CAPITAL BUDGETING

Accounting 206 Strategic Business Analysis

CAPITAL BUDGETING
• It is also known as “Capital investment analysis”.
• It is used to describe how managers plan significant investment
in projects that have long-term implications such as the
purchase of new equipment or the introduction of new products.
• Capital investment decisions are concerned with the process of
planning, setting goals and priorities, arranging financing, and
using certain criteria to select long-term assets.
CAPITAL BUDGETING
• The process of planning expenditure on assets (long-term
investments, primarily plant and equipment), whose cash flows
are expected to go beyond one year
• Involves making long-term decisions, and involves large
expenditures
• Extremely important to a firm’s future
CAPITAL BUDGETING
• Is it worth it to put money or capital in this project?
• Is it worth it to use money to buy this machine?
• Is it worth it to put money in this business?
IMPORTANCE OF CAPITAL BUDGETING
• It creates accountability as it is used as a control tool in an
entity’s operations.
• It creates measurability.
• It allows the company to make the best use of its resources.
RISKINESS OF CAPITAL BUDGETING
DECISIONS DUE TO:
• Uncertainty of outcome
• Involvement of large amounts of money
• Entailment of long-term commitment
• Difficulty and/or irreversibility of capital budgeting decisions
already made
DIFFERENCE BETWEEN MASTER
BUDGET AND CAPITAL BUDGET
• A master budget is recurring and is made on a periodic basis. It is
a comprehensive plan of action for an organization for a future
period.
• In contrast, a capital budget is longer term in nature and it is
non-recurring. It is an investment and financing plan for a major
project or program that has long range effects on operations.
The resources specified in the capital budget of the current
period are included in the master budget of the period.
CLASSIFICATIONS OF CAPITAL
BUDGETING DECISIONS
• Cost reduction decisions
• Expansion decisions
• Equipment selection decisions
• Lease or buy decisions
• Equipment replacement decisions
SOME PROJECTS THAT CAN BE DECIDED
THROUGH CAPITAL BUDGETING
• Replacement Decisions
• Maintenance (replace damaged equipment)
• Cost Reduction Decisions (replace serviceable but obsolete
equipment to lower costs)
• Expansion of existing projects or markets (Jollibee Cebu
Branch 1,2,3)
• Expansion into new products or markets (Jollibee expand for
the first time to US, Singapore)
SOME PROJECTS THAT CAN BE DECIDED
THROUGH CAPITAL BUDGETING
• Safety (DNV/mining companies) and/or environmental
projects (Nestle Vietnam’s water purification system [ISO]) =
(mandatory investments)
• Mergers
• Others (Office buildings, parking lots, executive aircrafts)
THE CAPITAL BUDGETING PROCESS
• Project proposals are requested from departments, plants, and
authorized personnel.
• Proposals are screened by a capital budget committee.
• Officers determine which projects are worthy of funding.
• Board of directors approves capital budget.
STEPS IN CAPITAL BUDGETING
1. Identification of Capital Investment Needs
2. Formal Requests for Capital Investment
3. Preliminary Screening
4. Establishment of Acceptance-Rejection Standard
5. Evaluation of Proposals
STEPS IN CAPITAL BUDGETING
1. Estimate the project’s cash flows
2. Assess riskiness of the project’s cash flows
3. Determine r (WACC) for the project
4. Find payback period, discounted payback period, NPV, IRR,
and MIRR
5. Decide whether to accept or reject the project
CATEGORIES OF CAPITAL
INVESTMENT PROJECTS
• Screening decisions
• Relate to whether a proposed project is acceptable: whether it
passes a present hurdle.
• Preference decisions
• Relate to selecting from among several acceptable
alternatives.
TYPES OF CAPITAL BUDGETING
PROJECTS:
• Independent
• Projects with cash flows that are not affected by the
acceptance or non-acceptance of other projects.
• You can pick as many projects as you wish.

• Mutually Exclusive
• A set of projects where only one can be accepted.

