Accounting Ed 12 – Management Science 5.

purchase of machinery from an outside

CAPITAL BUDGETING
Capital budgeting
- the process of deciding whether to commit or not
funds and resources to projects or capital
expenditures whose costs and benefits are spread
over several time periods.
- actions relating to the planning and financing of
capital outlays, e.g., purchase of new machinery,
modernization of plant facilities or introduction of new
product lines.
- an investment concept, since it involves a
commitment of funds now in order to receive some
desired return in the future in the form of additional
cash inflows or reduced cash outflows.
Capital Expenditures – long term commitments of
resources to realize future benefits
Characteristics of a Capital Investment Decision:
1. substantial amounts of funds are required
2. uncertainty becomes more critical because of
the length of time
3. effect of managerial errors will be difficult to
reverse
4. uncertainty of the future
5. success or failure of the company may depend
upon a single or relatively few investment
decisions
supplier against assembly of the machinery
by the company’s own staff
Elements of Capital Budgeting:
1. the net amount of investment
2. the operating cash flows or returns from the
investment
3. the minimum acceptable rate of return on the
investment
Net initial investment or Project cost:
- the initial cash outlay that is required to obtain
future returns
- the net cash outflow to support a capital
investment project
- in some cases, it is the sacrifice of an inflow of
cash, i.e., the opportunity cost that arises when
a benefit is rejected
- computed as follows:
Initial cash outlay
Add: Additional cash outlay related to the asset
Add: Additional working capital
Less: Cash inflow arising from sales of old asset
being replaced
Less: Avoidable costs
Net investment
Illustrative Problem:

Categories of Capital Investments: Purchase cost of old machine P60,000

Residual value 10,000
A. Independent capital investment projects or Screening Purchase price of a new machine 96,000
decisions Trade-in allowance on old machine 16,000
- projects that are evaluated individually Repair cost for old machine 10,000
- reviewed against predetermined corporate Income tax rate 40%
standards of acceptability resulting to an Additional working capital required. 50,000
“accept” or “reject” decision.
- Examples: Required: net investment
1. investments in long-term assets
2. new product development Solution:
3. large scale advertising campaign
4. introduction of a computer program Purchase price of new machine 96,000
5. corporate acquisitions (e.g., purchase of Additional working capital 50,000
shares in subsidiaries or affiliates) Trade-in allowance on old machine. (16,000)
Avoidable repairs (net of tax) ( 6,000)*
B. Mutually exclusive capital investment projects or Net investment 124,000
Preference decisions
- projects that require the company to choose  avoidable repair: 10k x 60% net of tax
from among alternatives
- project to be acceptable must pass the criteria of
acceptability and must be better than other Net Cash Returns
investment alternatives - inflows of cash expected from a project reduced
- Examples: by the cash cost that can be directly attributed to
1. replacement against repair of equipment or the project
renovation of facilities - computation:
2. rent or lease against ownership of facilities
3. manual bookkeeping system against Incremental revenue from the project
computerized system Less: incremental cash operating costs
4. preventive maintenance against periodic Annual cash inflow before taxes
overhaul of machineries Less: Taxes
 Annual net cash inflow after taxes equity

or Screening Capital Investment Proposals:

Annual incremental revenue from the project
Less: incremental cash operating costs A. Non-discounted cash flow (unadjusted) approach
Annual cash inflow before taxes
Less: incremental depreciation 1. payback period
Net income before taxes - also known as payoff and payout period
Less: income taxes - measures the length of time required to recover
Net income after taxes the amount of initial investment
Add: incremental depreciation - formula:
Annual net cash inflow after taxes a) uniform periodic cash flows –
net investment / annual cash returns
Illustrative Problem: b) not uniform – cumulating the estimated annual
cash inflows and determining the point in time at
Acquisition cost of new machine P120,000 which they equal the investment outlay
Expected useful life 5 years
Scrap value P 20,000 Illustrative Problem:
Expected annual cash flow
before taxes P 40,000 Proposal
Estimated income tax rate 30% A B
Net investment in equipment
Required: annual cash flow after taxes P150,000 P300,00
0
Solution: Annual cash returns:
Years 1 to 3 75,000 75,000
Annual cash flow before taxes P 40,000 Years 4 to 5 100,000
Less: Depreciation (120k-20k)/5 yrs) 20,000 Salvage value of eqpt. at the
Net income before taxes P 20,000 end of useful life 15,000 15,000
Less: Income taxes 6,000 Economic life 3 years 5 years
Net income after taxes P 14,000 Required: payback period of both proposals
Add: Depreciation 20,000
Annual cash flow after taxes P 34,000 Solutions:
Acceptable Rate of Return (for discussion and Proposal A: P150,000 / P75,000 = 2 years
presentation upon resumption of classes) Proposal B:
3 yrs + [(P300,000 – P225,000) x 1 year]
1. Source: Debt P100,000
Cost of Debt: = 3.75 years
Interest rate x net of tax rate
Note: P225,000 = cumulative returns for 3 years
2. Source: Shares of Stocks P100,000 = cash returns in the 4th year
a) preference shares
cost: 2. accounting rate of return (simple or book value
Dividends per share rate of return)
Market value per share of preference shares - measures profitability by relating the required
investment to the future annual net income
- formula:
average annual net income /
b) ordinary shares initial or average investment
cost:
(i) book value based (if dividend growth rate is not Illustrative problem:
known)–
next year’s projected earnings per share Initial investment required P65,000
current price per share of ordinary shares
Estimated life 20 years
(ii) stock price-based
Annual cash inflows P10,000
expected cash dividends per share
current price per share of ordinary shares Salvage value of assets at the end of
20 years 0
+ dividend growth rate Straight line method of depreciation will be used

