CHAPTER 3: Fundamental Concepts and Tools of business finance Personal finance is concerned with the fundamentals of managing one's

als of managing one's own

personal money affairs. The finance of non-profit organizations includes private
This chapter is an attempt to present the fundamental concepts and some terms undertakings such as charity, religion, and some private educational institutions.
related to business finance.
DEFINITION OF BUSINESS FINANCE
BASIC CONCEPTS
The term business finance refers to the provision of money for commercial use.
Terms, unless they are clearly defined, are sometimes confusing. As some of them Business finance, however, is more than just the provision of money. It is also
are related, it is important to define them and discuss their relationships with concerned with the effective use of funds. As such, it covers the financial
other relevant terms. management of private profit-seeking concerns in the business of service, trade,
manufacturing, mining, public utilities, and financing. With the foregoing
Finance
requirements, business finance may be defined as the procurement and
Finance may be defined as the study of the acquisition and investment of cash for administration of funds with the view of achieving the objectives of the business.
the purpose of enhancing value and wealth.
Specifically, however, business finance may be concerned with three aspects:
Categories of Finance. Finance, in general, is divided into categories according to
1. small business finance;
the type of entity or organization served. These are the following:
2. corporation finance; and
1. public finance
3. multinational business finance.
2. private finance
It must be made clear that there are similarities and differences between the
Public Finance. Public finance is that category of general finance, which deals
three aspects of business finance. Figure 3. Categories of Finance
with the revenue and expenditure patterns of the government and their various
effects on the economy.

Private Finance. This category deals with the area of general finance not classified
under public finance. It is subdivided into the following:

1. personal finance;

2. the finance of non-profit organizations; and

3. Business finance.
THE GOALS OF BUSINESS FINANCE
Private business is established primarily for profit. This however, can be achieved
by the effective management of the various business functions. One of these is
the finance function. Like other functions; it has its own goals. The goals of
business firms are variously expressed as follows:
1. maximizing profit;
2. maximizing profitability,
3. maximizing profit subject to cash constraint;
4. maximizing net present worth; and
5. seeking an optimum position along a risk-return from
Maximizing Profit
Maximizing profit means realizing the highest possible peso or dollar income. A
firm, for instance, may seek to double its peso or dollar income for the current
year. This framework, however not very useful in making sound financial
decisions. The amount profit earned by the firm is not adequate to evaluate its
performance. For Instance, the net income earned by XYZ Company for a certain
year in the amount of P480 million does not provide much useful information for
the investor or financial manager. This is true even if the same amount represents
an increase from previous year profits of the firm.
Maximizing Profitability
When a firm decides on obtaining a higher rate of return on its investment, it is
said to be maximizing profitability. The following data show an improvement in
the company's performance.
MIKAELA COMPANY
(2006)
2005 2006
Net Worth P 100,000,000 P 200,000,000
Net Profit 1,000,000 5,000,000
Return on Investment 10% 25%
Maximizing Profit Subject to Cash Constraint
In the quest for profit maximization, undue emphasis is sometimes placed on cash
balances. Maintaining too large a cash balance reduces the chance of a favorable
rate of return, while running out of cash when needed is disastrous. The ideal set-
up is to maximize profits, while at the same time maintaining a cash balance that
can take care of cash requirements anytime. This condition is especially critical in
the operation of banks.
Maximizing Net Present Worth
Under the net present worth concept, the objective of the firm is to maximize the
current value of the company to its owners. The net present worth of the firm is
equal to the value now of the firm plus values arising in the future. The present
worth of values arising in the future are computed and added to the present
worth of the other values of the firm. Present values may be better understood
by way of knowing the concept of the time value of money.
Time Value of Money. This concept indicates that money Increases in value with
the passing of time. A peso today could be deposited in a bank and made to earn
interest. This capacity to earn makes the peso today worth more than the peso
that would be received in the future. Thus, to be able to find out the present
worth of a peso that would be received in the future, the corresponding interest
(or discount) should be deducted from that future peso.
Calculation of Present Worth. The present worth of a value to be received in the
future is illustrated as follows:

Question: What is the value today of P 100,000 to be received next year assuming
that the prevailing rate of interest is ten percent (10%) per annum?

