Capital Budgeting

Professor: JOHN ANTHONY M. LABAY, CPA, MBA

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TITLE: Capital Budgeting

I. Discussion
The term capital budgeting is used to describe how managers plan significant cash
outlays on projects that have long-term implications, such as the purchase of new
equipment and the introduction of new products. This chapter describes several tools that
can be used by managers to help make these types of investment decisions.

Capital budgeting analysis can be used for any decision that involves an outlay now in
order to obtain some future return. Typical capital budgeting decisions include:
Cost reduction decisions. Should new equipment be purchased to reduce costs?
Expansion decisions. Should a new plant or warehouse be purchased to increase
capacity and sales?
Equipment selection decisions. Which of several available machines should be
purchased?
Lease or buy decisions. Should new equipment be leased or purchased?
Equipment replacement decisions. Should old equipment be replaced now or
later?

The time value of money concept recognizes that a peso today is worth more than a
peso a year from now. Therefore, projects that promise earlier returns are preferable to
those that promise later returns.

The capital budgeting techniques that best recognize the time value of money are those
that involve discounted cash flows.
The net present value method compares the present value of a project’s cash inflows
with the present value of its cash outflows. The difference between these two streams of
cash flows is called the net present value. The net present value is interpreted as follows
If the net present value is positive, then the project is acceptable.
If the net present value is zero, then the project is acceptable.
If the net present value is negative, then the project is not acceptable.

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The internal rate of return is the rate promised by an investment project over its useful
life. It is sometimes referred to as the yield on a project. The internal rate of return is the
discount rate that will result in a net present value of zero. The internal rate of return works
very well if a project’s cash flows are identical every year. If the cash flows are not identical
every year, a trial-and-error process can be used to find the internal rate of return. If the
internal rate of return is equal to or greater than the minimum required rate of return, then
the project is acceptable. If it is less than the required rate of return, then the project is
rejected. When using internal rate of return, the cost of capital acts as a hurdle rate that a
project must clear for acceptance.

A profitability index can be computed as the net present value of the project divided by
the investment required. The higher the profitability index, the more desirable the project.

Other methods of making capital budgeting decisions

The payback method focuses on the payback period, which is the length of time that it
takes for a project to recoup its initial cost out of the cash receipts that it generates. When
the annual net cash inflow is the same every year, the formula for computing the payback
period is the investment required divided by the annual net cash inflow. When the cash
flows associated with an investment project change from year to year, the payback formula
introduced earlier cannot be used. Instead, the un-recovered investment must be tracked
year by year.

The simple rate of return method (also known as the accounting rate of return or the
unadjusted rate of return) does not focus on cash flows; rather it focuses on accounting
net operating income.

II. Learning Exercises

1. The following data concern an investment project:

Investment in equipment P16,000
Annual Net cash inflows P3,600
Working capital required P4,500
Salvage value of the equipment P2,000
Life of the project 12 years
Discount rate 14%

The working capital will be released for use elsewhere at the conclusion of the project.

Required:
Compute the project's net present value.

2. The management of Sem Corporation is considering the purchase of a machine that would
cost P41,110 and would have a useful life of 6 years. The machine would have no salvage value.
The machine would reduce labor and other operating costs by P10,000 per year.

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Required:
Determine the internal rate of return on the investment in the new machine.

3. XY Company is considering the purchase of a machine that promises to reduce operating costs
by the same amount for every year of its 6-year useful life. The machine will cost P83,150 and
has no salvage value. The machine has a 20% internal rate of return.

Required:
What are the annual cost savings promised by the machine?

4. The management of an amusement park is considering purchasing a new ride for P40,000 that
would have a useful life of 15 years and a salvage value of P6,000. The ride would require annual
operating costs of P22,000 throughout its useful life. The company's discount rate is 12%.
Management is unsure about how much additional ticket revenue the new ride would generate-
particularly since customers pay a flat fee when they enter the park that entitles them to unlimited
rides. Hopefully, the presence of the ride would attract new customers.

Required:
How much additional revenue would the ride have to generate per year to make it an attractive
investment?

5. The management of Cont Corporation is considering the following three investment projects:
Project A Project B Project C
Investment required P34,000 P60,000 P81,000
Present value of cash inflows P37,060 P61,800 P85,050

The only cash outflows are the initial investments in the projects.

Required:
Rank the investment projects in terms of preference.

