CAPITAL BUDGETING

CAPITAL BUDGETING deals with analyzing the profitability and/or liquidity of a given project proposal.
It is premised on the following:

* Funds are available

* Business opportunities (i.e. Project proposals) abound waiting to be tapped
* Business opportunities are subject to quantitative evaluation

Striking characteristics of capital expenditure projects:

1. Amount involved is material

2. The project life-cycle extends beyond one year.

Several projects that need capital budgeting analyses are the following:

* Replacement or expansion

* Establish a branch or not

* Purchase or lease a long-term asset
* Introduce a new product or not
* Develop a new channel of distribution or establish alliance with existing distribution
channels.

* Improvement or retention

* Retain the old technology or introduce a new/modern technique or technology

* Improve channel of distribution or not

* Others

* Research and development

* Exploration
* New projects
* Internally develop a major marketing program or services from available service
contractors
* Similar strategic decisions

Major concerns in Capital Budgeting

Net Cost of Investment

How much is the net cost of investment?
How much money is needed?
Net returns
How should the investment be returned?
Cost of Capital
How much is the cost of using the funds?

Project Evaluation Techniques

Which investment proposal would give the highest return on investment, profitability
wise and liquidity wise

The net cost of investment

It refers to the net cash outflows, after tax considerations that are normally paid by investors in
relation to the investing transactions.
 Cash outflows

* Net purchase price of the new asset (net of discount, whether taken or not taken).
* Additional or incidental cost paid or incurred to prepare (ready) the asset for use
* Increase in working capital
* Additional tax paid or incurred cost in case of gain from sale or disposal of old asset
* Additional tax paid from cost savings on avoided cost of repairs, if the old asset is
replaced.

Cash Inflows

* Proceeds from sale or trade-in allowance from disposal of old asset

* Tax savings from loss on sale of old asset
* Savings from avoided repairs and maintenance, if the old asset is replaced.

CAPITAL INVESTMENT = CASH OUTFLOWS MINUS CASH INFLOWS

Example: C Co. Is planning to purchase a new machine costing P4,780,000, freight and installation costs
amounting to P145,000. The old unit will be given a trade-in allowance of P1,200,000. Other assets that
are to be retired as a result of the acquisition of the new machine can be salvaged and sold for P12,000.
The loss on the retirement of these other assets amounting to P20,000 will reduce taxes by P8,000. If
the new machine is not purchased, extensive repairs on the old machine will have to be made at an
estimated cost of P450,000. This cost can be avoided by purchasing the new machine. Additional gross
working capital of P350,000 will be needed to support operations planned with the new machine.
Required: The net investment assigned to the new machine for decision analyses.

Solution:
Cash Cash
Outflow Inflow
Cost of New Machine P4,780,000
Freight and Installation costs 145,000
Trade-in Allowance P1,200,000
Cash proceeds from sale of old 12,000
Reduction in taxes due to loss on
retirement 8,000
Avoided repairs 450,000
Additional tax paid due to avoided
repairs (Tax at 30%) 135,000
Additional working capital 350,000 0
Total P5,410,000 P1,670,000

Net Capital Investment (5,410,000 –1, 670,000) = P3,740,000

Net Returns

It refers to net cash inflows (or net cash income). The formula is:

Cash Flows from operations before tax Pxxxx

Less: Depreciation expense xxxx
Net income before income taxes Pxxxx
Less: Income Tax xxxx
Net income Pxxxx
Add: Depreciation expense xxxx
Net Cash Inflows (Annual cash inflows) Pxxxx
Sample Problem: The ND Corp is planning to add a new product line to its present business. The new
product will require a new equipment costing P1,200,000, having a five-year useful life with no residual
value. The following estimates are made available:
Annual Sales P6,000,000
Annual costs and expenses:
Materials 800,000
Labor 1,200,000
Factory overhead (excluding depreciation
on new equipment) 540,000
Selling and administrative expenses 700,000
Income tax rate, 30%

Compute: Annual income after tax

Annual net cash inflow after tax

Solution:
Annual Income after Tax
Annual Sales P6,000,000
Annual Cost and expenses:
Materials P 800,000
Labor 1,200,000
Factory Overhead 540,000
Depreciation expense
(1,200,000/5 yrs) 240,000
Selling and administrative expense 700,000 3,480,000
Net income before tax 2,520,000
Income Tax (30% x 2,520,000) 756,000
Net Income P1,764,000

Annual Cash Inflow after tax

Net Income P1,764,000
Add: Depreciation 240,000
Annual Cash Inflow after tax P2,004,000

Project Evaluation Techniques (PETs)

Project investments are evaluated on their liquidity and profitability. Net cash inflow is used to
measure liquidity, while net income is used to measure profitability.

