MANAGEMENT ADVISORY SERVICES

CAPITAL BUDGETING
Reviewer: Noelen Monarca Carreon, CPA, MBA

Topic Outline
● Basic Concepts
● Elements of capital budgeting
● Techniques in capital budgeting
● Investment decisions

I. Basic concepts

Capital Budgeting is a process of identifying, evaluating, planning and financing capital investment
projects of an organization.

Capital Budgeting is an INVESTMENT CONCEPT

Receive Returns

Additional
Invest or commit cash inflows
funds Reduced
cash outflows

TODAY FUTURE
High Risk and Uncertainty

Note:
You are investing funds today with an expectation to receive returns in the future. Expected
returns may come either in additional cash inflows or reduced cash outflows.

Capital budgeting involves investment in LONG TERM ASSETS. These type of investments have
high risk and uncertainty as it requires longer period for the returns to be realized.

Capital budgeting is usually used on the following decision:

● Replacement and Acquisition of Long term assets
● Improvement of products
● Expansion of facilities
● Trading or Exchanging assets

Capital Budgeting Process

1. Identification and definition
2. Search for potential investment projects
3. Information gathering both quantitative and qualitative
4. Selection- choosing the investment projects after evaluating their projected costs and
benefits.
5. Financing
6. Implementation and monitoring (post audit evaluation)

Types of Projects
a. Independent projects
b. Mutually exclusive projects

Time Value of Money

● Present value of 1 (PV of1)
● Present Value of Ordinary Annuity of 1 (PV of OA of 1)
 II. Elements of Capital Budgeting

These are the factors of capital budgeting used in evaluating capital investment proposals.
● Net Investment
● Cash Flows or Net returns
● Discount Rate

a. NET INVESTMENT
Net investments represent 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.

NET INVESTMENT
WORKING
OLD ASSET NEW ASSET
CAPITAL

Proceeds from sale (-)

Trade in value (-)
Tax on gain on sale (+) Acquisition costs (+ ) Increase in working
Tax on loss on sale (-) Other direct costs (e.g. capital (+)
Avoidable reapirs net of tax (-) shipping installation, testing Decrease in working
Removal cost, net of tax (+) (+) capital (-)

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.

b. 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 cashflows.

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.

Operating Cash-flows after tax

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

2
 EXAMPLE:
Operating Cash-flows after tax
Cost savings/ Cash operating income 100
Incremental depreciation (20)
Cash Inflow before tax 80
Incremental Tax (30%) (24)
Incremental net income 56
Add back incremental depreciation 20
OPERATING CASH FLOWS AFTER TAX 76

Note:
In Replacement decision, compare the depreciation of the new asset against the depreciation of
the old asset. The incremental depreciation is the difference in the depreciation between the old
asset and the new asset. However, in an Acquisition decision only the depreciation of the new
asset is incremental depreciation.

Depreciation is added back which is a non-cash expense.

END OF LIFE CASH FLOWS

These are net cash flows occurring at the end of the project’s life.

Operating cash flows after tax xxx

Salvage value or net proceeds from sale xxx
Return of increase in working capital xxx
Return of decrease in working capital (xxx)

c. Discount Rate
This is the weighted average cost of capital of long term funds obtained from different sources.

A.K.A minimum required rate of return or cut off rate or target rate or desired rate of return or
hurdle rate.

SAMPLE EXERCISE 1.

During the current year, 2020, HANZO CORP. is planning to replace an old machine with the
following information:
Carrying amount P600,000
Useful life 5 years
Current market value 300,000

The new equipment could be purchased at a cost of P1,000,000 excluding payments for shipping
and installation for a total amount of P100,000. Other assets that are to be retired as a result of the
acquisition of the new machine can be salvaged for P40,000. The gain on the retirement of these
assets is P10,000, which will increase income taxes by P2,500.

Should the company decide not to acquire the new machine, it needs to repair the old one at a cost
of 100,000. Otherwise, additional cost of removing the unit is estimated at P20,000. Additional gross
working capital of P30,000 will be needed to support operation planned with the new equipment.

3
REQUIREMENT 1: How much is net investment?

Solution:
New Asset
Acquisition Cost 1,000,000
Directly Attributable costs 100,000___
Total 1,100,000

Old Asset
Market Value- Old Asset P(300,000)
Proceeds from sale- other assets (40,000)
Tax on gain-other assets 2,500
Tax on loss- Old asset (300k x 25%) (75,000)
Avoidable repairs, net of tax (P100,000 x 75 %) (75,000)
Removal cost, net of tax (20,000 x 75%) 15,000___
Total (472,500)

Working Capital
Increase in WC 30,000__
NET INVESTMENT P657,500

REQUIREMENT 2: What is the increase in annual net cash flows if the company replaces the
machine?
Solution:

