Chapter Objectives

1. Know the activities involved in the capital budgeting process

2. Know and understand the nature and characteristics of capital investment decisions
3. Know and understand the nature and computation of the capital investment factors
4. Know and understand the different methods of evaluating scapital investment proposals
5. Understand the qualitative factors that may affect capital investment decisions

Characteristics of Capital Investment Decisions

Investment- means any project for which the firm spends a certain amount and from
which it (the firm) expects something in return.

1. Capital investment decisions usually require relatively large commitments of

resources.
2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short-term decisions.

The capital investment process

1. Identification of Potential Projects- Potential projects came from the proposals submitted
by the managers of the different divisions or departments of the company that will be
evaluated by top management.
2. Estimation of Costs and Benefits Managers submit their proposals accompanied by the
estimates of expected costs that the firm would incur for the project as well as the
expected revenues or cost savings that may be derived from the project.
3. Evaluated of Proposed Projects- Proposals are evaluated in the light of the organizational
goals and policies.
4. Development of the Capital Expenditure Budget - Consists of all capital investment
project proposals that have been approved for the budget period.
5. Reevaluation of Projects

Capital expenditure or investment projects can be generally classified as follows:

1. Replacement When an existing capital investment item becomes obsolete or suffers
irreparable damage.
2. Improvement Management may consider the improvement of a certain product or
process.
3. Expansion Involves enlargement of facilities, setting up additional business segment
and invasion of new markets.

Dependent or contingent proposals the acceptance of one proposal is dependent on the

acceptance of one or more potentials.
Mutually exclusive projects acceptance of one proposal will mean automatic rejection of
another proposal.

EVALUATIGN CAPITAL INVESTMENT PROJECTS

Capital investment factors

1. Net investment- net cost of investment is defined as the net outflow of cash, a
commitment of cash, or the sacrifice of an inflow of cash
Costs or cash outflows
a. Initial cash outlay
Purchase price of an asset
Incidental project-related costs
b. Working capital requirement
c. Market value of an existing, currently idle asset
Savings or Cash Inflow
a. Trade-in value of old asset
b. Proceeds from sale of old asset to be disposed
c. Avoidable cost of immediate repairs on old asset to be replaced

In case of replacement projects, the book value of the asset to be replaced is

not included in the computation of the net cost of investment because such
book value is a sunk cost thus, irrelevant.

For decision making purposes:

1. Includes all cash outlays necessary to carry out the project
2. Working Capital or net current asset committed to the project is included
3. Includes opportunity cost
4. Historical or sunk costs are excluded
5. The net proceeds or trade-in value of assets to be disposed are deducted
from the purchase price of the new asset to be acquired
6. Considers time value of money
In financial accounting
Must be in accordance with GAAP. Distinctions between capital and revenue expenditures must
be considered.
Working capital components have their own place in the balance sheet, these are not
capitalized as fixed asset. Opportunity costs are not recorded in the books of accounts.
Historical costs are taken up in financial accounting records. These items are taken up
separately in the Fin.Acc. records. Time value of money is usually disregarded in the financial
accounting records.

Illustrative example:
The management of NADULPIT FITNESS CENTER is planning to replace an old slimming
machine which was acquired 5 years ago at a cost of P30,000. The old machine has been
depreciated to its salvage value of P4,000. Nadulpit has found a buyer who is willing to
purchase the old slimming machine for P6,000.
The new machine will cost P50,000. Incidental costs of installation, freight and insurance will
have to be incurred at a total cost of P10,000.

Should the company decide to retain the old slimming machine that must be upgraded and
subjected to major repairs. The estimated cost of this repairs expense amounts to P8,000. The
income tax rate is 35%.

Required: Compute the net cost of investment in the new machine for decision making
purposes.

Purchase price of the new machine P50,000

Add incidental costs of installation, freight and insurance 10,000
Total cost/cash outflow 60,000
Less savings/cash inflows:
Proceeds from the sale of old machine 6,000
Less tax on the gain on sale 700 5,300
Proceeds on sale, net of tax 8,000
Avoidable cost of repairs on old machine 2,800
Less income tax
Avoidable cost of repairs,net of tax 5,200 10,500
Net cost of investment 49,500

1. Assume that instead of selling the old machine for P6,000, Nadulpit will sell
it only for P3,000. How will this affect the computation?
Cash inflows/savings:
Proceeds from the sale of old machine P3,000
Add tax savings due to loss on sale
Proceeds
Less book value
P3,350
Loss on sale
X Tax rate

