Lecture on Capital Budgeting

Management Accounting 2

CAPITAL INVESTMENT - involves significant commitment of funds to receive a satisfactory return increase in
revenue or reduction in costs over an extended period of time.
Example: purchase of equipment for expansion, replacement of old equipment
GENERAL CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS
usually involves large expenditure of resources, relative to business size
As to COST
As to COMMITMENT usually funds invested are tied up for a long period of time
usually more difficult to reverse than short-term decisions
As to FLEXIBILTY
usually involves so much risks and uncertainties due to operational and economic
As to RISK
changes over an extended period of time
CAPITAL BUDGETING PROCESS
Identification

Evaluation

Capital Investment Decisions:

Replacement (Equipment)
Improvement (Products)
Expansion (Facilities)
Addition (Technology)
Reduction (Costs)

Decision Making

FACTORS OF CONSIDERATION

New Investments

New Returns

Non-discounted methods
Payback period
Bail-out payback
Accounting rate of return
Payback reciprocal

Costs of Capital

Discounted methods
Net present value
Profitability index
Internal rate of return
Present value payback

CAPITAL INVESTMENT FACTORS

Net Investments (for decision-making purposes)
Costs less savings incidental to the acquisition of the capital investment projects

Cash outflows less cash inflows incidental to the acquisition of the capital investment projects

Cost or cash outflows

1. Purchase price of the asset, net related cash discount
2. Incidental project-related expenses such as freight, insurance, handling, installation, test-runs, etc.

CONSIDER ALSO THE FOLLOWING, if any:

Additional working capital needed to support the operation of the project at the desired level.
Market value of existing idle assets to be used in operation of the proposed capital project.
Training cost, net of related tax

Savings or Cash inflows

Proceed from sale of old asset disposed, net of related tax
CONSIDER ALSO THE FOLLOWING, if any:
Trade-in value of old asset

Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax

Net Returns
ACCRUAL BASIS: Accounting net income (after tax)

CASH BASIS: Net cash inflows

DIRECT METHOD
Net cash inflows = Cash inflows Cash outflows

Lecture on Capital Budgeting

Management Accounting 2

INDIRECT METHOD
Net cash inflows = Net income (after tax) + noncash expenses (e.g., depreciation expense)
THE COST OF CAPITAL
The cost of capital used in capital budgeting is the Weighted Average Cost of Capital (WACC).
These are specific costs of using long-term funds, obtained from different sources: borrowed (debt) and
invested (equity) capital.
SOURCES
Debt
Preferred Stock (PS)
Common Stock (CS)
Retained Earnings (RE)

The aftertax cost debt is computed based on: yield rate (1 tax rate)
Dividend yield = dividend per share price per share

Cost of CS and RE =

COSTS
Interest rate (after tax)
Dividend yield
Dividend yield plus growth rate
Dividend yield plus growth rate

Expected cash dividend per share

Market price per common share

+ Dividend growth rate

The dividend growth rate is assumed to be constant over time.

In computing cost of CS & PS, the market price should be net of flotation costs (e.g., underwriting
fees).
In computing the cost of RE, flotation cost should be ignored.
Alternatively, the cost of equity capital may be computed based on Capital Asset Pricing Model
(CAPM)
Refer to page 4 of MSQ 10 for detailed discussions on CAPM and Dividend Growth Model.

Other terms used to denote the weighted average cost of capital (WACC):

Minimum required rate of return

Minimum acceptable rate of return

Cut-off rate

Target rate

Desired rate of return

Standard rate

Hurdle rate
CAPITAL BUDGETING TECHNIQUES IN EVALUATING PROJECTS
Non-discounted methods methods that do not consider the time value of money
1. Payback period method
2. Bail-out payback method
3. Accounting rate of return method
4. Payback reciprocal method
Discounted method methods that consider the value of money
1. Net present value method
2. Profitability index method
3. Internal rate of return method
4. Present value payback method
NON-DISCOUNTED TECHNIQUES: METHODS THAT IGNORE THE VALUE OF MONEY

Payback Period =

Net initial cost of investment

Annual net after-tax cash inflows

Lecture on Capital Budgeting

Management Accounting 2

Advantages:
1. Payback is simple and easy to compute and understand.
2. Payback gives information about the liquidity of the project.
3. It is a good surrogate for risk. A quick or short payback period indicates a less risky project.
Disadvantages:
1. Payback does not consider the time value of money. All cash received during the payback period is
assumed to be equal value of in analyzing the project.
2. It gives more emphasis on liquidity rather than on profitability of the project. In the other words, more
emphasis is given on return of investment rather than the return of investment.
3. It does not consider the salvage of value of the project.
4. It ignores cash flows that may occur after the payback period (short-sighted)
Bail-out Payback Period

a modified payback period method wherein cash recoveries include the estimated
salvage value at the end of each year of the project life.