Cash cost savings P300,000

Incremental depreciation:
New Asset (100k / 5yrs ) 220,000
Old Asset (600k / 5 yrs) 120,000 (100,000)
Income before tax 200,000
Tax (200k x 25%) (50,000)
Incremental net income 150,000
Add back incremental Depreciation 100,000
Operating Cash flow after tax P250,000

Alternative solution:

Cost Savings after tax (300,000 x 75%) P225,000

Tax shield on incremental depreciation
(100,000 x 25%) 25,000
Operating Cash flow after tax P250,000

III. Techniques in Capital Budgeting

Profits / Net Accounting Rate

Income of Return (ARR)

Ignores Time
value of money Discounted Payback period

Cash flows
Net Present Value
Considers Time
value of money
Internal Rate of Return
(IRR)

Profitability Index

4
Accounting Rate of Return
● Type: Non discounting method
● Basis: Accounting Net income
● Purpose: tells managers how much net income a potential project is expected to generate
as a relative percentage of the investment required
● How used: compare ARR to the hurdle rate (minimum rate of return)
Accept: ARR > Hurdle rate
Reject: ARR < Hurdle rate

This is a conventional or traditional technique of measuring profitability by relating the required

investment to its incremental net income.

ARR = Incremental net income / 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.

ADVANTAGES DISADVANTAGES

ARR emphasizes
profitability rather than Ignores the time value of
liquidity money
The computation of
ARR considers income
income and book value based
over the entire life of the on historical cost accounting
project. data, the effect of inflation is
Availability of data from ignored.
the accounting records

Payback Period
● Type: Non-discounting method
● Basis: Cash flows
● Purpose: It shows the amount of time it takes for a capital investment to be recovered by
the company using the cash inflows from investment.
● How used: Generally, projects with shorter payback periods are safer investments than
those with longer payback periods.

Payback period is the length of time required for a project's cumulative cash flows to equal its net
investment.

If cash flows are even :

Payback = net investment / cashflow after-tax

If the cash flow is uneven, payback period is computed manually

5
 ADVANTAGES DISADVANTAGES

Payback gives
information about the Ignores time value of
projects liquidity money. After reaching
Payback is simple to the payback period
compute and easy to subsequent cash flows
understand are ignored

It is a good surrogate It does not consider

for risk. A quick payback the salvage value of the
period indicates a less project.
risky project.

SAMPLE EXERCISE 2:
BANE BUS COMPANY INC. is planning to install vending machines with a cost of P
300,000. It is estimated that this 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 average investment.

Solution:
Net investment P300,000

Sales (20,000 cups x P10) P200,000

Variable costs (20,000 cups x P4 (80,000)
Contribution margin 120,000
Cash fixed costs (50,000)
Cash operating income 70,000
Incremental Depreciation (250k / 5 yrs) (50,000)
Income before tax 20,000
Tax (20,000 x 35%) (7,000)
Incremental net income 13,000
Add back: incremental depreciation 50,000
Operating cash after tax 63,000

Alternative solution:
Cash operating income after tax (P70,000 x 65%) P45,500
Tax shield on depreciation (P50,000 x 35% 17,500
Operating cash flow after tax 63,000

(a.) Payback period (P300,000 / P63,000) 4.67 years

(b.) Simple rate of return (P13,000 / P300,000) 4.33%
(c.) average rate of return (P13,000 / P175,000) 7.43%

6
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 at the end of each year of the life of the project.

FOR FIRST YEAR FOR SECOND YEAR ONWARDS

Salvage value (at year end ) xxx

Salvage value (at year end ) xxx
CFAT (current year) xxx CAFAT (prior year) xxx
CFAT (current year) xxx
Total
Total
xxx
xxx

Note: CFAT = Cash flow after-tax

SAMPLE EXERCISE 3:
A Company purchased a new machine on January 1 of this year for P180,000 with an
estimated useful life of 5 years and a salvage value of P10,000. The machine will be depreciated
using the straight line method. The machine is expected to produce the following cash flow from
operations, net of income taxes:

Year Amount
1 60,000
2 70,000
3 80,000
4 70,000
5 60,000
The new machine’s salvage value is P20,000 in years 1 and 2, and P15,000 in years 3 and 4.

Requirement: (a) payback period (b) Bailout period

Payback period
1 60,000 = 1
2 70,000 = 1
3 50,000 = .625 (50,000/ 80,000)
180,000 2.625
Answer = 2.625 years

Bailout period
Year 1:
Salvage value P20,000
Cash flow after tax (current) 60,000
Total P80,000

Year 2:
Salvage value P20,000
Cash flow after tax (prior) 60,000
Cash flow after tax (current) 70,000
Total P150,000

Year 3:
Salvage value P20,000
Cash flow after tax (prior) 130,000
Cash flow after tax (current) 35,000
Total P180,000

7
Answer: 2 years + (35,000/80,000) = 2.4375

Discounted Payback
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.

