CAPITAL BUDGETING 1.

Cost or Cash Outflows

a. Initial cash outlay covering all expenditures
- Process of identifying, evaluating, planning and financing capital b. Working capital requirement to operate the project at the desired
investment project of an organization level
- Chinecheck yung cost ng project and titingnan yung benefits na c. Market value of an existing, currently idle asset, which will be
mabibigay nito transferred to or utilized on the operations
Project Classification
2. Savings or Cash Inflows
1. Replacement: Maintenance of business a. Trade-in value of old asset (in case of replacement)
2. Replacement: Cost reduction b. Proceeds from sale of old asset to be disposed (less tax, if there is
3. Expansion of existing products or markets gain, add tax savings, if there is loss on sale)
4. Safety and environmental projects c. Avoidable cost of immediate repairs on old asset to be replaced,
5. Other projects (office building, parking lots, executive aircraft) net of tax

Capital Investment Projects Problem 1

- Large commitments of resources The management of Shantal Company plan to replace a sorting machine that
- Long term commitments was acquired several years ago at a cost of 50,000. The machine has been
- More difficult to reverse than short term decisions depreciated to its salvage value of 5,000. A new sorter can be purchased for
- Involve so much risk and uncertainty 60,000. The old machine can be sold for 6,000. If a new machine is not
purchased, Shantal company will spend 20,000 to repair the old machine.
Factors Affecting Long Term Decisions
The cost to repair the old machine can be deducted in the first year to
1. Estimated cash flows compute income tax. Income tax is estimated at 40% of the income subject
a. Net Investments to tax. Assume also that the acquisition of the new machine will require
b. Cash Returns additional investment in working capital of 10,000.
c. Terminal Value / Residual / Scrap Value
Compute the net investment in the new machine for decision making
2. Cost of Capital
purposes. Answer: 52,400
3. Acceptance Criteria
Cash Returns vs. Net Returns ( Net Income)
Computing Net Investment

Net Investment
Cost – Savings
Cash Outflows – Cash Inflows
Sales xxx Problem 3
Expenses (COGS + OPEX) (xxx) Itable, Inc. uses a labor intensive manufacturing process. Existing equipment
Operating Income xxx has a book value of 20,000, a 5 years remaining life, and a 25,000 market
Income Taxes (xxx) value. Cash operating costs is 75,000. The proposed process requires
Net Income xxx machinery costing 120,000 with a useful life of 5 years and no salvage value.
Depreciation Expense xxx The new machinery, which will replace the old one, requires 35,000 in annual
Cash Returns xxx cash costs. The tax rate is 30% and the cost capital is 12%.

- Ina-add back yung lahat ng depreciation expense para maka-come up Determine the net investment and annual net cash inflow on the new
sa cash returns equipment. Answer:

Problem 2: Net Investment: 96,500

Net Cash Inflow : 35,200
Viray, Inc. is considering an investment of 2,000,000 in a new product line.
Depreciation of 200,000 is to be deducted in each of the next 10 years
(salvage value is estimated at zero). A selling price of 40 per unit is decided
Cost of Capital (Hurdle Rate, Required Rate of Return, Cut-Off Rate,
upon; unit variable cost is 18, and a fixed operating costs, excluding
Opportunity Cost)
depreciation are estimated at 400,000 per year. The sales division believes
that a sales estimate at 400,000 per year. The sales division believes that a Source Capital Cost
sales estimate of 50,000 units per year is realistic. Income tax is estimated at Creditors Long term debt After tax rate of interest
30% of income before tax. Stockholders
a. Preferred Preferred Stock Dividends
Determine the annual net cash inflows and net returns (net income) for the b. Common Common Stock Dividends
proposed investment project. Answer: 550,000 Retained Earnings Retained earnings Opportunity Cost

Sales xxx
Variable Cost (xxx) Common Evaluation Techniques
Continuation Margin xxx Methods that do not consider the time value of money
Fixed Cost (xxx)
Operating Income xxx 1. Payback (PB) – will tell you how long you’re going to recover your
Taxes (xxx) investment base on the annual cash return na mayroon.
Net Income xxx 2. Bailout (BO) – same with PB but yung annual cash return dito ay ina-
add always yung estimated salvage value at the end of each year,
Depreciation Expense xxx
every year may estimates ng salvage value.
Cash Returns xxx
 3. Accounting Rate of Return (ARR) – also known as book value rate of DISADVANTAGES
return or annual rate of return or average return on investment (ROI)
1. Does not consider time value of money
2. The effect of inflation is ignored

Methods that consider the time value of money:

Net Present Value
1. Net present value (NPV)
2. Profitability Index (PI) ADVANTAGES
3. Discount payback (DPB)
4. Discounted cash flow rate of return or Internal rate of return (IRR) 1. Emphasizes cash flows
2. Recognizes time value of money
Payback Period (PB) 3. Assures discount rate as the reinvestment rate
4. East to apply
ADVANTAGES
DISADVANTAGES
1. Simple to compute and easy to understand
2. Gives information about liquidity of the project 1. Requires predetermination of the cost of capital or the discount rate
3. Good surrogate for risk to be used
2. Different competing projects may not be comparable because of
DISADVANTAGES differences in magnitudes or sizes of the project
1. Does not consider time value of money’ Discounted Cash Flow Rate of Return or Internal Rate of Return (IRR)
2. Gives more emphasis on liquidity rather than profitability of the
project (return of investment vs. return on investment) ADVANTAGES
3. Does not consider salvage value
4. Ignores the cash flow that may occur after the payback period 1. Emphasizes cash flows
2. Recognizes the time value of money
Accounting Rate of Return (IRR) 3. Computes the true return of the project

ADVANTAGES DISADVANTAGES

1. Closely parallels accounting concepts of income measurement and
investment
2. Facilitates re-evaluation of projects due to the ready availability of of
data from the accounting records
3. Considers income over the entire life of the project
1. Assumes that the IRR is the reinvestment rate
2. When project includes negative earnings their economic life, different
rates of return may result.