Accounting rate of return (ARR) =

Average annual net income

Investment*

May be used on original or average investment

Advantages:
1. The ARR closely parallels accounting concepts of income measurement and investment return.
2. It facilities re-evaluation of projects due to availability of data from the accounting records.
3. This method considers income over the entire life of the project.
4. It indicates and emphasizes the projects profitability.
Disadvantages:
1. Like traditional payback methods, the ARR method does not consider the time value of money.
2. With the computation of income and book value based on the historical cost accounting data, the effect
of inflation is ignored.
Other terms used to denote the ARR:

Book value rate of return

Unadjusted rate of return

Simple rate of return

Payback Reciprocal =

Net cash inflows

Investment

Approximately rate of return method

Financial statement rate of return method
Average return of investment
=

1
Payback period

Payback reciprocal is a reasonable estimate of the discounted cash flow rate of return (a.k.a IRR) provided that
the following conditions are met:
1.

The economic life of the project is at least twice the payback period.

2.

The net cash inflows are constant (uniform) throughout the life of the project.

DICOUNTED TECHNIQUES: METHODS THAT CONSIDER THE TIME VALUE OF MONEY

The time value of money is an opportunity cost concept. A peso on hand today is worth more than a
peso to be received tomorrow because of interests a peso could earn by putting in a savings account or
placing in an investment that earns the income. The time value of money is usually measured by using a
discount rate that is implied to be the interest foregone by receiving funds at a later time.
Net Present Value (NPV) = Present value of cash Inflows Present value of cash Outflows

Cash inflows include cash infused by the capital investment project on a regular basis (e.g., annual
cash inflow) and cash realizable at the end of the capital investment project. (e.g., salvage value,

Lecture on Capital Budgeting

Management Accounting 2

return of working capital requirements)

The net investment cost required at the inception of the project usually represents the present
value of the cash inflows.

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate reinvestment rate.
Disadvantages:
1. It requires determination of the cost of capital or the discount rate to be used.
2. The net present values of different competing projects may not be comparable because of
differences in magnitudes or sizes of the projects.
Profitability Index =

Present value of cash inflows

Present value of cash outflows

NPV Index =

NPV
Investment

The profitability index method is designed to provide a common basis of ranking alternatives that require different
amounts of investments.
NOTE:

Profitability index method is also known as desirability index, present value index and benefit-cost ratio.

Internal Rate of Return (IRR) -

is the rate of the return that equates the present value of cash inflows to
present value of cash outflows. It is also known as discounted cash flow rate of
return, time-adjusted rate of return or sophisticated rate of return.

Guidelines in determining IRR:

1.
Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of the
following formula:
PVF for IRR =
2.

Net investment cost

Net cash inflows

Using the present value annuity table, find on line n (economic life) the PVF obtained in No. 1. The
corresponding rate is the IRR. If the exact rate is not found on the PVF table, interpolation process
may be necessary.

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes true return of project
Disadvantages:
1. Assumes that IRR is the re-investment rate.
2. When project includes negative earnings during its life, different rates of return may result.

Lecture on Capital Budgeting

Management Accounting 2

EXERCISE: CAPITAL BUDGETING

1.

NET INVESTMENTS FOR DECISION-MAKING

Bee-Cool Company plans to replace a unit of equipment that was acquired three (3) years ago and is
now recorded at a net book value of P 65,000. This equipment can be sod now for P 75,000. Tax rate is 25%.
New equipment can be acquired form Bag-You Company at a list price of P 200,000. Bag-You will grant a
2% cash discount if the equipment is paid within 30 days from acquisition date. Shipping, installation and
testing charges to be paid are estimated at P 14,000.
Other assets with a book of value of P 12,000 that are to be retired as a result of acquisition of the new
machine can be salvaged and sold for P 10,000.
Additional working capital of P 18,000 will be needed to support operations planned with the new
equipment.
The annual cash flow after income tax from the operations of the new equipment has been estimated
at P 50,000. The equipment is expected to have a useful life of 5 years with a salvage value of P 40,000 at
the end of 5 years.

