ROQUE

Capital Budgeting period. The capital expenditure budget is the end

- The process of identifying, evaluating, planning result of management’s decisions on capital
and financing capital investment projects of an investment proposals.
organization
- Involves capital investment projects which require 5. Re-evaluation
large sum of outlay and involve a long period of - Because of the long-term nature of capital
time investment projects, capital budget estimates are
coupled with uncertainty and risk. In view of this,
Investment once a project is approved, it must be reviewed
- Any project for which a firm spends a certain periodically to determine if the project meets the
amount and from which it expects something in original expectations.
return
Types of Capital Investment Projects
Characteristics of Capital Investment Decisions: 1. Replacement
1. Capital investment decisions usually require - When an existing capital investment item like a
relatively large commitments of resources. machine or equipment wears out, becomes obsolete
2. Most capital investment decisions involve long- or suffers an irreparable damage, such item should
term commitments. be quickly replaced in kind, so as not to unduly
3. Capital investment decisions are more difficult to interrupt operations. Urgency and maintenance of
reverse than short-term decisions. the status quo are the usual motives in this type of
project.
The Capital Budgeting Process
1. Identification of potential projects 2. Improvement
- Capital expenditure proposals come from the - Management may consider the improvement of a
different segments of the organization. In the certain product or process, which may necessitate
process of preparing the master budget plan for a the acquisition of capital investment projects. For
certain period, requests for acquisition of capital example, an existing manual operation may be
investment projects are submitted by the managers transformed into a mechanized or computerized one.
of the different divisions or departments of the The objective includes generation of additional
company. These proposals serve as the potential revenue, cost savings and more efficient and
projects that will be evaluated by top management productive operations.
for inclusion in the over-all plan for the coming
period. 3. Expansion
- This involves enlargement of facilities, setting up
2. Estimation of costs and benefits an additional business segment and invasion of new
- To be acceptable, a project proposal must meet markets. The main objective here is generation of
some minimum criteria set by the firm. To justify additional revenue or profit for the firm.
their requests, or to see to it that such requests meet
the criteria, managers submit their proposals Capital Investment Factors
accomplished by estimates of expected costs that the 1. Net Investment
firm would incur for the project, as well as the - Net cost of investment is defined as the net outflow
expected revenues or cost savings that may be of cash, a commitment of cash, or the sacrifice of an
derived from the project. inflow of cash
- In case of replacement projects, the book value of
3. Evaluation the asset to be replaced is not included in the
- Project proposals are evaluated in the light of the computation of the net cost of investment because
organizational goals and policies. The possible such book value is a sunk cost, therefore, irrelevant.
impact of each project in the organization is
carefully studied, particularly the anticipated costs Costs or Cash Outflows
and benefits. Various evaluation methods or a. The initial outlay covering all expenditures on the
analytical techniques are used to ensure that only the project up to the time when it is ready for use or
most desirable projects are accepted. operation:
- Purchase price of the asset
4. Development of the capital budget - Incidental project-related costs such as freight,
- The capital expenditure budget is usually insurance, taxes, handling, installation and test runs
incorporated in the master budget plan of the b. Working capital requirement to operate the
organization. It consists of all capital investment project at the desired level
projects that have been approved for the budget
c. Market value of an existing, currently idle asset b. Proceeds from sale of old asset to be disposed due
which will be transferred or utilized in the to the acquisition of the new project (less applicable
operations of the proposed capital investment project tax in case there is gain on sale, or add tax savings in
case there is loss on sale)
Savings or Cash Inflows: c. Avoidable cost of immediate repairs on old asset
a. Trade-in (swap) value of old asset (in case of to be replaced, net of tax
replacement)

Illustrative Problem
The management of Nadal Fitness Center is planning to replace an old slimming machine
which was acquired 5 years ago at a cost of 30,000.
The old machine has been depreciated to its salvage value of 4,000. (6,000 - 4,000 = 2,000 × 30% = 600 Less in
inflow)
Nadal has found a buyer who is willing to purchase the old machine for 6,000. inflow
The new machine will cost 50,000. outflow
Incidental costs of installation, freight and insurance will have to be incurred at a total cost of 10,000. outflow
Should the company decide to retain the old slimming machine,
the same must be upgraded and subjected to major repairs.
The estimated cost of this repairs expense (which is tax deductible) amounts to 8,000. (8,000 × 70% = 5,600)
The income tax rate is 30%.

Compute the net cost of investment.

 Assume that instead of selling the old machine for 6,000 (with a gain of 2,000),
Nadal will sell it only for 3,000.

 Assume that instead of selling the old machine, Nadal will just trade it in with a new one.
The dealer of the new machine will grant a trade-in allowance of 5,000 for the old asset.

