CAPITAL BUDGETING

Definition
Capital Budgeting is the process of identifying, selecting, and evaluating capital
projects/long-term investments that are consistent with firm’s goal, in general case
is maximizing shareholder’s wealth. So in other words, the capital budgeting process
is used to determine and select (the most) profitable long-term (greater than one
year) projects.

Step in Process

Proposal Generation Review and Decision Making Implementation Follow-

Analysis Up

Basic Terminology

1. Types of project
Independent Project :
Project that are unrelated to each other and allow for each project to be
evaluated based on its own profitability, because the project is not
affected by the others, the acceptance of project is not eliminate the
others.
Mutually Exclusive :
Only one project in a set of possible projects can be accepted and that the
projects compete with the others.

2. Availability of funds
Unlimited Fund :
If a firm has unlimited access to capital, the firm can accept all of
independent projects that provide an acceptable return.
Capital Rationing :
The fund of firm have only fixed number of dollars available for capital
expenditure.
3. Basic approach to make decisions
• Accept-Reject Approach
Evaluation of project that meet the firm’s minimum acceptance criteria.
• Ranking Approach
Ranking of project with the basis of some predetermined measure, such as
rate of return.

Capital Budgeting: The Technique

1. Payback Period (PP)

The amount of time required for affirm to recover its initial investment in a
project (Time for firm’s break event point)

Basic Formula Mixed Stream

n = the year when initial investment has not
been fully recovered a = initial investment b =
cumulative cash flow of the year-n c =
cumulative cash flow of the year-n+1

Decision Criteria
• Project accepted if PP of project less than the maximum firm’s acceptable PP
or the project have a smallest number of PP.
• Project rejected if PP of project greater than the maximum firm’s acceptable
PP or the project have a biggest number of PP.

2. Profitability Index (PI)

Profitability Index reflected the ratio of inflow of project to initial investment.
 *PV Proceed = Present value of cash inflow, PV Outlay = Present value of cash
outflow

The profitablity index is related to NPV, The NPV is the difference between the
present value of future cash flows and the initials cash outlay, and the PI is the
ratio value of future cash flows to the initial cash outlay.

Decision Criteria
• Project accepted if PI of project greater than the minimum firm’s acceptable
PI or the project have the biggest number of PI or if PI > 1.
• Project rejected if PI of project lower than the minimum firm’s acceptable PI
or the project have the smallest number of PI or PI < 1.

3. Net Present Value (NPV)

The number of dollar that founded by different of present value of cash inflow
with initial investment.

Decision Criteria
• Project accepted if NPV of project greater than the minimum firm’s
acceptable NPV or the project have the biggest number of NPV.
• Project rejected if NPV of project lower than the minimum firm’s
acceptable NPV or the project have the smallest number of NPV.

4. Internal Rate Of Return (IRR)

The discount rate that makes NPV of project equals to 0.
1

*i = Discount Rate

Decision Criteria
• Project accepted if IRR of project greater than the firm’s cost of
capital/required rate of return or the project have the biggest Percentage of
IRR.
• Project rejected if NPV of project lower than firm’s cost of capital/ required
rate of return or the project have the smallest number of IRR.

CAPITAL BUDGETING CASH FLOWS

Relevant Cash Flows The incremental cash outflow (investment) and resulting
subsequent inflows associated with a proposed capital expenditure
Incremental Cash Flows The additional cash flows – outflows or inflows – expected
to result from a proposed capital expenditure
MAJOR CASH FLOW COMPONENTS

Initial Investment is the relevant cash outflow for a proposed project at time zero.
Operating Cash Flow is the additional cash flow a new project generates.

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 (𝑂𝐶𝐼 )𝑓𝑟𝑜𝑚 𝑁𝑒𝑤 𝐴𝑠𝑠𝑒𝑡𝑠

− 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 (𝑂𝐶𝐼 ) 𝑓𝑟𝑜𝑚 𝑂𝑙𝑑 𝐴𝑠𝑠𝑒𝑡𝑠
= 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔

