Module 6 – CAPITAL BUDGETING

INTRODUCTION

Managers often consider decisions that involve an investment today in the hope of realizing future
profits.  Investments require committing funds today with the expectation of earning a return on those funds in
the future in the form of additional cash flows.  

In the last module we discussed the cost of capital. Now we turn to investment decisions involving fixed assets
or capital budgeting. Here capital refers to long term assets used in production, while budget is a plan that
outlines projected expenditures during some future period. Thus, capital budget is the summary of planned
investments in long-term assets. Capital budgeting is the whole process of analyzing projects and deciding
which one to include in the capital budget. Capital budgeting is used to describe how managers' plan significant
investments in projects that have long term implications, in terms of cash flows,  profitability, viability and
feasibility of these projects or investments.

The first part of the module focus in the basics of capital budgeting. Determining the cash flows:  the cash outlay,
that represent the cost of investment that will be spent today and the cash inflows that represent the future
returns.  And applying the different capital budgeting techniques.  The second part focus on the refinement of
capital budgeting:  cash flow estimation and risk analysis

Learning Objectives

At the end of this module, you would be able to:

1. Have a good understanding of capital budgeting and the factors to consider in capital budgeting.

2. Knowledge of different budgeting techniques  and criteria to evaluate the acceptability of the investment
projects.

3.To identify relevant cash flows that should be included in the capital budgeting analysis. - Replacement
analysis

4. Estimate the project relevant cash flows that can be used to calculate and evaluate acceptability of the
investments projects using different criteria in capital budgeting.

Explain - The Basics of Capital Budgeting

What is Capital budgeting?

* Analysis of potential acquisition or addition to fixed assets

*  Long term decision involving large expenditures

*  Very important to firm's future

What are the different categories of investment projects?

*  Replacement:

    -  assets needed to continue operations

    -  assets needed for cost reduction/savings

*  Expansion:

   -  existing products or market

   -  new products or market

*  Safety and/or Environmental projects

*  Lease or Buy (merger)

*  Other investment projects

What are the difference between independent and mutually exclusive projects?

* Independent projects - if the cash flows of one project are unaffected by the acceptance of the other.  The
acceptance or rejection of one project does not affect the other project.

*  Mutually exclusive projects - if the cash flows of one project  can be adversely  impacted by the acceptance of
the other.  The acceptance of one project makes the other rejected.

What are the two broad categories of Capital Budgeting Decisions:  

*  Screening decision - relate to whether a proposed project is acceptable.  It passed the capital budgeting
criteria - hurdle rate.  Accept or Reject decision

*  Preference decision - by contrast, relate to selecting from among acceptable investment projects, considering
the allocation of available funds for the projects. {fund rationing).

Factors considered in Capital budgeting process:

*  Cash Flows

     -  Cash outlay - this represent the initial cash outflow or outlay which is cost of the asset, its incidental cost or
expenses like the shipping cost, installation or training cost.  Also added is the application for the use of working
capital or the net operating working capital (NOWC). Cash outlay is also called the Net Investment cost or
the Net Cash Outlay (NCO)

      -  Cash inflows - this represent cash inflows expected to receive in some future time.  This is the net income
addback depreciation expenses, considering it is a non cash items deducted from the revenues.  This periodic
net cash inflows maybe in uniform amount or mixed streams. This is als called Net cash returns or net cash
inflows (NCI)

        -  Terminal Cash flow -  this represent cash inflows realized at the end of the life of the asset or investment
project. This is the proceeds from sale of the asset after considering the tax effect on gain or loss from the sale
of asset. This includes the release of the working capital applied at the start of the project.

*  Required Rate of Return - this represent the minimum required rate of return on the particular investment
project.  This is sometimes called the hurdle rate or the cost of capital (WACC). To make the project acceptable,
it should meet the project required rate of return or higher.

*  Required Recovery Period - this represent the project recovery period to recover its net investment cost. If
the project can be recovered lesser than the required recovery period, the project is acceptable. If the absence
of the stated required recovery period of the project, its accounting estimated life of the asset maybe the basis of
required recovery period.

*  Time Value of Money - the principles of time value of money is applied especially to some capital budgeting
technique that follows the principle of the time value of money.

*  Element of Risk

Sample Problem 1.A

A project proposal is submitted to you for analysis and recommendation:

*  Cost of the equipment ................................  P200,000

*  Shipping and installation cost ..................        40,000

*  Changes in net operating capital: 

     - Increase in inventories by      P25,000

    -  Increase in accounts payable -  P5,000 

*  Effect on operations:

     -  New sales - 100,000 units per year at P3.50 per unit

     - Cash operating expenses:  Variable cost is 60% of sales, and fixed operating expenses of P40,000 per
year.