Solution:

Seeking an Optimum Position along a Risk-Return Frontier

A firm can set a goal of achieving the best possible combination of risk and return.
A little more risk may be accepted, for instance, for an expected additional rate of
return.
Definition of Return on investment or Net Worth. The income generated by the
use of investments or the net worth of firm is referred to as return on investment.
When it is expressed in percentage, it is called the rate of return.
Definition of Risk. Uncertainty as to loss is called risk. When used in finance, the
term applies to the potential incurrence of the money or its equivalent. Risk is
discussed at length in a succeeding chapter.
Calculation of Expected Value Using Risk and Return Factor. The optimum
position of risk and return may be determined by calculating the expected value
of alternative decisions. The expected value of a return on investment is equal to
the return times the percentage of probability that it will happen (called the risk
factor).
THE FINANCIAL STATEMENT
Financial statements are those that present financial information to various
interested parties. Inasmuch as the finance manager is responsible for managing
the financial activities of the firm, he is naturally one of the most concerned
getting relevant information through the use of financial statements. There are
various types of financial statements, but only two of them are important from
the point of view of business finance. These are: (1) the balance sheet; and (2) the
profit and loss statement.
The Balance Sheet
The balance sheet is the statement produced periodically, normally at the end of
a financial year, showing an organization’s assets, liabilities, and the interest of
the owners.
Assets. The assets section of the balance sheet shows everything that the firm
owns and which has monetary value. Assets are classified into four items and are
presented in the balance sheet in the order of how quick they can be converted
into cash. The classifications are as follows:
 1. Current Assets. These are composed of cash, bank deposits, and other 6. Bonds Payable. When a large amount of long-term debt sought by the
items readily convertible into cash like accounts receivable, stocks and firm from a large number of creditors, bonds are usually issued. The
work-in-process, and marketable securities; amount borrowed is divided denominations like P500, P 1,000, P5,000,
and individual bond certificates are issued these amounts. Each creditors
2. Trade Investments. These are composed of investments in subsidiary or holds the bond, or the promise to pay, for his share of company's debt.
associated companies;
Net Worth. The net worth section of the balance sheet shows the interest of the
3. Fixed Assets. These items show the firm's ownership of property like land, owner or owners the company.
buildings, plant and machinery, equipment, vehicles, furniture and
fixtures, all valued at cost less depreciation written off; and In a single proprietorship, the owner’s interest usually appear as a single account,
for instance, "Isabelo Musngi, Capital." The represents sums Invested by the
4. Intangible Assets. These items present goodwill, patents, copyright which owner, which is increased by profit and decreased by losses and withdrawals.
are attributed to the firm.
In a partnership, the interests of the partners are present, separately like
Liabilities. The liabilities section of the balance sheet shows the profile of the the following:
debts of the company. They are classified into several items and are presented
first and referred to as current liabilities. Long-term liabilities are those which are Francisco Taguinod, Capital P 10, 000,000
payable after one year. The following are common liability items: Clarita Navarro, Capital P 20, 000,000
Angelita Ballesteros, Capital P 30, 000,000
1. Accounts Payable. These are usually composed of debts payable within a
few days, weeks, or months, like those incurred in the purchase of raw Total Net worth P60, 000,000
materials and stocks.
The Net Worth section of a corporation’s balance sheet will appear as follows:
2. Loans and Notes Payable. These are debts evidenced by promissory notes
and oftentimes backed up by collaterals. Creditor' of this type of liability 1. When the shares of stock have par value:
are composed of banks, suppliers, financing companies, and the public. Capital Stock P50,000,000
3. Advances from Customers, Sometimes, customers are required to make 2. when the shares of stock have no par value (but with an arbitrary stated
down payments before orders are processed. Inasmuch as this is not yet value):
earned by the company, they are considered liabilities.
Capital stock (stated value at P10 per share) P 20,000,000
4. Accrued Expenses. These represent obligations, which have been Paid-in-surplus P 30,000,000
incurred but not yet paid.
Total Net worth P 50,000,000
5. Mortgage Payable. This comprises borrowings and other sources of
funds. This item also represents long-term debts and is usually secured by
land, buildings, or equipment.
 Exhibit 1 A SAMPLE BALANCE SHEET 3. when there is a special class of ownership:

ANDRES NICOLA CORPORATION Capital Stock

Balance Sheet
Preferred (P500 par, 8%, 100,000 shares) P 50,000
December 31, 2006
Common (P500 par, 200,000 shares) P 100,000
ASSETS
Total Net Worth P150,000
Cash P 38,130,000
Accounts Receivable 97,943,000 The Income Statement
Inventory 161,351,000 The income statement represents the revenues realized from the sale of
Total Current Assets P 297,424,000 commodities and services produced by the company, as well as the costs and
expenses incurred in connection with the realization of said revenues. The income
Fixed Assets 131,067,000
Prepaid Expenses 9,239,000 statement is also referred to as profit and loss statement, as two possibilities are
presents i.e., net profit or net loss. Unlike the balance sheet which shows the
Cash Value, Life Insurance 22,431,000
financial condition of the firm on a given date, the income statement presents a
Total Assets P 460,161,000 summary of the transactions for a given period.

