*Chapter 1Capital budgeting: An overviewFPT School of Business

Assessment Scheme*

On-going assessment: - Quizzes (3): 5% each - Mid-term test: 20% - Individual Assignment: 15% - Group Assignment: 20% - Final Exam: 30% Completion Criteria: Final Result >=5 & Final Exam Score >=4

Main business activities*Production budgeting Income statement budgeting Capital budgetingProduction activitySelling activityInvestment activity

Production budgeting is about:**To produce:What product?How many?Production cost?

Income statement budgeting is about:*To sell:What product?At which price?How much is the profit?

*Should we build thisplant?Capital budgeting is about:

Capital budgeting is about:What to pay to day? (cash outflows)What to invest?How much?When? (year 0 and upgrade)What to receive in the future? (cash inflows) What to collect?How much?When?Then compare Net benefitTo answer question:Can we produce without any equipment/machine/plant (Fixed assets)?

Capital budgeting is about:Capital budgeting is the process of identifying, evaluating, and implementing a firms investment opportunities.It seeks to identify investments that will enhance a firms competitive advantage and increase shareholder wealth.Poor capital budgeting decisions can ultimately result in company bankruptcy.

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What is Capital Budgeting?*Is long-run planning decisions involving the acquisition of long-lived assets. Main goals of capital budgeting investments is to increase the value of the firm to the shareholders so that select projects increase the capital (value) of a business.

Requires a large initial cash outflow with the expectation of future cash inflowsFocuses primarily on projects that span multiple years.

Initial capital outlay Example

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Initial investmentY0 ($)Useful life (years)Fixed assetsLand20,000foreverBuilding10,00020Machine8,00010Tools1,0002

Structure of Initial capital outlay Structure of Initial capital outlay could be:Total Initial capital outlay: 100%From the Owner equity: 70%From lenders (Borrowing): 30%, in which:OriginalTermInterest ratePayment: Equal principle Annuity each year

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Capital Budgeting Within The Firm

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The capital budgeting process*Corporate goalStrategic planningIdentification of investment opportunitiesPreliminary screening of projectsFinancial appraisal of projectsQualitative factors in project evaluationThe accept/reject decisionProject implementation and monitoringPost-implementation auditXc nh mc tiu chungXy dng chin lcPhn tch C hi u tSng lc s b d nThm nh ti chnh d nThm nh yu t nh tnhRa quyt nh t chi/ph duyt d n u tThc hin v gim st d nKim tra sau thc hin

The capital budgeting process*2. Strategic planningA strategic plan is the grand design of the rm and clearly identies the business the rm is in and where it intends to position itself in the future. Strategic planning translates the rms corporate goal into specic policies and directions.3. Identification of investment opportunitiesTo identify investment opportunities that t in with a rms corporate goals, its vision, missionand long-term strategic plan.

The capital budgeting process4. Preliminary screening of projectsThere will be many potential investment proposals.This stage is to isolate the unsound proposals and explore the best proposals.5. Financial appraisal of projectsTo consider the expected costs and the expected benefits of alternative capital investments.

The capital budgeting process6. Qualitative factors in project evaluationQualitative factors are those which will have an impact on the project, but which are virtually impossible to evaluate accurately in monetary terms. Example: The societal impact of an increase or decrease in employee numbers The environmental impact of the project7. The accept/reject decisionTo choose projects for implementation.

The capital budgeting process8. Project implementation and monitoringTo get projects underway and monitor their performance.9. Post-implementation auditThe post-implementation audit is somewhat like a lessons learned activity in that it provides great information to use on future project engagements, but its more of an evaluation of the projects goals and activity achievement as measured against the project plan, budget, time deadlines, quality of deliverables, specifications, and client satisfaction.

