LCRC :MS 11_CAPITAL BUDGETING BATCH MAY 2020

Calamba Review Center - Laguna (LCRC)

2F MMCO Building, 8000 Lakeview Ph3 Angela Street, Halang, Calamba City Laguna, Philippines
Tel No. (02) 330-8617, (049) 523-6031; (02) 330-6057
CPA REVIEW (May 2020 Batch)
MAS Karim Abitago, CPA

MS11 – CAPITAL BUDGETING

TOPIC OUTLINE

Definition and
Purpose

Capital Bugeting
Process
Basic Concepts
Types of Projects

PV of 1
Time Value
of Money
PV of Ordinary Annuity of 1

Net Investment
Elements of Capital
Budgeting Cash Flows
CAPITAL
BUDGETING Discount Rate

Accounting Rate of
Profits
Return (ARR)

Payback Period
Techniques in Capital Non-
Budgeting Bail-out Period
discounted
Investment Decisions Payback Reciprocal

Capital Rationing Cash Flows Discounted Payback

Net Present Value

(NPV)
Discounted
Internal Rate of Return
(IRR)

Profitability Index (PI)

LECTURE NOTES
BASIC CONCEPTS
DEFINITION AND PURPOSE
Capital budgeting is the process of identifying, evaluating, planning, and financing capital investment projects of
an organization.
Capital budgeting is an investment concept by committing funds in current time with the purpose of receiving
desired returns in the future in the form of additional cash inflows or reduced cash outflows.
Capital budgeting involves long-term decision making with a large amount of resources and funds involved with
so much risk and uncertainty. Also, since it is a long-term decision making, decisions are usually more difficult
to reverse than short-term decision making.
Capital budgeting is usually used on the following decisions:
(1) Replacement and Acquisition of Long-term Assets (3) Trading or Exchanging Assets
(2) Improvement of Products
(3) Expansion of Facilities
CAPITAL BUDGETING PROCESS
(1) Identification and definition
(2) Search for potential investment projects
(3) Information gathering - both quantitative and qualitative information
(4) Selection- choosing the investment projects after evaluating their projected costs and benefits

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(5) Financing
(6) Implementation and monitoring (Monitoring part is known as POST-AUDIT evaluation)

NOTE: Capital investments screening is being done by the CAPITAL BUDGETING COMMITTEE and approved by
BOARD OF DIRECTORS
TYPES OF PROJECTS
(A) INDEPENDENT PROJECTS (MUTUALLY INCLUSIVE PROJECTS)
These are projects which are evaluated individually and reviewed against predetermined corporate
standards of acceptability resulting to an accept or reject decision.
(B) MUTUALLY EXCLUSIVE PROJECTS
These are projects which require the company to choose among projects under consideration. The project
to be acceptable must pass the criteria of acceptability set by the company and must be better than other
investment alternatives.
TIME VALUE OF MONEY
Discounting is mostly used in capital budgeting. The question is when to use present value factors.
Present value of 1 (PV of 1) – used if the cash flows flow on a lump-sum basis.
Present value of ordinary annuity – used if the cash flows flow evenly on an annual basis.
ELEMENTS OF CAPITAL BUDGETING
These are the factors of capital budgeting used in evaluating capital investment proposals.
(1) NET INVESTMENT
Net investment represents the initial cash outlay that is required to obtain future returns or the net cash
outflows to support a capital project.
Simply stated, net investment is net cash flows at time zero.
SOLUTION GUIDE
To compute net investment, let us divide it into three (3) parts
OLD ASSET NEW ASSET WORKING CAPITAL
Trade in value (-) Acquisition Costs (+) Increase in Working Capital (+)
Proceeds from sale (-) Other Direct Costs (+) Decrease in Working Capital (-)
Tax on gain on sale (+)
Tax on loss on sale (-)
Avoidable repairs, net of tax (-)
Removal cost, net of tax (+)
NOTE: If the decision is an acquisition decision, computation of net investment is limited only to new asset
and working capital section. If it is a replacement decision, the three sections are complete.
(2) CASH FLOWS
These are the expected returns directly attributable to the investment project. Cash flows could be
OPERATING CASH FLOWS AFTER TAX or END OF LIFE CASH FLOWS
OPERATING CASH FLOWS AFTER TAX
The incremental changes in cash arising from cash inflows and cash outflows directly attributable to the
project. These cash flows are assumed to occur at the end of the year.
SOLUTION GUIDE
EBITDA / Cost Savings / Cash Operating Income xxx
Incremental Depreciation (xxx)
Cash Inflow before Tax xxx
Incremental tax (xxx)
Incremental Net Income xxx
Add back Incremental Depreciation xxx
OPERATING CASH FLOWS AFTER TAX xxx
NOTE: EBITDA or cash operating income is used if the purpose of the capital project is to increase net
cash flows. On the other hand, cost savings is used if the purpose of the capital project is reducing the
operating costs.
ALTERNATIVE SOLUTION GUIDE
EBITDA / Cost Savings after tax [EBITDA / CS x (1-tax rate)] xxx
Tax Shield on Incremental Depreciation (Incremental Depreciation x tax rate) xxx
OPERATING CASH FLOWS AFTER TAX xxx

