Module 5 Basics of Capital Budgeting

BASICS OF CAPITAL BUDGETING
Introduction
We have assumed that the proposed investment projects do not involve any
risk in discussing the capital budgeting techniques. The assumption was made to
facilitate the understanding of capital budgeting techniques. In real-life
situations, the firm in general and its investment projects are exposed to different
degrees of risk.
Intended Learning Outcomes
At the end of this module, you are expected to:
1. explain the importance of Capital budgeting and;

2. Calculate and apply major capital budgeting decision criteria.
Course Outline
1. An Overview of Capital Budgeting
2. Net Present Value
3. Internal Rate of Return
4. Multiple Internal Rates of Return
5. Reinvestment Rate Assumptions
6. Modified Internal Rate of Return
7. Net Present Value Profiles
8. Payback Period
9. Conclusions on Capital Budgeting Methods
10. Decision Criteria Used in Practice
Content
Preliminary Activity
Take a look into the figure and state your own interpretation on it.
The module is for the exclusive use of the University of La Salette, Inc. Any form of reproduction, distribution, uploading, or
posting online in any form or by any means without the written permission of the University is strictly prohibited.
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1. basic concepts of capital budgeting- What's capital budgeting, series of
processes, different project that will be evaluated.
2. when we say elements of CB - factors of capital budgeting- items that

needed to evaluate certain projects, requirements/must
by applying the
techniques of CB- kung baga its a requirements to understand the
different 3. techniques of CB so you need to know the elements of CB
4. investment decisions- kailan natin i accrpt or irereject.
Cb its a topic which is border line topic of management accounting and

Fm
CB - IS THE PROCESS OF IDENTIFYING , EVALUATING, PLANNING AND

FINANCING CAPITAL INVESTMENT PROJECTS OF AN ORGANIZATION.
sir hindi ko gets ?

-ALwAYS REMEmBER IS AN INVESTMENT CONCEPT, IN WHAT WAY
I assumed that you already know what is investment
If you INVEST OR COMMIT FUNDS TODAY ? EXPECT
-RECEIVE RETUNRS IN THE FUTURE
FORMS OF RETURN na matatanggap natin
-ADDITIONAL INFLOW
-REDUCE CASH OUTFLOW
Iniivets natin sa capital busgeting is ?

LONG TERM ASSETS (INVESTM,ENT ASSETS) – involves HIGH RISK AND
UNCERTAINTY- maysadong matagal para may makungang return
DOUBT/- it creates
THE HIGHER THE RISK THE HIGHER THE RETURN.
CB-CAPITAL EXPOENDITUREs-LONG TERM ASSETS/INVETSMENT
2
CB- US USUALLY USE IN THE FF DECISIONS
REPLACEMENT/ACQUISITION OF LONG TERM ASSETS- bibili ka ng bago
or papalitan mo yung luma.
IMPROVEMENT OF PRODUCTS -
EXPANSION OF FACILITIES- magdagda ng production facilities
Umiikot laang sya sa long term assets or financing.
Before we invest on something we have to determine if we actually need

it .
You need to think first before we go o to the investment. If needed talaga
sya.
So I believe nakikita nyu na yung concept ng capitl busgeting ang

pinkasama hindi ka pwedeng mag invest ng wlaang kapera pera.
AN OVERVIEW OF CAPITAL BUDGETING
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CAPITAL BUDGETING - The process of planning expenditures on assets with
cash flows that are expected to extend beyond one year.
The same concepts used in security valuation are also used in capital
budgeting, but there are two major differences. First, stocks and bonds exist in
the security markets, and investors select from the available set; firms, however,
create capital budgeting projects. Second, for most securities, investors do not
influence the cash flows produced by their investments, whereas corporations
majorly influence projects' results. Still, insecurity valuation and capital
budgeting, we forecast a set of cash flows, find the present value of those flows,
and make the investment only if the PV of the inflows exceeds the investment's
cost.
A firm's growth, and even its ability to remain competitive and survive,
depends on a constant flow of ideas relating to new products, improvements in
existing products, and operating more efficiently. Accordingly, well-managed
firms go to great lengths to develop good capital budgeting proposals.
Strategic Business Plan is a long-run plan that outlines the firm's basic
strategy for the next 5 to 10 years. Analyzing capital expenditure proposals is not
costless—benefits can be gained, but the analysis does have a cost. For certain
types of projects, an extremely detailed analysis may be warranted, while simpler
procedures are adequate for other projects. Accordingly, firms generally
categorize projects and then analyze them in each category somewhat differently:
1. Replacement: needed to continue current operations. One category

