Chapter 2 – Capital Budgeting

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This chapter discusses techniques used to evaluate the potential financial costs and benefits of proposed capital projects.
Choosing the assets in which an organization will invest is one of the most important business decisions for managers.

Capital budgeting involves the evaluation and ranking of alternative future long-range projects to allocate limited resources
effectively and efficiently.

a. Managers and accountants apply various criteria to evaluate the feasibility of alternative projects.

b. Although financial criteria are used to assess virtually all projects, firms now also use nonfinancial criteria to
critically assess activities that have benefits that are difficult to quantify monetarily.

While accrual accounting has advantages over cash accounting in many contexts, for purposes of capital budgeting, estimated
cash inflows and outflows are preferred for inputs into the capital budgeting decision tools.
Sometimes cash flow information is not available, in which case adjustments can be made to accrual accounting numbers to
estimate cash flows.
The capital budgeting decision, under any technique, depends in part on a variety of considerations:
a. The availability of funds;
b. Relationships among proposed projects;
c. The company’s basic decision-making approach; and
d. The risk associated with a particular project.

Capital Budgeting Techniques

1. Cash Payback
The cash payback technique identifies the time period required to recover the cost of the capital investment from the net
annual cash inflow produced by the investment.

The formula for computing the cash payback period is:

Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period
Net annual cash flow can be approximated by adding depreciation expense to net income.

The evaluation of the payback period is often related to the expected useful life of the asset.
a. With this technique, the shorter the payback period, the more attractive the investment.
b. This technique is useful as an initial screening tool.
c. This technique ignores both the expected profitability of the investment and the time value of money.

2. Net Present Value Method

Under the net present value (NPV) method, cash flows are discounted to their present value and then compared with the
capital outlay required by the investment. The difference between these two amounts is the net present value (NPV).
a. The interest rate used in discounting the future net cash flows is the required minimum rate of return.
b. A proposal is acceptable when NPV is zero or positive.
c. The higher the positive NPV, the more attractive the investment.

When there are equal annual cash inflows, the table showing the present value of an annuity of 1 can be used in determining
present value. When there are unequal annual cash inflows, the table showing the present value of a single future amount
must be used in determining present value.

The discount rate used by most companies is its cost of capital—that is, the rate that the company must pay to obtain funds
from creditors and stockholders.

The net present value method demonstrated in the text requires the following assumptions:
a. All cash flows come at the end of each year;
b. All cash flows are immediately reinvested in another project that has a similar return; and
c. All cash flows can be predicted with certainty.
 Intangible Benefits
By ignoring intangible benefits, such as increased quality or improved safety, capital budgeting techniques might incorrectly
eliminate projects that could be financially beneficial to the company. To avoid rejecting projects that actually should be
accepted, two possible approaches are suggested; a. Calculate net present value ignoring intangible benefits, and then, if the
NPV is negative, ask whether the intangible benefits are worth at least the amount of the negative NPV. b. Project rough,
conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation.

Mutually Exclusive Projects

In theory, all projects with positive NPVs should be accepted. However, companies rarely are able to adopt all positive-NPV
proposals because (1) the proposals are mutually exclusive (if the company adopts one proposal, it would be impossible to
also adopt the other proposal), and (2) companies have limited resources.

In choosing between two projects, one method that takes into account both the size of the original investment and the
discounted cash flows is the profitability index. The profitability index formula is as follows:

Present Value of Future Cash Flows ÷ Initial Investment = Profitability Index

The project with the greater profitability index should be the one chosen.

Another consideration made by financial analysts is uncertainty or risk. One approach for dealing with uncertainty is
sensitivity analysis. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential
returns. In general, a higher risk project should be evaluated using a higher discount rate.

Post-Audit of Investment Projects

A post-audit is a thorough evaluation of how well a project’s actual performance matches the projections made when the
project was proposed.

Performing a post-audit is beneficial for the following reasons:

a. Management will be encouraged to submit reasonable and accurate data when they make investment proposals;
b. A formal mechanism is used for determining whether existing projects should be supported or terminated;
c. Management improves their estimation techniques by evaluating their past successes and failures.