LIABLITIES The income statement is characterized by four distinct items: (1) revenues; (2)
expenses; (3) other income; and (4) net profit and loss.
Due Banks P 45,000,000
Notes Payable 24,000,000 Revenues. This term refers to the gross income from the production and sale of a
Accounts Payable 40,203,000 firm's product or service. Revenues include cash collections and receivables or
Accruals 15,332,000 unpaid sale. This item does not include trade discounts allowed to distributors of
Taxes 5,906,000 other middleman. To obtain net income or net sales, returns and allowances and
Undistributed Earnings 2,109,000 deducted from the gross revenues.

Total Current Liabilities P 132,604,000 Expenses. This refers to the monetary values of the goods and services used in
the production and delivery process in order to obtain revenues. Expenses consist
OWNERS’ EQUITY of three items: (1) the cost of goods manufactured and sold; (2) operating
Common Stock P 104,500,000 expenses; and (3) other expenses.
Capital Surplus 0 1. Cost of Goods Manufactured and Sold. This item present a summary of
Earned Surplus 223,057,000 the cost of raw materials, labor, and various overhead costs directly
Total Liabilities and Net worth P460, 161,000 involved in the manufacturing process and which represent the
manufacturing cost of goods sold during the period under consideration.
 Overhead costs includes expenditures like salaries of supervisors,
depreciation, light and water, supplies, and factory rent.
The cost of direct materials is computed by deducting the raw materials inventory
at the end of the period from the total raw materials available for use. In turn, the
raw materials available for use are computed by getting the sum of raw materials
inventory at the beginning of the period and purchases during the period. The
formula for determining the cost of raw materials used is as follows:
As some of the goods manufactured may have been added to inventory, the cost
of goods sold may be computed by deducting the finished goods inventory (end)
from the total amount of goods available for sale. The cost of goods
manufactured and the finished goods inventory (beginning) comprises the total
amount of goods available for sale. Thus, the following formula is used in
determining the cost of goods manufactured and sold:

Exhibit 2 A SAMPLE INCOME STATEMENT

The cost of goods manufactured is computed by deducting the work-in-process, VIRGILIO ILAGAN COMPANY
end of the period, from the cost of goods processed. In turn, the cost of goods INCOME STATEMENT
processed is the sum of the cost of raw materials used, the direct labor, 12 Months to December 31, 2006
overhead, and if applicable, the work-in-process at the beginning of the period.
When the cost of goods manufactured is determined, the formula will appear as Sales P 150,817,000
Less: Royalties 8, 853,000
follows:
Net P 141,964,000

Cost of Goods Sold:

