Capital Budgeting

• process a business undertakes to evaluate

potential major projects or investments.

• used by companies to evaluate major projects

and investments, such as new plants or
equipment.

• involves analyzing a project’s cash inflows and

outflows to determine whether the expected
return meets a set benchmark.
 Characteristics
1. Requires large commitments of resources
2. Involve long-term commitments
3. More difficult to reverse than short-term
decisions
4. Involve so much risk and uncertainty
 Types of capital investment projects
1. Replacement

2. Improvement

3. Expansion
 Capital Investment Factors
1. Net investment

2. Cost of capital

3. Net returns
 Net investment
• Costs or cash outflows less cash inflows or
savings incidental to the acquisition of the
investment projects
 Cost or Cash Outflow
1. Initial cash outlay covering all expenditures on
the project up to the time when it is ready for
use or operation
Eg. Purchase price, freight, insurance taxes,
handling, installation, test-runs, etc.
2. Working capital requirement
3. Market value of existing, currently idle asset,
which will be transferred to or utilized in the
operations of the proposed capital investment
project
 Savings or Cash Inflow
1. Trade- in value of old asset (in case of
replacement)
2. Proceeds from sale of old asset to be
disposed
Eg. Gain- less tax paid; Loss- add tax savings
3. Avoidable cost of immediate repairs on old
asset to be replaced, net of tax
Sonny Corporation is planning to buy a new
equipment costing P150,000 to replace an old
one purchased 6 years ago for P90,000. The old
equipment is being depreciated on a straight-
line basis over 10 years to a zero salvage value.

Sonny pays tax at a rate of 32% of income before

tax. If the equipment is sold for P30,000 and the
new one is purchased, the net cash investment
at the time of purchase of the new one is
Purchase price 150,000
Less: Proceeds from sale 30,000
Add: Tax savings
SP 30,000
Less: CA 90,000
(90T/10=9T x 6) (54,000)
(36,000)
Loss on sale (6,000)
Tax rate x 32% 1,920 31,920
Net cash investment 118,080
 Capital Investment Factors
1. Net investment

2. Cost of capital

3. Net returns
 Cost of Capital
• Cost of using funds (hurdle rate, required rate
of return, cut-off rate)
• Weighted average rate of return the company
must pay to its long-term creditors and
shareholders for use of funds
 Capital Investment Factors
1. Net investment

2. Cost of capital

3. Net returns
 Net returns
1. Accounting net income

2. Net cash inflows

1. Economic life- period of time during which
asset can provide economic benefits
2. Depreciable life- period used for accounting
and tax purposes
3. Terminal value- net cash proceeds expected
to be realized at the end of project’s life
METHODS OF EVALUATING CAPITAL
INVESTMENT PROJECTS
1. Methods that do not consider the time value
of money
a. Payback
b. Bail-out
c. Accounting rate of return
2. Methods that consider the time value of
money (discounted cash flow methods)
a. Net preset value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return
 Payback Method

=length of time required by the project to return

the initial cost of investment
 Disadvantage:
Advantages: 1. Does not consider
1.Simple to time value of
compute and money
2. Emphasis on
easy to liquidity rather than
understand on profitability
2.Liquidity 3. Does not consider
3.Good indication salvage value
4. Ignores cash flow
for risk that may occur after
payback period
A new machine is expected to produce the
following after tax-cash inflows over a period of 5
years.
After-tax cash inflow
Year Per Year Cumulative
1 P16,000 P16,000
2 12,000
3 20,000
4 8,000
5 6,000

If the machine will cost 40,000, its payback period is

Cost of machine 40,000
Less: Cumulative cash flow Y2 28,000
Amount to be recovered Y3 12,000
/Total CF in Y3 20,000
Fraction of Y3 0.6

Payback period= 2 + 0.6 = 2.6years

 Bail-out Method
• Cash recoveries include not only the operating
cash flow but also the estimated salvage value
Maliya Corporation is planning to buy a new
machine costing P450,000. The new machine’s
useful life is 5 years. Its estimated disposal values
are:
Year Disposal Value
1 P100,000
2 100,000
3 75,000
4 75,000

If the new machine is expected to generate cash

inflows from operations, net of tax, of P180,000 per
year, its bail out period is
Cost 450,000
Less: CF Year 1 180,000
Balance 270,000
Less: Disposal Value Y2 100,000
Amount needed from 170,000
Operating cash flow
/CF, Year 2 180,000
Fraction of Year 2 0.94 Year

The bail out period is (1+ 0.94 year) 1.94 years

 Accounting Rate of Return
- Also called the book value rate of return ,
average return on investment