Project Classification*According to risk:Expansion projectsReplacement projects

According to dependence on other projects:Independent projectsMutually exclusive projectsContingent projects

Indipendent projects

**Is one that the acceptance or rejection of which does not directly eliminate other projects. A company can select one, or the other, or bothso long as they meet minimum profitability thresholds.Example: Introduce a new product line - product A (Project 1)Replace a machine is currently producing - product B (Project 2)Project 1and Project 2 are Indipendent projects

Mutually exclusive projects**Is one that the acceptance of one prevents the acceptance of the alternative proposal. A firm can select one or another but not both.

Example: A firm may own a block of land which is large enough to establish:A shoe manufacturing plant (Project A)A steel manufacturing plant (Project B)A and B are Mutually exclusive projects

Contigent projects**Is one that the acceptance or rejection of which is dependent on the decision to accept or reject other project. A company can select one, or the other, or bothdepends on the decision had made. Contigent projects is divided into two types:Complementary: ei: pharmacy project and doctors surgery project.Substitutes: ei: Chinese restaurant project and Thai restaurant project.

Evaluation of investment projects**Can be evaluated independently to select the project provided adds value to the firm. May chose 1 proposal or all the proposal.Can be evaluated independently to select the one which yields the highest NPV to the firm. Chose only1 proposal and must reject other.Can be evaluated in the interaction of all the projects.Indipendent projects

Mutually exclusive projects

Contigent projects

Asset expansion project and Asset replacement projects**Asset expansion project: is one that proposes to invest inaditional assets To expand an existing productTo launch a new product lineAsset replacement project: is one involves retiring one asset and replacing it with a more efficienct asset.

Point of views in project evaluation**TIPV: Total investment point of view (Tng vn u t)

EPV: Equity point of view (Vn ch s hu)

Point of views in project evaluation**TIPV : How much the owner and the lenders invest in the project today?How much the owner and the lenders may collect from exploring the project in the future?Evaluate the NET BENEFIT of both sides. It means NET CASH FLOWS for both sides.EPV:How much the owner in the project today?How much the owner may collect from exploring the project in the future?Evaluate the NET BENEFIT of the owner only.

Now, doing exercisePreparing loan payment scheduleEqual principle paymentAnnuity payment Preparing an Income statement with different cost classification.List of costsVariable costs and fixed costsProduction costs and Non-production costs*

Example 1: Preparing loan payment schedule Equal principle payment*

Original loan 10,000 year 0 (2009)Interest rate10% per yearPayment period5 year

Loan payment schedule (Equal principle payment)Step 1: Principle = Orginal loan / Number of periods Step 2: Beginning balance = Beginning balance of previous year Principle of previous year.Step 3: Interest expense = Beginning balance * Interest rate

200920102011201220132014Year012345 Beginning balance of the loan 10,000 8,000 6,000 4,000 2,000 Interest expense 1,000 800 600 400 200 Principle 2,000 2,000 2,000 2,000 2,000

Example 2: Preparing loan payment schedule (Annuity payment) *

Original loan 10,000 year 0 (2009)Interest rate10% per yearPayment period5 year

Loan payment schedule (Annuity payment)

Step 1: Annuity = -PMT(rate, total periods, orginal loan)Step 2: Interest expense = Beginning balance * Interest rateStep 3: Principle = Annuity - Interest expense

200920102011201220132014 Year012345Beginning balance of the loan10,000 8,362 6,560 4,578 2,398 Annuity 2,638 2,638 2,638 2,638 2,638 Interest expense 1,000 836 656 458 240 Principle 1,638 1,802 1,982 2,180 2,398

Example 3: Preparing Income StatementProject life time is 3 years.A new machine purchased to day (t=0) costs of $150,000. The useful life of new machine is 6 year (straight-line method).The project will increase annual revenues by $800,000 and operating expenses (exclude depreciation) by $400,000 in each year, for years 1 through 3. in which:Rent expense: $ 200,000Salary expense: $ 100,000Insurance expense: $ 60,000Office supplies expense: $ 40,000

The corporate tax rate is 30%. No ending inventory.REQUIRE: Prepare Income statement from year 1 to year 3.*

