Capital budgeting is the process of planning and controlling investments for long-term projects and programs.
The costs that are considered in capital budgeting analysis include:
- Avoidable cost – cost that may be eliminated by ceasing an activity or by improving efficiency.
- Common cost – cost that is shared by all options and is not clearly allocable to any one of them.
- Weighted-average cost of capital – is the weighted average of the interest cost of debt (net of tax) and the implicit cost of equity capital to be invested in long-term assets. It represents a required minimum return of a new investment to prevent dilution of owners’ interest.
- Deferrable or Postponable cost – cost that may be shifted to the future with little or not effect on current operation.
- Fixed cost – cost that does not vary with the level of activity within the relevant range.
- Imputed cost – cost that does not entail a specified peso outlay formally recognized by the accounting system, but its nevertheless relevant to establishing the economic reality analyzed in the decision-making process.
- Incremental cost – is the difference in cost resulting from selecting one option instead of another.
- Opportunity cost – is the benefit forgone by not selecting the best alternative use of scarce resources.
- Relevant cost – future differential cost that vary with the action.
- Sunk cost – cost that cannot be avoided because expenditure or an irrevocable decision to incur the cost has been made.
- Taxes – tax consequences of an investment.
Net investment is the net outlay, or gross cash requirement, minus cash recovered from the trade or sale of existing assets, with any necessary adjustments for applicable tax consequences.
Net cash flow is the economic benefit or cost, period by period, resulting from the investment.
Economic life is the time period over which the benefits of the investment proposal are expected to be attained, as distinguished from the physical or technical life of the asset involved.
Depreciable life is the period used for accounting and tax purposes over which cost is to be systematically and rationally allocated. It is based upon permissible or standard guidelines and may have no particular relevance to economic life.
Techniques that may be applied in evaluating capital investment proposals:
Discounted cash flow approaches:
Discounted or Internal rate of return. This is an interest rate computed such that the net present value (NPV) of the investment is zero. Hence the present value of the expected cash outflows equals the present value of the expected cash inflows.
Investment = Annual cash inflow x Present value factor
Net Present Value – this is the difference between the present value of the estimated net cash inflows and the present value of the net cash outflows.
Excess Present Value or Profitability Index – this is the ratio of the present value of the future net cash inflows to the present value of the initial investment.
PV Index = Present value of Cash Inflows / Present value of Cash Outflows
Nondiscounted Cash Flow Approaches
Payback Period – this is the number of years required to complete the return of the original investment. It is computed as follows:
Payback period = Investment / Annual cash inflows
Accounting Rate of Return (ARR) – this is the increase in accounting net income divided by the required investment. This is computed as follows:
ARR = Average cash inflow – Depreciation
Under the time-adjusted rate of return capital budgeting technique, it is assumed that cash flows are reinvested at the rate earned by the investment.
The net present value capital budgeting technique can be used when cash flows from period to period are uniform and uneven.
Time-adjusted rate of return is a capital budgeting techniques that assumed that cash flows are reinvested at the rate actually earned by the investment.
The net present value and internal rate of return methods of capital budgeting are superior to the payback method in that they: consider the time value of money.
The payback method measure: how quickly investment pesos may be recovered.
The capital budgeting method that divides a project’s annual incremental net income by the initial investment is the : Simple (or accounting) rate of return method.
The relevance of a particular cost to a decision is determined by: potential effect on the decision.
The term that refers to costs incurred in the past that are not relevant to a future decision is sunk cost.