Saint Ferdinand College

College of Business Education

Financial Analysis and Reporting

MIDTERM HANDOUT #2
CAPITAL BUDGETING Continuation
Process of capital budgeting
The capital budgeting can be divided into seven significant phases:

1. Finding investment opportunities

 Many capital expenditures proposals can be identified during the strategic or long-term planning process.
Since the long-term profitability of most companies depends on the nature and quality of their capital
investments, these investment opportunities should be carefully analyzed and evaluated.
2. Collect relevant information about opportunities
 To effectively evaluate any investment opportunity, the expected cash flows from the project must be
estimated and the total cash outlay necessary to place the investment in operative form must be determined. A
plan for implementing the opportunity must be developed and other nonfinancial information must be
assembled.
3. Select discount rate
 Before the cash flow can be evaluated, the discounted (cost of capital) must be established if the discounted
cash flow approach is to be applied.
4. Financial analysis of cash flows
 The techniques of capital budgeting are applied to estimated cash flows developed in the second phase.
5. Decision
 Many factors, quantitative as well as qualitative, should be given consideration before the final decision is
made as to the selection of a particular investment. They will include among others, relationship of this
opportunity to other aspects of the company operations and long-term goals, the timing of the cash flows, the
availability of the funds for investment purposes, the impact on the financial structure of the company, social
impact of the opportunity, and legal ramifications.
6. Project implementation
 Once the decision has been made to invest funds, more detailed plans for making the project operational are
developed.
7. Project evaluation and appraisal
 This last phase involves the assessment of how the investment actually is. The evaluation may be in the form
of continuous monitoring of the project, so that corrective action can be taken. Regardless of how difficult this
may be, it is important that not only the effectiveness of the project be determined, but the overall decision-
making process be appraised for possible improvement.
The way capital investments are implemented depends on:
 Nature of the project
 Size of the capital outlay
 Length of time to place the project in operation

Categories of project cash flows

Cash inflows
1. Periodic cash inflows from operations, net of taxes
 To generate positive periodic operating cash flows is usually the primary reason for acquiring long-term
assets. These positive flows may result from such revenue generating activities as new products or they may
stem from cost saving programs.
2. Investment tax credit
 The investment tax credit allows a credit against a company’s income tax liability based on the cost of an
acquired asset. If the present income tax allows investment tax credit, it would reduce the cost of making
investments by giving companies a credit against their corporate income taxes equal to a percentage of the
cost of assets.
3. Proceeds from sale of old assets being replaced, net of taxes
 If an old asset is to be sold, the proceeds from such sale is treated as a reduction from cost of initial
investment. If the old asset is sold at a gain, the incremental income tax should be deducted from the
proceeds. If the old asset is sold at a loss, that is, the book value exceed the selling price, the tax savings will
be added to the proceeds.
4. Avoidable costs, net of taxes
 In some instances, purchase of new asset may result to the avoidance of incurring expenses to repair the old
asset. The avoidable repairs cost, net of incremental tax will be treated as a deduction in computing the initial
cost of investment.

5. Return of working capital

  When a project ends, there are usually some leftover inventory, cash or other working capital items that were
used to support operations. These working capital items are then freed for use elsewhere and treated as cash
inflow.
6. Cash inflow from salvage of the new long-term asset at the end of its useful life
 Ending a project will usually require disposal of its assets. In some cases, more money is spent in
disassembling the assets and disposing these than is gained from their sale. Any net outflows from the
disposal of a project’s asset become tax deductions in the year of disposal. The net salvage value of an asset is
listed as a cash inflow at the time it is expected to be realized. If the net salvage value of the asset is negative,
then it is cash outflow also at the time it is expected to be incurred.
Cash outflows
7. Acquisition of cost of purchasing and installing assets
 These acquisition costs represent the primary outflows for most capital investments. They are listed as cash
outflows in the years in which they are incurred.
8. Additional working capital
 Many projects require fund for working capital needs (for example to build up inventories, additional cash
balance to handle increased level of activities). These cash flows often occur before the project is in operation.
Screening Capital Investment Proposals
 Several methods are available for the evaluation of alternative capital investment proposals. One method may
be used exclusively or in combination with another. The most commonly used methods of evaluating capital
investment projects are:
A. Non discounted cash flow (unadjusted) approach
1. Payback period
2. Accounting rate of return (book value rate of return)
3. Payback reciprocal
B. Discounted cash flow (time-adjusted) approach
1. Net present value
2. Discounted rate of return or internal rate of return
3. Profitability index
4. Discounted payback period
Payback period
 Also known as payoff and payout period, measures the length of time required to recover the amount of
initial investment. It is the time interval between time of initial outlay and the full recovery of the investment.
 When the periodic cash flows are uniform, payback period is computed as follows:
Net Investment
Annual Cash Return
 Decision Rule:
The desirability of the project is determined by comparing the project’s payback period against the maximum
acceptable payback period as predetermined by management. The project with shorter period than the
maximum will be accepted. In short:

If: Payback period ≤ Maximum allowed Payback period; Accept

If: Payback period > Maximum allowed Payback period; Reject

 Advantages of payback period method

 It is easy to compute
 It is used to measure the degree of risk associated with a project
 Generally, the longer the payback period, the higher the risk.
 It is used to select projects which provide a quick return of invested funds.
 Disadvantages of payback period method
x It does not recognize the time value of money
x It ignores the impact of cash inflows after the payback period
x It does not distinguish between alternatives having different economic lives.
x The conventional payback computation fails to consider salvage value, if any.
x It does not measure profitability – only the relative liquidity of the investment.
x There is no necessary relationship between a given payback and investor wealth maximization so an
investor would not know what an acceptable payback is.

Illustrative Problem:
1. Assume the following cash flows for two alternative investment proposals:

Proposal A Proposal B
Net Investment in equipment P150,000 P300,000
Annual Cash Returns:
Year 1 to 3 P75,000 P75,000
Year 4 to 5 P100,000
Salvage Value of Equipment
at the end of useful life P15,000 P15,000
Economic Life 3 years 3 years

Required: determine the payback period of the two proposals.

2. A project requires an investment of P600,000, with 5 years useful life, no salvage value and uses straight line
method of depreciation. Other data are:
Expected sales revenue 2,000,000
Out of pocket cost 1,600,000
Tax rate 40%
Additional Working Capital P500,000

Required: Compute the payback period.

3. An investment of P400,000 can bring in the following annual income, net of tax:
Year 1 40,000
Year 2 95,000
Year 3 85,000
Year 4 160,000
Year 5 86,000
Year 6 70,000

Required: compute the payback period.