CAPITAL

BUDGETING
Topic Contents:

 Introduction

 What is Capital Budgeting

 Capital Budgeting Process
 Capital Budgeting Techniques
 Payback Period
 Accounting Rate of Return (ARR)
 Net Present Value (NPV)
 Profitability Index
CAPITAL BUDGETING
 Capital Budgeting is “a process for evaluating proposed long-
range projects or courses of future activity for the purpose of
allocating limited resources.” (Barfield, Raiborn, & Kinney)

 Capital Budgeting is the process of planning expenditures on

assets whose cash flows are expected to extend beyond one year.
(Weston & Brigham)

 Capital Budgeting is the process of deciding whether or not to

commit resources to a project whose benefits will be spread over
several time periods.
Capital budgeting decisions are key factor in long-term profitability
of a firm. To make wise investment decisions, managers need tools
at their disposal that will guide them in comparing the benefits
and costs of various investment alternatives. ( CRC – ACE Review
PLANNING

 A good plan must be S.M.A.R.T

S pecific to be clear
M easurable to be fair in the evaluation process
A ttainable to elicit outstanding performance
R ealistic to allow people to relate to
T ime bounded to impress urgency and deadline
CAPITAL BUDGETING PROCESS

 CREATIVE SEARCH FOR INVESTMENT

OPPORTUNITIES
 SCREENING OF INVESTMENT PROPOSALS
 EVALUATION OF THE PROPOSALS
 IMPLEMENTATION OF THE PROJECT
 MANAGEMENT AND CONTROL OF THE PROJECT
 POST PROJECT EVALUATION AND AUDIT
CREATIVE SEARCH FOR INVESTMENT
OPPORTUNITIES

Identifying investment opportunities.

SCREENING OF INVESTMENT PROPOSALS

Project Classifications—capital budgeting projects usually are

classified using the following terms:

Cost Reductions Decision – Should new equipment be

purchased to reduced cost?

Equipment Selection Decision – Which of several available

machines would be the most effective to purchase?
 Lease or Buy Decision - Should new equipment be leased
or purchase?

 Replacement decision - a decision concerning whether an

existing asset should replaced by a newer version of the
same machine or even a different type of machine that
does the same thing as the existing machine. Such
replacements are generally made to maintain existing
levels of operations, although profitability might change
due to changes in expenses (that is, the new machine
might be either more expensive or cheaper to operate than
the existing machine).
 Expansion decision—a decision concerning whether the
firm should increase operations by adding new products,
additional machines, and so forth. Such decisions would
expand operations. Should a new plant, warehouse, or
other facility to be acquired to increase capacity and sales?

 Independent project—the acceptance of an independent

project does not affect the acceptance of any other project
—that is, the project does not affect other projects.
For example, if you have a large sum of money in the bank
that you would like to spend on yourself, say, $150,000. You
decide you are going to buy a car that costs about $30,000
and a new stereo system for your house that costs less
than $5,000. The decision to buy the car does not affect the
decision to buy the stereo—they are independent decisions.
 Mutually exclusive projects—in this case, the decision to
invest in one project affects other projects because only
one project can be purchased.
For example, if in the above example you decided you were
going to buy only one automobile, but you were looking at
two different types of cars, one is a Chevrolet and the other
is a Ford. Once you make the decision to buy the Chevrolet,
you have also decided you are not going to buy the Ford.

 Vertical Integration Project – expansion along the same

product line (service).
EVALUATION OF THE
PROPOSALS
 Evaluation involves estimating the cash flows of
the various proposals and applying cash flow
based criteria for making a decision to accept or
reject the project.
IMPLEMENTATION OF THE
PROJECT
 A project should be implemented according to the plan as closely
as possible.
GOALS: a) attainment of budgeted cost of project investment
The projects investment cost should not exceed the budgeted level.
Because investment is incurred at the start of the project, an
excessive spending level drastically reduces project viability.

b) completion of the project investment within the timetable

Attainment of the due to delays in the timetable for installing the
investment is crucial to the viability of the project.

c) implementation of the project according to technical and

operating plans
The project stands the best chances for operating according to the
cost budget if it had been set up according to the original design.
MANAGEMENT AND
CONTROL OF THE PROJECT
Once the project has been set up, operating
managers should take over the project and
manage its facilities. Operating managers
should use the capital budget as standard in
managing the project.
POST PROJECT
EVALUATION AND AUDIT
Once the project is completed, management
should conduct an evaluation and audit to
ascertain lessons learned from the experience.
The knowledge and experience that come to
light are not shared with the rest of the
managers in the company. When these
managers implement similar projects, they tend
to commit the same mistakes
Capital Budgeting
Techniques
 Payback Period
 Accounting Rate of Return (ARR)
 Net Present Value (NPV)
 Profitability Index
Payback Period

 Payback period refers to the length of time

before an investment is recovered. It is the time
period where the cumulative cash inflows is
equal to the cost of investment. It is otherwise
known as the breakeven time. Net cash inflows
may be even or uneven.
Even Cash Inflows

Payback Period = Cost of investment

Net Cash Inflows

Example : A project requires an investment of P600,

000, with 5 years useful life, no salvage value, and
uses straight line method of depreciation. Other data
are:
Expected sales revenue P 2, 000, 000
Out-of-pocket costs 1, 600, 000
Tax rate 40%

Compute the Payback Period.