END OF LIFE CASH FLOWS

These are the net cash flows occurring at the end of the investment project’s life.
SOLUTION GUIDE
Operating Cash Flows After-tax xxx
Salvage Value or Net Proceeds from sale xxx
Return of Increase in Working Capital xxx

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Return of Decrease in Working Capital (xxx)

END OF LIFE CASH FLOWS xxx
(3) DISCOUNT RATE
A.K.A. minimum required rate of return or cut-off rate or target rate or desired rate of return or hurdle
rate.
This is the weighted average cost of capital of long-term funds obtained from different sources. (The
computation of this is to be discussed on the cost of capital material)
CAPITAL BUDGETING TECHNIQUES
NON-DISCOUNTED TECHNIQUES
(1) ACCOUNTING RATE OF RETURN (ARR)
A.K.A. Book rate of return (BRR).
This is a conventional or traditional technique of measuring profitability by relating the required
investment to its incremental net income.
ADVANTAGES DISADVANTAGES
(1) ARR closely parallels
accounting concepts of income
(1) Ignores time value of money
measurement and investment
return.
(2) With the computation of
(2) It facilitates re-evaluation of
income and book value based
projects due to the ready
on the historical cost
availability of data from the
accounting data, the effect of
accounting records.
inflation is ignored.
(3) ARR considers income over
the entire life of the project.
(4) ARR emphasizes profitability
rather than liquidity
SOLUTION GUIDE
= Average Annual Net Income
ARR
Net Investment*
NOTE: Net investment could be based on original investment or average investment. Average investment
is computed as original investment plus salvage value divided by two.
(2) PAYBACK PERIOD
Payback period is the length of time required for a project’s cumulative cash flows to equal its net
investment. Simply stated, it is the measure of time for the project to break-even. With that, PAYBACK
PERIOD is a measure of LIQUIDITY rather than PROFITABILITY.
ADVANTAGES DISADVANTAGES
(1) Payback is simple to compute
(1) Ignores time value of money
and easy to understand.
(2) More emphasis is given on
return of investment rather
(2) Payback gives information than the return on investment.
about the project's liquidity After reaching the payback
period, subsequent cash flows
are ignored.
(3) It is a good surrogate for risk.
(3) It does not consider the
A quick payback period indicates a
salvage value of the project.
less risky project.
SOLUTION GUIDE
The below solution guide is used only if the operating cash flows after tax are even. Otherwise, payback
period computation is done manually.
Net Investment
Payback Period =
Operating Cash Flow After-tax
(3) BAIL-OUT PERIOD
Is a variation of payback period where cash recoveries include not only the operating net cash inflows but
also the estimated salvage value or proceeds from sale at the end of each year of the life of the project.

(4) PAYBACK RECIPROCAL

Payback reciprocal measures the rate of recovery of investment during the payback period, thus
emphasizes profitability rather than liquidity.
Payback reciprocal is a reasonable estimate of Internal Rate of Return (IRR) provided the following
conditions are present:
(a) The payback period is at most half of the life of the project.
(b) The operating cash flows after-tax are even throughout the life of the project.

