Week 6 & 7: Unit Learning Outcomes (ULO): At the end of the unit, you are expected

to:
a. utilize the various techniques in evaluating capital investments.
b. understand the financial aspect of the feasibility study.

Big Picture in Focus: ULOa. utilize the various techniques in

evaluating capital investments.

Metalanguage
In this section, the most essential terms relevant to the topic and to demonstrate ULOa will be
operationally defined to establish a common frame of reference as to how the texts work in your
chosen field or career.
 Capital budgeting – is the process of deciding whether or not to commit resources to
projects.
 Capital expenditures – are long – term commitments of resources to realize future
benefits and budgeting them is one of the most important areas of managerial decision.

Please proceed immediately to the “Essential Knowledge”.

Essential Knowledge

Capital budgeting is used to describe actions relating to the planning and financing
capital outlays. It is an investment concept, since it involves a commitment of funds now
in order to receive some desired return in the future.

Capital investment analysis – is a planning task and is directly linked to budgeting,

thus the term capital budgeting.

Capital budgeting – is the process of identifying, evaluating and financing capital

investment projects of an organization. This type of budgeting is different from short-
term budgeting or periodic planning, since capital investment projects normally involve
large sum of money and long period of time.

Characteristics of capital investment decisions

1) Capital investment decisions usually require relatively large commitments of
resources.
2) Most capital investment decisions involve long-term period.
3) Capital investment decisions are more difficult to reverse than short-term
decisions.

The capital budgeting process may vary among firms, but such process generally
involves the following:
I. Identification of potential projects
 II. Estimation of costs and benefits
III. Evaluation of proposed projects
IV. Development of the capital budget
V. Reevaluation of proposed projects

Capital investment can be classified into:

1) Dependent or contingent project – is a project that is dependent on the
acceptance of one or more other projects.
2) Mutually exclusive project – is a project that is independent of another project
under consideration and that its acceptance will mean automatic rejection of the
other project.

Types of Capital Investment Projects

1) Replacement – is a capital investment decision in which an old item is replaced
by a new item of the same kind.
2) Improvement – is a capital investment decision in which an existing item is
upgraded or updated to be efficient and productive.
3) Expansion – is a capital investment decision that may involve the enlargement of
existing facilities, addition of new business segment and exploration of new
markets.

Factors to be considered in evaluating capital investment projects

I. Net investment

Net investment (initial investment) – is the net flow of cash, a commitment of

cash or the sacrifice of an inflow of cash. For decision making purposes, the
basic computation for net investment is cash outflows or costs less cash inflows
or savings incidental to the acquisition of the investment project. This may
computed as follows:

Initial cash outlay P

XX
Add: Additional cash outlay related to the asset P XX
Additional working capital XX
Total XX
Less Cash inflow arising from sale of old asset being
XX
: replaced
Avoidable costs XX XX
Net Investment P
XX
 The different items that must be included in the computation are enumerated
below.
 Cash outflows or costs which include:
a) The initial cash outlay covering all expenditures on the project up to the
time when it is ready for use or operation. Examples are purchase
price of the assets and incidental project – related costs such as
freight, insurance, taxes, handling, installation, test runs, etc.
b) Working capital requirement to operate the project at the desire level.
c) Market value of an existing currently idle asset which will be
transferred or utilized in the operations of the proposed capital
investment project.

 Cash inflows or savings which include:

a) Trade-in value of old asset (in case or replacement)
b) Proceeds from sale of an old asset to be disposed due to the
acquisition of the new project (less applicable tax in case there is gain
on sale, or add tax savings in case there is loss in sale)
c) Avoidable cost of immediate repairs on old asset to be replaces, net of
tax.

Sample problem:

Key Corp. plans to replace a production machine that was acquired several years ago.
Acquisition cost is P450,000 with salvage value of P50,000. The machine being
considered is worth P800,000 and the supplier is willing to accept the old machine at a
trade-in value of P60,000. Should the company decide not to acquire the new machine,
it needs to repair the old one at a cost of P200,000. Tax-wise, the trade-in transaction
will not have any implication but the cost to repair is tax-deductible. The effective
corporate tax rate is 35% of net income subject to tax. For purposes of capital
budgeting, the net investment in the new machine is?