*  Life of the asset -  4 years         Depreciation method:  Straight method

*  Salvage value - P40,000

*  Market value after the life of the asset ......   P50,000

*  WACC ................12%       Tax rate  ..........  25%

Required:  Compute for the project's cash flow:

Solution:

a.  Net Cash outlay:  (Net investment cost)

      Cost of the asset ..................................   P 200,000

      Incidental expenses ...............................      40,000

      Net change in Working capital ...........        20,000

          Net Cash outlay ...................................P260,000

b.  Net Cash Inflows: 

        Sales ..........................................… P 350,000

       Variable expenses                           210,000

       Fixed expenses                                  40,000

       Depreciation expenses                     50,000

        Net Income before tax                      50,000

       Income tax                                          12,500

       Net income after tax                          37,500

        Depreciation                                       50,000

       Net Cash inflows .........................      P 87,500

     note:  Every year, from the 1st to 4th, there is uniform cash inflows of P87,500

 c)   Terminal Cash Flow:

          Proceeds from sale of asset ..................................    P50,000

         Tax effect on gain on sale:

           ( P50,000 - P40,000) x 25% ...................................     2,500

               Net proceeds after tax effect  ...........................    47,500

         Released of working capital  ....................................    20,000

                  Terminal Cash flow  .......................................     P67,500

Sample Problem 1.B. 

Same with information given in Problem 1.A except that the fixed asset is depreciated using Sum of Years Digit
(SYD) method and that after 4 years the unit will be sold for only P25,000.

Required:  a. Net Investment cost

                  b. Net Cash Inflows

                  c.  Terminal Cash flow

  a,  Net Investment Cost:

        Cost of the Equipment .......................................  P200,000

        Incidental expenses ............................................      40,000

       Increase in working capital ...............................         20,000

       Total Net Investment Cost or Net Cash outlay  P260,000

  b. Net Cash Inflows:

                                              Year 1         Year 2          Year 3          Year 4

      Sales                             P350,000    P350,000    P350,000  P350,000

      Variable costs                210,000      210,000       210,000    210,000

      Fixed costs                      40,000        40,000          40,000      40,000

     Depreciation                     80,000        60,000          40,000      20,000

    Net Operating income      20,000        40,000          60,000      80,000

    Income tax                         5,000         10,000         15,000        20,000

   Net Income                          15,000        30,000         45,000       60,000

   Depreciation                       80,000         60,000         40,000       20,000

  Net Cash Inflows              P95,000       P90,000       P85,000     P80,000

Depreciation schedule:

Amount subject to depreciation - P200,000 (240,000-40,000)

Y1  -  P200,000 x 4/10  =     P80,000

Y2  -    200,000 x 3/10   =       60,000

Y3  -    200,000 x  2/10   -       40,000

Y4  =   200,000 x 1/10     =      20,000

c) Terminal Cash Flow:

     Proceeds from sale of equipment .............................      P25,000

     Tax effect on loss on sale of equipment:

      (25,000   -  40,000)  x 25% .......................................          3,750

      Net Proceeds  ...............................................................P  28,750 

     Working capital released  ...........................................         20,000

              Terminal Cash flow   ........................................         P48,750

Sample Problem 1.C

     Same with information given in Problem 1.A except that the asset is depreciated using Modified Accelerated
Cost Recovery System (MACRS) and the asset can be sold for P35,000 after 4 years. Compute for the
necessary cash flows.

a.  Net Cash Outlay   =   P260,000  (same with Problem 1.A & 1.B)

b.  Net Cash Inflows:

                                                 Y1             Y2                Y3              Y4

     Sales                            P350,000    P350,000   P350,000    P350,000

     Variable costs               210,000       210,000     210,000      210,000

     Fixed costs                      40,000         40,000       40,000        40,000

    Depreciation                    79,200       108,000       36,000        16,800

    Operating income           20,800           (8,000)      64,000        83,200

    Income tax                     (   5,200)          2,000     (16,000)      (20,800)

   Net Income after tax        15,600           (6,000)     48,000        62,400

   Depreciation                     79,200         108,000     36,000        16,800

   Net cash inflows              94,800          102,000     84,000        79,200

Depreciation schedule (MACRS)

Y1         rate - 0.33   x   240,000    =   P79,200

Y2                   0.45    x   240,000    =   108,000

Y3                   0.15   x    240,000     =    36,000

Y4                   0.07   x    240,000     =    16,800

                        1.00                                240,000

c) Terminal cash flow:

      Proceeds from sale  .................................      P35,000

      Tax on gain on sale:

           35,000 (MP) -  0 (BV)  x  25%...............       8,750

   Net cash proceeds  ..........................................    26,250

    Working capital released ................................   20,000

       Terminal cash flow  .....................................     46,250

         

Activity 1 - Assignment - Capital Budgeting

Instructions:

1. Submission will be online (Upload on canvas thru MS (Word, Excel, Pdf) an image of your handwriting on a
clean and clear paper.