Traditional Models (do not consider the time value of money)

(1) Payback Period – refers to the length of time before an investment is recovered. The
formula (applicable only if the Net Cash inflows after taxes is even or similar) is:
Cost of Investment
Payback period = ----------------------------------------
Net Cash Inflows after Taxes
If Net Cash inflows after taxes are uneven, these are accumulated until it equalize the Cost of
Investment.

(2) Payback Reciprocal is one over payback period. It represents the percentage of annual net
cash returns provided by an investment. The formula is
1
Payback reciprocal = --------------------------------
Payback period
(3) Payback Bailout Period
There are times where a project could be terminated anytime during its life such as
projects funded by government money where the budget depends on congress approval and
projects where their continuity depends on the approval of the funding agency.
 The bailout period, variation of the payback period, also measures the amount of time it
needs to recover the Investment. However, the bailout period measures this time frame on the
assumption that the investment will be liquidated at the moment the cash flows will be enough
to recover the investment.

Example: BOY Corporation plans to invest in a facility that produces hog feeds. It requires an
investment of P1,000,000. Should it decide to shut down the facility at the end of the first year, the
facility can be sold at an amount of P400,000. If it will be shut down at the end of the second year, it
can be sold at P300,000 at the end of the third year, at P100,000. What is the bailout period if the after-
tax cash flows to the company as a result of the investment in the facility for the first three years are
expected to be P300,000, P200,000 and P400,000 respectively.

Solution:
If the facility stops at the end of the first year
Amount of Investments
Year Cash In Flow Salvage Value t o be recovered
0 (1,000,000)
1 300,000 400,000 700,000 ( 300,000)

If the facility stops at the end of the second year

Amount of Investments
Year Cash In Flow Salvage Value t o be recovered
0 (1,000,000)
1 300,000 ( 700,000)
2 200,000 300,000 800,000 ( 200,000)

If the facility stops at the end of the third year

Amount of Investments
Year Cash In Flow Salvage Value t o be recovered
0 (1,000,000)
1 300,000 ( 700,000)
2 200,000 ( 500,000)
3 400,000 100,000 1,000,000 0

(4) Accounting Rate of Return

It measures the profitability of a proposed project. It is sometimes referred to as

unadjusted rate of return, return on investment, return on assets, simple accounting rate of
return.

The following are the formula:

ARR = Net Income / Original Investments

ARR (Ave) = Net Income / Average Investments
= Net Income / (Original Inv + Salvage Value / 2)
Problem:

D Co. Is planning to buy a new machine costing P500,000 with a useful life of five years, no
salvage value. Other data were made available: Expected annual sales revenue, P600,000 Annual out-
of-pocket costs P450,000; Income tax rate 40% and Depreciation method, straight line.
Determine the following:
1. Payback period
2. Payback reciprocal
3. Accounting rate of return on original investment
 4. Accounting rate of return on average investment
Solution:
1. Payback period
Expected annual sales revenue P600,000
Less: Annual out-of-pocket expenses 450,000
Depreciation (P500,000/5 yrs) 100,000
Net income before tax P 50,000
Income Tax (50,000 x 40%) 20,000
Net Income after tax P 30,000
Add: Depreciation 100,000
Net Cash Inflow after tax P130,000
Payback period = Investment / CIF after T
= 500,000 / 130,000 = 3.85 years

2. Payback Reciprocal = 1 / Payback period

= 1 / 3.85 = 25.97%

3. Accounting Rate of Return (ARR) = NIAT / Investment

= P30,000 / P500,000
= 6%
4. ARR (Ave) = NIAT / Average Investment
= P30,000 / (P500,000 + 0)/2
= P30,000 / P250,000
= 12 %