First let us determine the net cash inflows:

Sales P 2,000,000.00
Out-of-pocket costs (1,600,000.00)
Depreciation expense (120,000.00)
IBIT 280,000.00
Less: Income Tax (40%) 112,000.00
Net Income 168,000.00
Add: Depreciation expense 120,000.00
Net Cash Inflows 288,000.00
 Therefore:
Payback Period = P600, 000 / P 288, 000
= 2.08 yrs.

Assume an investor wants a payback period of 3 years, the

proposed project is acceptable because its expected
payback period is 2.08 years which is shorter than 3 years.
This means that the proposed project shall be recovered
faster than the 3-year recoverability standard set by the
business.
Uneven Cash Inflows

Payback period is where :

Cash to date = Cost of investment

Example : An investment of P400,000 can bring in

the following annual cash income, net of tax :

1st year, P40,000; 2nd year, P95,000; 3rd year,

P85,000; 4th year, P160,000, 5th year, P86,000,
6th year, P70,000.
The payback period is determined as
follows:
Year Net Cash Cash to date Payback
Inflows Period
1 P40, 000 P40, 000 1

2 95, 000 135, 000 1

3 85, 000 220, 000 1

4 160, 000 380, 000 1

5 86, 000 400, 000 .23

(20,000/86,000)

6 70,000 4.23
The fraction of the last year is computed by dividing the
remaining cash needed to complete the recovery of
investment (e.g., P400, 000 – P380, 000 = P20, 000)
divided by the total net cash inflows in the year where the
cash is taken (e.g., 5th yr., P86, 000).

Assume an investor wants a payback period of 3 years, the

proposed project is to be rejected because its payback
period of 4.23 years is longer that the desired payback of 3
years.
Payback Reciprocal

 Payback reciprocal is one over payback period. It

represents the percentage of annual net cash
returns provided by an investment. Say, a
project has a payback period of 3.75 years, then
the payback reciprocal is:

Payback reciprocal = 1/Payback period

= 1/3.75
= 26.67%

The higher the payback reciprocal, the better.

Payback Bailout Period

 There are times where a project could be

terminated anytime during its life such as
projects funded by government money where
the budget depends on congress approval and
projects where there continuity depends on the
approval of funding (or mother) agency. In this
case, the salvage value is considered in
determining the total cash provided by the
project.
 It is the basis of using the payback bailout
period.
 Payback bailout period also determines the number of years
to recoup the investment where total cash includes the
regular net cash inflows plus the salvage value. If there is a
fraction of a year, it is determined as follows:

a. Compute how much more cash is needed to recover the

cost of investment (i.e., cost of investment less cash to
date).
b. Deduct the salvage from the amount computed in letter
“a” above.
c. Divide the amount determined in letter “b” over the net
cash inflows for the year.

The shorter the payback period, the better!

Sample Problem
An investment of P500, 000 can bring in the following annual cash inflows
and salvage values:

Net cash inflows Salvage values,

end of year
First year P130, 000 P 230, 000
Second year 90, 000 100, 000
Third year 85, 000 40, 000
Fourth year 160, 000 20, 000
Fifth year 75, 000 10, 000
Sixth year 70, 000 5, 000

Determine the payback bailout period.

 Solutions/Discussions:
The payback bailout year is computed below:

Year Net Cash Cash to Salvage Total Payback

Inflows Date Values Cash to bailout
date period
1 P130, 000 P130, 000 P 230, 000 P360, 000 1
2 90, 000 220, 000 100, 000 320, 000 1
3 85, 000 305, 000 40, 000 345, 000 1
4 160, 000 465, 000 20, 000 485, 000 1
5 75, 000 500, 000 10, 000 500, 000 0.33 (35,000 -
10,000/75,000)
TOTAL 4.33 yrs.
 The remaining cash needed to complete the recovery of the
P500,000 investment is P35,000 in year (i.e., P500,000-
P465,000). The recovery of the P35,000 shall be applied
first to salvage value of P10,000 and the balance will be
coming from the regular net cash inflows, which is P75,000
in year 5.
Accounting Rate of Return
 Accounting rate of return (ARR) measures the profitability of
a proposed project. ARR may be computed based on
original or average investment. Average investment is the
sum of original investment plus salvage value divided by 2.
It is the average investment balance over the entire life of
the investment.

ARR (original)=Net income / Original Investment

ARR (average)=Net income / Average Investment

=Net income / [(Original Investment + Salvage
value)/2
 ARR is the only evaluation technique that uses net income
to measure the attractiveness of a proposed investment
based on profitability.