• Mutually Inclusive
• A set of projects where when you accept the primary project,
you have to accept all other secondary projects connected with
the primary project
ELEMENTS OF CAPITAL
BUDGETING
• Project Cost or Net Investment
• Cost of Capital
• Annual cash inflow

An emphasis on cash flows and not accounting

income, because cash is used to pay for capital
investments.
What comprises cash flows?
• Cash outflows
• Initial investment
• Increased working capital needs
• Repairs and maintenance
• Incremental operating costs

• Cash inflows
• Incremental revenues
• Reduction in costs
• Salvage value
• Release of working capital
SIMPLIFYING ASSUMPTIONS
• All cash flows other than the initial investment occur at the end
of periods.
• All cash flows generated by an investment project are
immediately reinvested at a rate of return equal to the discount
rate.
SAMPLE PROBLEM
• The Mabuhay Corporation plans to acquire a new equipment costing P1,227,500 to replace
the equipment that is being used to manufacture a single product. Freight charges on the
new equipment are estimated at P75,000 and it will cost P90,000 to install. Special
attachment to be used with this unit will be needed and will cost P64,000.
• If the new equipment is acquired, operations will be expanded and this will require
additional working capital of P250,000 at time zero and P150,000 at the end of year 2. The
desired rate of return is 18%.
• The old equipment had a net book value of P45,000 and will be sold for P25,000. If the new
equipment is not purchased, the old equipment must be overhauled at a cost of P320,000.
This cost is deductible for tax purposes in the year incurred. Tax rate is 30%.
Compute the net investment in the new equipment for decision making purposes.
CASH FLOW ESTIMATION
• Net Cost of Investment
NET COST OF INVESTMENT
The standard guideline in computing the cost of investment in a new asset shall be:
Cash OUTFLOWS (+)
Net purchase price of the new asset, net of discount, whether taken or not taken x
Additional necessary costs paid or incurred to bring the assets to its intended location and use x
Additional tax paid or incurred in the case of gain from sale or disposal of old asset x
Additional tax paid from savings on avoided cost of repairs, if the old asset is replaced x
Increase in working capital x
Cash INFLOWS (-)
Proceeds from sale or trade-in allowance from disposal of old asset (x)
Tax savings from loss on sale of old asset (x)
Savings from avoided repairs and maintenance, if the old asset is replaced (x)
Net cost of strategic investment x
CASH FLOW ESTIMATION
• Net Cash Inflows
NET CASH INFLOWS
The standard guideline in computing the cost of investment in a new asset shall be:
Indirect Method Direct Method

Sales P x P x
Less: Out-of-pocket expenses (x) (x)
Cash flows before tax x x
Less: Depreciation expense (x)
Profit before tax x
Less: Income tax (x) (x)
PROFIT x
Add back: Depreciation expense x ____
NET CASH INFLOWS (INCOME) P x P x
SAMPLE PROBLEM
• The new equipment has excess capacity that will allow
Mabuhay Company to add a new product line to its
present business. The following estimates pertaining to
the new product line based on a feasibility study are
made available:
SAMPLE PROBLEM
• At the end of its useful life of 5 years, the new equipment will
have a residual value of P20,000 (i.e., additional cash inflow). At
the end of year 5, the working capital requirement at year 0
amounting to P250,000 will be recovered. At the end of its useful
life, the equipment will be sold atP30,000.
SAMPLE PROBLEM
Annual sales 2,476,651
Annual costs and expenses:
Materials (594,396)
Labor (767,762)
Factory overhead (excluding depreciation on new (314,535)
equipment)
 Depreciation on new equipment includes purchase
price, freight, installation and attachment
Selling and administrative expenses (210,515)
Income tax rate is 30%
 Round income tax to the nearest peso
Time Value of Money Concept and
Present Value Factors
• Since capital budgeting involves long term decisions, the time
value of money must be recognized when evaluating investment
proposals.
• Projects that promise earlier returns are preferable to those
projects whose returns come later.
COST OF CAPITAL/DISCOUNT RATE
REVIEW
• Angel Company has a capital structure of 40% debt and 60%
equity. Cost of debt is 10%. The risk free rate is 5%, beta is 1.2
and return on the market is 12%. Tax rate is 40%. Compute for
the WACC.
Time Value of Money Concept
and Present Value Factors:
• Since capital budgeting involves long term decisions, the time
value of money must be recognized when evaluating investment
proposals.
• Projects that promise earlier returns are preferable to those
projects whose returns come later.
METHODS IN CAPITAL
INVESTMENT ANALYSIS
• Non-discounted Cash Flow Methods
• Payback period
• Payback reciprocal
• Payback bailout
• Accounting rate of return or ROI or Simple rate of return

