CAPITAL BUDGETING DECISION
Learning objectives
By the end of this topic, readers are expected to
be able to;
Explain what is meant by investment decision.
Explain the difference between capital and
revenue expenditure.
Explain the different stages of capital
budgeting.
Discuss the rationale for capital budgeting.
CAPITAL BUDGETING DECISION
Learning objectives
Identify and apply the principles of capital
budgeting.
Determine cash flows expected form an
investment project.
Evaluate a project using the different
appraisal techniques.
Explain the relevant and irrelevant cash flows
for project appraisal.
Investment decision refers to the
commitment of financial resources in
assets from which future returns are
expected. Depending on how long the firm
is expected to hold onto an investment,
the decision may be termed either as a
long term or short term investment
decision.
Cont.
So when a firm decides to commit financial
resources in long term assets such as Buildings,
Land, Plant, Machinery or Common stock
(Ordinary Shares) with expectation of holding
them for more than a year, we say they are
making capital budgeting decision.
Investments in short term assets such as
receivables, inventory, raw materials or
commercial papers whose benefits are
expected within a year, are termed as short
term investment decision/liquidity decision.
So what is capital budgeting?
Capital budgeting is defined as the
process of identifying, evaluating,
selecting and implementing feasible
projects/investments from which, future
cash inflows are expected into the
organization for a number of years.
Types of capital budget projects
Capital budget projects is categorized into two
different ways; (1) by nature of the projects and (2)
by association with other projects.
Categorization by their nature, long term
investments may be looked at to include;
New business set ups;
An expansion projects;
A replacement/modernization projects;
Research and development;
Regulatory, safety and environmental projects;
Categorization by association include;
Mutually exclusive investments;
Contingent investments;
Independent investments;
Before a firm makes a decision to undertake
any of the above projects, it under goes a
number of stages in determining their
feasibility, this may be in terms of social impact,
functionality and financial benefits.
Stages of capital budgeting
A number of stages are taken to ensure thorough
assessment of the projects.
Review of a firm’s strategic investment plan;
Generation of investment alternatives;
Screening;
Cash flow determination;
Evaluation;
Selection and implementation;
Monitoring and Review;
Rationale for capital budgeting
Firms are expected to pay special attention to long
term investment decisions because of the
following;
Involves Large initial outlays;
Presence of risks and uncertainties;
Irreversible nature of the decision;
Capital budget projects are complex in nature;
Strategic in nature; - shapes a firms direction
and competitiveness
Target growth rate of a firm;
Principles of Capital Budgeting
Capital budgeting decision is based on 5 key
principles;
The decision is based on incremental after
tax cash flows;
Cash flow timing is critical;
Opportunity costs must be considered;
Financing costs are excluded;
Sunk Costs are irrelevant;
Determination of cash flows in capital budgeting
Cash flow determination under capital
budgeting is considered at three
different levels which include; Net
Initial outlay, Periodic net cash flows
and Terminal net cash flow.
Capital budgeting principles states that
only incremental cash flows are
considered relevant for decision
making.
Relevant cash flows
Cash flows are considered relevant only if it is
current and futuristic in nature and capable of
influencing the decision to either accept or reject
a project. Examples of relevant cash flows
include;
Invoice Value of an Asset(s);
Directly attributable costs;
Training cost;
Opportunity cost;
Changes in net working capital;
Relevant cash flows – cont.
Working capital recoverable;
Investment allowances/incentives
Net salvage value;
Depreciation /Capital allowance;
Externalities; - cannibalization
Cost savings;
Tax payments;
Format of Cash Flows Determination
As earlier indicated, cash flows are
determined at three different levels to
include; Initial outlay, periodic cash
flows and terminal cash flows.
Net Initial Cash Outlay; these are cash
flows expected to occur at the beginning
of the project and necessary for a
project to be implemented.
Initial outlay - Format
Items Ugx Ugx
Invoice Value of Equipment XXX
Add: Directly Attributable Costs/Capitalized
Transportation XXX
Insurance XXX
Taxes XXX
Clearing charges XXX
Installation XXX XXX
Total Value of the equipment XXX
Add: Other costs
Other fixed assets eg Land, building etc. XXX
Opportunity Cost-(Owned Asset) XXX
Increase in net Working Capital XXX XXX
Total Investment cost XXX
Less: Benefits/inflows
Decrease in net working capital XXX
Investment allowances/free offers (tax incentive) XXX XXX
Net Initial Outlay XXX
Periodic Net Cash flow;
These are net cash flows expected
to occur during the
implementation stage of the
project or the project life after
deduction of all the relevant
costs.
Periodic Net Cash flow - Format
Items Y1 Y2 Y3 Y4
Revenue XXX XXX XXX XXX
Add: Cost Savings XXX XXX XXX XXX
Total Revenue XXX XXX XXX XXX
Less: Total Variable cost XXX XXX XXX XXX
Gross contribution XXX XXX XXX XXX
Less: Operating Expenses XXX XXX XXX XXX
Earnings Before Depreciation and Tax(EBDT) XXX XXX XXX XXX
Less: Depreciation charge XX XX XX XX
Earnings Before Tax (EBT) XXX XXX XXX XXX
Less: Tax XX XX XX XX
Earnings After Tax (EAT) XXX XXX XXX XXX
Add back Depreciation charge XXX XXX XXX XXX
Periodic Net Cash flows (PNCF) XXX XXX XXX XXX
Terminal Net cash flows;
These are cash flows expected
to occur in the final year of
the project life.
Terminal Net Cash flow - Format
Items Year 4
Periodic Net Cash flow (PNCF) XXX
Add: Net Salvage Value XXX
Working Capital Recovered XXX
Terminal net cash flow XXX
Capital Budgeting Approaches
The approaches are categorized either as
formal or informal.
Informal analysis; The decision to
undertake a project is informed either
by past experiences, intuition/gut
feeling, peer advice, group discussions,
management meetings, Delphi
techniques, statutory requirement etc.
Capital Budgeting Approaches
Formal analysis; these are approaches
that undertake a detailed financial
analysis of a project in determination
of its viability and can also be
categorized into two;
o Techniques that do not incorporate time
value of money and
o Techniques that incorporate time value of
money