Terminal Cash Flow is the after tax non-operating cash flow occurring in the final year
of a project. It is usually attributable to liquidation of the project.
• Cost of New Asset: The net outflow necessary to acquire a new asset
• Installation Cost: Any added costs that are necessary to place an asset into
operation
• Installed Cost of New Asset: The cost of new asset plus its installation costs;
equals the asset’s depreciable value
• After-tax Proceeds from Sale of Old Asset: The difference between the old asset’s
sale proceeds and any applicable taxes or tax refunds related to its sale
• Proceeds from Sale of Old Asset: The cash inflows, net of any removal or clean
up costs resulting from sale of an existing asset
• Tax on Sale of Old Asset: Tax that depends on the relationship between the old
assets’ sale price and book value and on existing government tax rules
• Book Value: The strict accounting value of an asset, calculated by subtracting its
accumulated depreciation form its installed cost
Book Value = Installed cost of asset – Accumulated depreciation
• Change in Net Working Capital: The difference between a change in current
assets and a change in current liabilities

REFINEMENTS IN CAPITAL BUDGETING

In Capital Budgeting there’s chance that a project will prove unacceptable. Behavioral
approach for dealing with risk:

Sensitivity Analysis, is a technique to determine how different values of an

independent variable will impact a particular dependent variable under a given set of
assumptions, so it very useful when attempting to determine the impac the actual
outcome of particular variable (i.e. cash inflow & NPV) will have it differs from what
was previously assumed

Scenario Analysis, is a method that use several estimated values for a given variable
(such as cash inflows, rate of return, cost of capital) in estimated condition that might
be happen (pessimistic, most likely, optimistic). Scenario analysist commonly focuses
on estimating what a outcome value would decrease to if an unfavorable event, or
the worst case scenario were realized.
Simulation, statistically-based behavioral approach that applies predetermined
probability distribution and random numbers to estimate risky outcomes.

Annualize Net Present Value (ANPV)

An approach to evaluate unequal-lived projects that converts the NPV of
unequal-lived, mutually exclusive projects into an equivalent annual amount (in
NPV terms).

Modified Internal Rate of Return (MIRR)

The MIRR represents the discount rate that causes the terminal value just to equal
the initial investment.

CASE
ABC Industry wishes to determine whether it would be advisable for it to replace an
existing, fully depreciated machine with a new one. The new machine will have an
after tax installed cost of $600,000 and will be depreciated under a 3-year under
straight line method. The old machine can be sold today for $150,000 after taxes. The
firm is in 40% marginal tax bracket and requires a minimum return on the
replacement decision of 18%. The firm’s estimation of its revenues and expenses
(excluding depreciation) for both the new and the old machine (in $ thousand) over
the next 5 years are given below.

Years New Machine Old Machine

Revenue Expense (excl. Revenue Expenses (excl.
depreciation depreciation)
1 950 725 675 575
2 1,115 770 680 590
3 1,125 815 695 615
4 1,145 860 725 625
5 1,155 915 740 650
ABC industry also estimates the values of various current accounts that would be
impacted by the personal replacement. They are shown below for both the new and
the old machine over the next four years. Currently (at time 0) the firm’s investment
in these current accounts is assumed to be $150,000 with the new machine and
$95,000 with the old machine.

New Machine
Year 1 2 3 4 5
Cash 20,000 25,000 30,000 40,000 45,000
A/R 100,000 105,000 110,000 120,000 125,000
Inventory 90,000 100,000 103,000 112,000 115,000
A/P 55,000 60,000 63,000 70,000 78,000

Old Machine
Year 1 2 3 4 5
Cash 19,000 19,000 19,000 19,000 19,000
A/R 64,000 65,000 73,000 79,000 86,000
Inventory 45,000 50,000 51,000 56,000 59,000
A/P 55,000 60,000 63,000 70,000 78,000

ABC estimates that after 5 years of detailed cash flow development, it will assume
in analyzing this replacement decision that the year 5 incremental cash flows of
the new machine over the old machine will grow at a compound annual rate of 4%
from the end of year 5 to infinity.

a. Find the incremental operating cash flows (including any working capital
investment) for year 1 to 5 for ABC’s proposed machine replacement decision.

b. Calculate the terminal value of ABC’s proposed machine replacement at the

end of year 5.

c. Show the relevant cash flows (initial outlay, operating cash flows and terminal
cash flow) for year 1 to 4 for ABC’s proposed machine replacement.
d. Using the relevant cash flows from part c, find the NPV and IRR for ABC’s
proposed machine replacement.

e. Based on your findings in part d, what recommendation would you make to

ABC regarding its proposed machine replacement?