Initial cash outlay P 800,000

Less Trade-in value
P 60,000
:
Avoidable costs
130,000 190,000
[200,000*(1-.35)]
Net Investment P 610,000

II. Net returns

The concepts of return or income may be considered for purposes of evaluating

investment projects. These return are the:
  Accounting net income – this refers to the net income (after tax) expected
to be earned from the project being evaluated. The procedures used in the
computation of accounting net income for a project are the same as those
used in financial accounting, where proper matching of costs and revenues
is considered.

 Net cash inflows – involves only the cash revenues, costs and expenses. It
is computed by deducting from cash inflows to be generated from operating
the project all the cash outflows to be incurred for the project’s operations.
This is computed as follows:

Annual incremental revenue from the

P XX
project
Less Incremental cash operating costs
XX
:
Annual cash inflow before taxes XX
Less Incremental depreciation
XX
:
Net income before taxes XX
Less Income taxes
XX
:
Net income after taxes XX
Add: Incremental depreciation XX
Annual net cash inflow after taxes P XX

In some cases, the proposed projects are not expected to generate cash inflows,
but they will yield returns in the form of cash savings. These cost savings should
be treated as income or return that may be derived from the project. The cost
savings, after being adjusted from tax effects, will represent the net return from
the project to be evaluated. This is computed as follows:

Cash operating costs (if the old asset or method is used) P XX

Less Annual cash operating costs (if the new asset or method is
XX
: used)
Cash saving before taxes XX
Less Incremental depreciation
XX
:
Increase in income before taxes XX
Less Income taxes
XX
:
Increase in income after taxes XX
Add: Incremental depreciation XX
 Net cash savings after taxes P XX

Sample problem:

The Lino Company, a calendar company, purchased a new machine for P280,000 on
January 1. Depreciation for tax purposes will be P35,000 annually for eight years. The
accounting (book value) rate of return (ARR) is expected to be 15% on the initial
increase in required investment. On the assumption of a uniform cash inflow and the
tax rate is 30%, this investment is expected to provide annual cash flow from
operations, net of income taxes, of?

Net income before taxes

P 42,000
(280,000*15%)
Less Income taxes (42,000*30%)
12,600
:
Net income after taxes 29,400
Add: Incremental depreciation 35,000
Annual net cash inflow after taxes P 64,400

III. Cost of capital

Cost of capital (also called as cut-off rate, minimum desired rate, minimum
acceptable rate, target rate, standard rate and hurdle rate) – is the cost of using
funds, which serve as the standard rate with which comparison are to be made.
Examples of cost of capital are interest and dividends. When financing can be
traced directly to a specific source, the cost of capital is determined as follows:

Source Cost of capital

Bonds After tax rate of interest

Dividend per share

Preference share (PS)
Present market price per share of PS

EPS (after tax & preference

Ordinary share (OS) dividends)
Present market price per share of OS
 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. Theoretically, the weighted
average cost of capital should be computed at any point in time. However, in
practice the task is difficult because a lot of factors affect the computation, such
as changes in cost of borrowing, current prices of stocks and government rules
and regulation.

IV. Economic

Life is the period of time during which the asset can provide economic benefits or
positive cash inflows. The concept of economic life is different from the so
called useful life – the period of time between the date if acquisition of the asset
up to the time that the asset can no longer serve the purpose for which it is
determined. In many instances, the economic life is shorter than the useful life,
since at a certain point in time, an asset can still be used (still within the useful
life) but it can no longer provide income or net cash inflow for the firm (already
beyond the economic life).

In evaluating capital investment projects, the net returns should be computed

using the economic life, and not the useful life of the project.