6. The Company has an old machine that is fully depreciated but has a current salvage value of
P5,000. The company wants to purchase a new machine which would cost P60,000 and have a
5-year useful life and zero salvage value. Expected changes in annual revenues and expenses if
the new machine is purchased are:
Increased revenues P63,000
Increased expenses:
Salary of additional operator P20,000
Supplies 9,000
Depreciation 12,000
Maintenance 4,000 (45,000)
Increased net operating income P 18,000

Required:
a. Compute the payback period on the new equipment.
b. Compute the simple rate of return on the new equipment.

7. The Company is considering purchasing a machine that would cost P436,800 and have a useful
life of 5 years. The machine would reduce cash operating costs by P132,364 per year. The
machine would have no salvage value.

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Required:
a. Compute the payback period for the machine.
b. Compute the simple rate of return for the machine.

8. The management of Unt Company is considering an investment with the following cash flows:
Year Investment Cash Inflow
1 P 150,000 P 10,000
2 80,000 20,000
3 25,000
4 40,000
5 50,000
6 60,000
7 50,000
8 40,000
9 30,000
10 20,000

Required:
Compute the payback period of the investment.

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III. Assessment

MULTIPLE CHOICE QUESTIONS

1. Which of the following capital budgeting techniques ignores the time value of money?
A. payback period
B. net present value
C. internal rate of return
D. profitability index

2. When using one of the discounted cash flow methods to evaluate the desirability of a capital
budgeting project, which of the following factors is generally not important?
A. method of financing the project under consideration
B. timing of cash flows relating to the project
C. impact of the project on income taxes to be paid
D. amounts of cash flows relating to the project

3. With regard to a capital investment, net cash inflow is equal to the

A. cost savings resulting from the investment.
B. sum of all future revenues from the investment.
C. net increase in cash receipts over cash payments.
D. net increase in cash payments over cash receipts.

4. The net present value method of evaluating proposed investments

A. measures a project's internal rate of return.
B. ignores cash flows beyond the payback period.
C. applies only to mutually exclusive investment proposals.
D. discounts cash flows at a minimum desired rate of return.

5. The profitability index is

A. the ratio of net cash flows to the original investment.
B. the ratio of the present value of cash flows to the original investment.
C. a capital budgeting evaluation technique that doesn't use discounted values.
D. a mandatory technique when capital rationing is used.

6. The Corporation just invested in a project that has an internal rate of return of 24%. This project
is expected to generate P44,000 of net cash inflows each year of its 6-year life. The project has
no salvage value. What was the initial investment required for this project?
A. P63,360
B. P72,600
C. P132,880
D. P160,000

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7. High, Inc., is considering investing in automated equipment with a ten-year useful life.
Managers at High have estimated the cash flows associated with the tangible costs and benefits
of automation, but have been unable to estimate the cash flows associated with the intangible
benefits. Using the company's 10% discount rate, the net present value of the cash flows
associated with just the tangible costs and benefits is a negative P184,350. How large would the
annual net cash inflows from the intangible benefits have to be to make this a financially
acceptable investment?
A. P18,435
B. P30,000
C. P35,000
D. P37,236

8. Par Company is considering an investment proposal in which a working capital investment of

P10,000 would be required. The investment would provide cash inflows of P2,000 per year for six
years. The working capital would be released for use elsewhere when the project is completed. If
the company's discount rate is 10%, the investment's net present value is:
A. P1,290
B. P(1,290)
C. P2,000
D. P4,350

9. The management of Bo Corporation is considering the purchase of a machine that would cost
P330,980 and would have a useful life of 6 years. The machine would have no salvage value.
The machine would reduce labor and other operating costs by P76,000 per year. The internal rate
of return on the investment in the new machine is closest to:
A. 11%
B. 10%
C. 12%
D. 7%

10. Dig Corporation is investigating buying a small used aircraft for the use of its executives. The
aircraft would have a useful life of 6 years. The company uses a discount rate of 12% in its capital
budgeting. The net present value of the investment, excluding the salvage value of the aircraft, is
-P250,113. Management is having difficulty estimating the salvage value of the aircraft. To the
nearest whole peso how large would the salvage value of the aircraft have to be to make the
investment in the aircraft financially attractive?
A. P30,014
B. P2,084,275
C. P250,113
D. P493,320

11. Tan Corporation is considering three investment projects: X, Y, and Z. Project X would require
an investment of P38,000, Project Y of P49,000, and Project Z of P91,000. No other cash outflows
would be involved. The present value of the cash inflows would be P42,180 for Project X, P53,900
for Project Y, and P91,910 for Project Z. Rank the projects according to the profitability index,
from most profitable to least profitable.
A. Y,X,Z
B. X,Z,Y
C. Z,X,Y
D. X,Y,Z

