Capital Budgeting

A budget that details the planned expenditures for

facilities, equipment, new products, and other
long-term investment.
Steps in capital budgeting:
- Identifying potential investments
- Selecting the investments to undertake
- Follow up monitoring, or postaudit of
investment.
Capital budgeting models:
1. Discounted cash flow
2. Pay back
3. Rate of return.

Discounted cash flow

A type of capital budgeting model that focuses
on cash inflows and outflows and explicitly and
systematically incorporates the time value of
money.
Tools :
net present value (NPV)
Internal rate of return (IRR)

NPV
A discounted cash flow approach to capital budgeting
that discounts all expected future cash flow to the
present using a minimum desired rate of return.

Applying the NPV:

1. Prepare a diagram of relevant expected
cash inflows and outflows.
2. Find the present value of each expected
cash inflows and outflows.
3. Sum the individual present value.
Rules of decision:
NPV positive (NPV > 0), favourable.
NPV negative (NPV < 0), unfavourable.
NPV = 0, break even.

Consideration:
MITs Engineering School is considering the purchase of
a special machine for $60,000. It is expected to have a
useful life of 3 years with no terminal salvage value. The
universitys controller estimates the following savings in
cash operating costs:
Year
1
2
3

Amount
$28,000
26,000
24,000

Required rate of return is 12% per year.

Should the planning be accepted or rejected?

Internal Rate of Return (IRR)

The discount rate that makes the net present value of
the project is equal to zero.
Steps:
1.
2.
3.

Prepare a diagram of the expected cash inflows and outflows.

Find the interest rate that equates the present value of the
inflows to the present value of the cash outflows.
Compare the IRR with the minimum desired rate of return.

Rules of decision:

IRR > desired rate of return, favourable.

IRR < desired rate of return, unfavourable.
IRR = desired rate of return, break even.

Tools:
1.
2.
3.

Interpolation.
Rhapson and Newton.
Spread sheets software.

Exercise:
The Orlando Novelty Company has just been
established. The following are the expected cash flows:
Initial investment $105,000
End of year

Outflows

Inflows

$ 75,000

$ 100,000

100,000

125,000

125,000

150,000

150,000

200,000

175,000

225,000

Desired rate of return is 14%, use the NPV and then the IRR to
decide the investment whether to be accepted or rejected.

Capital Budgeting (Tax effects)

1.
2.
3.

Consideration:
Initial investment: $125,000
Life years of the investment: 5 years
Inflow per year: $130,000
Operating costs per year: $70,000
Income tax: 40%; desired rate of return: 12%
Straight line depreciation, no disposal value.
Straight line depreciation, no disposal value, at the end
of year 5th the investment will be sold for $20,000.
Double declining balance method, no disposal value,
at the end of year 5th the investment will be sold for
$20,000.