Proceeds from sale of old machine incl. tax savings due to loss on
sale
2. Assume that instead of selling the old machine, Nadulpit will just trade it in
with a new one. Assume that the dealer of the new machine will grant a
trade-in allowance of P5,000 for the old asset. How will this affect the
computation?
NET RETURNS

Accounting Net Income refers to the net income expected to be earned from project being
evaluated.
Net Cash Flow- It involves only the cash revenues, costs, and expenses

Example:

Pinky Company plans to buy a new machine to increase its plants productive capacity. The new
machines estimated installed cost is P50,000. It is expected to have no salvage value at the
end of its useful life of 5 years.
Based on Pinkys projections, the new machine can produce 100,000 units of product per year.
Because of the high demand for this product which the company sells at P5 each, it is expected
that all the units produced will be sold.
Relevant production, selling and administrative costs related to the product amount to P3 each,
exclusive of depreciation. The company pays income tax at the rate of 35% of taxable income.
Required:
1. Accounting net income from the new machine
2. The net cash inflows from the project

1.
Sales(100,000 units x P5) P500,000
Less costs and expenses:
Production, selling and administrative costs excluding depreciation (100,000 x P3) 300,000
Depreciation of new machine (P50,000 / 5 years) 10,000 310,000
Income before tax 190,000
Less income tax (35%) 66,500
Net Income P123,500 P3,350 P123,500

2. Cash inflows (sales) P500,000

Less cash outflows:
Production, selling and administrative costs excluding depreciation 300,000
Income tax 66,500 366,500
Net Cash Inflow 133,500
Net income 123,500
Add depreciation 10,000
Net cash inflow 133,500 133,500

In some cases, the proposed projects are not expected to produce cash inflows, buy they
will yield retuns in the form of cost savings. These cost savings should be treated as
income or return that may be derived from the project. After being adjusted for tax
effects, the cost savings will represent the net return from the project to be evaluated.

Cost of capital- also called by such other names as cut-off rate, minimum desired rate,
minimum acceptable rate, target rate, standard rate, and hurdle rate. The cost of capital
is the cost of using funds. When the company floats bonds or obtain debt to finance
project, it is obliged to pay interest; when it issues stocks, it has to pay dividends. Even
when the company uses retained earnings, there is still an interest cost implicit in the
utilization of the companys resources.

It can be computed as follows:

Source Cost of Capital
Bonds After tax rate of interest
Preferred stock Dividend per share divided by the present market price
of the preferred stock
Common stock and retained earnings Earnings per share (after tax and preferred
dividends) divided by the current market price of the
common stock

When financing comes from combination of various sources, the weighted average cost
of capital must be computed

Capital structure: P1,000,000

P1.22 % of Capital
Bonds payable, 10% P500,000 50%
Preferred stock, 8%, P100 par value 100,000 10%
Common stock, 100,000 shares 300,000 30 40%
Retained earnings 100,000 10
Total

Other Data:
Income before tax P200,000
Less tax (35%) 70,000
Net Income 130,000
Less preferred dividends 8,000
 (P100,000 x 8%)
Balance for common stockholders 122,000
/ no. of common shares 100,000 shares
Earnings per share P1.22

Current market prices:

Common Stock P5
Preferred stock 160

Computation:
Bonds = after tax rate of interest = 10% (1-0.35) = 6.5%
Preferred stock = div. per share/ present market price = P100X8%/P!60 =
P8/P160 = 5.0%
Common stock and retained earnings = EPS/Present market price = P1.22/P5 = 24.4%

Computation of Weighted Average Cost of Capital:

Source of funds Proportion of funds After tax cost Weighted cost

Bonds payable 50% 6.5% 3.25%
Preferred stock 10 5.0 0.50
Common stock and
retained earnings 40 24.4 9.76

Weighted Average cost of capital 13.51%

13.51%
Economic Life
The concept of economic life is different from the so called physical or useful life. Useful
life is the period of the time between the acquisition of the asset up to the time when the asset
can no longer serve the use for which it is intended. Economic life is the period of time during
which the asset can provide economic benefits or positive cash inflows. Thus, economic life is
usually shorter than useful.
 Terminal Values
Terminal value or end-of-life recovery value refers to the net cash proceeds expected to
be realized at the end of the projects economic life.

For purposes of evaluating capital investment projects, if the project has given terminal
value, the amount must be considered as cash inflow at the end of the life of the project.

