ACC 121: FINANCIAL MANAGEMENT

CAPITAL BUDGETING
By: Dr. Leomar B. Virador, CPA, MSA-MA, CMITAP

CAPITAL BUDGETING
• Deals with analyzing the profitability and liquidity of a given

project proposal over its economic life.

• Process of identifying, evaluating, and implementing a firm’s

investment opportunities.

➢ FINANCING DECISION

Judgment regarding the method of raising capital to fund an investment.

➢ INVESTMENT DECISION

Judgment about which assets to acquire to achieve the company’s stated objectives.’

• Assumptions

– Long-term

– Cash flows – cash transactions, inflows (beg), outflows (end)

– Cash reinvestments

– Return on investments – rates: IRR, WACC

– Working capital – outflow (beg), inflow (end)

– Residual values – end

– Discount rates – cost of capital, IRR

• Characteristics

– Capital investment decisions usually require large commitments of resources.

– Most capital investment decisions involve long-term commitments.

– Capital investment decisions are more difficult to reserve than short-term

decisions.

– Capital investment decisions involve so much risk and uncertainty.

Types:

– Replacement

– Improvement

– Expansion

• Independent Projects. Do not compete with the firm’s resources. A company can select one, or the other, or
both—so long as they meet minimum profitability thresholds.

• Mutually Exclusive Projects are investments that compete in some way for a company’s resources—a firm can
select one or another but not both.

• If the firm has unlimited funds for making investments, then all independent projects that provide returns
greater than some specified level can be accepted and implemented.

• However, in most cases firms face capital rationing restrictions since they only have a given amount of funds
to invest in potential investment projects at any given time.

• Accept or Reject Approach

• Capital Investment Factors

– Net investment

• Costs or cash outflows less cash inflows or savings incidental to the acquisition of the

investment projects.

• Initial cash outlay, working capital requirement, market value of an existing asset which will

be utilized in the proposed project.

• Trade in value of old asset, proceeds from sale of and old asset (less tax if gain on sale and

add tax savings if loss on sale)

– Cost of capital
• Cost if using funds, WACC

– Net returns

• Accounting net income

• Net cash inflows

METHODS OF EVALUATING CAPITAL INVESTMENT PROJECTS

➢ Payback period. The length of time required by the project to return

the initial cost of investment.
• Formula:
Net cost of initial investment
Annual net cash inflows
• The maximum acceptable payback period is determined by management.
• If the payback period is less than the maximum acceptable payback period,accept the project.
• If the payback period is greater than the maximum acceptable payback period, reject
the project.

EXAMPLE:
• Payback period:
1. Vhong Corporation has determined that if a new = 120,000 / 30,000* = 4 years
equipment
costing P120,000 is purchased, the company’s net income will
increase by P10,000 per year. if the new equipment will be *10,000 + (120,000/6)
depreciated using the straight-line methods over a period of six
years to a zero-salvage value, what is the payback period?

2. A new machine is expected to produce the

following after-tax cash inflows over a period of 5 years: Year 1 16,000 16,000 1

Year 1 16,000 2 12,000 28,000 1

2 12,000 3 20,000 40,000 0.6

3 20,000 4 8,000

4 8,000 5 6,000

5 6,000 Payback period = 2.6

If the machine will cost P40,000, what is the payback period?

 ➢ Net present value is found by subtracting the present value of the

after-tax outflows from the present value of the after-tax inflows.

– Formula:
Present value of cash inflows – PV of cash outflows or PV of cost of
investments or cost of investments

Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent

EXAMPLE:
Kyla Corporation is planning to buy a new

equipment costing P600,000. The PV of cash inflows

equipment will be depreciated using the Annual cash inflow [180,000*{1-(1.12^-5)}/.12]
straight-line method over a period of 5 = 648,859.72
years. It is expected to have a salvage of Cash flow end 10,000*(1.12^-5) = 5,674.27
P10,000 at end of its life. Total PV of cash inflows = 654,533.99

Less: cost of investment = 600,000.00

The equipment will produce annual cash NPV = 54,533.99
flows from operations, net income taxes, of

180,000 per year. The income tax rate is

32%. The company’s hurdle rate is 12%. ACCEPT THE PROJECT!!

What is the net present value?
➢ The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the
outflows with the present value of the inflows. NPV = 0.

Decision Criteria

If IRR > k, accept the project

If IRR < k, reject the project
If IRR = k, technically indifferent

EXAMPLE:

Cheryl Corporation is evaluating a Trial and error

proposal to acquire a new equipment. The
Cost of investment = 417,860
equipment would require an investment of
417,860, including freight and installation 10% - [70,000*{1-(1.10^-10)}/.10] = 430,119.70
cost of 20,000. It is expected to have a 10-
11% - [70,000*{1-(1.11^-10)}/.11] = 412,246.24
year life with no salvage value at the end of
its life.

It has been estimated that the new IRR = LR + {HR-LR*(PVLR-COI/PVLR-PVHR)

equipment would increase the company’s 10% + {11%-10%*(430,119.70 – 417,860/430,119.70 -
cash inflows, net of expenses and income 412,246.24)
taxes, by P70,000. The company is subject
to the 32% tax rate. Its cost of capital is 8%. IRR = 10.69%

ACCEPT THE PROJECT!

➢ The Payback bailout period determines the number of years to recoup the
investment when total cash already equals the cost of investment. Total cash includes the
regular annual cash inflows plus the residual value.
➢ The Payback reciprocal is one over payback period. It represents the percentage of annual cash
returns provided by an investment.

a. For example, if the payback period is 2.08, then the payback reciprocal is 48.08%
 ➢ The Accounting rate of return measures the annual profitability of a proposed project. It is
sometimes referred to as the unadjusted rate of return, return on investment, return on assets, or book
value rate of return.

• Simple ARR = Profit/original investment

• Average ARR = Profit/[(original investment + residual value)/2]

• The higher the ARR, the better!

EXAMPLE:
Bohol Company is considering the Cash flows before taxes P1,400,000
Less: depreciation (3M-200K)/10 280,000
production of a new product line which will
Income before tax 1,120,000
require an investment of P3,000,000, with
Less: taxes (40%) 448,000
P200,000 residual value. The investment Profit 672,000
will have a useful life of ten years during
which annual cash inflows before income Simple ARR = 672,000/3,000,000 22.40%
taxes of P1,400,000 are expected. The Average ARR = 672,000/[(3M+200k)/2] 42.00%
income tax rate is 40%.