Cost classification: List of costsTotal costs are divided into:Operating cost (exclude Depreciation): $400,000 Rent expense: $ 200,000Salary expense: $ 100,000Insurance expense: $ 60,000Office supplies expense: $ 40,000Depreciation expense*

Depreciation

YearCost of assetDepreciation expense/yearBook value0150,0001$25,000125,0002$25,000100,0003$25,00075,0004$25,00050,0005$25,00025,0006$25,0000

Income statement

Y1Y2Y3Sales$800,000$800,000$800,000Operating expense (Exclude D.)$400,000$400,000$400,000Depreciation$25,000$25,000$25,000EBIT$375,000$375,000$375,000Interest expense000EBT$375,000$375,000$375,000Taxes (30%)$112,500$112,500$112,500Net income$262,500$262,500$262,500

Example 4: Preparing Income StatementBackground information:Project life time is 3 years.A new machine purchased to day (t=0) costs of $150,000. The useful life of new machine is 6 year (straight-line method).Sales of 10,000 units/year; selling price is $50/unit.Variable cost per unit is $30.Other Fixed costs (Exclude Depreciation) are $50,000 per year. The tax rate is 30%. No ending inventory.REQUIRE: Prepare Income statement from year 1 to year 3.

Cost classification:Variable costs and fixed costsTotal costs are divided into:Operating cost (exclude Depreciation)Total Variable costsOther Fixed costsDepreciation expense*

Depreciation

YearCost of assetDepreciation expense/yearBook value0150,0001$25,000125,0002$25,000100,0003$25,00075,0004$25,00050,0005$25,00025,0006$25,0000

Y1Y2Y3Sales$500,000$500,000$500,000Unit sales10,00010,00010,000Selling price$50,000$50,000$50,000Operating cost(Excl.D)$350,000$350,000$350,000Total Variable costs$300,000$300,000$300,000Variable costs/unit$30$30$30Unit produced10,00010,00010,000Other Fixed costs$50,000$50,000$50,000Depreciation$25,000$25,000$25,000EBIT$125,000$125,000$125,000Interest expense000EBT$125,000$125,000$125,000Taxes (30%)$37,500$37,500$37,500Net income$87,500$87,500$87,500

Example 5: Preparing Income StatementInvested in a new machine purchased to day (t=0) costs of $150,000. The useful life of new machine is 6 year (straight-line method). Project life is 3 years. Sales:10,000 units/year; selling price is $50/unit. Production costs (Exclude depreciation) include:Direct material cost is $20/unit Direct labor cost is $10/unit Overhead costs are $30,000 per yearNon - Production costs (Exclude depreciation) include:Selling costs are $15,000 per year. Administrative costs are $5,000 per year. Other information:The tax rate is 30%. No ending inventory.REQUIRE: Prepare Income statement from year 1 to year 3.

Cost classification:Production costs and Non-production costTotal costs are divided into:Operating cost (exclude Depreciation)Production cost Cost of goods soldNon production costSelling costs Administrative costsDepreciation expenseIf Production volume = Sales volume,then COSG = Production cost

*In which, Production cost:+ Direct material cost + Direct labor cost+ Overhead cost

Depreciation

YearCost of assetDepreciation expense/yearBook value0150,0001$25,000125,0002$25,000100,0003$25,00075,0004$25,00050,0005$25,00025,0006$25,0000

Y1Y2Y3Sales$500,000$500,000$500,000Operating cost (Exc.D)$355,000 $355,000 $355,000 COGS=Production cost$330,000$330,000$330,000Total D.M cost$200,000$200,000$200,000Total D.L cost$100,000$100,000$100,000Overhead costs $30,000$30,000$30,000Selling costs $15,000$15,000$15,000Administrative costs $10,000$10,000$10,000Depreciation$25,000$25,000$25,000EBIT$125,000$125,000$125,000Interest expense000EBT$125,000$125,000$125,000Taxes (30%)$37,500$37,500$37,500Net income$87,500$87,500$87,500

End of chapter 1

*Thank you!

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