REQUIRED:
What is the initial cost of net investments for decision-making purposes?

2.

WIEGHTED AVERAGE COST CAPITAL (WACC)

The Bow Company wants to determine the weighted average cost of capital that it can use to evaluate
capital investment proposals. The companys capital structure with corresponding market values follows:
8% Term Bonds
P 600,000
5% Preferred stock (P 100 par)
200,000
Common stock (no par, 10,000 shares outstanding)
400,000
Retained earnings
800,000
TOTAL
P 2 , 000,000

Additional data:
Current market price per share:
Expected common dividend: P 2 per share
Preferred stock: P 50
Dividend growth rate: 4%
Common stock: P 40
Corporate tax rate: 30%
REQUIRED:
A) Given an operating income of P 500,000, how much is the earnings per share?
B) Determine the weighted average cost of capital.

SOLUTION GUIDE to Item 2

Operating income
-interests (8%)
Income before tax
-tax (30%)
Income after tax
- preferred dividends (5%)
Income available to common shares

SOURCES

Income available to common shares

P 500,000
(48,000)
P 452,000
(135,600)
P 316,400
(10,000)
P 306,400

EPS =

Number of outstanding shares

P 306,400

EPS =

WEIGHT (%)

P 30.64

10,000 shares

COSTS

Bonds
Preferred stock
Common stock & Retained Earnings
Weighted Average Cost of Capital (WACC)
3. NET RETURNS (INCREASE IN REVENUES)
The management of Star-Luck Cinema plans to install coffee vending machines costing P 200,000 in its
movie house. Annual sales of coffee are estimated at 10,000 cups at a price of P 15 per cup. Variable costs are

Lecture on Capital Budgeting

Management Accounting 2

estimated at P 6 per cup, while incremental fixed cash costs, excluding depreciation, at P 20,000 per year. The
machines re expected to have service life of 5 years, with no salvage value. Depreciation will be computed on
straight-line basis. The companys income tax rate is 30%.
REQUIRED: Assuming that the vending machines are installed, determine:
A) The increase annual net income
B) The annual cash inflows that will be generated by the project.
4. NET RETURNS (COST SAVINGS)
Moon-Use Corporation is planning to buy equipment that can reduce car wash service cost and other cash
expenses by an average of P 70,000 per year. The new cleaning equipment will cost P 100,000 and will be
depreciated for 5 years on a straight-line basis. No salvage value is expected at the end of the equipments life.
Income tax is estimated at 32% of income before tax.
REQUIRED:
Determine the net cash inflows that will be generated by the project.
5. PAYBACK PERIOD & ACCOUNTING RATE OF RETURN (WITH EVEN CASH FLOWS)
Green Niche Company considers the replacement of some old equipment. The cost of the new equipment is
P 90,000, with a useful life estimate of 8 years and salvage value of P 10,000. The annual pre-tax cash savings
from the use of the new equipment is P 40,000. The old equipment has zero market value and is fully
depreciated. The company uses a cost of capital of 25%.
REQUIRED: Assuming that the income tax rate is 40%, compute:
A) Payback period
B) Accounting rate of return on original investment
C) Accounting rate of return on average investment
6. PAYBACK PERIOD & ACCOUNTING RATE OF RETURN (WITH UNEVEN CASH FLOWS)
Pole-Land Company has an investment opportunity costing P 9,000 that is expected to yield the following
cash flows over the next five years: (assume a cut-off rate of 30%)
Year
Amount
1
P 40,000
2
35,000
3
30,000
4
20,000
5
10,000
P 135,000
REQUIRED:
A) Payback period in months
B) Book rate of return
7. BAIL-OUT PAYBACK PERIOD
A project costing P 180,000 will produce the following annual cash flows and salvage value:
Year
1
2
3
4

Cash flows
P 50,000
P 50,000
P 50,000
P 50,000

Salvage value
P 65,000
P 50,000
P 35,000
P 20,000

REQUIRED:
Bail-out payback period.
8. NET PRESENT VALUE (WITH UNIFORM CASH FLOWS)
Bull-Can Company plans to buy a new machine costing P 28,000. The new machine is expected to have a
salvage value of 4,000 at the end of its economic life of 4 years. The annual cash inflows before income tax from
this machine have been estimated at P 11,000. The tax rate is 20%. The company desires a minimum return of
25% on invested capital.