2. Due date is on April 21, 2022 6pm

3. This is a graded activity

Part 1 -  Answer the following problems from your textbook. 

         Problem  12-10           Problem 12 - 12

         Problem   12-13          Problem 12 - 14

         Problem   12-17          Problem 12 - 18

Part 2 - Computation of Cash Flows:

     Two project proposals are submitted to you for analysis and recommendation:

Project A:  A new machine to manufacture new product submitted by Production Dept.

     The machine costP180,000 with estimated life of 6 years with salvage value of P50,000 to be depreciated
using straight line method.  Freight and installation cost estimated to be P35,000. This machine can be sold for
P45,000 after its estimated life.  With this machine, P125,000 sales will be generated and a cash expenses of
P55,000 will be incurred. Expected rate of return of the project is 13%.

Project B:  Computer units submitted by the Admin Department

     The cost of the package is P120,000 with an estimated life of 4 years, with no salvage value.  The computers
will be depreciated using SYD.  After its estimated life, the units can be sold for P20,000. With this computers,
the accounting dept. estimated a yearly savings of P80,000.  Installation and training costs amounted to P15,000
and there will an increase in supplies inventories amounting to P10,000.  Expected rate of return of this project is
15%.

The VP Finance is interested to know the necessary cash flows of the two project proposals.   The corporation is
subjected to 25 percent tax rate.

Elaborate: Capital Budgeting Techniques

As already mentioned, Capital Budgeting is a process of analyzing projects whether it is acceptable after
applying certain criteria and using different capital budgeting techniques. These techniques can be divided into
two categories:

1. Those techniques that do not follow the principle of time value of money:

     a. Cash Payback Period or Regular Payback -  this is the first selection criterion used because of its
simplicity.  This is the method of determining the length of time the investment cash inflows to recover the total
investment cost. The formula is to divide the Net Cash Outlays against the Net Cash Inflows.  Using the
Cash Payback Period, the project is acceptable if the Net Cash Outlays can be recovered within or less than the
expected recovery period.
     b. Accounting Rate of Return or Simple Rate of Return - the rate of return is computed by dividing
the Accounting Profit against the Net Cash Outlays or investment.  The project is acceptable if the
accounting rate of return is equal or higher than the expected rate of return or Cost of Capital.

2.  Those techniques that follows the principle of time value of money.

     a. Discounted Payback Period -  This is the method where the future cash inflows are discounted at its cost
of capital or WACC, where the present value of the future cash inflows are used to compute the payback..

    b.  Net Present Value method (NPV) - this method shows the difference between the present value of the
expected cash inflows and the terminal cash flows discounted at cost of capital and the net investment cost (PV
of the cash inflows less the PV of the cash outlays).  If the NPV is positive, the investment project is acceptable.

    c. Internal Rate of Return (IRR) - IRR is the actual rate of the investment project. It is the rate wherein the
Present value of the cash inflows is equal to the Net cash outlays. The rate can be computed using interpolation
or by using excel, or financial calculator.

     d. Modified Internal Rate of Return (MIRR)  -  the discount rate at which, the present value of cost of the
project is equal to the present value of its terminal value, where the terminal value is found as the sum of the
future values of the cash inflows compounded at the firm's cost of capital.