2. Net Returns - Computed by deducting from the cash inflows to

a. Accounting Net Income be generated from operating the project all the cash
- Net income (after tax) expected to be earned from outflows to be incurred for the project’s operations
the project being evaluated - Non-cash items such as depreciation are excluded
- Net income computed using the financial from cash outflows though these items are
accounting considered in the determination of income tax;
Income tax is a cash outflow
b. Net Cash Inflows
- Involves only the cash revenues, costs and
expenses

Illustrative Problem
Pink Company plans to buy a new machine to increase its plant’s productive capacity.
The new machine’s estimated cost is 50,000. (50,000 ÷ 5 = 10,000 depreciation)
It is expected to have no salvage value at the end of its useful life of 5 years.
Based on Pink’s projections, the new machine can produce 100,000 units of product per year. (100,000 × 5 =
500,000 sales) ( 100,000 × 3 = 300,000 cost)
Because of the high demand for this product which the company sells at 5 each,
it is expected that all the units produced will be sold.
Relevant production, selling and administrative costs
related to the product amount to 3 each, exclusive of depreciation.
The company pays income tax at the rate of 30% of taxable income.

Required:
a. Accounting net income from the new machine
b. The net cash inflows from the project

3. Cost of Capital
Source Cost of Capital
a. Bonds After tax rate of interest
b. Preferred Stock Dividend per share divide by the present market price of the preferred stock
c. Common Stock and Earnings per share (after tax and preferred dividends) divide by
Retained Earnings the current market price of the common stock

When financing comes from a combination of various sources, the weighted average cost of capital must
be computed, the weight being the percentage component of each item in the firm’s capital structure.

Illustrative Problem
Assume the following data:
Capital Structure: Percentage
Bonds payable, 10% 500,000 50%
Preferred stock, 8%, 100 par value 100,000 10%
Common stock, 100,000 shares 300,000 30% Common + RE
Retained earnings 100,000 10% 40%
Total 1,000,000 100%

Other Data: Current Market Prices:

Income before tax 200,000 Common stock P5
Less: tax (30%) (60,000) Preferred stock 160
Net income 140,000
Less: preference dividends
(100,000 x 8%) (8,000)
Balance for common stockholders 132,000
Divide: No. of common shares 100,000
Earnings per share 1.32

Compute the Cost of Capital

Commonly Used Methods of Evaluation d. Discounted cash flow rate of return

1. Methods that do not consider the time value of
money Payback Method
a. Payback - Also called payout method
b. Bail-out - It involves the computation of the payback period
c. Accounting Rate of Return (ARR) which refers to the length of time required by the
project to return the initial cost of investment
2. Methods that consider the time value of money Illustrative Problem
(discounted cash flow methods) A company plans to buy equipment for 50,000 and
a. Net Present Value (NPV) the equipment is expected to generate
b. Present value index after-tax net cash inflows of 10,000 per year.
c. Present value payback Compute the payback period.

Illustrative Problem
A company plans to buy a machine for 50,000. No salvage value is expected at the end of its life and it is
expected to generate net cash inflows as follows:
Year Net Cash Inflows
1 18,000
2 14,000
3 12,000
4 8,000
5 6,000

Compute the payback period.

Characteristics of the Payback Method

Advantages:
1. Payback is simple to compute and easy to understand. There is no need to compute or consider any interest rate.
One has just to answer the question: “How soon will the investment cost be recovered?”
2. Payback gives information about liquidity of the project.
3. It is a good surrogate for risk. A quick payback period indicates a less risky project.
Disadvantages:
1. Payback does not consider the time value of money. All cash received during the payback period is assumed to
be of equal value in analyzing the project.
2. It gives more emphasis on liquidity rather than on profitability of the project. More emphasis is given on return
of investment rather than the return on investment.
3. It does not consider the salvage value of the project.
4. It ignores the cash flows that may occur after the payback period.

Bail-out Method
- Involves the computation of the bail-out period wherein cash recoveries include not only the operating net cash
inflows but also the estimated salvage value or proceeds from sale at the end of each year of the life of the project.

Illustrative Problem
Consider the following data:
Cost of Investment 150,000
Cash Inflows:
Year Net Operating Cash Inflows Salvage Value
1 40,000 100,000
2 30,000 70,000
3 25,000 60,000
4 20,000 50,000
5 20,000 30,000
6 20,000 10,000

Compute for the bail-out period.

Accounting Rate of Return (ARR) Method

- Other names for this method include book value rate of return, financial statement method, average return on
investment and unadjusted rate of return
- Unlike the payback method which emphasizes liquidity and measures returns in terms of net cash inflows, the
accounting rate of return focuses on profitability.
- The net return used is the accounting net income which is based on the accrual concept of accounting.
- When annual net income figures are not uniform, a simple average is used. This is computed by dividing the
sum of the annual income figures by the project’s economic life.

Average Annual Net Income / Investment

Illustrative Problem
A company is planning to acquire a new machine that will cost 60,000. This machine expected to generate net
income of 12,000 per year. No salvage is expected to be recovered at the end of its useful life of 10 years. What is
the accounting rate of return for this project?

