Robles, Ceejay, D.

CAPITAL BUDGETING

COURSE OBJECTIVES:

After completion of this module, LEARNERS will be able to know and

understand: 1. Know the definition of capital budgeting.
2. Understand the importance of capital budgeting.
3. Know the capital budgeting methods.
4. Understand the different techniques in capital budgeting.

Definition

Capital budgeting is the process that a business uses to determine which proposed fixed asset purchases
it should accept, and which should be declined. This process is used to create a quantitative view of each
proposed fixed asset investment, thereby giving a rational basis for making a judgment.

Importance

The amount of cash involved in a fixed asset investment may be so large that it could lead to the
bankruptcy of a firm if the investment fails. Consequently, capital budgeting is a mandatory activity for
larger fixed asset proposals. This is less of an issue for smaller investments; in these latter cases, it is
better to streamline the capital budgeting process substantially, so that the focus is more on getting the
investments made as expeditiously as possible; by doing so, the operations of profit centers are not
hindered by the analysis of their fixed asset proposals.

The Capital Budgeting Techniques

Discounted cash flows. Estimate the amount of all cash inflows and outflows associated with a project
through its estimated useful life, and then apply a discount rate to these cash flows to determine their
present value. If the present value is positive, accept the funding proposal.

Discounted cash flow is a technique that determines the present value of future cash flows. Under the
method, one applies a discount rate to each periodic cash flow that is derived from an entity's cost of
capital. Multiplying this discount by each future cash flow results in an amount that is, in aggregate, the
present value of all future cash flows.

By calculating the discounted cash flows for a number of different investment choices, one can select the
alternative that results in the greatest discounted cash flows. This concept is useful for calculating the value
of a prospective acquisition, of a possible annuity investment, or of a fixed asset purchase.

The foundation of discounted cash flow analysis is the concept that cash received today is more valuable
than cash received at some point in the future. The reason is that someone who agrees to receive
payment at a later date foregoes the ability to invest that cash right now. The only way for someone to
agree to a delayed payment is to pay them for the privilege, which is known as interest income.
For example, if a person owns P10,000 now and invests it at an interest rate of 10%, then she will have
earned P1,000 by having use of the money for one year. If she were instead to not have access to that
cash for one year, then she would lose the P1,000 of interest income. The interest income in this example
represents the time value of money.

Two analysis methods that employ the discounted cash flow concept are net present value and the internal
rate of return, which are described next.

Net Present Value

Net present value (NPV) analysis is useful for determining the current value of a stream of cash flows that
extend out into the future. It can also be used to compare several such cash flows to decide which has the
largest present value. NPV is commonly used in the analysis of capital purchasing requests, to see if an
initial payment for fixed assets and other expenditures will generate net positive cash flows.

To calculate net present value, we use the following formula:

NPV = X × [(1+r)^n - 1]/[r × (1+r)^n]

Where:
X = The amount received per period
n = The number of periods
r = The rate of return

Internal Rate of Return

The internal rate of return (IRR) is the rate of return at which the present value of a series of future cash
flows equals the present value of all associated costs. IRR is commonly used in capital budgeting to
discern the rate of return on the estimated cash flows arising from an expected investment. The project
having the highest IRR is selected for investment purposes.

This measure is commonly used in capital budgeting, where the IRR of a proposed investment should be
higher than an entity's cost of capital before the investment will be accepted.

If the IRR for the cash flows associated with a proposed project is unusually high, then it is reasonable to
invest in the project, subject to the availability of a sufficient amount of cash. Conversely, if a business
cannot locate any projects with an IRR higher than the rates to be earned on investment-grade securities,
then a reasonable alternative is to invest excess cash in the securities until better internal projects can be
devised.

The IRR is not applicable when a business is forced to make an investment for safety or legal reasons, in
which case no rate of return at all is acceptable.

This analysis method provides no guidance on which project to select when there are two or more
proposed projects having identical rates of return. In this situation, other analysis methods must be used.
This method also provides no guidance when deciding whether to invest in the bottleneck operations of an
entity (known as constraint analysis).
The easiest way to calculate the internal rate of return is to open Microsoft Excel and then follow these
steps:
 1. Enter in any cell a negative figure that is the amount of cash outflow in the first period. This is normal
when acquiring fixed assets, since there is an initial expenditure to acquire and install the asset. 2.
Enter the subsequent cash flows for each period following the initial expenditure in the cells
immediately below the cell where the initial cash outflow figure was entered.