consists of expenditures to replace worn-out or damaged equipment
required to produce profitable products. The only questions here are
whether the operation should continue, and if so, should the firm continue
using the same production processes? The project will be approved without
an elaborate decision process if the answers are yes.
2. Replacement: cost reduction. This category includes expenditures to

replace serviceable but obsolete equipment and lower costs. These decisions
are discretionary, and a fairly detailed analysis is generally required.
3. Expansion of existing products or markets. These expenditures increase

existing products' output or expand retail outlets or distribution facilities in
markets now being served. Expansion decisions are more complex because
they require an explicit forecast of growth in demand, so a more detailed
analysis is required. The go/no-go decision is generally made at a higher
level within the firm.
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4. Expansion into new products or markets. These investments relate to
new products or geographic areas, and they involve strategic decisions that
could change the fundamental nature of the business. Invariably, a detailed
analysis is required, and the final decision is generally made at the top
management level.
5. Safety and environmental projects. Expenditures necessary to comply

with government orders, labor agreements, or insurance policy terms fall
into this category. How these projects are handled depends on their size,
with small ones being treated much like the Category 1 projects.
6. Other projects. This catch-all includes office buildings, parking lots, and
executive aircraft. How they are handled varies among companies.
7. Mergers. In a merger, one firm buys another one. Buying a whole firm is
different from buying an asset such as a machine or investing in a new
airplane, but the same principles are involved. The concepts of capital
budgeting underlie merger analysis.
In general, relatively simple calculations, and only a few supporting

documents, are required for replacement decisions, especially maintenance
investments in profitable plants. More detailed analyses are required for cost-
reduction projects, expansion of existing product lines, and investments in new
products or areas. Also, projects are grouped by their dollar costs within each
category: Larger investments require increasingly detailed analysis and approval
at higher levels. Thus, a plant manager might be authorized to approve
maintenance expenditures up to $10,000 using a relatively unsophisticated
analysis. Still, the full board of directors might have to approve decisions that
involve more than $1 million or expansions into new products or markets.
If a firm has capable and imaginative executives and employees and its
incentive system is working properly, many ideas for capital investment will be
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advanced. Some ideas will be good ones, but others will not. Therefore,
procedures must be established for screening projects. Companies use, and we
discuss, the following criteria for deciding to accept or reject projects:
Major Methods Many formal methods are used in capital budgeting, including the techniques
as followed:
1. Net present value (NPV)

2. Internal rate of return (IRR)
3. Modified internal rate of return (MIRR)
4. Regular Payback
5. Discounted Payback
The NPV is the best method, primarily because it directly addresses the
central goal of financial management—maximizing shareholder wealth. However,
all methods provide useful information, and all are used in practice at least to
some extent.
NET PRESENT VALUE (NPV)
A method of ranking investment proposals using the NPV is equal to the

present value of the project's free cash flows discounted at the cost of capital.
Recall that free cash flow represents the net amount of cash available for all
investors after considering the necessary investments in fixed assets (capital
expenditures) and net operating working capital.
The net present value (NPV) tells us how much a project contributes to
shareholder wealth—the larger the NPV, the more value the project adds; added
value means a higher stock price. Thus, NPV is the best selection criterion.
Net present value is a tool of Capital budgeting to analyze the profitability

