CAPITAL BUDGETING Why Capital Budgeting Decisions Are Riskier Than Short-Term Ones

Capital Budgeting  The company expects to recoup its investment over a longer period. Much time
- The process of identifying, evaluating, planning, and financing capital investment expires between making the expenditure and receiving the cash.
projects of an organization.  Reversing a capital budgeting decision is much more difficult than reversing a short-
- Process for evaluating proposed long-range projects or courses of future activity for term decision.
the purpose of allocating limited resources.
- Capital budgeting decisions involve long-term commitments, investments made now Types of Capital Investment Projects
in the expectation of increased returns in the future. 1. Replacement – When an existing capital investment wears out, becomes obsolete, or
suffers an irreparable damage, such item should be quickly replaced in kind so as not
Characteristics of Capital Investment Decisions to unduly interrupt operations.
1. Capital investment decisions usually require large commitments of resources. 2. Improvement – May consider improvement of a certain product or process, which
2. Most capital investment decisions involve long – term commitments. may necessitate the acquisition of capital investment projects.
3. Capital investment decisions are more difficult to reverse than short – term decisions. 3. Expansion – Involves enlargement of facilities, setting up an additional business
4. Capital investment decisions involve so much risk and uncertainty. segment and invasion of new markets.

How to make decisions on Capital Budgeting? Capital Budgeting Analyses

 The Capital Budgeting Process 1. Replacement or Expansion
1. Identification of potential projects  Example:
- Process of preparing the master budget plan for a certain period. - Establish a branch or not
- Generating the proposals for investment. - Purchase or lease a long-term asset
- Proposals serve as the potential projects that will be evaluated by top - Introduce a new product or not
management for inclusion in the over-all plan for the coming period. - Develop a new channel of distribution or establish alliance with
2. Estimation of costs and benefits existing distribution channels (distributorship)
- Project proposal must meet some minimum criteria set by the firm.
- Estimates of expected costs that the firm would incur for the project 2. Improvement or Retention
as well as the revenues or cost savings that may be derived from the  Example:
project. - Retain the old technology
3. Evaluation 3. Others
- Proposals are evaluated in the light of the organizational goals and  Example:
policies. - Research and Development
- Various evaluation methods or analytical techniques are used to - Exploration
ensure that only the most desirable projects are accepted. - Internally develop a major marketing program or outsource services
4. Development of the capital expenditure budget from available service contractors
- Consist all capital investment project proposals that have been
approved for the budget period. Capital Investment Factors
- The budget may be a simple listing of the capital expenditure  Net investment
projects and the amounts of required investment for each, or it may  Net returns
provide additional descriptive data about the projects.  Cost of capital
5. Re-evaluation
- Must be reviewed periodically to determine if the project meets the Methods of Analyzing Investment Decisions
original expectations.  Net Cost of Investment
 Net Returns
 Cost of Capital old asset INDIRECT 2. Savings from avoided repairs and
 Project Evaluation Techniques / Methods maintenance, if the old asset is
replaced
1. Net Cost of Investment
 costs or cash outflows less cash inflows or savings incidental to the
acquisition of the investment projects FORMULA:

Cost or cash outflows: Cash outflow xx

a. The initial cash outlay covering all expenditures on the project up to the Less: Cash inflow xx
time when it is ready for use or operation, e.g. purchase price of the Net Cost of Investment xx
asset, incidental project – related costs such as freight, insurance taxes,
handling, installation, test – runs, etc. SAMPLE PROBLEM:
b. Working capital requirement to operate the project at the desired level The XYZ Company plans to buy new equipment costing P1,200,000 to replace the
c. Market value of an existing, currently idle asset, which will be equipment that is now being used. The terms of the acquisition are 3/30, n/90. Freight
transferred to or utilized in the operations of the proposed capital charges on the new equipment are estimated at P23,000 and will cost P14,000 to
investment project. install. Special attachment to be used with this unit will be needed and will cost
P36,000. If the new equipment is acquired, operations will be expanded and this will
Savings or cash inflows:
require additional working capital of P250,000. The old equipment had a net book
a. Trade – in value of old asset (in case of replacement)
value of P300,000 and will be sold for P180,000. If the new equipment is not
b. Proceeds from sale of old asset to be disposed due to the acquisition of
the new project purchased, the old equipment must be overhauled at a cost of P90,000. This cost is
 less applicable tax, in case there is gain on sale; or deductible for tax purposes in the year incurred. Tax rate is 35%.
 add tax savings, in case there is loss on sale Compute the net cost of investment in the new equipment for decision-making
c. Avoidable cost of immediate repairs on old asset to be replaced, net of purposes.
tax