V. Terminal value

Terminal value (or end of line recovery value, salvage value) – refers to the net
cash proceeds expected to be realized at the end of the project’s economic life.
This should be considered as cash inflow at the end of the project’s life, for
purpose of evaluating capital investment projects. In most cases, however, this
amount is simply assumed to be zero, because of the difficulty of estimating a
reasonable amount that could be realized in the future. The terminal value is
computed as follows:

Proceeds from sale of the project P XXX

Add: Previously committed working capital XXX
Total XXX
Less: Dismantling costs XXX
Cost of removal XXX
Terminal value P XXX

Methods of Evaluation

The various methods used in evaluating capital investment projects may be grouped
into two major classifications:
 1. Methods that do not consider the time value of money (non-discounted cash
flow) approach
a) Payback period
b) Bail-out period
c) Accounting rate of return
d) Payback reciprocal

2. Methods that consider the time value of money (discounted cash flow) approach
a) Net present value
b) Profitability index
c) Discounted payback period
d) Discounted cash flow rate of return

Under the discounted cash flow techniques or present value approach, cash
outflows and cash inflows are discounted to their present value using an
appropriate rate of interest.

I. Non-discounted cash flow Approach

a) Payback period

Payback period (also known as payoff and payout period) – measures the
length of time required to recover the amount of initial investment (a measure
of liquidity). Since payback means recovery of investment costs, a quick and
short payback period indicates less risky project.

Net cost of initial investment

Payback period =
Annual net cash inflows

Decision rule:
The acceptability of the project is determined by comparing the project’s
payback period against the maximum acceptable payback period as
predetermined by management. If the project’s payback period is shorter
than the maximum payback period, the decision should be to accept the
project. On the other hand, if the project’s payback period is longer than the
maximum payback period, the decision should be to reject the project.

Advantages of payback period method:

1) It is easy to compute and understand.
2) It is used to measure the degree of risk associated with a project.
Generally, the longer the payback period, the higher the risk.
3) It is used to select projects which provide a quick return of invested
funds.
Disadvantages of payback period method:
1) It does not recognize the time value of money.
 2) It ignores the impact of cash inflows after the payback period.
3) It does not distinguish between alternatives having different economic
lives.
4) The conventional payback computation fails to consider salvage value,
if any.
5) It does now measure profitability – only the relative liquidity of the
investment.

Sample problem:
If an asset costs P35,000 and is expected to have a P5,000 salvage value at the end of
its ten-year life, and generates annual net cash inflows of P5,000 each year, the cash
payback period is?

Net cost of initial investment

Payback period =
Annual net cash inflows

P 35,000
Payback period =
P 5,000
= 7 years

b) Bail – out period

In normal payback computations, the salvage value of investment is usually

ignored. An approach, that incorporates the salvage value in payback
computation is the bail-out period.

The bail-out period is arrived at when the cumulative cash earnings plus the
salvage value at the end of a particular year equals the original investment.

Sample problem:
An investment of P200,000 is expected to produce annual cash returns of P75,000 for 5
years. Its estimated salvage value is P120,000 during the first year and this is expected
to decrease by P20,000 annually. What is the bail-out period?

The bail-out period may be determined using the following table:

Year Annual cash returns Salvage value Cumulative value*
1 P 50,000 P120,000 P 170,000
2 50,000 100,000 200,000
3 50,000 80,000 230,000
4 50,000 60,000 260,000
5 50,000 40,000 290,000
*cumulative annual ash returns + salvage value at the end of the year
The bail-out period is 2 years, because the cumulative value at the end of Year 2 is
equal to the cost of the investment.

c) Accounting rate of return (ARR)

ARR (also known as book value rate of return, financial statement method,
average return on investment and unadjusted rate of return) – measures
profitability from the conventional accounting standpoint by relating the
required investment to the future annual net income. The formula of ARR is:

Average annual net income

ARR =
Investment or Average Investment

Salvage vale of the

Initial
+ asset at the end of
Average Investment = investment
economic life
2

Decision rule:
Under the ARR method, if the ARR is greater than the required rate of return
(normally, the cost of capital), the project should be accepted; however, if the
ARR is lower than the required rate of return, the project should be rejected.
When two or more projects are being evaluated and their ARR’s are greater
than the cost of capital, the project with the highest rate of return is accepted.

Advantages of ARR:
1) It is easily understood by investors acquainted with financial
statements.
2) It is used as a rough preliminary screening device of investment
proposal.

