Camano, Ma. Reina Niña B.

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CAPITAL BUDGETING

Capital budgeting (or investment appraisal) is the process of determining the viability to long-term investments
on purchase or replacement of property plant and equipment, new product line or other projects.

Capital budgeting consists of various techniques used by managers such as:

1. Payback Period
2. Discounted Payback Period
3. Net Present Value
4. Accounting Rate of Return
5. Internal Rate of Return
6. Profitability Index

All of the above techniques are based on the comparison of cash inflows and outflow of a project however they
are substantially different in their approach.

A brief introduction to the above methods is given below:

1. Payback Period measures the time in which the initial cash flow is returned by the project. Cash flows
are not discounted. Lower payback period is preferred.
2. Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash inflows. Higher
NPV is preferred and an investment is only viable if its NPV is positive.
3. Accounting Rate of Return (ARR) is the profitability of the project calculated as projected total net
income divided by initial or average investment. Net income is not discounted.
4. Internal Rate of Return (IRR) is the discount rate at which net present value of the project becomes
zero. Higher IRR should be preferred.
5. Profitability Index (PI) is the ratio of present value of future cash flows of a project to initial
investment required for the project.

What is capital budgeting?

Capital budgeting is a process used by companies for evaluating and ranking potential expenditures
or investments that are significant in amount. The large expenditures could include the purchase of
new equipment, rebuilding existing equipment, purchasing delivery vehicles, constructing additions
to buildings, etc. The large amounts spent for these types of projects are known as capital
expenditures.

Capital budgeting usually involves the calculation of each project's future accounting profit by period,
the cash flow by period, the present value of the cash flows after considering the time value of
money, the number of years it takes for a project's cash flow to pay back the initial cash investment,
an assessment of risk, and other factors.

Capital budgeting is a tool for maximizing a company's future profits since most companies are able
to manage only a limited number of large projects at any one time.

Capital Budgeting and Its Importance in Business

To understand capital budgeting, you have to understand both parts of the term. "Capital," in this

context, represents long-term, fixed assets, or the capital investment, such as a building or

machinery. "Budget" is the plan that details anticipated revenue and expenses during a particular

time period, often the duration of the project. The term "capital budgeting" is the process of

determining which long-term capital investments should be chosen by the firm during a particular

time period, and thus included in the capital budget.

Capital Budgeting versus Budgeting for Financial Assets

The financial process for determining the value of capital investment projects, such as buying a

building or a piece of equipment and determining the value of stocks and bonds is exactly the same.

They are all assets in which a firm invests.

However, there are two important differences. Businesses create capital projects, but financial

assets pre-exist in the financial markets. The second difference is that investors in stocks and bonds

have no influence over the cash flows of the companies they invest in, but a company does have

influence over their capital projects through good financial management.

Independent and Mutually Exclusive Capital Investment Projects

Capital investment projects are some of the most important financial investments made by a business

owner because they involve large amounts of money. Making a poor capital investment decision can

have a disastrous effect on a business.

Capital investment projects can be divided up into two types: independent projects and mutually

exclusive projects. Independent capital investment projects are those projects that do not affect the

cash flows of other projects. Mutually exclusive capital investment projects are those projects that

are the same or so similar to other capital investment projects that they do impact the cash flows of

other projects.

The difference between these two types of investment projects is very important in capital budgeting

and the financial analysis that is required to select or reject investment projects.
How is an independent or mutually exclusive project selected? The most important thing that a

business owner absolutely must do is compare the rate of return that the project will earn to

the weighted average cost of capital or what the company pays to obtain financing. The decision rule

is the if the rate of return is greater than the weighted average cost of capital, then accept and invest

in the project. If the rate of return of the project is less than the weighted average cost of capital,

then reject and do not invest in the project.

This rate of return is actually an opportunity cost. In other words, the rate of return is the cost of

investing in one project as opposed to another.

Factors to Consider When Making a Capital Investment Decision

1. Comparing the rate of return of a project to the weighted average cost of capital of the firm is not as

simple as it sounds. There is a relatively complex financial analysis process the business owner has to

go through in order to get there. Consider professional accounting assistance.

1. The business owner has to estimate the cash flows that will be generated by the project. Often, the cash

flows are the single hardest variable to estimate when trying to determine the rate of return on the

project. Both the quantity and timing of the cash flows have to be considered. If you are writing a

business plan, for example, you need to estimate about five years of cash flows. Usually, cash flows are

estimated for the economic life of the project and, of course, should be as accurate as possible.

There are a number of cash flow forecasting methods that business owners can use to choose their

projects.