CAPITAL BUDGETING

MANAGEMENT ECONOMICS
CAPITAL BUDGETING

• The process of identifying, evaluating, planning, and financing

capital investment projects of an organization.
• Involves capital investment projects which require large sum of
outlay and involve a long period of time longer than the usual
cut-off of one year or normal operating cycle.
 CHARACTERISTICS OF CAPITAL
INVESTMENT DECISIONS
• Capital investment decisions usually require relatively large commitments of
resources
• Most capital investment decisions involve long-term commitments
• Capital investment decisions are more difficult to reverse than short-term decisions
• Capital investment decisions influence the firm’s growth in the long run
• They affect the risk of the firm
• They are among the most difficult decisions to make
CAPITAL BUDGETING PROCESS

1. Identification of Investment Proposal

2. Estimation of Costs and Benefits
3. Evaluation of Proposed Projects
4. Development of the Capital Expenditure Budget
5. Implementing the Investment Proposal
TYPES OF CAPITAL INVESTMENT PROJECTS

• Replacement
• Improvement
• Expansion
BASIC CONCEPTS TO UNDERSTAND

• Unlimited Funds versus Capital Rationing

• Accept-Reject versus Ranking Approaches
• Conventional versus Non-Conventional Cash Flow Patterns
• Expansion versus Replacement Cash Flows
• Independent Projects versus Mutually Exclusive Projects
UNLIMITED FUNDS VERSUS CAPITAL
RATIONING

• Problems in Capital Budgeting exists because the funds we

allocate for it are normally limited. In such case, we have to
make the best decision out of it.
ACCEPT-REJECT VERSUS RANKING
APPROACHES
• Since budget is limited, we have to evaluate capital investment proposals.
• When you have certain criteria for a capital investment, accept-reject approach
happens when you accept proposals which meet these criteria and you reject
those that do not. Most of the time, this is used when the projects are mutually
exclusive.
• Ranking approach, on the other hand, is when you are allowed to accept more
than one capital proposal. Normally you rank these proposals in such a way that
the best will be done first and so on.
• These two may both be done in evaluating proposals. You may first do an accept-
reject approach then the ranking approach.
CONVENTIONAL VERSUS NON-
CONVENTIONAL CASH FLOW PATTERNS
• Conventional cash flow pattern is an investment where outflow
happens at the beginning of the project then you expect inflows
thereafter.
• Example: you bought a machine, the machine makes the goods you sell
• Non-conventional cash flow pattern is when you have to make
outflows in between cash inflows.
• Example: continuing franchise fees wherein you pay monthly franchise
fees to the franchisor
EXPANSION VERSUS REPLACEMENT CASH
FLOWS
• In terms of capital budgeting, expansion has a more straightforward
cash flows. You just have to consider your investment versus the
expected returns.
• Example: when you buy a new machine to increase production without
selling the old one
• In replacement, on the other hand, initial investment is affected by
the proceed of the sale from the old investment.
• Example: When you buy a service vehicle and you surrender the old
one to decrease the purchase price of the new one (trade-in)
INDEPENDENT PROJECTS VERSUS
MUTUALLY EXCLUSIVE PROJECTS
• Independent projects are standalone projects that is not affected by
other projects
• Example: Investment in Shell gas station and investment in Jollibee
franchise
• Mutually exclusive projects are those which cannot exist when
another is already existing.
• Example: Investment in Jollibee franchise versus investment in
McDonald’s franchise (assuming investing in competitors is not
allowed)
CAPITAL INVESTMENT FACTORS

1.The Net Investment (net cost) of Investment

• It is the difference between the initial costs or initial cash
outflows and the initial savings or initial cash inflows.
CAPITAL INVESTMENT FACTORS – NET INVESTMENT

ILLUSTRATION 1 Net Cost of Investment

The management of AAA Company 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. The company has found a buyer who is willing to purchase the old
slimming machine for its salvage value.
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.
REQUIRED: Determine the net cost of investment in the new machine for decision making
purposes.
CAPITAL INVESTMENT FACTORS – NET INVESTMENT

Solution:
Initial costs or initial cash outflows:
Purchase price P50,000
Incidental cost 10,000 P60,000
Initial savings or cash inflows:
Proceeds from sale of old machine (4,000)
Net investment P56,000
CAPITAL INVESTMENT FACTORS

2. Net Returns
(Net Benefits or Net Savings or Annual After-tax Cash Flows)
• Two concepts of return or income may be considered for purposes of
evaluating investment projects. These returns are
• accounting net income; and
• net cash inflows expected form the proposed project.
 CAPITAL INVESTMENT FACTORS – NET RETURNS

Accounting Net Income Net Cash Inflow

Net Sales P xxx Net income (income after tax) P xxx
Less: Cost of sales xxx Add: Noncash expenses xxx
Gross Profit xxx Less: Noncash income xxx
Less: Operating expenses xxx Annual After-tax net cash flow P xxx
Operating income xxx
Less: Income tax xxx
Annual income after tax P xxx
CAPITAL INVESTMENT FACTORS – NET RETURNS

ILLUSTRATION 2 Net Returns

AAA Company is contemplating to add a new product to its current operations. The new product will
require a machine which will cost P100,000 and will have a new useful life of 20 years with no residual
value. The following estimates related to the new product are made available:
Net sales P100,000
Operating expenses (inclusive of P5,000 depreciation) 20,000
Gross profit rate 40%
Income tax rate 30%
REQUIRED: Determine the amount of the following:
a. Accounting income b. Net cash inflow
CAPITAL INVESTMENT FACTORS – NET RETURNS

Solution- Accounting Income:

Accounting income
Net sales P100,000
Cost of sales (60,000)
Gross profit 40,000
Operating expenses (inclusive of P5,000 depreciation) (20,000)
Operating income 20,000
Tax (30%) (6,000)
Accounting net income P14,000
CAPITAL INVESTMENT FACTORS – NET RETURNS

Solution – Net Cash Inflow:

Net cash inflow
Accounting net income P14,000
Add: Depreciation 5,000
After tax net cash flow P19,000
CAPITAL INVESTMENT FACTORS

3.Terminal Cash Flow

• Terminal value or end-of-life recovery value refers to the net cash proceeds
expected to be realized at the end of the project’s economic life.