Considerations for Cash Outflows/Inflows Purchase cost - new equipment (1,200,000*97%) 1,164,000
Example: Replacing an Old Asset: Freight 23,000
Installment 14,000
CASH OUTFLOWS/Disbursements Special attachment 36,000
DIRECT COSTS INDIRECT COSTS/FUTURE COSTS Additional working capital 250,000
1. Net purchase price of new asset 1. Additional tax paid or incurred in Tax to be paid on avoided repairs (90,000*35) 31,500
(net of discount, taken or not) case of gain from sale or disposal of
2. Additional incidental costs paid or old asset (in case of gain) Total 1,518,500
incurred to prepare the asset for use 2. Additional tax paid from savings on Sales proceeds - old equipment 180,000
2. 3. Increase in working capital base avoided cost of repairs, if the old Tax savings from loss on sale of old equip. (120k*35%) 42,000
asset is replaced Avoided repairs 90,000 (312,000)
Net cost of investment 1,206,500
CASH INFLOWS/RECEIPTS
DIRECT COSTS INDIRECT COSTS/FUTURE COSTS
1. Proceeds from sale or trade-in 1. Tax savings from loss on sale of 2. Net Returns
allowance/value from disposal of old asset (in case of loss) a. Accounting net income / Net Income
 b. Net cash inflows / Net Cash Income
FORMULA Computation using Indirect Method: 3. Cost of Capital
 cost of using funds
Cash flows from operations before tax xx  also called cut – off rate, minimum desired rate, minimum acceptable rate,
Less: Depreciation Expense xx target rate, desired rate of return, standard rate, and hurdle rate.
Income before income Tax (IBIT) xx
Less: Income Tax xx Computation:
Accounting NET INCOME xx Source Cost of Capital
Add back: Depreciation Expense xx Bonds After – tax rate of interest
NET CASH INFLOWS (NET CASH INCOME) xx Preferred stock Dividends per share divided by the present market price
of the preferred stock.
SAMPLE PROBLEM: Common stock and Earnings per share (after – tax and preferred dividends)
The ISABELA Corporation is planning to add a new product line to its present business. retained earnings divided by the current, market price of the common
The new product will require a new equipment costing P2,400,000 with a five-year life, stock.
no salvage value. The following estimates are made available:
Economic life – the period of time during which the asset can
Annual sales P 12,000,000
Materials 4,400,000 provide economic benefits or positive cash
Labor 2,200,000 inflows.
Factory overhead (excluding depreciation on new equipment) 1,300,000 Terminal value (or end – of – life recovery value) – net cash
Selling and administrative expenses P 2,100,000 proceeds expected to be realized at the end of
Income tax rate 40% the project’s economic life.

Compute the net income and the net cash inflows.  Cost of capital is the cost, expressed as a percentage, of obtaining the money
needed to operate the company.
 Capital is obtained from two sources, creditors and owners, corresponding to
Annual sales 12,000,000
divisions of liabilities and owners' equity on the balance sheet.
Cost of goods saold
Materials 4,400,000 Cutoff Rate
Labor 2,200,000 - Because of the practical difficulties of determining cost of capital,
Factory overhead 1,300,000 (7,900,000) managers might simply use their judgment to set a minimum
acceptable rate, called a cutoff rate, hurdle, rate (minimum rate of
Gross profit 4,100,000
return), or target rate.
Depreciation expense (2.4M/ 5) (480,000)
Selling and administrative expenses (2,100,000)  How much is the cost of using the funds?
Income before tax 1,520,000
Income tax expense (1.52M*40%) (608,000) FORMULA:
Net income 912,000  Long-term liabilities (e.g. bonds payable)
Cost of Capital = Interest rate (1-tax rate)
Net income 912,000  Preferred/Preference Shares Equity
Depreciation expense 480,000 Dividends per share
Cost of Capital =
Net cash inflows 1,392,000 Market price per share x (1−Floatation Cost )
 Common/Ordinary Shares Equity
 Dividends per share+ Growth Rate Market values: Bonds Payable (P2,000,000*102%) 2,040,000
Cost of Capital = or
Market price per share x (1−Floatation Cost ) Preferred Equity (30,000 shares*P96) 2,880,000