SAMPLE PROBLEMS:  

Problem 1.A

Given:  NCO - P260,000, NCI -P87,500 per year;  TCF - P67,500; WACC - 12%

1. Cash Payback Period = P260,000/P87,500 = 2.97 or 2 years & 11.64 months

2. Accounting rate of return:  P37,500/260,000 = 14.42%

3. Discounted Payback period:

      PV for 3 years P87,500 x 2.402 =  210,175

     PV on the 4th year 87,500 x 0.636 = 55,650

    P260,000 - 210,175 = 49,825/55,650 =  .895 x 12 = 10.74 months

  DPP  =  3 years and 11 months

4. Net Present Value 

    PV of cash inflows - regular  =       87,500 x 3.037 = P265,737.50

   PV of Terminal Cash flow      =       67,500  x  .636   =     42,930.00

         Total PV of cash inflows                                             P308,667.50

         Net Cash outlays or Investment costs                        260,000,00

                Net Present Value                                               P  48,667.50

5. Internal Rate of Return (IRR)

    Approximate IRR = 260/87.50 =2.971 (F) PV annuity = between 13-14%

    Exact IRR  =  13%  =  2.974  -  2.971 = 0.003

                           14%  =  2.914

            Difference  1%  = 0.06

           Interpolate:  13% + (0.003/0.06 x 1%) = 13.05%

6.  Modified Internal Rate of Return (MIRR)

    ist step - find the terminal value (future value of Cash inflows)

                    4th year =  87,500 x  1.0    =    P87,500

                    3rd year  =  87,500 x 1.12  =      98,000

                    2nd year  =  87,500 x 1.254 =   109,725

                    1st year  =  87,500 x  1.405 =   122,938

                         Terminal Value      =                 418,163

Find Approximate MIRR =  260,000/418.163 =  0.622 (F) = between 12%- 13%

Find Exact MIRR  - use interpolation

               12%    =     0.636  -  0.622  =  0.014

               13%     =    0.613

                 1%     =    0.023

     MIRR =  12% +  ( 0.014/0.023  x  1%)  = 12.63%

SAMPLE PROBLEM - 1.C

Given:  Cash outlay - P260,000

              Cash inflows:  P94,800; P102,000; P84,000; P79,200

             Terminal cash flow - P46,250

1. Cash payback period:   Cash outlays -                      P260,000

                                                Cash inflows - 1-2 years     196,800

                                                 Remaining balance                63,200

                                               divide by inflow in 3rd year   84,000

                                                       months recovered            0.752 x12 =  9.03 months

                    Cash payback period  =          2 years and 9 months

2. Accounting Rate of return:

    Since the net income are mixed streams, get the average net income

     Average net income:  (15,600 + (6,000) + 48,000 + 62,400)/4 = 30,000

      ARR =   P30,000/P260,000  =   11.54%

3. Discounted Payback Period:

         Compute the present value of each cash inflows:

         1st  year - P94,800 x 0.893   =  P84,656

         2nd year - 102,000  x 0.797   =   81,294

         3rd year  -   84,000  x  0.712   =   59,808

                     Total PV (1 -3 years)    =  P225,758

           Remaining balance to recover = P34,242  (P260,000 - P225,758)

           4th year - P79,200 x  0.636    =  P50,371

          months to recover:  34,242/50,371 = 0.68 x 12  =  8.157 months

      Discounted Payback period  =   3 years and 8 months

4. Net Present Value Method  (NPV):

 Present value of operating cash inflows:

         (P84,656 + P81,294  + P 59,808 + P50,374)       P276,132

   Present value of terminal cash flow (P46,250 x 0.636)  29,415

           Total PV of cash inflows                                        P305,547               

           Total cost of investment (NCO)                               260,000

           Net Cash Present Value (NPV)                               P 45,547

5. Internal Rate of Return: (this can be computed using financial calculator or   excel or manual calculation)

     1st step: look for the factor (net cash outlay divide by average cash inflows)

          Average cash inflows:( 94,800 + 102,000 +  84,000 + 79,200)/4 =  P90,000

         Approximate IRR :  260,000/90,000  =  2.889  (at n=4) = between 14% - 15%

       Exact IRR:  @ 14%  - 2.914  -  2.889  = 0.025

                            @15%  - 2.855

       Difference       1%       0.059

       Interpolation:

                       14% + (0.025/0.059 x .01) =  14.42%

6. Modified IRR  (this can can computed using financial calculator or excel or manual computation using the
factor table)

     1st compute for Terminal value of cash inflows:

             4th year  =  94,800 x  1.0   =  P 94,800  

             3rd year  =  102,000 x 1.12 =  114,240

             2nd year  =  84,000  x  1.254 = 105,336

             1st year   =   79,200  x 1.405  = 111,276

               Total Terminal value              = P425,652

    Approximate MIRR = 260,000/425,652 =  0.611 (F) -  between 13% - 14%

     Exact MIRR  =   13%  = 0.613 -  0.611 =  0.002

                               14%  = 0.592

      Difference            1%      0.038

     Interpolate:   

              MIRR (Exact)  =  13% + (0.002/0.038 x .01) =  13.05% 

  

Activity 2-Assignment - Capital Budgeting (Due date: April 5, 2022 10pm)

Using the Cash flows computed in Activity 1 for the two (2) project investments:

One (unit) Machine and Computer package, apply the following capital budgeting techniques to determine the
acceptability of the projects:

a. Cash Payback Period

b. Accounting rate of return

c. Discounted Payback period

d. Net Present Value method

e. Internal Rate of return (IRR)

f. Modified Internal Rate of return(MIRR)

Make your recommendation which project will be accepted/prioritized.