3. Access the IRR function and specify the cell range into which you just made entries. The internal
rate of return will be calculated automatically. It may be useful to use the Increase Decimal
function to increase the number of decimal places appearing in the calculated internal rate of
return.

As an example, a company is reviewing a possible investment for which there is an initial expected
investment of P20,000 in the first year, followed by incoming cash flows of P12,000, P7,000 and P4,000 in
the next three years. If you input this information into the Excel IRR function, it returns an IRR of 8.965%.

Constraint analysis. Examine the impact of a proposed project on the bottleneck operation of the
business. If the proposal either increases the capacity of the bottleneck or routes work around the
bottleneck, thereby increasing throughput, then accept the funding proposal.

A constraint is a restriction on the output of a system. The constraint acts as a throttle, essentially
establishing an upper limit on the amount of output that can be created. A constraint can be circumvented
by designing a process or system to work around it, or by outsourcing work to another entity that is not
subject to the same constraint. The output from a constrained system can be maximized by ensuring that
the constrained resource operates as close to 100% of its capacity as possible. Examples of constraints
are:

∙ A production work station that is operating at the top of its rated capacity
∙ A selling process in which the sales demonstration team is already performing the maximum number
of demonstrations per day
∙ A supplier that has put a company on allocation for a critical raw material

Breakeven analysis. Determine the required sales level at which a proposal will result in positive cash
flow. If the sales level is low enough to be reasonably attainable, then accept the funding proposal. (see
Budgeting module for more details)

Discounted payback. Determine the amount of time it will take for the discounted cash flows from a
proposal to earn back the initial investment. If the period is sufficiently short, then accept the proposal.

The discounted payback period is the period of time over which the cash flows from an investment pay
back the initial investment, factoring in the time value of money. This approach adds discounting to the
basic payback period calculation, thereby greatly increasing the accuracy of its results. The basic formula
to determine the payback period is:

Amount invested ÷ Average annual cash flows

The discounted payback period is instead derived by following these steps:

1. Create a table in which is listed the expected cash outflow related to the investment in Year 0.
2. In the following lines of the table, enter the cash inflows expected from the investment in each
 subsequent year.
3. Multiply the expected annual cash inflows in each year in the table by the applicable discount rate,
using the same interest rate for all of the periods in the table. No discount rate is applied to the
initial investment, since it occurs at once.
4. Create a column on the far right side of the table that lists the cumulative discounted cash flow for
each year. The calculation in this final column is to add back the discounted cash flow in each
period to the remaining negative balance from the preceding period. The balance is initially
negative because it includes the cash outflow to fund the project.
5. When the cumulative discounted cash flow becomes positive, the time period that has passed up
until that point represents the payback period.

To make the calculation even more accurate, include in subsequent periods any additional cash outflows to
pay for the project, such as may be associated with upgrades or maintenance.

This approach is significantly more accurate than the basic payback period formula. However, it also
suffers from a higher level of complexity, which is what makes the payback period such a commonly-used
calculation.

Accounting rate of return. This is the ratio of an investment’s average annual profits to the amount
invested in it. If the outcome exceeds a threshold value, then an investment is approved.

The accounting rate of return is used in capital budgeting to estimate whether to proceed with an
investment. The calculation is the accounting profit from the project, divided by the initial investment in the
project. One would accept a project if the measure yields a percentage that exceeds a certain hurdle rate
used by the company as its minimum rate of return. The formula for the accounting rate of return is:

Average annual accounting profit ÷ Initial investment

- Where the profit is calculated as the profit related to the project using all accruals and non-cash
expenses required under the GAAP or IFRS frameworks (thus, it includes the costs of depreciation and
amortization). If the project involves cost reduction instead of earning a profit, then the numerator is the
amount of cost savings generated by the project. In essence, then, profit is calculated using the accrual
basis of accounting, not the cash basis.

- Where the initial investment is calculated as the fixed asset investment plus any change in working
capital caused by the investment.

The result of the calculation is expressed as a percentage. Thus, if a company projects that it will earn an
average annual profit of P70,000 on an initial investment of P1,000,000, then the project has an
accounting rate of return of 7%.

There are several serious problems with the accounting rate of return concept, which are:

∙ Time value of money. The measure does not factor in the time value of money. Thus, if there is
currently a high market interest rate, the time value of money could completely offset any profit
reported by a project - but the accounting rate of return does incorporate this factor, so it clearly
overstates the profitability of proposed projects.
∙ Constraint analysis. The measure does not factor in whether or not the capital project under
consideration has any impact on the throughput of a company's operations.
 ∙ System view. The measure does not account for the fact that a company tends to operate as an
interrelated system, and so capital expenditures should really be examined in terms of their impact
on the entire system, not on a stand-alone basis.