Beginning Inventory 17,161,000
Purchases 79,600,000
Freight 1,179,000
Labor 12,970,000
Indirect Manufacturing Expenses 4,847,000
P 115,757,000
Less: Ending inventory 53,400,000
P 62, 357,000
Gross Profit P 79,607,000 Net Profit or Net Loss. Net profit or net income refers to the difference between
revenues less period expenses and product costs. When expenses and costs are
Operating, Expenses: greater than the revenues, the result is a net loss.
Salaries-administrative P27,090,000
Salaries-secretarial 5,625,000 THE BUDGET
General Office 2,120,000
Concerning the finance function of the manager, one of the useful tools he could
Travel and Entertainment 7,650,000
Auto Expenses 4,374,000 use is the budget.
Depreciation and Amortization 1,016,000 The budget is defined as an estimate of income and expenditures for a
Legal and Accounting 4,366,000 future period. The budget is contrasted with the income statement, which is a
Payroll Taxes 4,753,000 summary of the performance of the firm for past period, and with the balance
Business Taxes 1,749,000 sheet which presents the financial condition of the firm at a given date, past or
Telephone 1,749,000 present. The budget completes the financial picture by referring to the future.
Insurance 1,515,000
Management Fee 9,895,000 Budgets are essential elements in the planning and control of the
Research and Development 2,996,000 financial affairs of the business. Large corporations place so much emphasis in the
Miscellaneous 4,990,000 annual budget which is normally broken down into monthly and Weekly periods,
Contributions 2,508,000 and which may take several month to prepare.
Advertising 509,000
In preparing the budget, an estimate of sales and income for the period is
Literature 808,000
made, followed by estimates of expenditures in purchasing, administration,
Interest 2,447,000
production, distribution, and research. Detailed budgets of cash flow and capital
Bad debts 2,580,000
expenditures are also included.
Commission -
P 88,740,000 The Sales Budget
Net Loss -P 9,133,000 The sales budget is the starting point of company budgets. It shows an estimate
of sales in units and dollars or pesos for each major subdivision of sales.
2. Operating Expenses. These represent marketing, general, and
administrative expenses. Examples are advertising, salaries, and wages. The Materials and Purchases Budget
3. Other Expenses. These include interest expense and sales discounts. This portion of the company budget refers to the estimate of the materials
required by the firm, specified in quantities, costs, timing of purchase, the
Other Income. This item refers to non-operating income such as interest
required delivery dates, and other requirements.
income and purchase discounts.
The Production Budget
The production budget is an estimate of the quantity of products that should be
produced in accordance with the sale budget. It also shows the monthly
breakdown of quantities to be produced for each product depending upon the
firm's seasonal sales index. The total units to be produced could be derived using
the following equation:
SIGNIFICANCE OF FINANCIAL STATEMENTS AND BUDGETS
There are five distinct groups interested in knowing the financial standing of the
firm. These are: (1) the owners, (2) the management, (3) the creditors, (4) the
government, and (5) prospective investors. In some cases, customers and
employees require financial data about the firm. Financial statements and
budgets provide most of the information required by interested parties.
The owners are primarily concerned with receiving information on the anticipated
financial benefits that will be generated by the firm. They also need to know
whether it is wise or not to continue their relationship with the firm as owners.
These information requirements are provided by the financial statements.
The management is concerned with effective planning and control of the
activities of the firm. As various financial information is provided by the financial
statements and budgets, they are particularly useful to management.
The creditors will be interested to know if the firm is credit worthy. The use of the
firm's financial statements will help them find out the answer.
Financial statements are required by the government for tax and regulatory
purposes. Examples of the areas of concern are income tax assessment and the
regulation of the issuance of securities like stocks and bonds.
Financial statements are also especially important to prospective investors. They
are mainly interested in the protection of their investments and the earnings they
require over a period of years. The balance sheet and the income statement will
be very useful in this regard.
Budgets are especially important to management because they are able to do the
following:
1. anticipate asset needs;
2. plan for necessary financing; and
3. establish standards by which to test current operating performance.
Customers who would want to establish long-term relationship with the firm
would be particularly interested to know how stable the firm is. Financial
statements could provide them with initial information.
Employees who would want to consider long-term employment with the firm
would also want to know the long-term prospects of the firm. Financial
statements would be useful regard.
THE ANNUAL REPORT
The report sent out each year by the company to its stockholders or members is
called the annual report. It normally contains the following:
1. the balance sheet;
2. the profit and loss statement;
3. the auditor’s report; and
4. the chairman’s report.
In case the firm is part of a group, the report must also contain a consolidated KEY TERMS AND CONCEPTS
balance sheet and a consolidated profit and loss statement.
finance maximizing net present worth
SUMMARY
public finance optimum position along a risk-return frontier
An understanding of the basic concepts related to a certain topic will facilitate
actual learning of the more advanced concepts. The study of business finance is private finance balance sheet
no exception. personal finance assets
Finance refers to the study of the acquisition and investment of cash for the finance of non-profit organization liabilities
purpose of enhancing value and wealth. It may be categorized as either public
finance or private finance business finance net worth finance

Private finance may be subdivided into: (1) personal finance; (2) the finance of small business income statement
non-profit organizations; and (3) business finance.
corporation finance revenues
Business finance refers to the provision of money for commercial use, as well as
multinational business finance expenses
the effective use of funds. It covers three sub-topics: (1) small business finance;
(2) corporation finance; and (3) multinational business finance. maximizing profit budget
The various goals of business finance are: (1) maximizing profits; (2) maximizing
profitability; (3) maximizing profit subject to cash constraint; (4) maximizing net
present worth; and (5) seeking an optimum position along a risk-return frontier.

The balance sheet and the profit and loss statement are two documents that are
important from the viewpoint of business finance.