A post-audit involves the same evaluation techniques that were used in making the original capital budgeting decision—for
example, use of the net present value method. The difference is that, in the post-audit, actual figures are inserted where
known, and estimation of future amounts is revised based on new information.

3. Internal Rate of Return Method

The internal rate of return method differs from the net present value method in that it finds the interest yield of the potential
investment. The internal rate of return is the interest rate that will cause the present value of the proposed capital expenditure
to equal the present value of the expected net annual cash flows.

The determination of the internal rate of return involves the use of a financial calculator or computerized spreadsheet to solve
for the rate (if the cash flows are uneven).

If the net annual cash flows are equal, an easier approach to solving for the internal rate of return can be used. This approach
involves two steps:
(1) Compute the internal rate of return factor.
(2) Use the factor and the present value of an annuity of 1 table to find the internal rate of return.

The formula for determining the internal rate of return factor is:
Capital Investment ÷ Net Annual Cash Flows = Internal Rate of Return Factor.

Once managers know the internal rate of return, they compare it to the company’s required rate of return (the discount rate).

The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return,
and reject the project when the internal rate of return is less than the required rate.
4. Annual Rate of Return Method
The annual rate of return method is based directly on accounting data rather than on cash flows.

The annual rate of return method indicates the profitability of a capital expenditure and its formula is:
Expected Annual Net Income ÷ Average Investment = Annual Rate of Return

Average investment is based on the following:

Original investment + Value at end of useful life 2 = Average Investment

The annual rate of return is compared with management’s required minimum rate of return for investments of similar risk.
The minimum rate of return (the hurdle rate or cutoff rate) is generally based on the company’s cost of capital.

The decision rule is: A project is acceptable if its rate of return is greater than management’s minimum rate of return; it is
unacceptable when the reverse is true.

The higher the rate of return for a given risk, the more attractive the investment.

The principal advantages of this method are the simplicity of its calculation and management’s familiarity with the
accounting terms used in the computation.

A major limitation of this method is that it does not consider the time value of money.

REVIEW PROBLEMS:

A. A Company is considering a project that would have an eight-year life and require a P2,400,000 investment in equipment. At
the end of eight years, the project would terminate and the equipment would have no salvage value. The project would
provide net operating income each year as follows:

Sales P 3,000,000
Variable Expense 1,800,000
Contribution Margin P 1,200,000
Fixed Expenses:
Advertising, salaries, and other P 700,000
fixed out-of-pocket costs
Depreciation 300,000
Total Fixed Expenses 1,000,000
Net Operating Income P 200,000

The company’s discount rate of is 12%.

Required:
1. Compute the annual net cash inflow from the project.
2. Compute the project’s net present value. Is the project acceptable?
3. Find the project’s internal rate of return the nearest whole percent.
4. Compute the project’s payback period.
5. Compute the project’s simple rate of return.

Solution:
1. The annual net cash inflow can be computed by deducting the cash expenses from sales:

Sales P 3,000,000
Variable Expense 1,800,000
Contribution Margin P 1,200,000
Fixed Expenses:
Advertising, salaries, and other 700,000
fixed out-of-pocket costs
Net Operating Income P 500,000

Or the annual net cash flow can be computed by adding depreciation back to net operating income:
Net Operating Income P 200,000
Add: Noncash deduction for depreciation 300,000
 P500,000
2. The net present value is computed as follows:
Item Year(s) Amount of 12% Factor Present Value
Cash Flows of Cash Flows
Cost of new equipment …………….. Now P (2,400,000) 1.000 P (2,400,000)
Annual net cash inflow 1-8 P500,000 4.968 2,484,000
……………..
Net Present Value P 84,000
…………………...
Yes, the project is acceptable because it has a positive net present value.