Earnings per share Common Equity (800,000 shares*P10) 8,000,000

Cost of Capital =
Market price per share x (1−Floatation Cost )
Preferred dividend per share (12%*100) 12.00
SAMPLE PROBLEM:
Earnings per share (1,200,000/ 800,000 shares) 1.50
CAGAYAN Company discloses the following data in evaluating capital expenditure
proposals. Earnings, capital structures, and current market prices of the company’s
Weighted
securities are:
Sources of Market Capital Average Cost of
Capital Values Individual Cost of Capital Fraction Capital
EARNINGS:
Earnings before interest and tax 2,800,000 Bonds Payable 2,040,000 10% (1-40%) = 6% 2,040/ 12,920 0.95%
Less: Interest expense on bonds 200,000 Preferred Equity 2,880,000 P12/ (P96*95%) = 13.16% 2,880/ 12,920 2.93%
Income before income tax 2,600,000 Common Equity 8,000,000 (P1.50/ (10*95%))*1.07 = 16.89% 8,000/ 12,920 10.46%
Less: Income tax (40%) 1,040,000 Total 12,920,000 14.34%
Net Income 1,560,000
Less: Preferred stock dividends 360,000 4. Project Evaluation Techniques / Methods
Earnings available to common stockholders 1,200,000  Which investment proposal would give the highest return on investment,
Less: Common stock dividends 500,000 profitability wise and liquidity-wise?
Increase in retained earnings 700,000  TRADITIONAL MODELS THAT DO NOT CONSIDER THE TIME
VALUE OF MONEY
CAPITAL STRUCTURE:  Payback period
Mortgage bonds, 10%, 10 years 2,000,000
 Payback reciprocal
Preferred stocks, 12%, P100 par value 3,000,000
 Payback Bailout period
Common stock, no par, 800,000 shares outstanding 2,500,000
Additional paid in capital 1,500,000  Accounting Rate of Return
Retained earnings 1,000,000  METHODS THAT CONSIDER THE TIME VALUE OF MONEY
TOTAL 10,000,000 (DISCOUNTED MODEL)
1. Net Present Value
MARKET PRICES: 2. Internal Rate of Return
Preferred stock 96 3. Profitability Index
Common stock 10 4. Net Present Value Index
Bonds 102 5. Discounted Payback Method

OTHER INFORMATION: TRADITIONAL MODELS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY
Floatation costs (underwriting costs) 5%
Common dividend per share P 1.50 PAYBACK PERIOD
Expected growth rate 7%  The shorter, the better.
 Time required for project's cash inflows to equal the original investment or the time
before an investment is recovered
- The longer it takes to recover the original investment, the greater the risk
- Management sets a maximum payback period
 Ignores
 - inflows that occur after payback has been reached
- desired rate of return b. EVEN CASH FLOWS
- time value of money A project requires an investment of P 600,000, with 5 years’ useful life, no salvage
value, and uses straight line method of depreciation. Other data are:
Advantages Disadvantages
 It is an important method to a  It tells nothing about the Expected sales revenue P 2,000,000
Out-of-pocket costs 1,600,000
company experiencing liquidity profitability of the investment.
Tax rate 40%
problems.  Payback ignores the return on
 Payback also serves as a rough the investment.
Expected sales revenue 2,000,000
screening device for investment  The appropriate payback period
Out-of-pocket costs (1,600,000)
proposals. is a subjectively determined
Depreciation (600,000/ 5) (120,000)
 The payback method is widely number. Income before tax 280,000
used by large firms to evaluate  Thus, payback fails to fully Income tax expense (280,000*40%) (112,000)
small projects and by small consider the time value of Net income 168,000
firms to evaluate most projects. money. Depreciation 120,000
 It is simple, intuitive, and  It also fails to consider the Net Cash Flows 288,000
considers cash flows rather than principle of wealth
accounting profits. maximization because it is not Initial investment 600,000
 It also gives implicit based on discounted cash flows Divided by: Net cash flows 288,000
consideration to the timing of and thus provides no indication Payback Period 2.08 years
cash flows and is widely used as as to whether a project adds to
a supplement to other methods firm
such as NPV& IRR c. UNEVEN CASH FLOWS
An investment of P400.000 can bring in the following annual cash income, net of tax:
 "how long (in years and/or months) it takes to recover the initial investment." 1st year, P 40,000;
 The maximum acceptable payback period is determined by management. 2nd year, P 95,000;
 If the payback period < the maximum acceptable  ACCEPT the project rd
3 year P 85,000:
 If the payback period > the maximum acceptable  REJECT the project. th
4 year, P160,000,
5th year, P 86.000,
FORMULA: th
6 year, P 70.000.
Initial Investment
Payback period =
Net Cash Flows
Payback period = 4 +
SAMPLE PROBLEM: 400,000−(40,000+ 95,000+85,000+160,000)
a. If an asset costs P35,000 and is expected to have a P5,000 salvage value at the end of 86,000
its ten-year life, and generates annual net cash inflows of P5,000 each year, the cash 400,000−380,000
payback period is? =4+
86,000
d. Consider
35 ,000 a project that requires cash outflow of P50,000 with a life of eight years and a salvage
Payback period = value of P5,000. Annual before-tax cash inflow amounts to P10,000 assuming a tax
5,000
= 7 years
 rate of 30% and a required rate of return of 8%. Salvage value is ignored in Second Year 90,000 100,000
computing depreciation. The project has a payback period of? Third Year 85,000 40,000
Fourth year 160,000 20,000
Fifth Year 75,000 10,000
Net investment 50,000
Sixth year 70,000 5,000
Divide by: Net cash inflows
Cash inflow before tax (10,000*70%) 7,000
Depreciation [(50,000/ 8)*30%] 1,875 8,875 Determine the payback bailout period.
Payback period 5.63 years
Net Cash Salvage Total cash
PAYBACK RECIPROCAL Year Inflow Cumulative value inflow
 Payback reciprocal is 1/payback period. 1 130,000 130,000 230,000 360,000
 Represents the % of annual net cash returns 2 90,000 220,000 100,000 320,000
 The higher the payback reciprocal, the better 3 85,000 305,000 40,000 345,000
4 160,000 465,000 20,000 485,000
FORMULA: 5 75,000 500,000 10,000 500,000
1
Payback reciprocal =
Payback Period