• Discounted Cash Flow Methods

• Discounted payback period
• Discounted payback bailout period
• Profitability index
• Net present value
• Internal rate of return
PAYBACK PERIOD
• A breakeven analysis
• Refers to the number of years or length of time required to
recover a project’s cost.
• How long does it take to get your money back?
• You must add the project’s cash inflows to its cost until the
cumulative cash flows of the project turns positive
• Uses Nominal Cash Flows
• Two possible scenarios:
• When annual cash inflows are equal
• When annual cash inflows are unequal.
Payback Period – Equal annual
cash flows
• Payback period = Investment required / Annual net cash inflow
• SS Shipping is considering an investment of P130,000 in new
equipment. The new equipment is expected to last 10 years. It
will have a zero salvage value at the end of its useful life. The
annual cash inflows are P200,000 and the annual cash outflows
are P176,000. What is the payback period?
• Further assume that at SS, a project is unacceptable if the
payback period is longer than 60% of the asset’s expected useful
life. Should the project be accepted?
Payback Period – Uneven annual
cash flows
• Chen Company proposes an investment in a new website that is
estimated to cost P300,000. The net annual cash flows for Years
1 to 5 are P60k, P90k, P90k, P120k, and P100k, respectively.
Compute for the payback period.
PAYBACK PERIOD
• If projects are independent
• Accept all the projects that fit into the firm’s “acceptable” criteria.
Otherwise, reject.
• If projects are mutually exclusive
• Accept the project with the shortest payback period and that which fits
into the firm’s “acceptable” criteria. Otherwise, reject.
• If projects are mutually inclusive
• Accept the primary and the subsequent secondary projects connected to
the former if they fit into the firm’s “acceptable” criteria. Otherwise,
reject the projects.
PAYBACK PERIOD
• Advantages:
• Indicates a project’s risk and liquidity
• Risk: Cash flows expected in the distant future are generally
riskier than near-term cash flows
• Liquidity: The shorter the payback period, ceteris paribus, the
greater the project’s liquidity
• Serves as a screening tool
• Identifies investments that recoup cash investments quickly.
• Identifies products that recoup initial investment quickly.
• Easy to calculate and understand
PAYBACK PERIOD
• Advantages:
• It helps control the risks associated with the uncertainty of
future cash flows.
• It helps minimize the impact of an investment on a firm’s
liquidity problems.
• It helps control the risk of obsolescence.
• It helps control the effect of the investment on performance
measures.
• Easy to calculate and understand.
PAYBACK PERIOD
• Disadvantages:
• Ignores the time value of money
• Ignores cash flows occurring after payback period. Therefore,
in mutually exclusive projects, it is possible that you might
choose the project with the faster payback period but with
lower total returns.
PAYBACK PERIOD
• Disadvantages:
• Does not take into account time value of money.
• Ignores salvage value.
• No concrete decision criteria to indicate if an investment
increases the firm value.
• Does not consider the cash flows occurring after the
payback period, consequently ignoring a project’s total
profitability.
PAYBACK RECIPROCAL
• This is the reciprocal of payback period.
• Payback Reciprocal = 1 / Payback Period
• Often gives a quick and accurate estimate of the IRR of an
investment when:
• The project life is more than twice the payback period.
• Cash inflows are uniform every period.
PAYBACK RECIPROCAL
• ABC Company is contemplating three projects, each of which
would require an initial investment of P10,000, and each of
which is expected to generate cash inflow of P2,000 per year.
Project A’s useful life is 10 years, Project B’s useful life is 15 years,
and Project C’s useful life is 20 years.
• What is the payback reciprocal?
PAYBACK RECIPROCAL
• If projects are independent
• If you have two or more projects which fit the firm’s
“acceptable criteria”, you should accept those projects.
• If projects are mutually exclusive
• If you have two or more projects which fit the firm’s
“acceptable criteria”, accept the project with the highest
payback reciprocal.
• If projects are mutually inclusive
• If the primary project and all related secondary projects fit the
firm’s “acceptable criteria”, you should accept the project
PAYBACK RECIPROCAL
• Advantages:
• It helps control the risks associated with the uncertainty of
future cash flows.
• It helps minimize the impact of an investment on a firm’s
liquidity problems.
• It helps control the risk of obsolescence.
