIME?
TIME allows one the opportunity to postpone
consumption and earn INTEREST.
NOT having the opportunity to earn interest

on money is called OPPORTUNITY COST.

Three important reasons why the value of
money decreases progressively over time are
as follows:
1. Inflation
2. Risk
3. Preference for Liquidity

INFLATION
Inflation refers to a general price increase in the economy.
Example: Inflation
If general prices increased by 5% annually, the purchasing power
one dollar today would be 5% less one year from now. In other
words, $1.00 today would depreciate in value to $0.95 one year
from now. If consumers could buy 100 pins with a dollar today,
they would be able to buy only 95 pins a year from now. Simply
stated, the higher the rate of inflation, and the longer the period
of time involved, the less a given amount of money will be worth
in the future.
RISK
Risk, or uncertainty about the future, also causes a decline
in the value of money
Because the future is uncertain, risk increases with time.
Since uncertainty increases the further one looks into the

future, risk also increases and the value of money
promised in the future diminishes accordingly.

PREFERENCE FOR LIQUIDITY
Liquidity is important to an investor or a firm. Liquidity
refers to how easily assets can be converted into cash.
Cash, government bonds, and other marketable securities (company assets

guaranteed to lenders to ensure repayment of a loan) increase the liquidity
of a firm.
Example: Liquidity versus Future Returns

If a person deposits cash in bank that is FDIC insured, she will be willing to
accept 5% interest, whereas if she buys the long-term bond of an unknown
company, a higher rate of interest, say 15%, would be required. In both
cases, cash, or 100% liquidity, is given up, and the return must compensate
for the risk.
YOU SHOULD REMEMBER
Aside from the fact that money invested wisely
today will yield a return in the future (a fact that
creates a natural investor desire for cash today),
money loses value over time because if inflation,
risk, and preference for cash. The concept that the
value of a dollar today is more than the value of a
dollar tomorrow is central to financial theory.

FUTURE VALUE AND COMPOUND INTEREST
Any reasonable investment or commitment of cash
must provide for an increase in value over time. Given the
amount of cash that you want to commit, you can find
out how much that cash value will increase in the future
once the expected rate of return is known.
This calculation is called finding the future value of an

investment.

Example: Future Value after One Year
Suppose an investor saves $100. This cash is deposited in

the bank at a 10% annual interest rate. After one year the
investor will have the original $100 plus $10 in interest:
Original deposit + Interest on deposit = FV

$100 + (10%)($100) = $110

FV = P(1 + i)n
where FV = future value
P = initial deposit (principal)
i = annual rate of interest
N = number of years

Example: Future Value after Any Number of
Years
The equation just introduced can be used for any number
of years. Here are two instances involving a $100 deposit
at a 10% interest rate:

1 Year on Deposit 2 Years on Deposit
FV = P(1 + i)1 FV = P(1 + i)2
FV = $100(1 + .10) FV = $100(1 + .10) 2
FV = $100(1.10) FV = $100(1.10)(1.10)
FV = $110 FV = $121
USING FUTURE VALUE TABLES
Reading the future value table is fairly
simple. Suppose you wish to find the FV of an
original investment of $100 over a 3-year
period at 10% interest. Look up the factor
(1.33), and multiply it by the original
investment: $100(1.33) = $133.
Appendix A

FUTURE VALUE ANNUITY
An annuity is a series of equal payments (or receipts) made
at any interval of time.
An annuity can be a payment or an investment each year,

each half-year (semi-annually), each quarter, or each
month.