Disadvantages of ARR:
1) It ignores the time value of money by failing to discount the future cash
inflows and outflows.
2) It does not consider the timing component of cash inflows.
3) Different averaging techniques may yield inaccurate answers.
4) It utilizes the concepts of capital and income primarily designed for the
purpose of financial statements preparation and which may not be
relevant to the evaluation of investment proposals.

Sample problem:
A piece of labor saving equipment that Marubeni Electronics Company could use to
reduce costs in one of its plants in Angeles City has just come onto the market.
Relevant data relating to the equipment follow:
Purchase cost of the equipment P432,000
Annual cost savings that will be provided by the equipment 90,000
Life of the equipment 12 years

What is the simple rate of return to be provided by the equipment?

P 54,000
ARR =
P 432,000
= 12.5%

Annual cash savings P 90,000

Less: depreciation
(432,000/12 yrs.) 36,000
Annual income P 54,000

d) Payback reciprocal

When economic life of the project is at least twice the payback period and the
annual net cash inflows are constant (uniform), the payback reciprocal may
be used to estimate the discounted cash flow rate of return (DCFRR). A
project with an infinite life would have a DCFRR exactly equals to its payback
reciprocal. The formula for the payback reciprocal is:

Net cash inflows

Payback reciprocal =
Net investment

1
Payback reciprocal =
Payback period
Sample problem:
A piece of labor saving equipment that Marubeni Electronics Company could use to
reduce costs in one of its plants in Angeles City has just come onto the market.
Relevant data relating to the equipment follow:
Purchase cost of the equipment P432,000
Annual cost savings that will be provided by the equipment 90,000
Life of the equipment 12 years

What is the payback reciprocal?

Payback reciprocal = P 54,000*
 P 432,000
= 12.5%
*refer to the previous problem for the computation of the net cash savings.

II. Discounted cash flow approach

a) Net present value (NPV)

NPV – is the excess of the present value of cash inflows generated by the
project over the present value of the initial investment. The NPV method
assumes that earning are reinvested at a rate of return equal to the firm’s cost
of capital. The formula of the NPV method is:
Present value of cash inflows P XXX
Present value of cash outflows (initial
XXX
investment)
Net present value P XXX

Decision rule:
If the NPV is positive or zero, accept the project. If the NPV is negative,
reject the project. When the NPV is positive, this means that the project will
earn greater than the discount rate (or hurdle rate). If the projects do not meet
the hurdle rate, they should be rejected.

Sample problem:
Consider a project that requires an initial cash outflow of P500,000 with a life of eight
years and a salvage value of P20,000 upon its retirement. Annual cash inflow before tax
amounts to P100,000 and a tax rate of 30 percent will be applicable. The required
minimum rate of return for this type of investment is 8 percent. The present 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?

Present value of cash inflows:

PV for after tax cash flow (88,750*5.747) P 510,046.25
PV for after tax salvage value (14,000*0.54) 7,560.00
Total 517,606.25
Investment (500,000)
Net present value P 17,606.25
 Annual cash flow before tax P 100,000
Less: depreciation (500,000/8 yrs.) 62,500
Income before tax P 37,500
Less: taxes 11,250
Income after tax 26,250
Add: depreciation 62,500
Annual net cash inflow after tax 88,750

Salvage value P 20,000

Less: tax shield (20,000*30%) 6,000
Salvage value after tax P 14,000

b) Profitability index

The profitability index (also known as present value index, desirability index,
benefit-cost rate, total present value index) – is the ratio of the present value
of cash inflows to the present value of net investment (cash outflows). It is
used as a basis in ranking projects in descending order of desirability. The
formula for this index is:

PV of cash inflows
Profitability index =
PV of net investment (cash outflows)

Decision rule:
If the profitability index is equal or more than 1, the project is accepted. If
the profitability index is less than 1, the project is rejected. The higher the
profitability index, the more desirable the project is.

Sample problem:
A project has an initial cost of P100,000 and generates a present value of net cash
inflows of P120,000. What is the project's profitability index?

P 120,000
Profitability index =
P 100,000
= 1.2

c) Discounted payback period

 The discounted payback period – is a method that recognizes the time value
of money in a payback context. This is used to compute the payback in terms
of discounted cash flows received in the future. The payback period is
computed using the discounted cash flow values than the actual cash flows.
Sample problem:
An investment of P200,000 is expected to produce annual cash returns of P75,000 for 5
years. If the cost of capital is 15%. What is the discounted payback period?