In the performance of the finance function of the manager, the budget, which is
an estimate of income and expenditures for a future period, is a useful tool.

Financial statements and budgets of the firm are the concern of the owners, the
management, the creditors, the government, and prospective investors.

The annual report is sent out each year by the company to its stockholders or
members.
Capital budgeting
Management is originally hired to take control of the funds of the owners of the
business. In most cases, it involves the maximization of the earning power of
these funds. The planning, and control of capital expenditures is, therefore, a
basic executive function. As such, the budgeting of funds for capital expenditures
is a very important activity of management.
In this chapter, capital budgeting as an important segment of business finance is
presented. Among those included are the relevant concepts pertaining to
investment, valuation, risk, and uncertainty
BASIC TERMS IN CAPITAL BUDGETING
For a better understanding of capital budgeting concepts, the following
terms are defined and explained: capital expenditures, capital budgeting,
valuation, and investments.
Capital Expenditures
The term capital expenditure refers to substantial outlay of funds the
purpose of which is to lower costs and increase net income for several years in
the future. It includes expenditures that tie up capital inflexibility for long periods.
It covers not only outlays for fixed assets but also expenditures for major research
on new products and methods and for advertising that has cumulative effects.
Classes of Capital Expenditures. Capital expenditures may be classified into the
following:
1. replacement investments — this refers to investments on replacement of
worn-out or obsolete facilities;
2. expansion investments — this type of expenditure will provide additional
facilities to increase the production and /or distribution capabilities of the
firm
3. Product-line or new market investments – this refers to expenditures on
new products or new markets, and on improvement of old products with
the combined features of replacement and expansion investments.
4. Investments in safety and/or environmental projects - these are
expenditures necessary to comply with government orders, labor
agreements, or insurance policy terms. These are sometimes called
mandatory investments or non-revenue producing projects.
5. Strategic investments - these are investments designed to accomplish the
overall objectives of the firm.
6. Other investments — this catch-all term includes office buildings, parking
lots, executive aircraft.
Capital Budgeting
The planning and control of capital expenditures is referred to as capital
budgeting. This activity is essential because it provides a systematic evaluation of
the firm's alternatives. It helps management in choosing an alternative that will
provide the best yield for the company.
Valuation
Management is, at times, confronted with the problem of evaluating a proposal.
When the proposal's real worth to the firm is determined, the process is called
valuation.
Investment
An investment is made when a firm spends some of its funds for the
establishment of a project. By doing so, the opportunity to use the same funds in
other possible projects is lost.
Investments take two forms: (1) initial; and (2) later. Initial investment refers to
the amount that has been devoted to a project until it generates cash inflows
from operations. Expenditures made after the first cash inflow is called later
investments.
OBJECTIVES OF CAPITAL BUDGETING
The objectives of capital budgeting are the following:
1. establishing priorities;
2. cash planning;
3. construction planning;
4. eliminating duplication; and
5. revising plans.
Establishing Priorities
The resources of the firm is said to be limited. The total numbers of opportunities
available for investment cannot all be accommodated by the firm. Capital
budgeting will help to solve this difficulty. This is possible because investment
priorities are established in capital budgeting.
Cash Planning
The objective of the cash planning activities of the firm is to ensure the availability
of funds that will be sufficient to meet the cash requirements, including those
concerning the acquisition of capital assets. A periodic cash expenditures
estimate included in the capital budget helps to attain such objective.
Construction Planning
The objective of construction planning is to minimize the period expended for the
construction or acquisition of a capital asset. The construction plan, a
requirement for capital budgeting, will be presented before the capital budget is
prepared. This requirements ensures the preparation of such plans.
Eliminating Duplication
A centralized capital budgeting activity will help identify effort undertaken at
various levels in a decentralized organization. The duplication of efforts, as a
result, will be minimized if not total eliminated.
Revising Plans
Changes in the environmental factors may require appropriate revisions in the
authorization of investment projects which includes expected profitability,
construction cost, and the timing of start-up where coordination with related
activities is essential. Such requirements will be made obviously by a good capital
budgeting system. A timely response to such problems, then becomes a
possibility.
THE CAPITAL BUDGETING SYSTEM
The capital budgeting system in composed of the following:
1. preparation and submission of budget requests;
2. approval of budget;
3. request for appropriation;
4. submission of progress reports; and
5. post approval reviews.
Budget Requests
Budget requests are those made to include in the corporate budget capital
projects which are felt to be desirable by those in the lower organizational levels.
The budget request contains the following:
 1. project title; Request for Appropriation

