Lesson 5

Long-Term Investment Decision

OVERVIEW OF CAPITAL BUDGETING

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the
irm’s goal of maximizing owners’ wealth.

Motives for capital expenditure

A capital expenditure is an outlay of funds by the irm that is expected to produce bene its over a period of time
greater than 1 year. An operating expenditure is an outlay resulting in bene its received within 1 year. Fixed-asset
outlays are capital expenditures, but not all capital expenditures are classi ied as ixed assets.

For example:
A purchase of machine with a useful life of 15 years is capital expenditure that would appear as ixed asset
on the irm’s balance sheet. An outlay for advertising campaign that is expected to produce bene its over a long
period is also a capital expenditure but would not appear as ixed assets.

Capital budgeting process consists of ive distinct but interrelated steps:

1. Proposal generation. Proposals for new investment projects are made at all levels within a business
organization and are reviewed by inance personnel. Proposals that require large outlays are more
carefully scrutinized than less costly ones.
2. Review and analysis. Financial managers perform formal review and analysis to assess the merits of
investment proposals.
3. Decision making. Firms typically delegate capital expenditure decision making on the basis of peso limits.
4. Implementation. Expenditures for a large project often occur in phases.
5. Follow – up. Results are monitored, and actual costs and bene its are compared with those that were
expected.

Capital Budgeting Techniques

To ensure that the investment projects selected have the best chance of increasing the value of the irm,
inancial managers need tools to help them evaluate the merits of individual projects and to rank competing
investments. A number of techniques are available for performing such analyses. The preferred approaches
integrate time value procedures, risk and return considerations, and valuation concepts to select capital
expenditures that are consistent with the irm’s goal of maximizing owners’ wealth.

PAYBACK PERIOD
The payback period is the amount of time required for the irm to recover its initial investment in a project,
as calculated from cash in lows. In the case of an annuity the payback period can be found by dividing the initial
investment by the annual cash in low. For a mixed stream of cash in lows, the yearly cash in lows must be
accumulated until the initial investment is recovered. Although popular, the payback period is generally viewed
as an unsophisticated capital budgeting technique, because it does not explicitly consider the time value of money.

Decision criteria (accept/reject project)

 If the payback period is less than the maximum acceptable payback period, accept the project.
 If the payback period is greater than the maximum acceptable payback period, reject the project.

Illustration 1:
A company is contemplating on what project to be accepted. Project A requires an initial
investment of P42,000; project B requires an initial investment of P45,000. The following cash low and
timeline is presented below.
The payback period in this example is 3.0 years for project A. 42,000 (initial investment) ÷ 14,000 (annual
cash low).

In project B, since it generates a mixed stream of cash in lows, the calculation of its payback period is not
as clear-cut.
Year 1 – the irm will recover P28,000 out of 45,000
Year 2 – the irm will recover P12,000 (45,000 – 28,000 – 12000)
Year 3 – since P50,000 will be collected for 3rd year and the company needs to recover the remaining
P5,000. Only 50% of the year-3 cash in low of P10,000 is needed to complete the payback of the initial
P45,000. The payback period for project B is therefore 2.5years. (2 years + 50% of year 3).

The major weakness of the payback period is that the appropriate payback period is merely a
subjectively determined number. It cannot be speci ied in light of the wealth maximization goal because
it is not based on discounting cash lows to determine whether they add to the irm’s value. Instead, the
appropriate payback period is simply the maximum acceptable period of time over which management
decides that a project’s cash lows must break even.

Illustration 2:
Seema Mehdi is considering investing P20,000 to obtain a 5% interest in a rental property. Her
good friend and real estate agent, Akbar Ahmed, put the deal together and he conservatively estimates
that Seema should receive between P4,000 and P6,000 per year in cash from her 5% interest in the
property. The deal is structured in a way that forces all investors to maintain their investment in the
property for at least 10 years. Seema expects to remain in the 25% income-tax bracket for quite a while.
To be acceptable, Seema requires the investment to pay itself back in terms of after-tax cash lows in less
than 7 years. Seema’s calculation of the payback period on this deal begins with calculation of the range
of annual after-tax cash low:

After-tax cash low = (1 – tax rate) x pre-tax cash low

= (1 – 0.25) x P4,000 = P3,000
= (1 – 0.25) x P6,000 = P4,500

The after-tax cash low ranges from P3,000 to P4,500. Dividing the P20,000 initial investment by
each of the estimated after-tax cash lows, we get the payback period:

Payback period = Initial investment ÷ After-tax cash low

= P20,000 ÷ P3,000 = 6.67 years
= P20,000 ÷ P4,500 = 4.44 years

Because Seema’s proposed rental property investment will pay itself back between 4.44 and 6.67
years, which is a range below her maximum payback of 7 years, the investment is acceptable.
NET PRESENT VALUE (NPV)
A sophisticated capital budgeting technique; found by subtracting a project’s initial investment from the
present value of its cash in lows discounted at a rate equal to the irm’s cost of capital.
The net present value (NPV) is found by subtracting a project’s initial investment (CF 0) from the present
value of its cash in lows (CFt) discounted at a rate equal to the irm’s cost of capital (r).