The discounted payback period may be determined as follows:

PV factor @ Discounted cash
Year Cash flows Balance
15% flow
0 P(200,000) - P(200,000) P(200,000)
1 75,000 0.870 65,250 134,750
2 75,000 0.756 56,700 78,050
3 75,000 0.658 49,350 28,700
4 75,000 0.572 42,900 (14,200)

28,700
DPP = 3 +
42,900
= 3 + 0.67
= 3.67 years
The discounted payback period is 3.67.

d) Discounted cash flow rate of return (DCFRR)

DCFRR (also known as the time-adjusted rate of return, adjusted rate of

return, internal rate of return and 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. When the DCFRR is used as the discount
rate, the present value of cash inflows will be equal to the present value of net
investment (cash outflows). Thus, the resulting net present value is equal to
zero. The DCFRR assumes that earnings are reinvested at the rate of return
of the particular project being considered.

Decision rule:
If the DCFRR is equal to or greater than the minimum desired rate of return
or cost of capital, the project is acceptable. If the DCFRR is lower than the
minimum desired rate of return, the project is not acceptable.

Net cost of investment

PV factor =
Net cash inflows

Equal net cash inflows:

Lower rate XXX
 Add: Diff. in PVF of lower rate and DCFRR XXX
Divided by: Diff. in PVF of lower and higher XXX
rate
Multiplied by: Diff. in lower rate and higher XXX XXX
rate
DCFRR XXX

Unequal net cash inflows:

Lower rate XXX
Add: Diff. in NVF of lower rate and DCFRR XXX
Divided by: Sum of NVF of lower and NPV of XXX
higher rate
Multiplied by: Diff. in lower rate and higher XXX XXX
rate
DCFRR XXX

Note: If the present value factor computed is present in the annuity table, the
corresponding rate is the DCFRR.

Sample problem:
Smoot Automotive has implemented a new project that has an initial cost, and then
generates inflows of P10,000 a year for the next seven (7) years. The project has a
payback period of 4.0 years. What is the project's internal rate of return (IRR)?

P 40,000
PV factor =
P 10,000
= 4.0

*refer to the table for Present value of an ordinary annuity of P1. The number of period
is equal to 7 years, within the row for the 7 period, look for the nearest value of the PV
factor 4.0; lower rate is 16% with PV factor of 4.0386 and the higher rate is 18% with
factor of 3.8115.

Equal net cash inflows:

 Lower rate 16%
Add Diff. in PVF of lower rate and DCFRR 0.038
: (4.0386 – 4.0) 6
Divided by: Diff. in PVF of lower and higher rate 0.227
(4.0386 – 3.8115) 1
Multiplied by: Diff. in lower rate and higher rate 2 .34
(18% - 16%)
Internal Rate of Return 16.34%

Ranking Investment Projects

1. Rank the projects according to their desirability and acceptability as dictated by
the evaluation methods.
2. If problems in ranking arise due to the conflicting results shown by the evaluation
methods, the result shown by the DCF methods must be given more weight.
3. If ranking problems still exist despite the use of the DCF methods, the result
shown by the NPV method or better still by the profitability index, should be
preferred to the result shown by the DCFRR method.

Qualitative Factors Influencing Capital Investment Decisions

The qualitative methods discussed above, provide managers with general guidelines
that can be used in making capital investment decisions. However, the final decisions
should not be based only on quantitative factors, but also on qualitative factors. Among
the qualitative factors that must be considered are the following:
1. Economic conditions
2. Growth policies
3. Risk evaluation
4. Availability of funds

Self Help: You can also refer to the sources below to help
you further understand the lesson.

Cabrera, M.E (2017). Management Accounting: Concepts and Applications. GIC

Enterprises & Co.

Bobadilla, D. (2015). Comprehensie reviewer in management advisory services. Manila,

Philippines: Lares Bookstore.
Guia, M. B. M.(2016). Basics of managerial accounting. Ma-a, Davao City: MS Lopez
Printing & Pub.