Lecture on Capital Budgeting

Management Accounting 2

REQUIRED:
Determine the net present value. (Round-off factors to three decimal places)
SOLUTION GUIDE to Item 8
Cash inflows before tax
-Depreciation
Earnings before tax
- Tax (20%)
Earnings after tax
+Depreciation
Cash inflows after tax
(PRESENT)
Year 0
PV factor

Year 1

Year 2

Year 3

Year 4

9. NPV, PROFITABILITY INDEX & INTERNATIONAL RATE of RETURN (EVEN vs. UNEVEN CAS FLOWS
Can-Yeah Corporation gathered the following data on two capital investment opportunities:
Project No. 1 Project No. 2
Cost of investment
P 195,200
P 150,000
Cost of capital
10%
10%
Expected useful life
3 years
3 years
Net cash inflows
P 100,000
P100,000*
*This amount is to decline by P 20,000 annually thereafter.
REQUIRED: Round-off factors to three decimal places in all cases.
Fill-in the blanks.
Project 1
Project 2
NPV:
A)
B)
P. Index:
C)
D)
E) What is project 1s internal rate of return?
a. 23%
c. 25%
b. 27%
d. 24%
F) What is project 2s time-adjusted rate of return?
a. Below 30%
c. Between 31% and 32%
b. Between 30% and 31%
d. Above 32%
10. PAYBACK RECIPROCAL
Live-Biz Company is planning to buy an equipment costing P 640,000 that has an estimated life of 30 years
and is expected to produce after-tax net cash inflows of P 128,000 per year.
REQUIRED:
Without using present value factors, estimate the IRR.
11. DISCOUNTED & NON-DISCOUNTED CAPITAL BUDGETING TECHNIQUES
MallAsia Company is considering buying a new machine, requiring an immediate P400,000 cash outlay.
The new machine is expected to increase annual net after-tax cash receipts by p 160,000 in each of the next five
years of its economic life. No salvage value is expected at the end of 5 years. The company desires a minimum
return of 14% on invested capital.
REQUIRED: round-off factors to three decimal places in all cases.
A) Payback period

Lecture on Capital Budgeting

B)
C)
D)
E)

Management Accounting 2

ARR (based on original investment)

Net present value
Profitability
Internal rate of return

Answers to item 11:

A) Payback period: 400,000 160,000 = 2.5 years
B) Accounting rate of return (based on original investments): 80,000 400,000 = 20%
C) Net present value: 160,000 (3433) 400,000 = P 149,280
D) Profitability index: 549.280 400,000 = 1.37 times
E) Internal rate of return: 28.65% (approximation through trial and error or interpolation)
12. RELATIONSHIPS DISCOUNTED TECHNIQUES
Fill in the blanks for each of the following independent cases. In all cases, the investment has a useful life
of ten (10) years no salvage value. Round off factors to three decimal places.
Project
1
2
3
4

Annual Cash Flow

P 45,000
P 75,000
(5)
(7)

Investment
P 188,640
(3)
P 300,000
P 450,000

Cost of Capital
14%
12%
(6)
12%

IRR
(1)
18%
16%
(8)

NPV
(2)
(4)
P 81,440
P 115,000

13. CAPITAL RATIONING RANKING PROJECTS

Case-Zone Corporation is considering five different investment opportunities. The companys cost of
capital is 12%. Data on these opportunities under consideration are given below.
Project
Investment
PV Cash Flow
NPV
IRR (%)
P.. Index
1
P 35,000
P 39,325
P 4,325
16
1.12
2
20,000
22,930
2,930
15
1.15
3
25,000
27,453
2,543
14
1.10
4
10,000
10,854
854
18
1.09
5
9,000
8,749
(251)
11
0.97
REQUIRED:
A) Rank the projects in descending order of preference according to NPV, IRR and benefit/cost ratio.
B) If only a budget of P 55,000 is available, which projects should be chosen?
SOULUTION GUIDE to Item 13
Project
1
2
3
4
5

NPV
1st
2nd
3rd
4th
5th

IRR

P. Index

***End of the Lecture**