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SOLUTION GUIDE
1
Payback Reciprocal =
Payback Period
or
Operating Cash Flows After-tax
Payback Reciprocal =
Net Investment

DISCOUNTED TECHNIQUES
(1) NET PRESENT VALUE
NPV is the excess of the present value of cash inflows over present value of cash outflows generated by
the project throughout its life.
SOLUTION GUIDE
Present Value of Cash Inflows xxx
Present Value of Cash Outflows (xxx)
NET PRESENT VALUE xxx
NOTES:
(a) Cash inflows include the operating cash flows-after tax, salvage value or net proceeds from sale and
the return of working capital from original investment. Simply stated, these are the end of life cash
flows. Just remember to multiply them to their appropriate present value factors.
(b) Cash outflows are represented by the initial cost of the investment or the net investment. Since it
occurred at time zero, it is NOT DISCOUNTED.
ADVANTAGES DISADVANTAGES
(1) It requires predetermination of
(1) Emphasizes cash flows rather
the cost of capital or the discount
than net income
rate to be used.
(2) The net present value of
different competing projects
(2) Recognizes the time value of may not be comparable
money because of differences in
magnitudes or sizes of the
projects.
(3) Assumes discount rate as the
reinvestment rate
(c) Fisher rate is the rate where the projects will generate the same net present value.
(2) INTERNAL RATE OF RETURN
A.K.A. Discounted cash flow rate of return, time-adjusted rate of return or sophisticated rate of return.
This is the rate which equates the present value of cash inflows to present value of cash outflows. Simply
stated, it is the rate where present value is zero.
Guidelines in determining IRR:
(a) Determining the present value factor of IRR with the use of the below formula:
Net Investment
IRR factor =
Operating Cash Flow After-tax
NOTE: The above formula is the same as payback reciprocal, so, it can also be used if the cash flows after-
tax are even and the cash inflows consist only cash-flows after tax. (If there are salvage value and return
of working capital the formula cannot be used)
(b) Using the present value annuity table, find on line “n” (economic life) the factor computed in (a). The
corresponding rate is the IRR. If the exact rate is not found on the table, interpolation process may
be necessary.
(3) PROFITABILITY INDEX
A.K.A. NPV index.
Profitability index is designed to provide a common basis of ranking alternatives that require difference
amounts of investment.
SOLUTION GUIDES
Present Value of Cash Inflows
Profitability Index =
Present Value of Cash Outflows

NPV
Profitability Index = + 1
Net Investment

PV factor Discount Rate

Profitability Index =
PV factor IRR
(4) DISCOUNTED PAYBACK PERIOD

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It is the period required for the discounted cumulative cash inflows on a project to equal the discounted
cumulative cash outflows (usually the initial cost). It is the same concept as payback period except that
cash flows should be discounted.
INVESTMENT DECISIONS
For independent projects:
Accept Reject Indifferent
NPV + - 0
IRR > DR < DR = DR
PI >1 <1 =1
Payback > ½ of Life < ½ of Life = ½ of Life
ARR > DR < DR = DR
For mutually exclusive projects:
If same size – basis would be NPV.
If different size – basis would be PI
CAPITAL RATIONING
Capital rationing is a situation in which management places a constraint on the total size of the firm’s capital
budget during a particular period. It is also described as the selection of the investment proposals in a situation
of constraint on availability of capital funds to maximize the wealth of the company by selecting those projects
which will maximize overall NPV.
STEPS IN CAPITAL RATIONING
(1) Rank the projects according to their profitability index
(2) Choose the combination of projects with the highest total NPV.