Characteristics of the Accounting Rate of Return

Advantages:
1. The ARR computation closely parallels accounting concepts of income measurement and investment return.
2. It facilitates re-evaluation of projects due to the ready availability of data from the accounting records.
3. This method considers income over the entire life of the project.
4. It indicates the project’s profitability.

Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not consider the time value of money.
2. With the computation of income and book value based on the historical cost accounting data, the effect of
inflation is ignored.

Net Present Value

- All cash inflows or outflows related to the investment project are discounted at a minimum accepted rate of
return which in most cases is the firm’s cost of capital
- The project is acceptable if the present value of cash inflows is greater than the present value of cash outflows.
- The difference of the two present values
- PV of CI less PV of CO or PV of CI less Cost of Investment

Illustrative Problem
A Company is contemplating the purchase of new machine that will cost 350,000. It is expected to generate cash
inflows, net of income taxes in the amount of 120,000 per year during its economic life of 5 years. No salvage
value is to be recovered at the end of 5th year. A Company’s cost of capital is 20%. The present value of ordinary
annuity of 1 for 5 periods at 20% is 2.99. Compute for the net present value.

Illustrative Problem
JJ Company is considering the purchase of another machine that will cost 50,000 and will generate the following
net cash inflows: (No salvage value is expected; Minimum desired rate of return is 20%)
Year 1 25,000
Year 2 30,000
Year 3 20,000

The present value factors of 1 for the following periods at 20% are as follows:
Year PV Factor
1 0.833
2 0.694
3 0.579

Compute for the net present value.

Assume that in the previous problem, the salvage value is 5,000 at the end of year 3.
Compute for the net present value.

Characteristics of the Net Present Value Method

- The net present value method considers the time value of money and the timing of cash flows in evaluating the
project. It considers cash flow over the entire life of the project. Some limitations involve difficulty in
computation. The computation of present values requires the use of a discount rate, such that if an overstated or
understated rate is used, the evaluation would be misleading.
Profitability Index
- Called by other names as present value index, desirability index or total present value index
- The purpose is to provide a basis for comparison between or among projects of different sizes.

Profitability Index = Present Value of Cash Inflows or Present Value of Cash Inflows
Present Value of Cash Outflows Cost of Investment
Illustrative Problem
Consider the following project proposals:
Project A Project B
Cost of investment 20,000 40,000
Annual net cash inflows 8,000 16,000
Economic life 5 years 5 years
Cost of capital 10% 10%

PV of ordinary annuity of 1 for 5 periods at 10% is 3.791.

Compute for the net present value and profitability index of both projects.

Net Present Value Index

= Net Present Value
Cost of Investment

Present Value Payback Method

- The conventional payback method determines the time required to recover the cost of investment, without regard
to present value considerations. In fact, this is one of the disadvantages cited about paybacks: it does not consider
the time value of money. To solve this problem, the present value payback method may be used. Under this
method, the cash flows to be used in computing the payback period are converted to their present values.
Illustrative Problem
Consider the following data:
Cost of investment 100,000
Net cash inflows: PV factor using 6%
Year 1 30,000 0.943
Year 2 40,000 0.890
Year 3 35,000 0.840
Year 4 20,000 0.792
Year 5 15,000 0.747

Cost of capital is 6%. Compute for the present value payback.

Discounted Cash Flow Rate of Return

- Known as Internal Rate of Return (IRR), time adjusted rate of return, discounted rate of return
- Refers to the interest or discount rate that equates the present value of the returns or net cash inflows with the
investment
- The resulting net present value is equal to zero

Movement of Interest Rate and Present Value Amount

- Interest rate and PV amount has an inverse relationship.
- Increase interest rate decrease PV amount
(Decreases the PV factor)
- Decrease interest rate increase PV amount
(Increases the PV factor)

Formula for Discounted Cash Flow Rate of Return (DCFRR)

DCFRR = LR + [(HR - LR) x PVF LR - PVF DCFRR]

PVF LR - PVF HR
Where:
LR - Lower Rate
HR - Higher Rate
PVF - Present Value Factor
PVF LR - PVF of Lower Rate
PVF HR - PVF of Higher Rate
PVF DCFRR - PVF of DCFRR

Payback Reciprocal
- If one wants to use the DCFRR method but he does not want to go through the complicated computations, he
can simply compute the payback reciprocal. The payback reciprocal is a reasonable estimate of the DCFRR,
provided that the following conditions are met:
a. The economic life of the project is at least twice the payback period
b. The net cash inflows are constant (uniform) throughout the life of the project

= 1 / (Payback Period)
= 1 / (Cost of Investment / Annual Net Cash Inflows)
= Annual Net Cash Inflows
Cost of Investment

Illustrative Problem
Consider the following data:
Cost of investment 100,000
Annual net cash inflows 25,000
Economic life 10 years
Payback period (100,000 / 25,000) 4 years

Compute for the payback reciprocal and estimate the DCFRR.