Problem:
An investment of P400,000 can bring in the following annual cash income net of tax:
First Year P 70,000
Second year 90,000
Third year 85,000
Fourth year 160,000
Fifth year 75,000
Sixth year 70,000
Determine the payback period

Solution:
Year CIF after T Accumulated CIF/T
1 70,000 P 70,000
2 90,000 160,000
3 85,000 245,000
4 160,000 405,000
The payback period is between 3 and 4 yrs and therefore the
answer is 3 years
.97 (400,000-245,000)/160,000
3.97 years
Problem

An equipment costing P1,000,000 is expected to yield the following net cash inflows and salvage
values:
Year Net Cash Inflow Residual Value net of Tax
1 P300,000 P200,000
2 400,000 100,000
3 200,000 50,000
4 150,000 20,000
Determine the payback bailout period.
Solution:
Net Cash Cash Residual Total Cash Payback
Year Inflows to date Values to date Bailout Period
1 300,000 300,000 200,000 500,000 1
2 400,000 700,000 100,000 800,000 1
3 200,000 900,000 50,000 950,000 1
4 150,000 1,000,000 20,000 1,000,000 .53*
Bailout Period 3.53
*(100,000 – 20,000)/150,000 = .53

Discounted Models (consider the time vale of money)

1. Net Present Value determines the cash inflows and outflows at the same time period. Since
cash inflows are to be received in the future while cash outflows (cost of investment) are made
at the start of the project, there is an apparent inconsistency in the timing of cash flows. The
solution is to discount the future cash inflows to their present values before comparing to the
cost of investment.
It is computed as follows:
Present Value of Cash Inflows
Less: Cost of Investment
Net Present Value

2. Profitability Index and the Net Present Value Index

The indexes are normally used to rank projects that are acceptable. The ranking of
acceptable projects is done when there is a constraint on resources such as money, manpower,
and materials. The process of allocating available money to the most prioritized investment
proposals is known as “capital rationing”. In the ranking process, the project that has the
highest index has the highest priority. The profitability index and NPV index are computed as
follows:

Profitability Index = Present Value of Cash Inflow / Cost of Investment

Net Present Value Index = Net Present Value / Cost of Investment

Problem: An equipment costing P800,000 will produce annual net cash inflows of P300,000. At the end
of its useful life of five years, the equipment will have a residual value of P20,000. The desired rate of
return is 18%. Calculate the following: (1) Net Present Value (2) Profitability Index (3) Net Present
Value Index
Solution:
a. Compute the present value factor
Year 1 = 1 / 1.18 = 0.8475
Year 2 = 0.8475 / 1.18 = 0.7182
Year 3 = 0.7182 / 1.18 = 0.6086
Year 4 = 0.6086 / 1.18 = 0.5158
Year 5 = 0.5158 / 1.18 = 0.4371
PV of annuity of 1 for 18% at 5 years = 3.1272

b. Compute the Net Present Value

PV of Cash Inflow (300,000 x 3.1272) P938,160
PV of residual value (20,000 x 0.4371) 8,742
P946,902
Cost of Investment 800,000
Net Present Value P146,902
 Profitability Index = PVCI/COI
= P946,902 / P800,000
= 1.18

Net Present Value Index = NPV/COI

= P146,902/P800,000
= 0.18 or 18%

Problem: An equipment costing P600,000 with a residual value of P30,000 at its useful life of five years,
is expected to bring the following net cash inflows:
First Year P350,000
Second Year 250,000
Third Year 150,000
Fourth Year 100,000
Fifth Year 50,000
The company uses a 12% discount rate.
Compute the following (1) Net present value (2) Profitability Index (3) Net present value index

Solution
Year Cash Inflow PV Factor Present Value
1 P350,000 (1/1.12 ) 0.8929 P312,515
2 P250,000 (0.8929/1.12) 0.7972 199,300
3 P150,000 (0.7972/1.12) 0.7118 106,770
4 P100,000 (0.7118/1.12) 0.6355 63,550
5 P 50,000 (0.6355/1.12) 0.5674 28,370
RV 30,000 0.5674 17,022
Total Present Value P727,527
Cost of Investment 600,000
Net Present Value P127,527
Profitability Index = P727,527 / 600,000 = 1.21
Net Present Value Index = 127,527 / 600,000 = .21 or 21%