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DISCUSSION EXERCISES
STRAIGHT PROBLEMS
NET INVESTMENT & OPERATING CASH FLOW AFTER TAX
1. FREYA CORP. is planning to replace an old machine with the following related information:
Book value P300,000
Remaining useful life 5 years
Current market value 150,000
Additional information:
• The replacement machine can be acquired at a list price of P500,000. A 5% cash discount is
available if the said machine is paid within 30 days from acquisition date. Freight and installation
costs is estimated at P75,000.
• Should the company decide not to acquire the new machine, it needs to repair the old one at a cost
of P50,000. Otherwise, additional cost of removing the old unit is estimated at P10,000.
• Additional gross working capital of P15,000 will be needed to support operation planned with the new
equipment.
• The new machine is estimated to reduce cash operating costs amounting to P150,000 per year and is
to be depreciated using the straight-line method over its useful life of 5 years.
• FREYA is subject to a 30% income tax rate.
REQUIREMENTS:
(1) What is the net initial cost of investment to be used in decision making?
(2) What is the increase in annual net income?
(3) What is the increase in annual net cash flows if the company replaces the machine?
NON-DISCOUNTED TECHNIQUES
2. BANE BUS TERMINAL INC. is planning to install vending machines with a cost of P300,000. It is estimated
that these vending machines will generate annual sales of 20,000 cups with a price of P10 per cup. Cash
variable costs are P4 per cup while cash fixed costs are expected to be P50,000 per year. The vending
machine’s estimated economic life would be 5 years with a salvage value of P50,000 and depreciated
using the straight-line method. BANE is subject to a 35% income tax rate.
REQUIREMENTS: (a) Determine the payback period; (b) Determine the accounting rate of return based on
original investment; (c) Determine the accounting rate of return based on the average investment
3. ALPHA CORP. received three capital investment proposals for its intention to acquire a new machine in the
near future. Information on these proposals are as follows:
PROPOSAL A PROPOSAL B PROPOSAL C
Initial Investment P150,000 P190,000 P250,000
Working Capital Requirements - 10,000 -
Reduction in Cash Operating Costs:
Year 1 50,000 75,000 90,000
Year 2 50,000 80,000 90,000
Year 3 50,000 80,000 90,000
Year 4 50,000 60,000 90,000
Salvage Value at each year-end:
Year 1 90,000 120,000 150,000
Year 2 80,000 90,000 80,000
Year 3 50,000 60,000 75,000
Year 4 20,000 60,000 60,000
Working Capital Returned - 10,000 -
REQUIREMENT: Determine payback period and bail-out period of each proposal.
DISCOUNTED TECHNIQUES
4. TERIZLA INC. is considering two independent projects. Their related information is as follows:
PROJECT 1 PROJECT 2
Cost of investment 300,000 250,000
Estimated salvage value 30,000 20,000
Useful life 5 years 5 years
Cost savings:
1st Year 100,000 90,000
2nd Year 100,000 90,000
3rd Year 100,000 90,000
4th Year 100,000 90,000
5th Year 100,000 90,000
The income tax rate is 30% and the cut-off rate is 10%.
REQUIREMENT: Determine the discounted payback period of PROJECT 1 and PROJECT 2.

5. ZILONG CORP. is planning to acquire a new asset with the following expectations:

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Annual expected sales volume 80,000 units for five years

Selling price P15
Unit variable cost 6
Cost of required machinery 550,000
Salvage value 50,000
Annual cash fixed costs 100,000
Increase in receivables 60,000
Increase in inventory 40,000
The increase in working capital will be returned in full at the end of the five years. The tax rate is 30%
and cost of capital is 12%.
REQUIREMENT: How much is the project’s NPV?
6. Fill in the blanks for each of the following independent cases. Each investment has a useful life of ten
years and no salvage value.
A. B. C. D. E.
Annual Net Investment Cost of Capital Internal Rate Net Present
Cash Inflow of Return Value
1. P 45,000 P 188,640 14% ____ P_______
2. P 75,000 P_______ 12% 18% P_______
3. P______ P 300,000 ____ 16% P 81,440
4. P______ P 450,000 12% ____ P 115,000
7. Fill in the blanks for each of the following independent cases. There are no salvage values for the
investments.
A. B. C. D. E. F. G.
Annual After-tax Cutoff Rate of Internal Rate Net Present Profitability
Useful life Investment
Case Cash Flows Return of Return Value Index
1 15 P40,000 _______ ___% 14% ____ 1.109
2 8 ______ P448,470 16% 18% ____ ____
3 __ P80,000 P361,600 12% ___% ____ 1.25
COMPREHENSIVE
8. Two independent proposals are under consideration by ALUCARD INC. during the current year:
PROPOSAL ABC PROPOSAL XYZ
Initial cost 350,000 600,000
Cash flows at each year
Year One 200,000 250,000
Year Two 200,000 300,000
Year Three 200,000 200,000
Year Four 200,000 200,000
REQUIREMENT:
(1) Should the company accept or reject each of the projects on the basis of the following techniques:
(Discount rate is 10%)
(a) Net present value (d) Payback period
(b) Internal rate of return (e) Book rate of return
(c) Profitability index
(2) Assuming the projects are mutually-exclusive projects, which project should be accepted?
FISHER RATE
9. Two independent potential capital projects are under evaluation by PHARSA INC. Project 1 costs P400,000,
will last 10 years, and will provide an annual annuity of after-tax cash flows of P85,000. Project 2 will cost
P600,000, last 10 years, and provide an annual annuity of P110,000 in annual after-tax cash flows.
REQUIREMENT: At what discount rate would management be indifferent between these two projects?
CAPITAL RATIONING
10. GORD CORP. is contemplating four independent projects A, B, C and D. The company’s desired after-tax
opportunity costs is 12% and has P900,000 capital budget for the year. In assisting the company in its
decision making, the following information is provided:
Proposals Net Investment NPV IRR PI
A P400,000 P7,540 12.70% 1.02
B 470,000 59,654 17.60% 1.13
C 380,000 54,666 17.20% 1.14
D 420,000 (15,708) 10.60% 0.96
REQUIREMENT: Which projects should the company choose?