Group Case Study - Case no.3: The Dilemma at Day-Pro

Due date of submission: April 6, 2022 10 pm

Elaborate: Capital Budgeting - Replacement of asset

SAMPLE PROBLEM:

     Pazzar, Inc. owns a machine costing P85,000. This has an estimated useful life of 6 years with a scrap value
of P10,000 using the straight line method of depreciation.. After using this for two (2) years, management feels
its efficiency is not enough.  If management opted to continue this machine, a repair cost of P20,000 will be
incurred. The machine can be sold now to ready buyer for P40,000. 

     A new machine can be purchased now at a cost of P150,000 and can be depreciated over four (4) years  with
no salvage value but will have a market price of  P40,000 after the life of the asset. Straight line method of
depreciation will still be used. Hauling and installation cost P30,000 and an increase in working capital of 
P20,000. 

      With this new machine, revenues is expected to increase by P125,000 and cash expenses due this
replacement will also increase by P65,000. Cost of capital estimated to be 13% p.a. and a corporate tax of 25%.

Required: 

1. Necessary computation to determine the following:

     a. Net investment cost (Net cash outlay)

     b. Net Cash Inflows 

     c.  Terminal cash flows

2.  Evaluate the acceptability of the project using:

      a. Cash payback period

     b. Discounted payback period

    c.  Net Present Value Method

    d. Internal Rate of Return

    e.  Modified Rate of Return

Analysis of given information:

Old Asset: 

     Original cost -------------------          P 85,000

     Accumulated depreciation:

     (P85,000 - 10,000)/6 x 2 years ....     25,000

   Book value after 2 years                    P 60,000

   Market value after 2 years                P  40,000

   Loss on sale  after 2 years                 P  20,000

   Tax saving on loss (25% of P20,000)P   5,000

New Asset:

      Cost ........................................                     P150,000

      Incidental expenses .............                         30,000

     Cost of asset subject for depreciation    P180,000

    Annual depreciation - P180,000/4         P   45,000

Incremental analysis of depreciation

       Depreciation of new asset  ----------- P  45,000

       Depreciation of old asset  ....................  12,500

            Incremental depreciation  ..............     32,500

Repair cost avoided if new asset is acquired  P20,000

Tax savings on repair cost avoided:

               P 20,00 x 25%                                       P 5,000

1. Computation of Net Investment cost:

      Cost of New asset -------------------------  P150,000

       Incidental expenses  ;----------------------    30,000

       Increase in working capital  --------------      20,000

      Proceeds from sale of old asset ------------( 40,000)

      Tax savings due to loss on sale 

            of  old asset ........................................ (  5,000)

     Avoidable repair cost  -----------------------    ( 20,000)

    Avoidable tax savings on repair  ---------------    5,000

         Net Cash Outlay (Net investment cost)    P140,000

2. Computation of Net Cash Inflows:

      Expected increase in revenue ..................       P125,000

       Expected increase in cash expenses               ( 65,000)

        Incremental depreciation  .....................         (   32,500)

        Net Income before tax  -----------------      P27,500

         Net Income after tax  ...........................            P20,625

       Add back - Depreciation .......................               32,500

           Net Cash Inflows per year ...................        P  53,125

3. Computation of Terminal Cash Flow:

      Proceeds from sale of new asset after 4 years P40,000

      Tax on gain on sale of asset:

          (MV - 40,000) - (BV - 0)  x 25%                      ( 10,000)

      Released of working capital  .....................          20,000

          Terminal Cash Flow ....................................       P 50,000

Activity 4- CB: Replacement of Asset

Due date: April 8, 2022 10pm

Based on the sample problem given in Elaborate: Capital Budgeting - Replacement of asset, evaluate the
acceptability of the acquisition of new asset for replacement using the following capital budgeting techniques:

1. Cash Payback period

2. Discounted Payback period

3. Net Present Value method

4. Internal Rate of return

5. Modified Internal Rate of Return

Make your recommendation.

Activity no. 5 - Assigned Problems:

Problems 13-8, 13-9, 13-10