3. The formula for computing the factor of the internal rate of return is:
Factor of the internal rate of return = Investment required
Annual net cash flow
= P2,400,000
P 500,000
= 4.800
Scanning along the present value table, we will find the factor of 4.800 represents a rate of return of about 13%.
4. The formula for the payback period is:
Payback Period = Investment required
Annual net cash flow
= P2,400,000
P 500,000
= 4.8 years
5. The formula for the simple rate of return is:
Simple rate of return = Annual incremental net operating income
Initial Investment
= P 200,000
P2,400,000
= 8.3%

B. The management of A Company is considering the purchase of a P40,000 machine that would reduce operating costs by
P7,000 per year. At the end of the machine’s eight-year useful life, it will have zero scrap value. The company’s required
rate of return is 12%.

Required:
1. Determine the net present value of the investment in the machine.
2. What is the difference between the total, undiscounted cash inflows and cash outflows over the entire life of the
machine.

Solution:
1. 12% Present Value
Item Year(s) Cash Flow Factor of Cash Flows
Annual cost savings..................... 1-8 P7,000 4.968 P 34,776
Initial investment......................... Now P(40,000) 1.000  (40,000)
Net present value......................... P (5,224)

2. Item Cash Flow Years Total Cash Flows

Annual cost savings..................... P7,000 8 P  56,000
Initial investment......................... P(40,000) 1  (40,000)
Net cash flow............................... P 16,000

C. Donut’s Shoppe is investigating the purchase of a new P18,600 donut-making machine. The new machine would permit
the company to reduce the amount of part-time help needed, at a cost savings of P3,800 per year. In addition, the new
machine would allow the company to produce one new style of donut, resulting in the sale of 1,000 dozen more donuts
each year. The company realizes a contribution margin of P1.20 per dozen donuts sold. The new machine would have a
six year useful life.

Required:
1. What would be the total cash inflows associated with the new machine for capital budgeting purposes?
2. Find the internal rate of return promised by the new machine to the nearest whole percent.
 3. In addition to the data given previously, assume that the machine will have P9,125 salvage value at the end of six
years. Under these conditions, compute the internal rate of return to the nearest whole percent. (Hint: You may find
it helpful to use the net present value approach; find the discount rate that will cause the net present value to be
closest to zero)
Solution:
1. Annual savings in part-time help............................................................................ P3,800
Added contribution margin from expanded sales (1,000 dozen × $1.20 per
dozen).................................................................................................................  1,200
Annual cash inflows................................................................................................ P5,000

2. Factor of the internal rate of return = Investment required

Annual cash inflow

= P 18, 600

P5,000

= 3.720

Looking at the present value table, and scanning along the six-period line, we can see that a factor of 3.720 falls closest to the
16% rate of return.
3. The cash flows will not be even over the six-year life of the machine because of the extra $9,125 inflow in the sixth year.
Therefore, the above approach cannot be used to compute the internal rate of return in this situation. Using trial-and-error or
some other method, the internal rate of is 22%:

Amount of Cash 22% Present Value of

Item Year(s) Flows Factor Cash Flows
Initial investment......................... Now P(18,600) 1.000 P(18,600)
Annual cash inflows.................... 1-6 P5,000 3.167 15,835
Salvage value.............................. 6 P9,125 0.303     2,765
Net present value......................... P       0

D. Information on four investment proposals is given below:

Investment Proposal
A B C D
Investment required P (90,000) P (100,000) P (70,000) P (120,000)
Present value of cash inflows 126,000 138,000 105,000 160,000
Net Present value P36,000 P 38,000 P 35,000 P40,000
Life of the project 5 years 7 years 6 years 6 years

Required:

1. Compute the project profitability index for each investment proposal.

2. Rank the proposals in terms of preference.

Solution:

1. The project profitability index for each proposal is:

Project Profitability
Net Present Value Investment Index
Proposal Number (a) Required (b) (a)  (b)
A P36,000 P90,000 0.40
B P38,000 P100,000 0.38
C P35,000 P70,000 0.50
D P40,000 P120,000 0.33

2. The ranking is:

Proposal Number Project Profitability Index

C 0.50
A 0.40
B 0.38
 D 0.33

Note that proposal D has the highest net present value, but it ranks lowest in terms of the project profitability index.