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12. The Kee Company is planning a P200,000 equipment investment which has an estimated
five-year life with no estimated salvage value. The company has projected the following annual
cash flows for the investment.
Year Cash Inflows
1 P 120,000
2 60,000
3 40,000
4 40,000
5 40,000
Total P 300,000
Assuming that the cash inflows occur evenly over the year, the payback period for the investment
is:
A. 0.75 years
B. 1.67 years
C. 4.91 years
D. 2.50 years

13. The management of Mort Corporation is considering a project that would require an
investment of P284,000 and would last for 7 years. The annual net operating income from the
project would be P135,000, which includes depreciation of P37,000. The scrap value of the
project's assets at the end of the project would be P25,000. The payback period of the project is
closest to:
A. 2.1 years
B. 1.5 years
C. 1.9 years
D. 1.7 years

14. Den Corporation is considering replacing a technologically obsolete machine with a new state-
of-the-art numerically controlled machine. The new machine would cost P450,000 and would have
a ten-year useful life. Unfortunately, the new machine would have no salvage value. The new
machine would cost P20,000 per year to operate and maintain, but would save P100,000 per year
in labor and other costs. The old machine can be sold now for scrap for P50,000. The simple rate
of return on the new machine is closest to:
A. 8.75%
B. 20.00%
C. 7.78%
D. 22.22%

15 – 18. Iso Corporation is considering the purchase of new presentation equipment at a cost of
P150,000. The equipment has an estimated useful life of 10 years with an expected salvage value
of zero. The equipment is expected to generate net cash inflows of P35,000 per year in each of
the 10 years. Iso's discount rate is 16%. Iso uses the straight-line method of depreciation for its
assets.

15. What is the net present value of the presentation equipment?

A. P950
B. P19,155
C. P(36,500)
D. P(53,340)

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16. Between what two percentages does the internal rate of return of the presentation equipment
fall?
A. 5% and 6%
B. 8% and 10%
C. 14% and 16%
D. 18% and 20%

17. What is the payback period of the presentation equipment?

A. 2.3 years
B. 3.0 years
C. 4.3 years
D. 5.8 years

18. What is the simple rate of return of the presentation equipment?

A. 13.3%
B. 22.7%
C. 23.3%
D. 26.0%

19 – 20. Dem Inc. is considering an investment project that would require an initial investment of
P290,000 and that would last for 8 years. The annual cash receipts from the project would be
P189,000 and the annual cash expenses would be P85,000. The equipment used in the project
could be sold at the end of the project for a salvage value of P29,000. The company's tax rate is
30%. For tax purposes, the entire initial investment will be depreciated over 7 years without any
reduction for salvage value. The company uses a discount rate of 13%.

19. When computing the net present value of the project, what are the annual after-tax cash
receipts?
A. P56,700
B. P104,000
C. P132,300
D. P147,571

20. The net present value of the project is closest to:

A. P121,972
B. P114,339
C. P59,367
D. P67,000

21. Hop Corporation bought a piece of machinery. Selected data is presented below:
Useful life 6 years
Yearly net cash inflow P45,000
Salvage value -0-
Internal rate of return 18%
Cost of capital 14%

The initial cost of the machinery was

A. P157,392.
B. P174,992.
C. P165,812.

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D. impossible to determine from the information given.

22. The Industries is considering the purchase of a P100,000 machine that is expected to result
in a decrease of P15,000 per year in cash expenses. This machine, which has no residual value,
has an estimated useful life of 10 years and will be depreciated on a straight-line basis. For this
machine, the accounting rate of return would be
A. 10 percent.
B. 15 percent.
C. 30 percent.
D. 35 percent.

23. An investment project is expected to yield P10,000 in annual revenues, has P2,000 in fixed
costs per year, and requires an initial investment of P5,000. Given a cost of goods sold of 60
percent of sales, what is the payback period in years?
A. 2.50
B. 5.00
C. 2.00
D. 1.25

24. A project has an initial cost of P100,000 and generates a present value of net cash inflows of
P120,000. What is the project's profitability index?
A. 0.20
B. 1.20
C. 0.80
D. 5.00

25. The Corporation faces a marginal tax rate of 35 percent. One project that is currently under
evaluation has a cash flow in the fourth year of its life that has a present value of P10,000 (after-
tax). The Corporation assumes that all cash flows occur at the end of the year and the company
uses 11 percent as its discount rate. What is the pre-tax amount of the cash flow in year 4?
A. P15,181
B. P23,356
C. P9,868
D. P43,375