c) retained earnings – same as cost of ordinary Required: ARR based on

 a) initial investment Less: PV of the investment 80,000
b) average investment Net present value P15,810

Solutions: b) uneven cash flows

a) (P10,000 – P3,250) / P65,000 = 10.38% DCE Corp. plans to invest in a four-year project that will
b) (P10,000 – P3,250) / [(P65,000 + 0)/2] =20.77% costs P750,000 with a cost of capital of 8%. Additional
information is as follows:
3. payback reciprocal
- estimates the rate of return or recovery for a Year Cash Inflows PV of P1 @ 8%
project or investment during the payback period 1 P200,000 0.926
- computed by dividing the digit 1 by the payback 2 P220,000 0.857
period expressed in years 3 P240,000 0.794
4 P260,000 0.735
Problem: Compute for the payback reciprocal of the Required: net present value
payback period of 2 years.
Solution:
Solution: 1 / 2 = 50% Year Amount PV Factor PV
1 P200,000 0.926 P185,200
4. bail-out period
2 P220,000 0.857 188,540
- the approach that incorporates the salvage
3 P240,000 0.794 190,560
value in payback period computations
- reached when the cumulative cash earnings 4 P260,000 0.735 191,100
plus the salvage value at the end of a particular Total P755,400
year equals the original investment. Less: PV of investment 750,000
(the approach to this will be discussed Net present value P5,400
during the resumption of classes)
2. discounted rate of return, internal rate of return or
B. Discounted cash flow (time adjusted or present time-adjusted rate of return (to be discussed
value) approach during resumption of classes)
- cash outlays and cash inflows are both - rate which equates the present value of the
discounted back to the present period using an future cash inflows with the cost of investment
appropriate discount rate which produces them
- the equivalent maximum rate of interest that
1. net present value or excess present method could be paid each year for the capital employed
- determines the excess of the difference between over the life of an investment without loss on the
the present value (PV) of cash inflows generated project
over the amount of the initial investment
- computed as follows: 3. profitability index
- also known as present value index, benefit-cost
PV of cash inflows based on minimum rate, and desirability index
desired discount rate - the ratio of the total present value of future cash
Less: Present value of investment inflows to the initial investment
Net present value - formula:
PV of cash inflows / PV of net investment
Illustrative problems:
Illustrative Problem: (same as the data for net
a) uniform cash flow present value)
ABC wants to invest in a machine costing P80,000 with
a useful life of six years and no salvage value. The Solution:
machine will be depreciated using the straight-line a) uniform or even cash flows
method and is expected to produce annual cash inflow PI = 95,810 / 80,000 = 1.2 or 120%
from operations, net of income taxes, of P22,000. The b) uneven cash flows
present value of an ordinary annuity of P1 for six periods PI = P755,400 / 750,000 = 1.01 or 101%
at 10% is 4.355. The present value for the 6th period at
10% is 0.564. Assuming that ABC wants a minimum rate 4. discounted payback period
of return of 10%, what is the net present value of this - recognizes the time value of money in payback
proposed investment? context
- used to compute the payback in terms of
Solution: discounted cash flows received in the future
- the payback period is computed using the
PV of cash inflows for 6 periods @ 10% discounted cash flow values rather than the
(P22,000 x 4.355) P95,810 actual cash flows
Illustrative Problem:
A project requiring an investment of P170,000 is
expected to generate the following cash inflows:

Year Amount
1 P60,000
2 60,000
3 60,000
4 60,000
5 60,000
Required: Discounted payback period

Solution:

Year Cash PV@15% Discounted Balance

Flow Cash Flow
0 (170k) - (170k) (170k)
1 60k 0.870 52k (118k)
2 60k 0.756 45k (73k)
3 60k 0.658 39k (34k)
4 60k 0.572 34k -

The discounted payback period is 4 years.

Preference Decisions – Ranking of Investment Projects

Preference decisions
- come after screening decisions
- determines the rank of investment proposals in
terms of preference
- usually makes use of internal rate of return
method or the net present value method

a) internal rate of return method

- the higher the IRR, the more desirable the
project
b) net present value method
- uses the profitability index since its result is
expressed in rates
- the higher the PI, the more desirable the project

Reference:
Cabrera and Cabrera, Management Accounting
Concepts and Applications , 2017 edition