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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.

There are two (2) striking characteristics of capital expenditure projects.

First, the amount involved is material, and second, the project life-cycle extends beyond one
year. It makes deciding on capital budgeting complicated and highly strategic not only in terms
of the amount of money involved but also because the business shall develop its tactical and
operational strategies in line with the objectives and goals of its capital investment decisions.

Several projects that need capital budgeting analyses are the following
● Replacement or expansion
○ Establish a branch or not
○ Purchase or lease a long-term ander
○ 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 outsource services from
available service contractors
○ Similar strategic decisions

Main issues in capital budgeting

Before millions of money are poured in as equity in financing a project and before resources are
mobilized accordingly, several issues need to be ironed out and doubts (ie., risk) need to be
reduced with respect to the proposed project. Product attractiveness, product marketability and
distribution models, industry growth, pricing strategies, production and technical competence,
socio-economic and other demographic aspects, and effects of technology are some major
issues that need competent answers.
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In this capital budgeting discussions, the major concerns are:

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

The cost of investment refers to the net cash outflows, after tax considerations, that are
normally paid by investors in relation to the investing transaction. It includes opportunity cost
such as possible savings and tax effect on possible gain, loss or savings on related
transactions.
To illustrate, let us say that we are considering to replace an old asset which has been
scheduled for major repairs to restore its usefulness. The following cash outflows and inflows
would be considered:

NET COST OF INVESTMENT

Cash OUTFLOWS Cash INFLOWS

● Net purchase price of Direct cost ● Proceeds Direct cost

the new asset (net of from sale in
discount whether trade-in
taken or not taken)
allowance
from disposal
of old act

● Additional or Direct cost ● Tax savings Indirect Future cost

incidental costs paid from loss on
or incurred to prepare sale of old
(ie, ready) the asset asset
for use

● Increase in working Direct cost ● Savings from Indirect / Opportunity

capital base. avoided cost
repairs an
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maintenance,
if the old asset
is replaced

● Additional tax paid or Indirect/

incurred in case of Future cost
gain from sale or
disposal of old asset

● Additional tax paid Indirect/

from savings on Future cost
avoided cost of
repairs, if the old
asset is replaced.

The net cost of investment is the difference between the outflows and the inflows. The
computation includes direct costs, indirect costs, and opportunity costs. The tax effects on gain,
loss or savings are also considered in the determination of net cost of investment. The gain and
loss on disposal of old assets have no direct effect in the computation of the net cost of
investment. However, the tax effects of the gain and loss on disposal affect the cost of
investment.

In this context, the determination of the net cost of investment is used for strategic decision
making purposes and is different from the strict definition of cost of investment followed in
financial accounting where opportunity costs, tax effects, and savings are not considered.

Sample Problem 1. Net cost of investment

The World Trade Center Company plans to acquire a new equipment costing P1,200,000 to
replace the equipment that is now being used. The terms of the acquisition are 3/30. n/90.

Freight charges on the new equipment are estimated at P21,000 and it will cost P14,000 to
install. Special attachment to be used with this unit will be needed and will cost P36,000 If the
new equipment is acquired, operations will be expanded and this will require additional working
capital of P250,000. The old equipment had an amortised cost of 1300,000 and will be sold for
P180,000. If the new equipment is not purchased, the old equipment must be overhauled at a
cost of P90,000. This cost is deductible for tax purposes in the year incurred. Tax rate is 35%.

Compute the net investment in the new equipment for decision-making purposes.
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Solutions

Purchase price (12 million x 97%) P1,164,000

Freight charge 23,000

Installation costs 14,000

Special attachment 36,000

Additional working capital 250,000

Proceeds from sale of old asset (180,000)

Tax savings from loss on sale of old assets (42,000)

(P120,000 x 35%)

Avoidable repairs (90,000)

Tax to be paid on avoided repairs (P90,000 x 31,500

35%)

Net cost of investment P1,206,500

Discussions

The purchase discount is deducted automatically regardless of whether it is taken or not.

Cash inflows are deducted. Reduction in tax payments (ie, tax savings) and cost of avoidable
repairs are savings and are considered inflows.

The loss from sale of old asset amounting to P120,000 (ie, P180,000 P300,000) is not included
in the computation If there is a loss, net income decreases, and tax paid. decreases. The
decrease in tax payment is a saving, an inflow, Hence, a deduction from the cost of investment.

If the new asset is acquired, the cost of repairing the old asset is avoided. It is a saving and an
inflow (ie., P90,000). However, if the repairs are avoided, the net income increases resulting to
higher amount of tax paid amounting to P1,500 (i.c., P90,000 x 35%). Eventually, the net effect
of the avoided repairs is P58,500 (i.c., P90,000 P31,500).

The additional working capital is an outflow at the date of investment which shall be recovered
and treated as an inflow on the date the investment is terminated.
STRAIGHT PROBLEMS
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1. Net cost of investment. The management of True-Life Company plans to replace a sorting
machine that was acquired several years ago at a cost of P120,000. The machine has been
depreciated to its residual value of P12,000. A new sorter can be purchased for P140,000. The
dealer will grant a trade-in allowance of P7,000 on the old machine, Ifa new machine is
purchased, True-Life will spend P25,000 to repair the old machine. Gains and losses on trade-in
transactions are not subject to income tax. The cost to repair the old machine can be deducted
in the first year for computing income tax. Income tax is estimated at 40% of the income subject
to tax.

Required: The net investment assigned to the new machine for decision analysis.

2. Net cost of investment. Tingaling Corporation is planning to purchase a new machine

costing P4,800,000, freight and installation costs amounting to P45,000. The old unit will be
given a trade-in allowance of P200,000. 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 GP8,000. If the new
machine is not purchased, extensive repairs on the old machine will have to be made at an
estimated cost of P400,000. 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 analysis.

3. Net cost of investment. The Mabuhay Corporation plans to acquire a new equipment 60,67
costing P900,000 to replace the equipment that is now being used. Freight charges on the new
equipment are estimated at P25,000 and it will cost P22,000 to install. Special attachments to
be used with this unit will be needed and will cost P55,000.

If the new equipment is acquired, operations will be expanded and this will require additional
working capital of P110,000.

The old equipment has a net book value of P60,000 and will be sold for P22,000. If the new
equipment is not purchased, the old equipment must be overhauled at a cost of P120,000. This
cost is deductible for tax purposes in the year incurred. Tax rate is 25%.

Required: Compute the net investment in the new equipment for decision making purposes.