Example: Using FV Factors to Calculate
Annuities
PROBLEM: Find the total future value of payments for a $100
annuity paid once a year over a period of 4 years. Assume
10% compound interest.
SOLUTION: Finding the total future value of this series of

payments is relatively Easy task. All you have to do is sum up
the future value factors for the number of years that cover
the annuity. From the FV table, then, the factor for a 4-year
annuity at a 10% compound interest rate would be 1.000 +
1.100 + 1.210 + 1.331, or 4.641. In 4 years, annuity payments
of $100 would be worth $100(4.641), or $464.10.
USING FUTURE VALUE ANNUITY TABLES
The simple mathematical formula for computing the FV
of an annuity is
Sn = a(FVIi,NFA)

Where Sn = total future value of the annuity at the end of a
given period
a = annuity payments
FVIi,NFA = annuity factor, or future value interest annuity
factor
Appendix C
YOU SHOULD REMEMBER
There are two ways to determine the future value of a deposit:
using a formula and using a future value table. The formula for the
future value is
FVN = P(1 + i)N
Where FVN = future value in period N.
P = initial deposit (principal)
i = annual rate of interest
N = number of periods
If you want to use the table, multiply your initial deposit by the
value of FVIF. In the case of annuities, you should multiply the
amount of annuity by the value of FVIFA available in the table.
PRESENT VALUE AND DISCOUNT RATES
Why is present value of crucial interest to financial

people?
The answer is that it provides them with a basis for

comparing the profitability of different projects or
investments over a period of years.

Present value, therefore, is the cash value of future returns
or income once a discount (capitalization) rate has been
applied to it.
The discount, or capitalization, rate is an interest rate

applied to a series of future payments to adjust for risk
and the uncertainty of the time factor.

ADJUSTING FOR RISK
To calculate present value, a discount rate must be
determined that takes into consideration how much risk
is associated with each project or investment. Risk levels
follow a simple rule:
High risk means a high discount (capitalization) rate,

and low risk means a low discount rate.

Evaluating Discount Rates
1. Between two incomes, the one that will take longer to
reach maturity should have a higher discount rate.
2. The lower the perceived risk, the lower the discount

rate should be.
3. If general interest rates in the market rise, the discount

rate should increase also.

Table 3-3 Inverse Relationship between
Present Value and Risk
Future PV of
Income
(3 years from Discount PV of $1 in Future
Rate (%) 3 years Income
now) (dollars)
(dollars)
1,000 15 (high risk) .658 658
1,000 10 (average .751 751
risk)
1,000 5 (low risk) .864 864

ADJUSTING FOR TIME
The present value of any future returns declines the further
out into the future you look. Obviously, this procedure
employs a mathematical adjustment for the time value of
money.
As it turns out, the principle involved is not a difficult one to

grasp - the present value of future returns is merely the
reverse of future value compounding.

Calculating Present Value
if FV = P(1 + i)N
Then PV = FV /(1 + i)N
It is evident from Appendix B that the factors increase as time

passes and as the compound interest rate rises. You can
observe that, if these factors are plugged into the
denominator in the last equation, the present value of $1,000
3 years hence is $1,000 / (1 + .10)3 = $751
Appendix B
USING PRESENT VALUE TABLES
To find the present value of $1,000 3 years hence, all you

had to do was to lookup the length of time and its
corresponding present value factor at a given discount
rate in Appendix B. This factor is shown to be .751.

PRESENT VALUE OF AN ANNUITY
They can do two things:
1. Calculate the present value of each future year by
discounting each payment or receipt with its
appropriate present value factor. This is a long and
redundant method.
2. Calculate the PV annuity of future cash flows by

employing a present value annuity factor. This is the
short and easy method.
Appendix D
Assume you expect a cash flow of $100 in the next 3 years
and wish to find out the PV of these cash flows given a
discount rate, or risk level, of 10%.
PVIF Present
Year Cash Flow (10%) Value
1 $100 .909 $90.90
2 100 .826 82.60
3 100 .751 75.10
Total 2.486 $248.60

Mathematically, the equation for PV
annuity is:
PVa = A
(1 + i)N
Where PVa = present value of an annuity
A = amount of annuity
I = discount rate
N = number of years or periods