= Average annual net income/ Investment

Advantage
1. ARR closely parallels accounting concepts of
income measurement and investment return
2. Considers income over the entire life of
project
3. Indicates the project’s profitability
Disadvantage:
1. Does not consider time value of money
2. Effect of inflation is ignored
Following are selected data pertaining to Sabon Company’s Bath
Soap Division:
Sales P500,000
Variable cost 300,000
Direct fixed cost 50,000
Average Invested Capital 100,000
Imputed interest rate on 10%
average invested capital

For the next year, the Division is considering to acquire a new soap-
making equipment for P150,000. The equipment is expected to
result in a decrease of P60,000 in cash operating expenses per year.
The equipment will be depreciated on a straight line basis over 5
years.
For the new equipment, the accounting rate of return (ARR) based
on initial investment would be
ARR= Net income/ Initial Investment
30,000/150,000= 20%

Decrease in cash operating expense 60,000

Less: Depreciation (150T/5) (30,000)
Net income 30,000
2. Methods that consider the time value of
money (discounted cash flow methods)
a. Net preset value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return
 Net Present Value
NPV= Total Cash inflow – Total Cash outflow

Or

NPV= Total Cash inflow – Cost of investment

Kelvin Corporation is considering the purchase of
a new machine costing 450,000. The machine will
have an economic life of 5 years. It will be
depreciated using the straight line method and is
expected to produce annual cash flows from
operations, net of income taxes, of 150,000. The
Corporation’s cost of capital is 10%. It is subject to
an income tax rate of 32%.

What is the net present value of this capital

investment project?
Present value of cash inflows (150,00 x 3.791)
568,650
Less: Cost of investment (450,000)
Net Present Value 118,650
2. Methods that consider the time value of
money (discounted cash flow methods)
a. Net preset value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return
 PROFITABILITY INDEX
Profitability Index= Total PV of Cash inflow
Total PV of Cash Outflow

* If the profitability index is over 1.0, then the

profitability is positive, but if it is below 1.0 then
the investment will probably fail. To put it
another way, profitability index is constituted of
the ratio between the present value of future
cash flows and the initial investment.
Kelvin Corporation is considering the purchase of
a new machine costing 450,000. The machine will
have an economic life of 5 years. It will be
depreciated using the straight line method and is
expected to produce annual cash flows from
operations, net of income taxes, of 150,000. The
Corporation’s cost of capital is 10%. It is subject to
an income tax rate of 32%.

What is the profitability index of this capital

investment project?
Present value of cash inflows (150,00 x 3.791)
568,650/
Divided by cost of investment (450,000)
Net Present Value 1.26
 Net Present Value Index
NPV Index= Net Present Value
Investment
Kelvin Corporation is considering the purchase of
a new machine costing 450,000. The machine will
have an economic life of 5 years. It will be
depreciated using the straight line method and is
expected to produce annual cash flows from
operations, net of income taxes, of 150,000. The
Corporation’s cost of capital is 10%. It is subject to
an income tax rate of 32%.

What is the net present value index of this capital

investment project?
Present value of cash inflows (150,00 x 3.791)
568,650
Less: Cost of investment (450,000)
Net Present Value 118,650

NPV Index= NPV/ Cost of investment

= 118,650/450,000
=0.26
 INTERNAL RATE OF RETURN
- The rate of return which equates the present
value (PV) of cash inflows to PV of cash
outflows.
- It is the rate of return where NPV = 0.
• When the cash flows are uniform, the IRR can
be determined as follows:
1. Determine the PVF for the IRR with the use
of the following formula:
PVF for IRR = Net cost of investment
Net cash inflows
2. Use PV annuity table to find the rate for IRR.

• When the cash flows are not uniform, the IRR

is determined using the trial-and-error
method.
Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Compute the true return of the project

Disadvantages:
1. Assumes that the IRR is the reinvestment rate
2. When project includes negative earnings
during their economic life, different rate of
return may result.
Bilog Corporation is planning to buy a vending machine costing
P50,000. This machine will be depreciated over a five-year period
using the straight-line method. It is estimated that the machine will
yield an annual cash inflow, net of depreciation and income taxes, of
P14,000. At the following discount rates, the net present values of the
investment in this machine are:
Discount rate Net Present Value
10% P3,074
12% 470
14% (1,938)
16% (4,164)

Bilog corporation’s desired rate of return on this investment is 10%.

The investment project is expected to have an internal rate of return of
a. More than 12% and more than 14%
b. Less than 14% and less than 12%
c. Less than 12% and more than 14%
d. More than 12% and less than 14%
The factor for the IRR is P50,000 / P14,000 =
3.571, which is between 3.605 (for 12%) and
3.433 (for 14%) for 5 periods. Thus, the IRR is
between 12% and 14%.
IRR= LR + [HR-LR] X PVFLR – PVFIRR
PVFLR- PVFHR

Where: LR= lower rate

HR= Higher rate
PVF= present value factor