Commonly used methods of evaluation

METHODS THAT DO NOT CONSIDER TIME VALUE OF MONEY

Payback Method- also called payout ratio, involves the computation of the payback
period, which refers to the length of time required by the project to return the initial cost of
investment.

For example, if a company plans to buy an equipment for P50,000 and the equipment is
expected to generate after tax net cash inflows of P10,000 per year,, the payback period is 5
years, computed as follows:

Payback period = Net Cost of Initial Investment / Annual Net Cash Inflows
=P50,000/P10,000 = 5 years

Since payback means recovery of investment cost, a quick or short payback period
indicates a less risky project.
The net cost of investment does not include net working capital committed to the
project.
Note that the concept of net return used in the formula is net cash inflow and not
accounting net income.

Assume that the company plans to buy a machine for P50,000. 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 P18,000
2 14,000
3 12,000
4 8,000
5 6,000
The payback period can be calculated as follows:
Net cost of investment P50,000
Less net cash inflows
Year 1 P18,000
2 14,000
3 12,000 44,000

Balance recovered in year 4 6,000

Fraction of the 4th year = balance needed in year 4 / Net cash inflows in year 4
= P6,000/ P8,000 = 0.75 or year

Another format:
Year Cost of investment to be recovered net cash inflows balance
Payback Years
Required
1 P50,000 P18,000 P32,000 1
2 32,000 14,000 18,000
1
3 18,000 12,000 6,000 1
4 6,000 8,000 - .75

3.75

Characteristics of Payback Method

Advantages
1. Simple to compute and easy to understand
 2. Gives information about the liquidity of the project
3. Good surrogate for risk
Disadvantages
1. Does not consider time value of money
2. Gives more emphasis on liquidity rather than profitability of the project
3. Does not consider the salvage value of the project
4. Ignores the cash flows that may occur after the payback period.

Project 1 Project 2
Cost of investment 240,000 240,000
Year 1 P30,000 P75,000
2 90,000 75,000
3 120,000 75,000
4 45,000 75,000
5 30,000 75,000

Total cash inflows P315,000 375,000

Payback period 3 YEARS 3.2 YEARS

After the payback period , Project 2 would generate P135,000 cash inflow (P375,000-P240,000)
which is greater than Project 1s P75,000.

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.

Example:
Cost of investment P150,000
Cost of inflows:

Year Net Operating Cash Inflows Salvage Value

 1 P40,000 P100,000
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

Year Cost of investment to be recovered Net operating Inflows Salvage Value Total Cash
Inflows bal Y
1 P150,000 P40,000 P100,000 P140,000 P10,000 1
2 110,000 30,000 70,000 100,000
10,000 1
3 80,000 25,000 60,000 85,000
- .80

Total bail-out years 2.8

years

Fraction of the third year = balance needed in year 3 / net operating cash inflows in year 3
= P80,000-P60,000/P25,000
= P20,000/P25,000 = 0.80 year

The net operating cash inflows are usually received during the year while the salvage value is
received at a certain time of the year.

Figure 13-1 (To ppt) page 665

If the company decide to sell the asset earlier than the end of year 3, the salvage value would still
be the same i.e., P60,000.

Accounting Rate of Return Method

Known as book value rate of return, financial statement method, average return on investment and
unadjusted rate of return. Involves the computation of a rate of return on investment with the use of
the following formula;

Accounting rate of return = average annual net income / Investment

Focuses on profitability.
Accounting net income is based on accrual method of accounting.
Simple average is used when annual net income figures are not uniform

Illustration:
Assume that the company is planning to acquire a new machine that will cost P 60,000. This
machine is expected to generate net income P12,000 per year. No salvage value is expected to be
recovered at the end of its useful life of ten years. What is the accounting rate of return for this
project?

Accounting rate of return = Net income / Investment = P12,000/P60,000 = 20%

The estimated average rate of return is compared with firms target or desired rate of return. When
two or more projects are being evaluated and their ARRS are all greater than the cost of capital, the
projects are ranked based on their probability as indicated by their respective accounting rate of
return.

Accounting rate of return = Net Income / Average Investment

When depreciation methods are used, the average investment is the average book value of the
asset over its useful life.

ARR = Net Income / Average Investment = P12,000/ 60,000 + 0 /2 = P12,000/P30,000 = 40%

Advantages
1. Closely parallels the accounting concepts of income measurement and investment return
2. Facilitates reevaluation of projects
3. Considers income over the projects entire life
4. Indicates the projects profitability
Disadvantages
1. Does not consider time value of money
2. The effect of inflation is ignored.