Apple:

Good day, everyone!

Today, we’re going to discuss Chapter 13: Capital Investment Decision, which focuses on an
important aspect of business decision-making: capital investment and budgeting. Let’s begin by
understanding the basics.

Let's first know what capital budgeting is.

Capital budgeting is the process of planning and evaluating long-term investments. These
investments often involve significant expenditures and aim to improve a company’s profitability
and growth. For instance, a company might use capital budgeting to decide whether to purchase
new machinery, open a new branch, or develop a new product.

Now that we know what capital budgeting is, let’s take a closer look at its characteristics.

Characteristics of Capital Investment Decisions

First, capital investment decisions usually require a large financial commitment. These are not
small, routine expenses but substantial investments that impact the company significantly.

Second, they have a long-term impact. Decisions like these shape the company’s operations and
performance for years, if not decades, making them difficult to reverse once implemented.

Third, there’s always an element of uncertainty and risk. Future returns depend on many factors,
such as market conditions, economic trends, and technological advancements.

Finally, these decisions are strategically important. They must align with the company’s goals
and objectives, influencing growth, competitiveness, and sustainability.

Now, let’s move on to the categories of capital investment decisions.

There are four main categories:

1. Expansion Projects

These are investments made to grow the business. For example, opening a new branch,
expanding a product line, or entering a new market.

2. Replacement Decisions
These involve replacing outdated or inefficient assets with better alternatives. Imagine replacing
manual machinery with automated systems to improve efficiency.

3. Cost Reduction Investments

These focus on lowering operating costs. A good example is investing in renewable energy to
reduce electricity expenses.

4. Strategic Investments

These are aimed at achieving long-term goals, such as developing innovative products or
adopting sustainable practices.

Finally, let’s discuss the elements of capital budgeting.

Making a sound capital budgeting decision requires analyzing several elements:

Cash Flows: Estimating the inflows and outflows of money throughout the investment’s lifespan
is crucial. A project must show positive net cash flow to be considered viable.

Time Value of Money: This principle recognizes that money today is worth more than the same
amount in the future. Tools like Net Present Value (NPV) and Internal Rate of Return (IRR) help
account for this.

Risk and Uncertainty: Every decision has risks, such as changing market conditions or
unforeseen challenges. These must be carefully analyzed to avoid costly mistakes.

Strategic Alignment: The investment must fit within the company’s overall strategy. For
example, a business focused on innovation should prioritize projects that support that vision.
(Kate)
Net Initial Investment or Project Cost
-​ Net investment represents the initial cash outlay that is required to obtain future returns or
the net cash outflow to support a capital investment project.
Formula:

Net Cash Returns

-​ The cash returns are the inflows of cash expected from a project reduced by the cash cost
that can be directly attributed to the project.
Formula:
Cash Savings
-​ Some projects however are expected to produce an inflow of cash but will yield returns in
the form of cash savings.
Formula:

Minimum or Lowest Acceptable Rate of Return

-​ The minimum or lowest acceptable rate of return or opportunity cost may equal the
average rate of return that the company will earn from alternative investment
opportunities or the cost of capital which is the average rate of return that the firm must
pay to attract investment funds. The cost of capital according to source may be computed
as follows:
The Minimum or Lowest Acceptable Rate of Return (often referred to as the hurdle rate) is
the minimum return a company expects to earn on an investment or project to make it
worthwhile. This rate is critical for making investment decisions, as it reflects the opportunity
cost of capital—the returns that could be earned from alternative investments with similar risk
profiles.

Here’s a breakdown of how the cost of capital is typically calculated, which is often used as the
minimum acceptable rate of return:

1. Cost of Debt:

The cost of debt is the interest rate a company pays on its borrowed funds, adjusted for taxes.
Since interest payments are tax-deductible, the formula is:

Cost of Debt=Interest Rate×(1−Corporate Tax Rate)Cost of Debt=Interest Rate×(1−Corporate

Tax Rate)

This reflects the after-tax cost of borrowing.

2. Cost of Preference Shares:

Preference shares typically pay a fixed dividend, and their cost is calculated by dividing the
dividend per share by the market price of the preference shares:
Cost of Preference Shares=Dividends per ShareMarket Price per Share of Preference SharesCost
of Preference Shares=Market Price per Share of Preference SharesDividends per Share​

This gives the return expected by preference shareholders.

3. Cost of Ordinary Shares (Equity):

This can be calculated in two ways:

●​ Stock price-based method: The cost of equity can be estimated by adding the expected
dividend per share to the expected growth in dividends, divided by the current stock
price:​
Cost of Ordinary Shares=Dividends per Share+Dividend GrowthCurrent Price per Share
of Ordinary SharesCost of Ordinary Shares=Current Price per Share of Ordinary
SharesDividends per Share+Dividend Growth​
●​ Book value-based method: When dividend growth is unknown, the cost of equity can be
estimated by dividing the projected earnings per share by the current stock price:​
Cost of Ordinary Shares=Next Year’s Projected Earnings per ShareCurrent Price per
Share of Ordinary SharesCost of Ordinary Shares=Current Price per Share of Ordinary
SharesNext Year’s Projected Earnings per Share​

4. Cost of Retained Earnings:

The cost of retained earnings is essentially the same as the cost of ordinary equity since retained
earnings are reinvested profits and have an opportunity cost (the return shareholders expect from
the company). Therefore, it is computed using the same formula as the cost of equity.