of a project or investment. It is calculated by taking the difference between the
present value of cash inflows and the present value of cash outflows over time.
The formula of the present value factor was discussed in our previous module.
Formula:
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To derive the cash flows' present value, we need to discount them at a
special rate. This rate is derived considering the investment return with similar
risk or cost of borrowing for the investment. NPV takes into consideration the
time value of money. NPV helps decide whether it is worth taking up a project
basis the present value of the cash flows.
After discounting the cash flows over different periods, the initial
investment is deducted from it. If the result is a positive NPV, then the project is
accepted. If the NPV is negative, the project is rejected. And if NPV is zero, then
the organization will stay indifferent.
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b. To answer the requirement in b, we need to know the difference between
independent or mutually exclusive projects.
Independent Projects are projects with cash flows that are not affected by
the acceptance or non-acceptance of other projects. If all the independent
projects have positive NPVs, they should be accepted.
Mutually exclusive projects are projects where the other must be

rejected if one project is accepted.
Summary of the NPV decision rules:
INDEPENDENT PROJECTS. If NPV exceeds zero, accept the project.

MUTUALLY EXCLUSIVE PROJECTS. Accept the project with the highest
positive NPV. If no project has a positive NPV, reject them all.
The answer in requirement b is:

 If the two projects are independent, both projects would be accepted
because both have positive NPVs.
 If the two projects are mutually exclusive, Project Y would be accepted
because it has a larger positive NPV.
INTERNAL RATE OF RETURN (IRR)
A project's IRR is the discount rate that forces the PV of its inflows to equal
its cost. This is equivalent to forcing the NPV to be equal to zero. The IRR is an
estimate of the project's rate of return.
We could use a trial-and-error procedure—try a discount rate, see if the

equation solves zero and if it doesn't. We could then continue until we found the
rate that forces the NPV to zero; that rate would be the IRR.
Why is the discount rate that causes a project's NPV to equal zero so
special? The reason is that the IRR estimates the project's rate of return. If this
return exceeds the cost of the funds used to finance the project, the difference
will be an
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additional return (in a sense, a "bonus") that goes to the firm's stockholders and
causes the stock price to rise. On the other hand, if the IRR is less than the cost of
capital, stockholders must make up the shortfall, which will hurt the stock price.
As we noted earlier, projects should be accepted or rejected depending on

whether their NPVs are positive. However, the IRR is sometimes used to rank
projects and make capital budgeting decisions. When this is done, here are the
decision rules:
Independent projects. Accept the project if IRR exceeds the project's WACC
(Cost of Capital). If IRR is less than the project's WACC, reject it.
Mutually exclusive projects. Accept the project with the highest IRR,
provided that IRR is greater than WACC. Reject all projects if the best IRR does
not exceed WACC.
The IRR is logically appealing—it is useful to know the rates of return on

proposed investments. However, NPV and IRR can produce conflicting
conclusions when a choice is being made between mutually exclusive projects;
and when conflicts occur, the NPV is generally better:
Required:
 What are the projects' IRRs?
 Which project(s) would the IRR method select if the firm had a 10% cost of
capital and the projects were (1) independent or (2) mutually exclusive?
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b.
 If both projects were independent, both projects would be accepted because
both IRRs are greater than the firm's WACC.
 If both projects were mutually exclusive, Project X would be chosen using
the IRR method because its IRR is greater than the IRR of Project Y, and it
is greater than the firm's WACC.
MULTIPLE INTERNAL RATES OF RETURN
The situation where a project has two or more IRRs. A problem with the IRR
is that a project may have more than one IRR under certain conditions. First, note
that a project is said to have normal cash flows if it has one or more cash outflows
(costs) followed by a series of cash inflows. If a cash outflow occurs sometime
after the inflows have commenced, meaning that the signs of the cash flows
change more than once, the project is said to have abnormal cash flows.
An example of a project with abnormal cash flows would be a strip coal mine
where the company spends money to purchase the property and prepare the site
for mining, which has had positive inflows for several years. Then the company
spends more money to return the land to its original condition. In such a case, the
project might have two IRRs, that is, multiple IRRs
Example (MIRR)
Suppose a firm is considering a potential strip mine (Project M) that has a