2. cost, including estimates on: After the approval of the budget, the next step undertakes getting an
appropriations request approved. The officers and managers of a corporation are
a. fixed capital usually given the authority to approve appropriations requests up to certain
b. working capital established limits.

c. non-operating outlays The appropriations request usually contains the following:

d. others, including opportunity cost; 1. the request and authority section — this serves to identify the originator
and the project;
3. priority rating of the project;
2. the narrative section - this details the requesting entity justification for
4. profitability of the project; undertaking the proposal. This section normally includes the following:

5. timing or the ability to adhere to a construction schedule; a. proposal;

6. financing method; b. objectives;

7. project classification; and c. conceptual framework;

8. Project narrative. d. alternatives; and

Approval of the Budget e. sensitivity and risk.

The approval of the budget is a process which requires the following steps:
1. budget requests are forwarded to top management;
2. top management decides which projects to recommend to the board of
directors;
3. supporting documentation section — this contains cost estimates and the
results of market studies and financial analysis.
Submission of Progress Reports
Progress reports are submitted at regular intervals for the following purposes:

3. top management sends recommendations to the board of directors; 1. to review the accuracy of the expenditures forecasts;

4. the board of directors approves or disapprove the recommendations; and 2. to provide updated expenditures forecasts; and

5. top management informs projects sponsors of the act taken on their 3. to verify the assumptions and economics underlying the acceptance of
projects. individual projects.
Post Approval Reviews
Post approval reviews are required to satisfy the following objectives:
1. to provide management with a standard method of evaluating the
abilities and judgment of project sponsors;
Since the primary objective of the firm is to make profits, every business activity
should be directed towards achieving this end. Capital investments are not
exempted from this requirement. It is, therefore, a requirement that investment
proposals should be analyzed and a determination of their economic value to the
firm should be made.

2. to identify errors or patterns of error in judgment which can be avoided in There are three basic methods of evaluating proposals. These are composed of
future similar situations; and the following: (l) the payback method; (2) the average rate of return methods;
and (3) the discounted cash flow methods. These methods will be discussed in
3. to help ensure that the quality and accuracy of information attains the succeeding pages using data indicated Exhibit 3.
highest feasible standards.
Exhibit 3
EVALUATION OF PROPOSED CAPITAL EXPENDITURES
A SAMPLE INVESTMENT PROPOSAL FOR THE PURCHASE OF A MACHINE
Proposed capital expenditures should be scrutinized since they involve large
outlays of funds. A number of primary factors should be considered by Acquisition Cost P 10,000,000
management. These are the following: Economic life 10 years
1. Urgency. Decisions should be made as quickly as possible for Salvage Value P 100,000
requirements that are urgent.
Earnings and Costs per year
2. Repairs. Management should consider the availability of spare parts and
maintenance experts. When these are critical and they are not available, Income 5,000,000
the concerned proposal should be ruled out.
Expenses - 2,000,000
3. Credit. This factor should be considered in the sense that some credit
terms may be highly favorable to the company. Net Income before tax and depreciation 3,000,000

Less: Depreciation (Straight line) 1,000,000

4. Non-Economic Factors. These refer to social considerations, and other
non-economic persuasions and preferences. Net Income before Tax - 2,000,000
5. Investment Worth. This refers to the economic evaluation of a certain Less: Income Tax 620,000
proposal.
Average Net Annual Earnings 1,380,000
6. Risk Involved. This refers to the uncertainty of an expected return.