5. Weighted Average Cost of Capital (WACC):

To determine the overall cost of capital for the company, the individual costs of the different
sources of capital (debt, preference shares, ordinary shares, and retained earnings) are weighted
according to their proportion in the company's capital structure. The WACC is calculated as:

WACC=(EV×Re)+(PV×Rp)+(DV×Rd×(1−Tc))WACC=(VE​×Re)+(VP​×Rp)+(VD​×Rd×(1−Tc))

Where:

●​ EE = Market value of equity

●​ PP = Market value of preference shares
●​ DD = Market value of debt
●​ VV = Total value of the firm (E + P + D)
●​ ReRe = Cost of equity
 ●​ RpRp = Cost of preference shares
●​ RdRd = Cost of debt
●​ TcTc = Corporate tax rate

The WACC represents the minimum rate of return that the company must earn on its investments
to satisfy its capital providers (equity holders, debt holders, and preference shareholders).

In summary, the minimum or lowest acceptable rate of return is the rate that reflects the firm's
cost of capital and is used as a benchmark for evaluating whether investment projects will
generate sufficient returns to justify the cost of the capital required to finance them.

PROCESS OF CAPITAL BUDGETING:

1.​ Identifying Investment Opportunities​
Companies identify potential investment projects during strategic planning. These
opportunities are assessed for their potential impact on long-term profitability.
2.​ Gathering Relevant Information​
Collect data about expected cash flows, costs to implement the investment, and any
non-financial details needed to evaluate the opportunity effectively.
3.​ Choosing a Discount Rate​
Determine the cost of capital to use for discounting cash flows in the evaluation process.
4.​ Analyzing Cash Flows​
Apply capital budgeting techniques to the estimated cash flows gathered earlier to assess
the project's financial viability.
5.​ Making a Decision​
Consider both quantitative and qualitative factors, such as alignment with company goals,
timing of cash flows, funding availability, and social or legal implications, before
deciding on an investment.
6.​ Implementing the Project​
Develop detailed plans to make the investment operational after the decision is made.
7.​ Evaluating and Reviewing the Project​
Monitor the project's performance to ensure it meets expectations. Evaluate both the
project's success and the decision-making process for future improvements.
CATEGORIES OF PROJECT CASH FLOWS:

Cash Inflows

1.​ Operating Cash Inflows: Net periodic cash flows from operations after taxes, typically
generated by new products or cost-saving programs.
2.​ Investment Tax Credit: Tax credits that reduce the investment cost, often based on a
percentage of the asset's price.
 3.​ Proceeds from Sale of Old Assets: Money earned from selling old assets being replaced,
adjusted for taxes.
4.​ Avoidable Costs: Savings from avoiding repairs or other costs related to old assets, net
of taxes.
5.​ Return of Working Capital: Leftover working capital (e.g., inventory, cash) recovered
at the project's end.
6.​ Salvage Value: Proceeds from selling or disposing of project assets at the end of their
useful life, adjusted for taxes.

Cash Outflows

1.​ Asset Acquisition Costs: Initial costs of purchasing and installing new equipment or
machinery.
2.​ Additional Working Capital: Funds needed to support operations, like increased
inventory or cash reserves.
3.​ Other Costs: Expenses like severance payments, relocation, or restoration cost

Niro Adriane Madlus:​

Screening Capital Investment Proposals:​

​ There are several methods available for evaluating capital investments in order to know
which investment to choose from. Gentle reminder, one method may be used solely or in
combination with the another.
​ There are two broad categories for evaluating capital investments and they are: (1)
Non-Discounted Cash Flows and (2) Discounted Cash Flow Approach. The key differences with
these two methods are whether they account for the time value of money.

Now, let us go through the Non-Discounted Cash Flow category which has the (1.a)
Payback Period as the first.
Payback Period is also known as the payoff and payout period, which measures the amount of
time it takes to recover the cost of an investment. Simply put, it is the length of time an
investment reaches a break even point.

Situational Example:​
The shorter the payback, the more desirable the investment. Conversely, the longer the payback,
the less desirable it becomes. For example, if solar panels cost $5,000 to install and the savings
are $100 each month, it would take 4.2 years to reach the payback period.

There is a conventional (based or in accordance with what is generally one or believed) payback
computation where the salvage value is recognized and not ignored like what we saw in the first
situation and this method is called the”Bail-out Period” where the salvage value is added at the
end of a particular year’s earnings and the original investment.​
​
​ Now, for the second one; The Accounting Rate of Return or Simple Rate of Return
which is also known as the “book value” rate of return to calculate an investment's profitability
in percentage.

As a general rule, the company/firm shall choose the project(investment) with the highest rate of
return.

…to be continued (nihilak kay katulgon na)