cost of ₱1.6 million and will produce a cash flow of ₱10 million at the end of Year
1. Then at the end of Year 2, the firm must spend ₱10 million to restore the land
to its original condition. Therefore, the project's expected cash flows (in millions)
are as follows:
10
NPV equals 0 when IRR is 25%, but it also equals 0 when 400%.10
Therefore, Project M has an IRR of 25% and another 400%, and we don't know
which one to use. Note that no dilemma regarding Project M would arise if the
NPV method were used; we would find the NPV and use it to evaluate the project.
We would see that if Project M's cost of capital were 10%, its NPV would be −
₱0.7736 million, and the project should be rejected. However, if r were between
25% and 400%, NPV would be positive, but those numbers would not be realistic
or useful for anything.
REINVESTMENT RATE ASSUMPTIONS
The NPV calculation assumes that cash inflows can be reinvested at the
project's risk-adjusted WACC, whereas the IRR calculation assumes that cash
flows can be reinvested at the IRR.
Which assumption is more reasonable? For most firms, assuming reinvestment at

the WACC is more reasonable for the following reasons:
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 If a firm has reasonably good access to the capital markets, it can raise all
the capital it needs at the going rate or WACC.
 Because the firm can obtain capital at a certain rate, if it has investment
opportunities with positive NPVs, it should take them on, and it can finance
them at the cost of capital.
 If the firm uses internally generated cash flows from past projects rather
than external capital, this will save it the percentage cost of capital. Thus,
the percentage cost of capital is the opportunity cost of the cash flows,
which is the effective return on reinvested funds.
To illustrate, suppose a project's IRR is 50%, the firm's WACC is 10%, and
the firm has adequate access to the capital markets. Thus, the firm can raise the
capital it needs at the 10% rate. Unless the firm is a monopoly, the 50% return
will attract competition, making it difficult to find new projects with similarly high
returns, which the IRR assumes. Moreover, even if the firm does find such
projects, it could take them on with external capital that costs 10%. The logical
conclusion is that the original project's cash flows will save the 10% cost of the
external capital, which is the effective return on those flows.
If a firm does not have good access to external capital and if it has many
potential projects with high IRRs, it might be reasonable to assume that a
project's cash flows could be reinvested at a rate close to its IRR. However, that
situation rarely exists: Firms with good investment opportunities generally have
good access to debt and equity markets.
The conclusion is that the assumption built into the IRR—that cash flows
can be reinvested at the IRR—is flawed, whereas the assumption built into the
NPV—that cash flows can be reinvested at the WACC— is generally correct.
Moreover, if the true reinvestment rate is less than the IRR, the actual rate of
return on the investment must be less than the calculated IRR; thus, the IRR is
misleading as a measure of a project's profitability.
MODIFIED INTERNAL RATE OF RETURN (MIRR)
The discount rate at which the present value of a project's cost is equal to
the present value of its terminal value, where the terminal value is found as the
sum of the future values of the cash inflows, compounded at the firm's cost of
capital.
This measure is similar to the regular IRR, except it is based on the