NPV = present value of cash in lows – initial investment

Decision criteria (accept/reject a project)

 If the NPV is greater than P0, accept the project.
 If the NPV is less than P0, reject the project.

If the NPV is greater than P0, the irm will earn a return greater than its cost of capital. Such action should
increase the market value of the irm, and therefore the wealth of its owners by an amount equal to the NPV.

Using the previous example. If the irm has a 10% cost of capital, the npv for projects A (an annuity) and
B (a mixed stream) can be calculated as follow:

Project A PV of 5 years (3.79078…x 14,000) = P53,071

Initial investment (42,000)
NPV P11,071

Project B year 1 = 28,000 x 0.90909 = P25,455

Year 2 = 12,000 x 0.82645 = 9,917
Year 3 = 10,000 x 0.75131 = 7,513
Year 4 = 10,000 x 0.68301 = 6,830
Year 5 = 10,000 x 0.62092 = 6,209
P55,924
Initial investment (45,000)
NPV P10,924

These calculations result in net present values for projects A and B of P11,071 and P10,924, respectively.
Both projects are acceptable, because the net present value of each is greater than P0. If the projects were being
ranked, however, project A would be considered superior to B, because it has a higher net present value than that
of B (P11,071 versus P10,924).
 A variation of the NPV rule is called the pro itability index (PI). For a project that has an initial cash
out low followed by cash in lows, the pro itability index (PI) is simply equal to the present value of cash in lows
divided by the initial cash out low:

PIA = P53,071 ÷ P42,000 = 1.26

PIB = P55,924 ÷ P45,000 = 1.24

NPV and EVA

The EVA method begins the same way that NPV does—by calculating a project’s net cash lows. However,
the EVA approach subtracts from those cash lows a charge that is designed to capture the return that the irm’s
investors demand on the project. That is, the EVA calculation asks whether a project generates positive cash lows
above and beyond what investors demand. If so, then the project is worth undertaking.
The EVA method determines whether a project earns a pure economic pro it. When accountants say that
a irm has earned a pro it, they mean that revenues are greater than expenses. But the term pure economic pro it
refers to a pro it that is higher than expected given the competitive rate of return on a particular line of business.
A irm that shows a positive pro it on its income statement may or may not earn a pure economic pro it, depending
on how large the pro it is relative to the capital invested in the business.

Suppose a certain project costs P1,000,000 up front, but after that it will generate net cash in lows each year (in
perpetuity) of P120,000. To calculate the NPV of this project, we would simply discount the cash lows and add
them up. If the irm’s cost of capital is 10%, then the project’s NPV is:

NPV = - P1,000,000 + (P120,000 ÷ .10) = P200,000

To calculate the investment’s economic value added in any particular year, we start with the annual
P120,000 cash low. Next, we assign a charge that accounts for the return that investors demand on the capital
that the irm has invested in the project. In this case, the irm invested P1,000,000, and investors expect a 10%
return. That means that the project’s annual capital charge is P100,000 (P1,000,000 x 10%), and its EVA is
P20,000 per year:

EVA = project cash low – [(cost of capital) x (invested capital)]

= P120,000 – P100,000
= P20,000

In other words, this project earns more than its cost of capital each year, so the project is clearly worth
doing. To calculate the EVA for the project over its entire life, we would simply discount the annual EVA igures
using the irm’s cost of capital. In this case, the project produces an annual EVA of P20,000 in perpetuity.
Discounting this at 10% gives a project EVA of P200,000 (P20,000 ÷ 0.10), identical to the NPV. In this example,
both the NPV and EVA methods reach the same conclusion, namely that the project creates P200,000 in value for
shareholders. If the cash lows in our example had luctuated through time rather than remaining ixed at
P120,000 per year, an analyst would calculate the investment’s EVA every year, then discount those igures to the
present using the irm’s cost of capital. If the resulting igure is positive, then the project generates a positive EVA
and is worth doing.