SAMPLE PROBLEM: Payback bailout period = 4 +

a. A payback period of 3.75 years, then the payback (500,000−465,000)−10,000
reciprocal is: 75,000
= 4 + 0.33
= 4.33 years
1 ACCOUNTING
Payback reciprocal = RATE OF
3.75
= 26.67% RETURN
 ARR measures the profitability of a proposed project
 The only project evaluation technique that uses net income to measure the
PAYBACK BAILOUT PERIOD attractiveness of a proposed investment based on profitability.
 Payback bailout period Payback bailout period determines the number of years to  The higher the ARR, the better!
recoup the investment where total cash includes the regular net cash inflows plus  Also known as:
the salvage value. • Return on Investment (ROI)
• Return on Assets (ROA)
 The shorter the payback bailout period, the better.
• Simple Rate of Return
• Book Accounting Rate of Return
SAMPLE PROBLEM:
a. An investment of P500,000 can bring in the following annual cash inflows
FORMULA:
and salvage values:

Net Cash Inflows Salvage Values, end of year

First year P 130,000 P 230,000
 Net Income Net Income
ARR = or = or =
Original Investment Average Investment
Annual cost savings 90,000
Average Net Income
Depreciation (432k/ 12) (36,000)
Average Investment Net Income 54,000
Divided by: Initial investment 432,000
Average Investment = (Original investment + Salvage value) / 2 Simple rate of return 12.50%

SAMPLE PROBLEM:
a. The BATANES Company is considering the production of a new product line which c. Show Company is negotiating to purchase an equipment that would cost P200,000,
will require an investment of P3,000,000, with P 200,000 salvage value. The with the expectation that P40,000 per year could be saved in after-tax cash operating
investment will have a useful life of ten years during which annual cash inflows costs if the equipment were acquired. The equipment's estimated useful life is 10
before income taxes of P1,400,000 are expected. The income tax rate is 40%. years, with no salvage value, and would be depreciated by the straight-line method.
Show Company's minimum desired rate of return is 12 percent. The present value of
Compute for the ARR based on original and average investment balances. an annuity of1 at 12 percent for 10 periods is 5.65. The present value of 1 due in 10
periods, at 12 percent, is 0.322.
Annual cash flows 1,400,000
Depreciation [(3M-200k)/ 10] (280,000) The average accrual ARR during the first year of asset's use is:
Income before tax 1,120,000
Income tax expense (1.12M*40%) (448,000) Annual after-tax cash flow 40,000
Net Income 672,000 Depreciation (200k/ 10) (20,000)
Net Income 20,000
Net Income 672,000 Divided by: Ave. investment [200k+(200k-20k)]/ 2 190,000
Divided by: Initial investment 3,000,000 Simple rate of return 10.53%
Accounting rate of return - original 22.40%