MULTIPLE CHOICE (THEORIES)

1. Capital budgeting
A. is the process of evaluating whether a segment is to be kept or dropped.

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B. is the process of determining the break-even point.

C. is the process of making capital expenditure decisions.
D. none from the choices.
2. S1: Capital expenditure proposals are initially screened by the stockholders.
S2: The capital budget for the year is approved by a company's capital budgeting committee since they
are part of the board of directors.
A. Only S1 is true C. Both statements are true
B. Only S2 is true D. Both statements are false
3. Performing a post-audit is important because
A. managers will be more likely to submit reasonable data when they make investment proposals if
they know their estimates will be compared to actual results.
B. it provides a formal mechanism by which the company can determine whether existing projects
should be terminated.
C. it improves the development of future investment proposals because managers improve their
estimation techniques by evaluating their past successes and failures.
D. all of these.
4. Which of the following items are deducted in computing net investment for capital budgeting purposes?
I. Tax on avoidable repairs III. Tax on removal cost of old asset
II. Proceeds from sale of old asset
A. I and II D. I, II and III
B. II and III E. Answer not given
C. I and III
5. In relation to operating cash flow after tax, which of the following statements is incorrect?
I. It is measured in terms of income before depreciation but after taxes.
II. Interest payments on funds borrowed to finance the project are not relevant in computing the cash
flow after-tax.
A. I only C. Both I and II
B. II only D. Neither I nor II
6. All of the following is an incorrect statement in relation to the payback period, except:
I. It does not consider all the cash flow over the life of the investment.
II. It measures the quickness of the investment to return the cash flow at time zero.
A. I only C. Both I and II
B. II only D. Neither I nor II
7. Disadvantages of the annual rate of return method include all of the following except that
A. it relies on accrual accounting numbers instead of actual cash flows.
B. it does not consider the time value of money.
C. no consideration is given as to when the cash inflows occur.
D. management is unfamiliar with the information used in the computation.
8. If a project has a positive net present value
I. Its profitability index is greater than one.
II. Its IRR is less than the cut-off rate.
A. I only C. Both I and II
B. II only D. Neither I nor II
9. In relation to capital budgeting, evaluate whether the following statements are true or false:
I. IRR can be computed for even cash flows, but not for uneven cash flows.
II. Discounted cash flow techniques apply to investments that involve either costs only, or both costs
and revenues.
III. Payback emphasizes the return of the investment and ignores the return on the investment.
A. B. C. D.
Statement I True True False False
Statement II False True True True
Statement III True False False True
10. Which of the following techniques considers time value of money?
I. IRR III. Payback period
II. NPV IV.
A. I and II D. I, II and III
B. II and III E. Answer not given
C. I and III
- END OF HANDOUTS -

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