Describe the capital budgeting process and distinguish among the various categories of capital

projects.
Capital budgeting process is the process of identifying and evaluating capital projects, that
is, projects where the cash flow to the firm will be received over a period longer than one
year.
Used to determine and select most profitable long-term project
Steps in capital budgeting process:
1. Generate idea: generate good investment idea from internal and external sources of idea (most
important step)
2. Analyzing individual(project) proposal: Collect information to forecast future cash flow for each
project and analyze the profitability of alternative projects
3. Planning the capital budget: Organize the profitable proposals to fit within the company’s
overall strategies; Because of financial and real resources issues, the scheduling and
prioritizing of projects is important.
4. Monitoring and post-auditing: Actual results are compared to planned or predicted results, and
any differences must be explained.
 Post auditing capital projects is important for several reasons:
o It helps monitoring the forecasts and analysis that underlie the capital budgeting
process.
o It helps improve business operations.
o Monitoring and post-auditing recent capital investments will produce concrete ideas
for future investments.

Capital projects categories or types

1. Replacement projects:
1) If a piece of equipment breaks down or wears out: the easiest capital budgeting
decision, it may not require careful analysis, and it is a waste of resources to
overanalyze the decision.
2) Replacing existing equipment with newer: these replacement decisions are often
amenable to very detailed analysis.
2. Expansion projects: expansion decisions may involve more uncertainties than replacement
decisions, and these decisions will be more carefully considered.
3. New products and services: These investments expose the company to even more
uncertainties than expansions, more complex and will involve more people in the decision-
making process.
4. Regulatory, safety, environmental projects: Required by governmental agencies, insurance
companies, or some other external parties. Generate no revenue and might be undertaken by
a company maximizing its own private interests.
 5. Others: These are projects of someone in the company (CEO buying a new aircraft).
Or so risky that are difficult to analyze by the usual methods (such as some research and
development decisions).
Basic principles of capital budgeting
1. Operating cash-flow
2. Decision are made based on the changes in after-tax cash-flow
3. Consider cash opportunity cost
4. Consider externalities –cannibalization
5. Consider timing of cash-flow
6. Don’t consider sunk cost (incremental cash-flow)
7. Don’t consider any project financial cost as it reflected in IRR

 Opportunity cost: It is what a resource is worth in its next-best use

 Incremental cash-flow: It is the cash flows that is realized because of a decision. The cash
flow with a decision minus the cash flow without that decision
 Externalities: It is the effect of an investment on other things besides the investment
itself. It can be positive or negative. If possible, these should be a part of investment decision
o Market cannibalization: is a situation where a new product "eats" up the
sales/demand of an existing product, potentially reducing overall sales, even if
sales of the new product are increasing
Types of cash-flow patterns
1. Conventional cash-flow: an initial outflow followed by series of inflow.
2. Nonconventional cash-flow: initial outflow not followed by inflow only but cash flow can flip
from positive to negative sign – two or more time change
Explain how the evaluation and selection of capital project is affected by mutually exclusive projects,
projects sequencing, and capital rationing. (Projects interaction)
1. Independent vs mutually exclusive vs dependent projects:
1) Independent projects: they are projects whose cash-flow are independent of each
other if X and Y are independent you can choose X and Y
2) Mutually exclusive: compete directly with each other X or Y
3) Dependent: have to be all selected or all refused as implement of one requires the
implementation of the other(s)
2. Unlimited fund vs capital rationing:
1) Unlimited fund: assumes that company can raise the funds it wants for all profitable
projects simply by paying required rate of return.
2) Capital rationing: exists when the company has a fixed amount of funds to invest. If the
company has more profitable projects than it has funds for, it must allocate the funds to
achieve the maximum shareholder value subject to funding constraints.
3. Project sequencing: investing in a project creates the option to invest in future projects
 Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period,
discounted payback period, and the profitability index (PI) of a single capital project
Net Present Value (NPV): Internal Rate of Return (IRR):
o Is the present value of future after-tax cash  Is the expected rate of return in the project
flows minus the initial investment outlay  The internal rate of return is the rate of return
o Expected change in the value of firm, in that equates the PV of future after-tax CFs to
current (PV) dollars, from the project the initial it makes NPV = 0

CF1 CF2 CF3 CFn NPV=0=

NPV = 𝑐𝑓0 + + + +…+ CF1 CF2 CF3 CFn
(1+k)1 (1+k)2 (1+k)3 (1+k)𝑛
𝑐𝑓0 + + + +…+
(1+IRR)1 (1+IRR)2 (1+IRR)3 (1+IRR)𝑛

𝑠𝑢𝑚 𝐶𝐹𝑡
= Outlay / cost = return
(1+𝑅)𝑡

 NPV > 1.0 / invest: capital project add value  If IRR > the required rate of return-cost of
 NPV < 1.0 / don’t invest: capital project capital (hurdle rate), accept the project.
destroy value  If IRR < the required rate of return- cost of
capital (hurdle rate), reject the project

Equivalent to NPV: If NPV>0 or IRR>cost of capital then PV of cash-flow>initial cash cost

Payback Period Discounted Payback Period

 Is the number of years required to
recover the original investment
 Primary measures of liquidity
 is the number of years it takes for the
cumulative discounted cash flows from
a project to equal the original
investment
 It is the length of time for the project to
reach NPV = 0.

Advantages: its simplicity Advantages:

 it relies on discounted cash flows, much
as the NPV criterion does
 address weakness of payback period
(time value of money)

Drawbacks Drawbacks
 Ignores the time value of money and  Ignores cash flows after the payback
the risk of the project. period is reached, salvage value not
 Ignores cash flows after the payback considered
period is reached, salvage value not
considered
  Useless measure of profitability
 Not measure of value

Annuity constant cash-flow: If a project has a negative NPV, it will usually

not have a discounted payback period since it
𝑖𝑛𝑡𝑖𝑎𝑙 𝑛𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 never recovers the initial investment.
𝑝𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 =
𝑎𝑛𝑛𝑢𝑎𝑙 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
Cash-flow not annuity:
𝑢𝑛𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑒𝑑 𝑐𝑜𝑠𝑡 𝑎𝑡 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟
𝑦𝑒𝑎𝑟 𝑏𝑒𝑓𝑜𝑟𝑒 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦
𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑑𝑢𝑟𝑖𝑛𝑔 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑦𝑒𝑎𝑟

 The shorter a project's payback period or discounted payback period, the better. However project
decisions should not be made on the basis of their payback period because if the method’s
drawback

Profitability index: present value of future cash flow divided by the initial cash outlay
𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑁𝑃𝐶
𝑃𝐼 = = 1+
𝐶𝐹0 𝐶𝐹0
Note PI>1 NPV is + IRR> cost of capital