assumption that cash flows are reinvested at the WACC (or some other explicit
rate if that is a more reasonable assumption).
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To calculate the MIRR formula of a project, we need to know: the future
value of a firm's positive cash flows discounted at the firm's cost of capital and the
present value of a firm's negative cash flows discounted at the cost of the firm.
Example (MIRR)
Projects A and B have the following cash flows:
Required:
 What are the projects' NPVs, IRRs, and MIRRs?
 Which project would each method select if the projects were mutually
exclusive?
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Using the NPV and MIRR criteria, you would select Project B; however, you
would select Project A if you use the IRR criteria. Because Project B adds the
most value to the firm, B should be chosen.
The MIRR has two significant advantages over the regular IRR. First,
whereas the regular IRR assumes that the cash flows from each project are
reinvested at the IRR, the MIRR assumes that cash flows are reinvested at the
cost of capital (or some other explicit rate). Because reinvestment at the IRR is
generally incorrect, the MIRR is generally a better indicator of a project's true
profitability. Second, the MIRR eliminates the multiple IRR problem—there can
never be more than one MIRR, and it can be compared with the cost of capital
when deciding to accept or reject projects.
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The conclusion is that the MIRR is better than the regular IRR; however, this
question remains: Is MIRR as good as the NPV? Here are the conclusions:
 The NPV, IRR, and MIRR always reach the same accept/reject conclusion
for independent projects, so the three criteria are equally good when
evaluating independent projects. MIRR Project A 10% Cash Flow x 1.10 PV
FV 1,265 -1,000 1,365 0 1 2 -1,000 1,150 100 Project B 10% Cash Flow x
1.10 PV FV -1,000 100 1,300 110 -1,000 1,410 0 1 2 PBSBAFM 001 –
FINANCIAL MANAGEMENT 9 The module is for the exclusive use of the
University of La Salette, Inc. Any form of reproduction, distribution,
uploading, or posting online in any form or by any means without the
written permission of the University is strictly prohibited.
 However, conflicts can arise if projects are mutually exclusive and differ in
size. In such cases, the NPV is best because it selects the project that
maximizes value.
 The overall conclusion ns are that (1) the MIRR is superior to the regular
IRR as an indicator of a project's "true" rate of return, but that (2) NPV is
better than IRR and MIRR when choosing among competing projects.
NPV PROFILES
Net Present Value Profile - A graph showing the relationship between a project’s
NPV and the firm’s cost of capital.
To make the profile, we find the project’s NPV at a number of different discount
rates and then plot those values to create a graph. Note that at a zero cost of
capital, the NPV is simply the net total of the undiscounted cash flows, $1,300 -
$1,000 =$300. This value is plotted as the vertical axis intercept. Also recall that
the IRR is the discount rate that causes the NPV to equal zero, so the discount
rate at which the profile line crosses the horizontal axis is the project’s IRR. When
we connect the data points, we have the NPV profile.
Now consider the below chart, which shows two NPV profiles—one for Project S
and one for L—and note the following points:
 The IRRs are fixed, and S has the higher IRR regardless of the cost of
capital.
 However, the NPVs vary depending on the actual cost of capital.
 The two NPV profile lines cross at a cost of capital of 11.975%, which is
called the crossover rate. The crossover rate can be found by calculating the
IRR of the differences in the projects’ cash flows, as demonstrated below:
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 Project L has the higher NPV if the cost of capital is less than the crossover
rate, but S has the higher NPV if the cost of capital is greater than that rate.
Crossover Rate - The cost of capital at which the NPV profiles of two projects
cross and, thus, at which the projects’ NPVs are equal.
NPV Profile for Project S
NPV Profiles for Project S and L
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PAYBACK PERIOD
The payback period is defined as the number of years required to recover

the funds invested in a project from its cash flows. For the calculation, we start
with the project's cost, a negative value, and then add the cash inflow for each
year until the cumulative cash flow turns positive. The payback year is the year
before full recovery plus a fraction equal to the shortfall at the end of that year
divided by the cash flow during the full recovery year. An investment with a
shorter payback period is better since the investor's initial outlay is at risk for a
shorter time. The calculation used to derive the payback period is called the
payback method. The payback period is expressed in years and fractions of years.
For
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example, if a company invests ₱300,000 in a new production line, the production
line then produces a positive cash flow of ₱100,000 per year. The payback period
is 3.0 years (₱300,000 initial investment ÷ 100,000 annual).
The formula for the payback method is simplistic: Divide the cash outlay
(which is assumed to occur entirely at the beginning of the project) by the amount
of net cash inflow generated by the project per year (if the same every year).
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The Payback has three flaws:
 All peso amounts received in different years are given the same weight (i.e.,
the time value of money is ignored).
 Cash flows beyond the payback year are given no consideration regardless
of how large they might be.
 Unlike the NPV, which tells us how much wealth a project adds, and the
IRR, which tells us how much a project yields over the cost of capital, the
Payback merely tells us when we will recover our investment. There is no
necessary relationship between a given payback and investor wealth
maximization, so we do not know an acceptable payback. The firm might use
two years, three years, or any other number as the minimum acceptable
Payback, but the choice is arbitrary.
To counter the first criticism, analysts developed the discounted Payback.