METHODS OF ECONOMIC EVALUATION

Cash Inflows Per Year = Net Earnings + Depreciation = P2,380,000
The Payback Method
The payback method determines the number of years required to recover the
cash investment made on a project. The recovery of cash comes from the cash
inflows generated from the projects. The formula used is as follows:
Substituting data from Exhibit 3, the payback period is presented as:
The cost of the machinery is expected to be recovered in full after 4.2 years. The
payback method is simple and easy to understand. When the firm does not favor
exposure of its own investments for longer periods, the proposal is rejected. This
decision can be made quickly with the use of the payback method.
The payback method, however, has some disadvantages. These are the following:
1. it does not consider the time value of money;
2. the accept-reject criterion is stated in terms of years rather than at a
discount rate;
3. the firm's attention is focused on cash flow rather than on rate of return;
4. careful projection of the timing of the investment outlays and the year-
by-year projection of cash inflows over the entire life of the proposal are
not encouraged; and
5. the salvage value of the proposal is not considered.
The Average Rate of Return Methods
The average rate of return methods consists of the following: (1) the average
return on investment; and (2) the average return on average investment.
Average Return on Investment. This method is simple and is easy to compute. It
shows the ratio of the average cash inflow to the investment. The formula is as
follows:
Substituting data from Exhibit 3, we have
The advantage of this method is that it is very easy to compute and the available
accounting data may be readily used. It’s made disadvantage, however, is that it
does not take into account the time value of money.
Average Return on Average Investment. This method is similar to the average
return on investment method except that the effect of the depreciation charge on
the investment is taken into consideration. The formula is as follows:
 will earn more than the desired rate of return. The proposal is accepted.
Conversely, if the discounted cash outflows are larger than the discounted cash
inflows, the project will not be able to generate the desired minimum rate of
return. The proposal is, then, rejected. To illustrate, the following formula and
computation are presented as follows:
Substituting data from Exhibit 3, the computation is shown as Follows:
NPV = PVCI - PVCO

Where NPV = net present value (also the net value derived after deducting the
discounted cash outflow from the discounted cash inflow)

PVCI = discounted value of the anticipated cash inflows

Under this method, the initial investment outlay is divided by two to derive the PVCO = discounted value of the anticipated cash outflows
average balance of the investment as it is decrease periodically by the
The formula for finding the present value of an expected cash inflow is as follows:
depreciation charge. This method is also simple and easy to compute. The true
rate of return is, however, overstated. Moreover, it does not also consider the
time value of money.

Discounted Cash Flow Methods

The time value of money is recognized under the discounted cash flow methods.
Where:
There are two approaches available: (1) the net present value method; and (2)
the internal rate of return method. Under these approaches, all future values of a A = expected cash inflow
proposal are discounted and compared to the values of other proposals. The
discounting factor makes these two methods preferred by users in evaluating R = desired rate of return
capital expenditure proposals. n = number of years the cash inflow is expected
Net Present Value Method. Under this method, a desired rate of return is used If the desired rate of return in Exhibit 3 is 25%, the cash inflows for the ten-year
for discounting purposes. The term discounting is synonymous to the calculation period may be computed to determine the present value for each year. For
of the present worth of a future value as presented in Chapter 3. The present example, the present value of the cash inflow for the second year is computed as
value concept is applied to the cash flows of a proposal and are discounted at the follows:
desired rate of return for the periods involved. The sum of the present values of
the outflows (i.e., the cost of the machine in Exhibit 3) is compared with the sum
of the present values of the inflows (i.e., net income plus depreciation). If the
discounted cash inflows are larger than the discounted cash outflows, the project
 NPV = PVCI – PVCO
= P 8,508,490 – P 10,000,000
= - (P 1,491,510)

The computation shows a negative net present value indicating that the sum of
the discounted cash outflow is greater than the sum of the discounted cash
inflows. On this basis, the proposal is rejected,
Applying the present value formula, the present values of the cash flows
Internal Rate of Return Method. This method and the net present value method
indicated in Exhibit 3 will appear as follows:
use the discount rate as a factor. The difference however, is that under the
internal rate of return method, the discount rate is not given. Rather, it becomes
the object of computation. The discount rate which will yield a net present value
of zero or one approximating zero is the correct discount rate. This means that
the present value of the cash inflows is equal to the present value of the cash
outflows. The correct discount rate may be determined by trial and error.

The acceptability of the proposal will depend on the prevailing interest rates as
compared with the computed correct discount rate. If the prevailing rate is
higher, the proposal is rejected, and conversely, if it is lower, the proposal is
accepted.

In our computation of the preceding method, a negative net present value of

P1,491,510 was shown. Since the discount rate of 25% was used, an attempt to
find the correct discount rate will be made using one which is lower than 25%.
Computations using various discount rates applicable to the example shown in
the preceding method are shown below.