Net Income 672,000 METHODS THAT CONSIDER THE TIME VALUE OF MONEY (DISCOUNTED
Divided by: Average investment [(3M+200k)/ 2] 1,600,000 MODEL)
NET PRESENT VALUE
Accounting rate of return - original 42.00%
 The net present value method (NPV) uses the minimum acceptable rate to find the
present value (PV) of the future returns and compares that value with the cost of the
investment.
b. A piece of labor saving equipment that Marubeni Electronics Company could use to  It determines the cash inflows & outflows at the same period.
reduce costs in one of its plants in Angeles City has just come onto the market.  NPV = 0  actual rate of return = desired rate of return (technically
Relevant data relating to the equipment follow: indifferent)
 NPV > 0  actual rate of return > desired rate of return (accept)
Purchase cost of the equipment P432,000
 NPV < 0  actual rate of return < desired rate of return (reject)
Annual cost savings that will be provided by the equipment 90,000
Life of the equipment 12 years
Decision Rules
What is the simple rate of return to be provided by the equipment?
  Under the NPV method, a project having a positive NPV should be accepted; others NPV
should be rejected. NPV Index =
Cost of Investment
 Under the IRR method, a project having an IRR greater than the company's cost of
capital should be accepted. SAMPLE PROBLEM:
a. NUEVA ECIJA Corporation has P12 million available money for investment. It has
FORMULA: already evaluated several project proposals and now considers the following
NPV = PV of cash inflows - Cost of the investment acceptable projects:
SAMPLE PROBLEM: Project Cost of Investment PV of Cash Inflows NPV
a. Consider a project that requires an initial cash outflow of P500,000 with a life of A P 5,000,000 P 5,500,000 P 500,000
eight years and a salvage value of P20,000 upon its retirement. Annual cash inflow
B P 6,000,000 7,200,000 1,200,000
before tax amounts to P100,000 and a tax rate of 30 percent will be applicable. The
C 4,000,000 4,850,000 850,000
required minimum rate of return for this type of investment is 8 percent. The present D 3,000,000 3,470,000 470,000
value of 1 and the annuity of 1, discounted at 8 percent for 8 periods are 0.54 and
5.747, respectively. Salvage value is ignored in computing depreciation. The net
present value amounts to Which project should the company invest?
Cash flow before tax (100k*70%) 70,000
Profitability NPV
Depreceiation tax shield (62.5k*30%) 18,750
Project COI PVCI NPV Index Index
Cash flow after tax 88,750
A 5,000,000 5,500,000 500,000 1.10 0.10
B 6,000,000 7,200,000 1,200,000 1.20 0.20
PV of After-tax cash flow (88,750*5.747) 510,046 C 4,000,000 4,850,000 850,000 1.21 0.21
PV of After-tax salvage value (20,000*70%*0.54) 7,560 D 3,000,000 3,470,000 470,000 1.16 0.16
Total 517,606
Investment (500,000)
If the indeces are used as straight forward decision critique you shall be guided as follows
Net Present Value 17,606
The problem assumed that the salvage value is ignored in the computation of annual depreciation so that If the Then, the project is
the annual cash flows will be greater. The problem did not include among the choices the assumption Profitability index > 1.00 acceptable
that salvage value will be deducted from the cost in computing the amount of annual depreciation.
Profitability index is < 1.00 rejected
NPV index = positive acceptable
PROFITABILITY INDEX NPV index = negative rejected
 Compares present value of net cash flows to net investment
 Measures efficiency of the use of capital INTERNAL RATE OF RETURN
 Should be greater than or equal to 1  The internal rate of return method (IRR) finds the rate of return associated with the
 Does not calculate the rate of return project and compares that rate with the minimum acceptable rate.
 The internal rate of return is a metric used in financial analysis to estimate the
FORMULA: profitability of potential investments. The internal rate of return is a discount rate that
PV of Net Cash Flows makes the net present value (NPV) of all cash flows equal to zero in discounted cash
Profitability Index =
Net Investment flow analysis.

FORMULA:
 PV of Future Flows
Factors for the discount rate and the number of periods =
Annual Cash Flows

DISCOUNTED PAYBACK METHOD