Chapter Exercises
1. A company has limited funds available for investment and must ration the funds among four competing projects. Selected
information on the four projects follows:
Investment Net Present Life of the project Internal Rate of
Project Required value (years) Return (Percent)
A P160,000 P44,323 7 18%
B P135,000 P42,000 12 16%
C P100,000 P35,035 7 20%
D P175,000 P38,136 3 22%
The net present values above have been computed using a 10% discount rate. The company wants your assistance in
determining which project to accept first, second, and so forth.
Required:

1. Compute the project profitability index for each project.

2. In order of preference, rank the four projects in terms of:
a. Net present value
b. Project profitability index
c. Internal rate of return.
3. Which ranking do you prefer? Why?
2. In eight years, Tewin Min will retire. He is exploring of opening a self-service car wash. The car wash could be managed
in the free time he has available from his regular occupation, and it could be closed easily when he retires. After careful
study, Mr. Min has determined the following:
a. A building in which a car wash could be installed is available under an eight-year lease at a cost of P1,700 per
month.
b. Purchase and installation costs of equipment would total P200,000. In eight years the equipment could be sold for
about 10% of its original cost.
c. An investment of an additional P2,000 would be required to cover working capital needs for cleaning supplies,
change funds, and so forth. After eight years, this working capital would be released for investment elsewhere.
d. Both a wash and a vacuum service would be offered with a wash costing P2.00 and the vacuum costing P1.00 per
use.
e. The only variable costs associated with the operation would be 20 cents per wash for water and 10 cents per use of
the vacuum electricity.
f. In addition to rent, monthly costs of operation would be: cleaning, P450; insurance, P75; and maintenance, P500.
g. Gross receipts from the wash would be about P1,350 per week. According to the experience of other car washes,
60% of the customers using the wash would also use the vacuum.
Mr. Min will not open the car wash unless it provides at least a 10% return.

Required: (Ignore Income taxes)

1. Assumsing that the car was will open 52 weeks a year, compute the expected annual net cash receipts (gross cash
receipts less cash disbursements) from its operation. (Do not include the cost of equipment, the working capital or
the salvage value in these computations.)
2. Would you advise Mr. Min to open the carwash? Show computations using the net present value method of
investment analysis. Round all figures to the nearest whole number.

3. Madisson Electronics has just developed a new device which, when mounted on an automobile, will tell the driver how
many miles the automobile is travelling per gallon of gasoline.
The company is anxious to begin production of the new device. To this end, marketing and cost studies have been made
to determine probable costs and market potential. These studies have provided the following information:
a. New equipment would have to be acquired to produce the device. The equipment would cost P315,000 and have a
12-year useful life. After 12 years, it would have a salvage value of about P15,000.
b. Sales in units over the next 12 years are projected to be as follows:
Year Sales in Units
1 6,000
2 12,000
3 15,000
4-12 18,000

c. Production and sales of the device would require working capital of P60,000 to finance accounts receivable,
inventories, and day-to-day cash needs. This working capital would be released at the end of the project’s life.
d. The devices would sell for P35 each; variable costs for production, administration, and sales would be P15 per unit.
e. Fixed costs for salaries. Maintenance, property taxes, insurance, and straight-line depreciation on the equipment
would total P135,000 per year. (Depreciation is based on cost less salvage value.)
f. To gain rapid entry into the market, the company would have to advertise heavily. The advertising program would
be:
Year Amount of Yearly
Advertising
1-2 P180,000
3 P150,000
4-12 P120,000
g. The company’s required rate of return is 14%.

Required: (Ignore Income taxes)

1. Compute the net cash inflow (cash receipts less yearly cash operating expenses) anticipated from sale of the device
for each of the next 12 years.
2. Using the data computed in (1) above and other data provided in the problem, determine the net present value of the
proposed investment. Would you recommend the Madisson would accept the device as a new product?