Example: Calculating Present Values of
Annuities-The Long Way
PROBLEM: Calculate the present value of a $100 annuity for
a 3-year period. Assume a discount rate of 10%.
SOLUTION: Present value of 1st payment = $100 / (1 + .10)1 = $90.90

Present value of 2nd payment = $100 / (1 + .10)2 = $82.60
Present value of 3rd payment = $100 / (1 + .10)3 = $75.10
Present value of all three payments = $90.90 + $82.60 + $75.10=
$248.60

USING PRESENT VALUE ANNUITY TABLES
Instead of having to go through laborious calculations, a
table has been set up that sums the PV factors. Appendix D
is a present value annuity interest factor table, and it is
relatively easy to read.
Appendix D

PRESENT VALUE OF VARIABLE CASH FLOWS
Suppose a firm expects to receive the following varying
amounts of money over the next 4 years:
Year Cash Flow

1 $1,000
2 1,200
3 1,500
4 900

The present value of this mixed cash flow is simply the sum
of the present values of the four individual cash flows. If
the discount rate is 10%, then the present value of such a
mixed cash flow will be $3,642.43:
PVIF
Present
Year Cash Flow (see
value
Appendix C)
1 $1,000 .9091 $909.10
2 1,200 .8264 991.68
3 1,500 .7513 1,126.95
4 900 .6830 614.70
Present value of 4 year cash flow = $3,642.43

PRESENT VALUE OF PERPETUITIES
A Perpetuity is a certain amount of money that will be paid
at regular periods of time permanently.
Dividends on a preferred stock or benefits from an

education endowment fund may be viewed as examples of
perpetuities.

The present value of a perpetuity is the sum of the present
value of infinite payment.
PVP = D1 / (1 + i)1 + D2 / (1 + i)2 + D3 / (1+i)3 . . . + D∞ / (1 + i)∞
Where PVP = present value of a perpetuity
D = amount of regular payment
i = discount factor
∞ = Infinity

YOU SHOUlD REMEMBER
There are two ways to determine the present value of a future
income: using a simple formula and using a present value
table. The formula for the present value is
PV = FVN / (1 + i)N
Where PV = present value of a future income
FVN = future income in period N
i = interest or discount rate
N = number of years or periods
If you want to use the table, multiply your future income by the
value of PVIF. In the case of annuities, multiply the amount of
annuity by the value of PVIFA as available in the table.

Graphical Presentation of Time Value
Relationships (See Exhibits Section)

The Relationship between Present Value and
Future Value

Exhibit 4-1 Future Value of $.68 at 10%
Value at the end of each period
$ 1.2
1.00
1
0.91
0.83
0.8 0.75
0.68
0.6
0.4
0.2
0
Period 0 Period 1 Period 2 Period 3 Period 4

Exhibit 4-2 Present Value of $1.00 at 10%
Value at the end of each period
$ 1.2
1
1
0.91
0.83
0.8 0.75
1.00
0.6
0.4
0.2
0
Period 0 Period 1 Period 2 Period 3 Period 4

The Relationship between the Present Value
of Single Amount and the Present Value of an
Annuity

Exhibit 4-3 Present Value of an annuity of $1.00 at 10%
The FV of a 2-year annuity is simply the
present value of one payment at the end
of period 1 and one payment at the
$ 2 period 2
1.8 1.7
4
1.6
1.4
0.91
1.2
0.8
0.6
0.91
0.4 0.83
0.75
0.68
0.2
0
Period 1 Period 2 Period 3 Period 4

$ 3 period 2
2.5 2.4
9
2 0.91
1.7
4
1.5
0.91
0.83
1
0.5 0.91 0.83 0.75 0.68
0

3.5 period 2
$
3
PV of $1.00 to be
0.91
received in 1 year
2.5 2.4
9
2 0.91
PV of $1.00 to be
0.83 received in 2 year
1.7
4
1.5
0.91 PV of $1.00 to be
0.83 received in 3 year
1 0.75
0.5 0.91 PV of $1.00 to be

