STRATEGIC COST MANAGEMENT: MODULE 6

CAPITAL BUDGETING

Capital Budgeting

● The process, by which management plan, evaluates and control its capital investments

● Expressing in financial terms a particular financial (in terms of capital expenditures) plan of an entity

● Also called Capital Investment Analysis

Capital Investment

● Any undertaking that requires a large amount of resources (usually cash), long term commitment of funds, and expected to provide
future benefits (inflow of cash and/or cost savings). However, it requires a long period of realization of such benefit which affects the
operation of the entity for number of years. Also include properties, human resources programs, etc.

Reasons for having Capital Investments

● Made to further strategic goals (Global distributions, increasing quality, etc)

● Increase capacity or reduce costs thus increasing profitability

● Mandated by law or policy (environmental, safety, and other laws)

● Non-financial reasons (Corporate social responsibility, human resource benefits, etc)

The Capital Budgeting Process

1. Identification Stage- this stage indicates which types of capital expenditure projects are necessary for the entity to accomplish its
organizational objectives

2. Search Stage- during this stage, the entity explores alternative capital investments that will achieve the organizational objectives.
Various technologies and other alternatives are researchable

3. Information-Acquisition Stage- the entity then must consider the expected costs and benefits (quantitative and qualitative) of
alternative capital investments

a. Determine the net investment and initial cost cash outflow

b. Determine additional net working capital requirements, which is the increase in net current assets that will result from the
investment decision

c. Determine the estimated subsequent net operating cash flows for each future period that will result using the assets that
are acquired

d. Determine the net cash flows at the end of the project relating to disposal of the long-term assets and release of working
capital

4. Selection Stage- at this stage the entity chooses projects for implementation on the basis of financial analysis and non-financial
considerations

5. Financing Stage- the entity obtains the necessary project funding

6. Implementation and Control Stage- this is final stage in which the project is implemented and monitored over time

Type of Cash flows

 Investment Period Operating Period Disposal Period

1. Purchase Price 5. Benefits (cash inflow or cost 1. Also referred to as Terminal

savings) Value
2. Other Directly attributable costs
6. Costs: 2. Proceeds (salvage value VS
3. Working Capital needed Book value = after tax Gain or
a. As to incurrence- Regular versus Loss)
4. Less: Proceeds (net of tax) of old once
properties being disposed for this 3. Recovery of working capital
investment b. As to cash flow- cash item versus
non cash item 4. Disposal Costs

Types of Evaluation Method

● Discounted Techniques - All cash flows over the life of an investment are discounted to their present value

● Non-discounted Techniques - Methods that do not consider the time value of money

Discounted Techniques

1. Net Present Value

● To determine whether the benefits to be received tomorrow is greater than the outlay required today

● If NPV ≥ 0 - the project should be accepted

● If NPV < 0 - the project should be rejected

● Choosing the hurdle (discount) rate usually the WACC

● Formula: PV of inflows - PV of outflows

1. Internal Rate of Return

● It is the discount rate for which the net present value is zero

● If IRR > DR = Project is accepted

● If IRR < DR = Project is rejected

● Formula for the Present Value factor : Net Investment Costs/ Annual Cash Inflows

1. Profitability Index

● Also known as the desirability index

● Provide a common basis of ranking alternatives for different investments requiring varying amount in initial cash outlay

● Formula: PV of all cash inflows/ Investment costs

Non-discounted Techniques

1. Payback Period

● How long before the firm can recover the investment? (expressed in years)
 ● Not a measure of profitability

● Return of capital rather than return on capital

● Advantage: Serves a rough screening device (longer= greater risk, shorter = lesser risk)

● Disadvantage: Does not tell anything about profitability and ignores the timing of expected future cash flows

● Methods:

○ Even Cash flows: Net Investment Costs / Annual After Tax cash flows

○ Uneven Cash flow: Investment - Annual After Cash flow

○ Bail out Method (it considers the salvage value, as if, the investment will be disposed by the time the investment is already
recovered)

1. Simple Rate of Return

● How fast is the firm recovering the investment

● General Formula= Accounting Net Income/Investment

● Initial Investment

● Average Investment= Initial Investment + Salvage Value/ 2

Assumptions in using Discounted Cash Flow Analysis

● All cash flows are treated as though they occur at year end

● Cash flows associated with an investment project as though they were known with certainty

● Both the NPV and IRR methods assume that each cash inflow is immediately reinvested in another project that earns a return for the
organization

○ In the NPV method, each cash inflow is assumed to be reinvested at the same rate used to compute the project’s NPV

○ In the IRR method, each cash inflow is assumed to be reinvested at the same rate as the project’s internal rate of return

● A discounted cash flow analysis assumes a perfect capital market (borrow in definite interest rate)

Different Types of cost used in Capital Budgeting Decisions

● Incremental Costs- the difference in cost resulting from selecting one option instead of another

● Sunk Cost- a cost that cannot be avoided because an expenditure has been made or an irrevocable decision to incur the cost has
been taken

● Opportunity Costs- the profit forgone by selecting one option instead of another

● Avoidable Cost- a cost that may be saved by not adopting an option

● Imputed costs- a cost that may not entail a specified peso outlay formally recognized by the accounting system but that is relevant to
establishing the economic reality analyzed in the decision making process

● Fixed Costs- a cost that does not vary with the level of activity within the relevant range

● Cost of Capital- the interest cost of debt proceeds (net of tax) or the cost of obtaining equity capital to be invested in long-term plant
and equipment
 ● Common Cost- a cost common to all possibilities in question and not clearly allocable to any of them

● Deferrable Cost- a cost that may be shifted to the future with little or no effect on current operations

Summary

Non-discounted Techniques

Uniform Cash flows Non-uniform Cash flows

Payback period Net Investment_

Annual Cash flow

Bailout Period Same with payback period except bailout Same with payback period except bailout
period considers salvage value. Salvage period considers salvage value. Salvage
value is added to annual cash return value is added to annual cash return

Payback Reciprocal 1/ PBP 1/ PBP

Summary

Non-discounted Techniques

Uniform Cash flows Non-uniform Cash flows

ARROC ANIAT/OC ANIAT/OC

ARRAC ANIAT/AC ANIAT/AC

Summary

Discounted Techniques

Uniform Cash flows Non-uniform Cash flows

NPV (PV of cash inflows (PV of cash inflows

- PV of Investment ) - PV of Investment )

PV of cash flows XX
 PV of salvage value XX

PV of cash inflows XX

Profitability Index PV of cash inflows PV of cash inflows

PV of outflow PV of outflow

Discounted Payback Period Net investment Net investment

PV of cash inflows PV of cash inflows