Discounted Payback is the length of time required for an investment's cash flows,
discounted at the investment's cost of capital to cover its cost. Here, cash flows
are discounted at the WACC; then, those discounted cash flows are used to find
the Payback.
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Although the payback methods have faults as ranking criteria, they provide
information about liquidity and risk. The shorter the Payback, other things held
constant, the greater the project's liquidity. This factor is often important for
smaller firms
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that don't have ready access to the capital markets. Also, cash flows expected in
the distant future are generally riskier than near-term cash flows, so the Payback
is used as one risk indicator.
CONCLUSIONS ON CAPITAL BUDGETING METHODS
We have discussed five capital budgeting decision criteria—NPV, IRR,

MIRR, payback, and discounted payback. We compared these methods with one
another and highlighted their strengths and weaknesses. In the process, we may
have created the impression that “sophisticated” firms should use only one
method, the NPV. However, virtually all capital budgeting decisions are analyzed
by computer, so it is easy to calculate all five decision criteria. In making the
accept/reject decision, large, sophisticated firms such as Boeing and Airbus
generally calculate and consider all five measures because each provides a
somewhat different piece of information about the decision.
NPV is the single best criterion because it provides a direct measure of

value the project adds to shareholder wealth. IRR and MIRR measure profitability
expressed as a percentage rate of return, which is useful to decision makers.
Further, IRR and MIRR contain information concerning a project’s “safety
margin.” To illustrate, consider a firm whose WACC is 10% that must choose
between these two mutually exclusive projects: SS (for small), which costs
$10,000 and is expected to return $16,500 at the end of 1 year, and LL (for large),
which costs $100,000 and has an expected payoff of $115,550 after 1 year. SS has
a huge IRR, 65%, while LL’s IRR is a more modest 15.6%. The NPV paints a
somewhat different picture—at the 10% cost of capital, SS’s NPV is $5,000 while
LL’s is $5,045. By the NPV rule, we would choose LL. However, SS’s IRR
indicates that it has a much larger margin for error: Even if its cash flow was 39%
below the $16,500 forecast, the firm would still recover its $10,000 investment.
On the other hand, if LL’s inflows fell by only 13.5% from its forecasted $115,550,
the firm would not recover its investment. Further, if neither project generated
any cash flows, the firm would lose only $10,000 on SS but $100,000 if it accepted
LL.
The modified IRR has all the virtues of the IRR, but it incorporates a better
reinvestment rate assumption and avoids the multiple rate of return problem. So,
if decision makers want to know projects’ rates of return, the MIRR is a better
indicator than the regular IRR.
In summary, the different measures provide different types of information.

Because it is easy to calculate all of them, all should be considered when capital
budgeting decisions are being made. For most decisions, the greatest weight
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should be given to the NPV, but it would be foolish to ignore the information
provided by the other criteria
Payback and discounted payback provide indications of a project’s liquidity

and risk. A long payback means that investment dollars will be locked up for a
long time; hence, the project is relatively illiquid. In addition, a long payback
means that cash flows must be forecasted far out into the future, and that
probably makes the project riskier than one with a shorter payback. A good
analogy for this is bond valuation. An investor should never compare the yields to
maturity on two bonds without also considering their terms to maturity because a
bond’s risk is significantly influenced by the number of years remaining until its
maturity. The same holds true for capital projects
DECISION CRITERIA USED IN PRACTICE
Surveys designed to find out which of the criteria managers actually use have
been taken over the years. Surveys prior to 1999 asked companies to indicate
which method they gave the most weight, while the most recent survey, in 1999,
asked what method(s) managers actually calculated and used. A summary of all
these surveys is shown in Table 5.1, and it reveals some interesting trends.
First, the NPV criterion was not used significantly before 1980, but by 1999, it
was close to the top in usage. Moreover, informal discussions with companies
suggest that if a survey were to be taken in 2017, NPV would be at the top of this
list. Second, the IRR method is widely used, but its recent growth is less dramatic
than that of NPV. Third, payback was the most important criterion years ago, but
its use as the primary criterion had fallen drastically by 1980. Companies still use
payback because it is easy to calculate and it does provide some information, but
it is rarely used today as the primary criterion. Fourth, “other methods,” primarily
the accounting rate of return and the profitability index, have been fading due to
the increased use of IRR and especially NPV.
These trends are consistent with our evaluation of the various methods. NPV is
the best single criterion, but all of the methods provide useful information and all
are easy to calculate; thus, all are used, along with judgment and common sense.
We will have more to say about all this in the next chapter.
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Table 5.1 shows the Capital Budgeting Methods used in Practice.
Activity 1
1. How Capital Budgeting is helpful for decision making?
2. Projects A and B have the following cash flows:
End-of-year Cash Flows