• It helps control the effect of the investment on performance
measures.
• It indicates a project’s risk and liquidity in percentage terms
• Easy to calculate and understand.
PAYBACK RECIPROCAL
• Disadvantages:
• Does not take into account time value of money.
• Ignores salvage value.
• No concrete decision criteria to indicate if an investment
increases the firm’s value.
• Does not consider the cash flows occurring after the payback
period, consequently ignoring a project’s total profitability.
PAYBACK BAILOUT PERIOD
• The length of time it would take to recover an investment
considering accumulated cash returns and terminal (salvage)
value.
PAYBACK BAILOUT PERIOD
• A project requires an investment of P25,000. Cash returns and
salvage value (in pesos) at the end of each year are as follows:
Cash Returns Salvage Value
Year 1 8,000 12,000
Year 2 6,000 10,000
Year 3 5,000 6,000
Year 4 8,000 2,000
• What is the payback bailout period?
PAYBACK BAILOUT PERIOD
• If projects are independent
• Accept all the projects that fit into the firm’s “acceptable” criteria.
Otherwise, reject.
• If projects are mutually exclusive
• Accept the project with the shortest payback bailout period and that
which fits into the firm’s “acceptable” criteria. Otherwise, reject.
• If projects are mutually inclusive
• Accept the primary and the subsequent secondary projects connected to
the former if they fit into the firm’s “acceptable” criteria. Otherwise,
reject the projects.
PAYBACK BAILOUT PERIOD
• Advantages:
• It helps control the risks associated with the uncertainty of
future cash flows.
• It helps minimize the impact of an investment on a firm’s
liquidity problems.
• It helps control the risk of obsolescence.
• It helps control the effect of the investment on performance
measures.
• Considers salvage value
• Easy to calculate and understand.
PAYBACK BAILOUT PERIOD
• Disadvantages:
• Ignores the time value of money.
• No concrete decision criteria to indicate if an investment
increases the firm value.
• Does not consider the cash flows occurring after the payback
bailout period, consequently ignoring a project’s total
profitability
PAYBACK BAILOUT PERIOD
• A project requires an investment of P25,000. Cash returns and
salvage value (in pesos) at the end of each year are as follows:
Cash Returns Salvage Value
Year 1 8,000 12,000
Year 2 6,000 10,000
Year 3 5,000 6,000
Year 4 8,000 2,000
• What is the payback bailout period?
Accounting Rate of Return or Return on
Investment or Simple rate of return
• The second commonly used non-discounting model.
• Measures the return on a project in terms of income, as opposed
to using a project’s cash flow.
• Based or original investment:
• ARR = Annual incremental net operating income or Average NI
after tax/Initial investment or Net investment
• Based on average investment:
• ARR = Annual incremental net operating income or Average NI
after tax
Accounting Rate of Return
• An investment requires an initial outlay of P100,000 and has a
five year life with no salvage value. The yearly cash flows are
P50,000, P50,000, P60,000, P50,000, and P70,000. Calculate the
accounting rate of return. Would you accept the project if WACC
is 20%?
Accounting Rate of Return
• The initial capital expenditure requirements are P100,000 for a
machine that will have a 5 year useful life. Depreciation is
calculated on a straight line basis. The scrap value of the
machine is P10,000 The project is expected to have a P30,000
annual gross profit. Assume that tax is 30%. Calculate the ARR.
• Assume that an existing machine is to be replaced when the new
one is bought. The selling price of the old machine is P8,000. It
has a book value of P2,000.
Accounting Rate of Return or Return on
Investment or Simple rate of return
• If projects are independent
• Accept if ARR > or at least = cost of capital

• If projects are mutually exclusive

• Accept the project with the highest ARR, provided it is > or at
least = cost of capital.
• If projects are mutually inclusive
• Accept if the primary project and all related secondary
projects’ overall ARR > or at least = cost of capital
Accounting Rate of Return
• Advantages:
• Indicates a project’s risk and liquidity.
• Encourages managers to focus on relationship among sales,
expenses, and investment, cost efficiency, and operating asset
efficiency.
• Easy to calculate and understand.
Accounting Rate of Return
• Disadvantages:
• Ignores time value of money.
• Can produce a narrow focus on divisional profitability at the
expense of overall firm profitability.
• Dependent upon net income, which is most likely to be
manipulated by managers.
• There are two ways of calculating ARR, which causes a
problem on comparability