0.83 0.75 0.68 received in 4 year
0

The Relationship between the Future Value of
Single Amount and the Future Value of an
Annuity

Exhibit 4-4 Future Value of an annuity of $1.00 at 10%
1.40
1.20
1.00 1.0
0.80
1.33
0.60 1.21
1.10
1.00
0.40
0.20
0.00
0 Period 1 Period 2 Period 3 Periods

The FV of a 2 year annuity is simply the future value of
one payment at the end of period 1 and one payment at
2.50 the end of period 2
2.10
2.00
1.00
1.50
1.00 1.0
1.33
1.21
1.10
0.50 1.00
0.00
1 Period 2 Period 3 Period 4 Periods

$ 3.50
3.31
The FV of a 2 year annuity is simply the future value of
3.00
one payment at the end of period 1 and one payment at
the end of period 2
1
2.50
2.10
2.00
1.00
1.00
1.50
1.00 1.0
1.33
1.10 1.21
0.50 1.00
0.00
1 Period 2Period 3 Period 4 Periods

Exhibit 4-4 Future Value of an annuity of $1.00 at 10% FV of a 4 year annuity
$ 5.00
4.641
4.50
The FV of a 2 year annuity is simply the future value of one FV of $1.00
payment at the end of period 1 and one payment at the end 1 invested at the
4.00 of period 2 end of period 4
3.50
3.31 FV of $1.00
3.00
1.1 invested for 1
year
1
2.50
2.10 FV of $1.00
2.00 1.21 invested for 2
years
1.00
1.00
1.50
1.00 1.0 FV of $1.00

invested for 3
1.21 1.33
0.50 1.00 1.10 years
0.00
1 Period 2 Periods 3 Periods 4 Periods

“A bird in the hand worth two in the bush”


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The Capital Budgeting Process

Is an investment decision-making as to whether or not a

The Capital Budgeting Process Ref. Foundations

Obviously, $1,000 today.

Money received sooner rather than later allows

The Capital Budgeting Process Ref. Foundations

NOT having the opportunity to earn interest

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

Because the future is uncertain, risk increases with time.

Since uncertainty increases the further one looks into the

The Capital Budgeting Process Ref. Foundations

Cash, government bonds, and other marketable securities (company assets

Example: Liquidity versus Future Returns

The Capital Budgeting Process Ref. Foundations

This calculation is called finding the future value of an

The Capital Budgeting Process Ref. Foundations

Suppose an investor saves $100. This cash is deposited in

Original deposit + Interest on deposit = FV

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

An annuity can be a payment or an investment each year,

The Capital Budgeting Process Ref. Foundations

SOLUTION: Finding the total future value of this series of

Why is present value of crucial interest to financial

The answer is that it provides them with a basis for

The Capital Budgeting Process Ref. Foundations

The discount, or capitalization, rate is an interest rate

The Capital Budgeting Process Ref. Foundations

High risk means a high discount (capitalization) rate,

The Capital Budgeting Process Ref. Foundations

2. The lower the perceived risk, the lower the discount

3. If general interest rates in the market rise, the discount

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

As it turns out, the principle involved is not a difficult one to

The Capital Budgeting Process Ref. Foundations

Then PV = FV /(1 + i)N

It is evident from Appendix B that the factors increase as time

To find the present value of $1,000 3 years hence, all you

The Capital Budgeting Process Ref. Foundations

2. Calculate the PV annuity of future cash flows by

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

SOLUTION: Present value of 1st payment = $100 / (1 + .10)1 = $90.90

Present value of all three payments = $90.90 + $82.60 + $75.10=

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

Year Cash Flow

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

Dividends on a preferred stock or benefits from an

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

The Capital Budgeting Process Ref. Foundations

0.5 0.91 0.83 0.75 0.68

The Capital Budgeting Process Ref. Foundations