Project 0 1 2 3
A -800 600 400 200
B -800 200 300 600
Their Cost of Capital is 12%
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Required:
 What are the projects' NPVs, IRRs, MIRRs and Payback Period?
 Which project would each method select if the projects were mutually
exclusive?
Summary:
In this chapter, we took the cash flows given and used them to illustrate the
different capital budgeting methods. As you will see in the next chapter,
estimating cash flows is a major task. Still, the framework established in this
chapter is critically important for sound capital budgeting analyses; and at this
point, you should:
 Understand capital budgeting.

 Know how to calculate and use the major capital budgeting decision
criteria, which are NPV, IRR, MIRR, and payback
 Understand why NPV is the best criterion and how it overcomes problems
inherent in the other methods.
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 Recognize that while NPV is the best method, the other methods do provide
information that decision makers find useful.
References:
Brigham, E. and Houston, J., n.d. Fundamentals of financial management. 8th ed.
5191 Natorp Blvd Mason, OH 45040 USA: Cengage Learning.
Anastacio, M. L., Dacanay, R. C., & Aliling, L. E. (2016). Fundamentals of
Financial Management (Revised ed.). REX Book Store.
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Module 5 Basics of Capital Budgeting

Uploaded by

Module 5 Basics of Capital Budgeting

Uploaded by

BASICS OF CAPITAL BUDGETING

Intended Learning Outcomes

At the end of this module, you are expected to:

1. explain the importance of Capital budgeting and;

2. when we say elements of CB - factors of capital budgeting- items that

Cb its a topic which is border line topic of management accounting and

CB - IS THE PROCESS OF IDENTIFYING , EVALUATING, PLANNING AND

sir hindi ko gets ?

Iniivets natin sa capital busgeting is ?

CB-CAPITAL EXPOENDITUREs-LONG TERM ASSETS/INVETSMENT

Umiikot laang sya sa long term assets or financing.

Before we invest on something we have to determine if we actually need

So I believe nakikita nyu na yung concept ng capitl busgeting ang

AN OVERVIEW OF CAPITAL BUDGETING

1. Replacement: needed to continue current operations. One category

2. Replacement: cost reduction. This category includes expenditures to

3. Expansion of existing products or markets. These expenditures increase

5. Safety and environmental projects. Expenditures necessary to comply

In general, relatively simple calculations, and only a few supporting

1. Net present value (NPV)

NET PRESENT VALUE (NPV)

A method of ranking investment proposals using the NPV is equal to the

Net present value is a tool of Capital budgeting to analyze the profitability

Mutually exclusive projects are projects where the other must be

Summary of the NPV decision rules:

INDEPENDENT PROJECTS. If NPV exceeds zero, accept the project.

The answer in requirement b is:

INTERNAL RATE OF RETURN (IRR)

We could use a trial-and-error procedure—try a discount rate, see if the

As we noted earlier, projects should be accepted or rejected depending on

The IRR is logically appealing—it is useful to know the rates of return on

MULTIPLE INTERNAL RATES OF RETURN

Suppose a firm is considering a potential strip mine (Project M) that has a

REINVESTMENT RATE ASSUMPTIONS

Which assumption is more reasonable? For most firms, assuming reinvestment at

MODIFIED INTERNAL RATE OF RETURN (MIRR)

This measure is similar to the regular IRR, except it is based on the

NPV Profile for Project S

NPV Profiles for Project S and L

The payback period is defined as the number of years required to recover

To counter the first criticism, analysts developed the discounted Payback.

CONCLUSIONS ON CAPITAL BUDGETING METHODS

We have discussed five capital budgeting decision criteria—NPV, IRR,

NPV is the single best criterion because it provides a direct measure of

In summary, the different measures provide different types of information.

Payback and discounted payback provide indications of a project’s liquidity

DECISION CRITERIA USED IN PRACTICE

1. How Capital Budgeting is helpful for decision making?

2. Projects A and B have the following cash flows:

End-of-year Cash Flows

Their Cost of Capital is 12%

 Understand capital budgeting.

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