To find out the net present value of the proposal presented in Exhibit 3, the
formula earlier stated is applied as follows:

The net present values at different discount rates may now be computed as
follows:
a. NPV at 22% discount rate = PVCI – PVCO
= P 9,350,800 – P10,000,000
= - (P649,200)
b. NPV at 21% discount rate = PVCI – PVCO
= P9,603,520 – P10,000,000
= - (P396,480)
c. NPV at 20% discount rate = PVCI – PVCO
= P9,994,080 – P10,000,000
= - (P5,920)
The results of the computation show net present values of different discount
rates. Obviously, the discount rate which yield the net present value nearest to
zero is 20%. If the standard interest rate is below 20%, the proposal is acceptable.
RISK, UNCERTAINTY, AND SENSITIVITY
Among the primary factors considered in the evaluation of proposed capital
expenditures, the uncertainty of expected return pose a challenge to one who
manages the firm's finances. In the preceding discussion of the methods of
economic evaluation, it is assumed that the returns are certain. This is misleading
because one can never be fully certain about the results that will be obtained
from an investment.
Meaning of Risk, Uncertainty, and Sensitivity
Risk is defined in Chapter 3 as the uncertainty concerning loss. Uncertainty, as a
term is synonymous to risk, and as such, they wise to be used interchangeably in
the discussions that will follow. At this point, however, it is worth mentioning
their similarity and differences. Uncertainty and risk both refer to variations of
actual values from average or expected values. They differ, however, in the cause
of the variations. The variations referred to in risks is caused by change while the
variations referred to in uncertainty is caused by errors in estimating.
Sensitivity refers to the effect on investment of changes in some factors, which
were not previously determined with certainty.
Factors Affecting Risk
There are four primary factors involved in the evaluation of risks pertaining to
capital expenditures. These are the following: (1) possible inaccuracy of the
figures used in the evaluation; (2) type of business involved; (3) type of physical
plant and equipment involved; and (4) the length of time that must pass before
all the conditions of the evaluation become fulfilled.
Estimates could be wrong or inaccurate at times. Accuracy, however, depends on
how the figures were obtained. Estimates can be made either by scientific
methods or by plain guesswork. A certain degree of reliability can be assigned to
the former and none to the latter method.
Every type of business has its own degree of risk that is peculiar to itself. One line
may be more stable in terms of demand than the others. The demand for food,
for instance, is more stable than the demand for specialized consumer items like
hair dyes. Also, more risk is involved in the operations of a new venture than a
business with a successful record of past performance.
Physical plants and equipment are also subject to risks. Some may become
obsolete before their economic life expires. The demand for special equipment,
like that for DVD players, may diminish without warning.
Finally, estimates involving longer periods are usually more prone to inaccuracies
than those involving shorter periods. This is true because, most often, changes in
the environment happen sooner than expected.
Sensitivity Analysis
The expected returns investment may change as changes in some relevant factors
happen. Capacity utilization at various levels, for instance, may yield various rates
of return on investment. As capacity utilization depends mostly on some relevant
factors like the availability of raw materials, it is important that an analysis of the
expected returns be made on various utilization levels. This is actually finding the
sensitivity of an investment to various changes.
Sensitivity analysis is applicable to capital expenditure, involving the purchase or
construction of a plant. It is useful for management to know the expected returns
that will be generated by the various capacity utilization in the operation of the
plan. Consider the following example:
The example cited above indicates that by using the plant, full capacity, the return
will be at its highest level, which is 43 However, if because of some factors, this is
not possible, the expecte return will still be 36% at 75% capacity operation, and
25% at 50 capacity operation. If the prevailing interest rate is below 25%, tht
proposal should be accepted.
SUMMARY
Capital budgeting is an important segment of business finance. It includes
relevant aspects of investment, valuation, risk, and uncertainty.
The substantial outlay of funds for the purpose of lowering costs and increasing
net income for several years in the future is called capital expenditure.
The planning and control of capital expenditure is called capital budgeting. When
the real worth to the firm of any proposal for capital expenditure is determined,
the process is called valuation.
An investment happens when the firm spends some of its functions for the
establishment of a project.
Capital budgeting is done for the following (J) establishing priorities; (2) cash
planning; (3) construction planning; (4) eliminating duplication; and (5) revising
plans.
The capital budgeting system consists of the following steps: (1) preparation and
submission of budget requests; (2) approval of budget; (3) request for
appropriation; (4) submission of progress reports; and (5) post approval reviews.
The primary factors considered in evaluating proposed capital expenditures are:
urgency, repairs, credit, non-economic factors, investment worth, and risk
involved.

The economic evaluation of proposals consists of three basic methods: (1) the
payback method; (2) the average rate of return method; and (3) the discounted
cash flow methods.

KEY TERMS AND CONCEPTS

investment Payback method

capital expenditure average rate of return method

replacement investments discounted cash flow method

expansion investment average return on investment

new market investments average return on average investment

investment in safety projects net present value

cash planning internal rate of return

construction planning risk

budget request uncertainty

budget approval sensitivity

progress report