Net Present Value

● Type: Discounted method
● Basis: Cash flow
● Purpose: Compares the PV of the project’s future cash inflows to the PV of cash the cash
outflows.
● How used:
Accept : NPV > or = 0
Reject: NPV < 0

NPV is the excess of the present value of the cash inflows over present value of cash
outflows generated by the project throughout its life.

PV of inflows:
CFAT xxx
Salvage value xxx
Working capital xxx
PV of Outflows:
Net investment (xxx)
NET PRESENT VALUE xxx

NOTE: PV factors to be used :

CFAT: PV of 1 for even cashflows / ordinary annuity of 1 for uneven cashflows
Salvage Value: PV of 1
Working Capital: PV of 1

Internal Rate of Return

● Type: Discounting method
● Basis: Cash flow
● How used:
Accept: IRR > Minimum required rate of return or Hurdle rate
Reject: IRR < Minimum required rate of return or Hurdle rate

This is the rate which equates the present value of cash inflows to the present value of
cash outflows. Simply stated, it is the rate where present value is zero.

A.K.A Discounted cash flow rate of return, time adjusted rate of return or sophisticated rate of
return.
Present value Factor = Cost of investment/ annual cash inflow

Note: Look for PVF in the table of PV factors or interpolate.

Profitability Index
● Type: Discounting method
● Basis: Cash flows
● Purpose:The ratio of the project’s benefit ( measured by the Pv of the future cash flows)
to its cost (or required investment).
● How used:
Accept: PI > 1
Reject: PI < 1

8
Profitability Index is designed to provide a common basis of ranking alternatives that require
different amounts of investment.

Profitability index = PV of Cash inflows / PV of Cash outflow

Profitability Index = Net present value / Net investment + 1

III. Investment Decisions

a. Independent Projects- unrelated to one another

The profitability index of an investment is the ratio of the present value of the future net
cash flows to the net initial investment. It is a variation of a net present value (NPV)
method, the profitability index will yield the same decision as the NPV for independent
projects. However, decisions may differ for mutually exclusive projects of different sizes.

b. Mutually exclusive Projects- competing alternatives where investing in one removes the
possibility of investing in another.

Investment projects may be mutually exclusive under conditions of capital rationing

(limited capital). In other words, scarcity of resources will prevent an entity from
undertaking all available profitable activities. When faced with capital rationing,an investor
will want to invest in projects that generate the most dollars in relation to the limited
resources available and the size and returns from the possible investment. Thus, the NPV
method should be used because it determines the aggregate present value for each
feasible combination of projects.

SAMPLE EXERCISE 4:
Two independent proposals are under consideration by ALUCARD INC. during the current year:

Proposal ABC Proposal XYZ

Initial cost 600,000 800,000
Cash flows at year end
Year 1 200,000 250,000
Year 2 200,000 300,000
Year 3 200,000 200,000
Year 4 200,000 200,000

The company’s discount rate is 10%

Requirement:
(1) Should the company accept or reject each of the projects on the basis of the following
techniques:
(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?

Solution: Proposal ABC

(a.) @ Discount rate

Cash flows after tax (200,000 x 3.1699 633,980
Net investment (600,000)
Net Present value 33,980

9
(b.) @ Internal Rate of Return
Cash Inflows after tax (200,000 x 3) 600,000
Net investment (600,000)
Net present Value -0-
Internal Rate of Return 12.59%

(c.) Profitability Index [(33,980 / 600,000)] + 1 = 1.06

(d.) Payback period (600,000/ 200,000) = 3 years
(e. ) book rate of return [(200,000-150,000) / 300,000] = 16.67%

TECHNIQUE DECISION
Net present value Accept
Internal rate of return Accept
Profitability Index Accept
Payback period Reject
Accounting rate of return Accept

Overall Decision: Accept Proposal ABC

Solution: Proposal XYZ

(a.) @ Discount rate

Cash flows after tax
(250,000 x 0.09091) 227,275
(300,000 x 0.8264) 247,920
(200,000 x 0.7513) 150,260
(200,000 x 0.6830) 136,600
Net investment (800,000)
Net Present value (37,945)

(b.) @ Internal Rate of Return

Cash Inflows after tax
(250,000 x 0.9288) 232,200
(300,000 x 0.8626) 258,780
(200,000 x 0.8012) 160,240
(200,000 x 0.7441) 148,820
Net investment (800,000)
Net present Value -0-
Internal Rate of Return 7.67%

(c.) Profitability Index [(-37,945 / 800,000)] + 1 = 0.95

(d.) Payback period [3 years + (50,000/ 200,000) = 3.25 years
(e. ) book rate of return [(237,500-200,000) / 400,000] = 9.38%

TECHNIQUE DECISION
Net present value Reject
Internal rate of return Reject
Profitability Index Reject
Payback period Reject
Accounting rate of return Reject

Overall Decision: Reject Proposal XYZ

If the projects are MUTUALLY-EXCLUSIVE, the company should accept PROJECT ABC only.

10