The higher the ARR, the better!

Sample Problem
The Tarlac Company is considering the production of a new
product line which will require an investment of P3,000,000,
with P200,000 salvage value. The investment will have a
useful life of ten years during which annual cash inflows
before income taxes of P1,400,000 are expected. The
income tax rate is 40%.
Required:
a. Annual net income
b. ARR based on original and average investment balances.
Solutions/Discussions:
The accounting net income is determined below:

Cash flows before taxes P1,400,000

Less: Depreciation expense
[(P 3 million – P200,000)/10 yrs.] 280,000
Income before income tax 1,120,000
Less: Tax (40%) 448,000
Net income P 672,000

ARR (original) = P 672,000/P3 million = 22.45%

ARR (average) = P 672,000 / [(3million + P 200,000)/2]

= P 672,000 / P 1,600,000 = 42%

ARR based on average investment is always greater than ARR based

on original investment. ARR based on average investment is twice
as much as the ARR based on original if there is no salvage value.
The Profitability Index and the NPV Index

 The indexes are normally used to rank projects

that are acceptable (say, several projects have
positive NPVs). The ranking of acceptable
projects is done when there is a constraint on
resources such as money, manpower, and
materials. The process of allocating available
money to the most prioritized investment
proposals is known as “capital rationing”. In the
ranking process, the project that has the
highest index has the highest priority.
The profitability index and NPV index are computed as follows:

Profitability Index = PVCI / COI

NPV Index = NPV / COI

Sample Problem
Millennium Corporation has P12 million available money for investment.
It has already evaluated several project proposals and now considers
the following acceptable projects:

Project COI PVCI NPV

A P 5,000,000 5,500,000 P 500,000

B 6,000,000 6,900,000 900,000

C 4,000,000 4,850,000 850,000

D 3,000,000 3,470,000 470,000

Which project should the company invest?

Solutions / Discussions :
The indeces, project ranking, and project investments are determined as follows:

Pro COI PVCI NPV Profit NPV

ability Index
Rank Investme
nt shall
jec Index be made
t to project
A 5 million 5,500,00 500,00 1.10 0.10 04
0 0
B 6 million 6,900,00 900,00 1.20 0.20 02
0 0
C 4 million 4,850,00 850,00 1.21 0.21 01
0 0
D 3 million 3,470,00 470,00 1.16 0.16 03
0 0
Profitability index = PVCI / COI
NPV index – NPV / COI
 The project with the highest priority is project B, because it
has the highest profitability index and NPV index
 The business shall invest its money to project B and C
having rank 1 and 2, respectively. The total investment
required for projects B and C is P10 million (i.e., P6 million +
P4 million). Since the business has only P12 million, it has
only remaining P2 million which is already insufficient for
investment to project D (which is the 3rd priority) and needs
P3 million investment or project A (which is the 4th priority)
and needs P5 million investment.
 There are times where the remaining fund balance for
investment is inadequate for the next (e.g., Project D)
project proposal but is enough for succeeding project
proposals (e.g.. Project A) and the company wishes to
maximize funds for investment. In this case, succeeding
rank projects will receive the allocation for investment.
 If the indeces are used as straight forward decision criteria,
you shall be guided as follows:

If the Then , the project is

Profitability index > 1.00 acceptable

Profitability index < 1.00 rejected

NPV index = positive acceptable

NPV index = negative rejected

Problem 1

Diamond Corp. is planning to buy a new machine

costing 500,000 with a useful life of 5 yrs, no
salvage value. Other data were made available:
Expected Annual Sales Revenue 600,000
Annual-out-of-pocket cost 450,000
Interest rate 40%
Depreciation method Straight line

Required: PP,PR,ARRi,ARRa
Problem 2

An investment of 400,000 can bring in the following

annual cash income, net of tax.

1 - 70,000
2 - 90,000
3 - 85,000
4 - 160,000
5 - 75, 000
6 - 70,000

Required: Payback period

Problem 3
An equipment costing 1,000,000 is expected to yield the
following net cash inflows and salvage values.

Year Net Cash Inflows Salvage Value,

net of tax
1 300,000 200,000
2 400,000 100,000
3 200,000 50,000
4 150,000 20,000
Required: Payback period
Problem 4

 Citizen Company is considering the purchase of

a P40,000 machine, which will be depreciated
on the straight-line basis of 8-year period with
no salvage value for both book and tax
purposes. The machine is expected to generate
an annual pretax cash inflow of P15,000. The
income tax rate is 40%.
Required:
 Determine the payback period.
 Compute the accounting rate of return of
original investment.
Problem 5

The RT Company is considering the production of a

new product line which will require an
investment of 1,000, 000 with no scrap value.
The investment will have a useful life of 10
years, during which annual net cash inflows
before taxes of 200,000 are expected, the
income tax rate is 40%.

Required: Annual net income, ARRi, ARRa