∙ Comparison. The measure is not adequate for comparing one project to another, since there are
many other factors than the rate of return that should be considered, not all of which can be
expressed quantitatively.

∙ Cash flow. The measure includes all non-cash expenses, such as depreciation and amortization, and
so does not reveal the return on actual cash flows experienced by a business.

∙ Time-based risk. There is no consideration of the increased risk in the variability of forecasts that
arises over a long period of time.

In short, the accounting rate of return is not by any means a perfect method for evaluating a capital project,
and so should be used (if at all) only in concert with a number of other evaluation tools. In particular, you
should find another tool to address the time value of money and the risk associated with a long-term
investment, since this tool does not provide for it. Possible replacement measurements are net present
value, the internal rate of return, and constraint analysis. This measure would be of the most use for
reviewing short-term investments where the impact of the time value of money is reduced.

Real options. Focus on the range of profits and losses that may be encountered over the course of the
investment period. The analysis begins with a review of the risks to which a project will be subjected, and
then models for each of these risks or combinations of risks. The result may be greater care in placing
large bets on a single likelihood of probability.

A real option refers to the decision alternatives available for a tangible asset. A business can use the real
options concept to examine a range of possible outcomes, and then make a choice based on this broad
set of alternatives. For example, a traditional investment analysis in an oil refinery would probably use a
single price per barrel of oil for the entire investment period, whereas the actual price of oil will likely
fluctuate far outside of the initial estimated price point over the course of the investment. An analysis
based on real options would instead focus on the range of profits and losses that may be encountered
over the course of the investment period as the price of oil changes over time.

A comprehensive real options analysis begins with a review of the risks to which a project will be subjected,
and then models for each of these risks or combinations of risks. To continue with the preceding example,
an investor in an oil refinery project could expand the scope of the analysis beyond the price of oil, to also
encompass the risks of possible new environmental regulations on the facility, the possible downtime
caused by a supply shutdown, and the risk of damage caused by a hurricane or earthquake.

A logical outcome of real options analysis is to be more careful in placing large investment bets on a single
likelihood of probability. Instead, it can make more sense to place a series of small bets on different
outcomes, and then alter the portfolio of investments over time, as more information about the various
risks becomes
available. Once the key risks have been resolved, the best investment is easier to discern, so that a larger
“bet the bank” investment can be made.

A concern with using real options is that competitors may be using the same concept at the same time, and
may use the placing of small bets to arrive at the same conclusions as the company. The result can be
that several competitors will enter the same market at approximately the same time, driving down the
initially rich margins that management may have assumed were associated with a real option. Thus, the
parameters of real options constantly change, and so must be re-evaluated at regular intervals to account
for changes in the environment.

Another concern relates to the last point, that competitors may jump into the same market. This means that
a business cannot evaluate the results of its options analyses in a leisurely manner. Instead, each option
must be evaluated quickly and decisions made to make additional investments (or not) before the
competition gets a jumps on the situation.

For example, an agriculture company wants to develop a new crop strain for either wheat or barley, to be
sold for export. The primary intended market is an area in which wheat is currently the preferred crop. The
company estimates that it can generate a 20% return on investment by developing a new wheat variant at
a cost of P30 million. Since wheat is already the primary type of crop being planted, the odds of success
are high. However, if the company can successfully develop a barley variant at a total cost of P50 million,
its projected profits are 50%. The key risk with the barley project is farmer acceptance. Given the high
profits that could be derived from selling barley, the company makes a small initial investment in a pilot
project. If the level of farmer acceptance appears reasonable, the company can then invest an additional
P8 million for a further roll out of the concept.

This use of real options allows the company to invest a relatively small amount to test its assumptions
regarding a possible alternative investment. If the test does not work, the company has only lost P1 million.
If the test succeeds, the company can pursue an alternative that may ultimately yield far higher profits than
the more assured investment in wheat.

END OF CHAPTER QUESTION

1. What are the advantages and disadvantages of the capital budgeting techniques discussed

above? REFERENCES:

∙ Managerial Accounting by Saylor

∙ Managerial Accounting for Managers by Noreen, Brewer and Garrison
∙ Management Accounting: Nature and Scope by Malik
∙ Cost and Management Accounting by The Institute of Company Secretaries of India ∙
Managerial and Cost Accounting by Walther & Skousen
∙ Management Accounting Study Manual by CPA Australia

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