Budgeting

- Quantified planning that guides an organization’s future activities toward the achievement of its goals.

Capital Budgeting-
-Is a process of identifying, evaluating, planning and financing capital investment projects of an organization.
-involves capital investment projects which require large sum of outlay and involve a long period of time (Longer than
one operating cycle).
Financing Decision-
-judgement regarding the method of raising capital fund to an investment
Investment Decision
Judgement about which assets to acquire to achieve the company’s stated objectives

Characteristics of capital investment decision

1. Capital investment decision usually require a large commitments of resources
- A large sum of money is involved.

2. Most Capital Investment Decisions involve long term commitments

-Capital investment projects require long period of time (more than a year or more than an operating cycle)
-The longer time period involved in the project, the more difficult it is to make predictions.
-Greater amount of risk is expected.

3. Capital Investment Decision are more difficult to reverse than short term decisions
- A Good Decision making must be observed

CAPITAL BUDGETING PROCESS

STEP 1. Generating Project Proposals

A firm’s sustained growth and even its ability to remain competitive and to survive depends upon a constant flow
of idea for new products, ways to making existing products better and ways to produce output at a lower cost. Then,
therefore the firm go to great lengths to develop good capital project proposals....

CAPITAL BUDGETING DECISION

1. Replacement decisions to continous current operation

- An outlay cost for replacing damaged equipment needed for the production.

2. Replacement to effect cost reduction

- An optional decision which includes an expenditure for replacing outdated equipment but still functional. As a
result to lower cost of production.
3. Expansions into new products or market
- This category needed a strategic decision making that could increase the capacity of the business and sales.
4. Expansions of existing products or markets
- A disbursement for increasing output of existing products to expand retail outlets in markets.
5. Equipment selection decision
- These investment relates to purchasing and renting machines.
6. Safety and/or environmental projects
- These expenses needs to comply with government orders, labor agreement and insurance policy terms.
7. Mergers
- Cost for buying another firm.
8. Other projects
- A category that involves expenses for everything such as office buildings, parking lots, car plans, etc.

Categories of Capital Investment Decision

2 CATEGORIES

1. Independent capital investment 2. Mutually Exclusive Capital Investment

projects or Screening Decisions Projects or Preference Decisions

These are projects which are evaluated
individually and reviewed against
predetermined corporate standards of
acceptability resulting in an “Accept” or
“Reject Decision”.
For example, a company have a policy that
accept project if they can promise a return
of at least 15% on the investment.
Examples of these are:
-Investment in long term assets
-New Product Development
-Corporate Acquisitions (purchase of shares
in subsidiaries or affiliates)
These relate to selecting among acceptable
alternatives which passed the company’s criteria
of acceptability.
For example a company may be considering
several different equipment on the assembly line.
The choice which machine to purchase is a
preference decision.
Examples are:
1. Replacement against renovation of
equipment
2. Rent against ownership of Facilities
3. Manual bookkeeping system vs computerized
system
Step 2. COLLECTING RELEVANT INFORMATION ABOUT OPPORTUNITIES
Capital budgeting is a dynamic process because the firm’s changing environment may affect the desirability of current or
proposed investment. Information is needed throughout the entire capital budgeting process to ensure that the process is
operating effectively, For instance, effective record keeping is important in evaluating the accuracy of past estimates of
revenue increases or cost savings. Information such as a project's expected cost and benefits forecasts of the economic
environment market research studies actions of competitors and regulatory decisions are used in the capital budgeting
process.

Step 3. ESTIMATING CASH FLOWS

In a dynamic business environment characterized by uncertainty, projecting the cash flows of a particular product is also
difficult. For example, estimating the cash flows of a totally new product over its useful life may be based on assumptions
that represent little more than educated guesses.
Deriving accurate estimates of cash flows is the most important and most difficult step in the entire capital budgeting
process. Estimating cash flows is important because no step later in the process can overcome inaccurate or unreliable
information generated by this step.
Net cash flow is the difference between inflows and outflows of cash that result from a firm undertaking a project.

Categories of Cash Flow

Cash flows of a project fall into three categories:

1. Net Initial Investment
2. Net Operating Cash Flows or Returns
3. Net Terminal Cash Flow

Only incremental after-tax cash flows are relevant. Historical costs arising from past decisions are sunk costs and therefore
cannot affect future alternatives.

NET INITIAL INVESTMENT

-is the net initial cash outlay needed to acquire a specific investment project.
Net investment is calculated by subtracting any initial cash inflows that occur in placing an asset into service from the
amount of the initial cash outflows required by the project.
-The net investment is assumed to occur at Time Period Zero although the cash inflows and cash outflows constituting the
net investment may occur at several points of time.
Format:
Purchase price of new asset
+Installation and Transportation cost
+Additional Net Working Capital
-Proceed from the sale of old asset
+/- Tax effects on disposal of old asset
And/or the purchase of new one
_________________________________________________________
= Net Investment
Initial Cash outflows include:
o Purchase price of new asset
o Outlays for installation and Transportation
o Additional Net Working Capital
o Any other cost incurred to put the asset into service
Initial Cash inflows include
o Proceeds from disposal of existing assets
o Tax impact of selling a depreciable asset
Computation of Net Investment
The Group 2 Enterprises plans to add a new machine to increase production capacity. The machine cost 180,000 plus
20,000 for installation and transportation cost and requires 40,000 additional working capital.

This expansion involves both initial cash inflows and initial cash outflows but it does not include any cash flows
associated with the disposal of an old asset. The Net investment is:

Purchase of New Machine Php. 180,000

+Installation and Transportation cost Php. 20,000
+Additional Net Working Capital Php.40,000
NET INVESTMENT PHP 240,000

The Depreciable basis of the machine is:

Purchase Price of the Machine Php. 180,000
+ Installation and Transportation 20,000
Depreciable Basis Php. 200,000

Illustrative Case No. 2

The management of Group 2 company plans to replace a photocopy machine that was acquired several years ago at a cost
of P 60,000. The machine has depreciated to its residual value of P10,000.
A new photocopy machine can be purchased for 96,000. The trader will grant a trade in allowance of 16,000 on the old
machine. If the new machine is not purchased, Group 2 company will spend 10,000 to repair the old machine. Gain and
losses on trade in transaction are not subject to income tax.
The cost to repair the old machine can be deducted in computing income taxes. Income taxes are estimated 40% of the
income subject to tax. Additional working capital required is 50,000.
Required: Compute the NET Initial Investment In this project

Solution:
Purchase Price of New Photocopy Machine P 96,000
ADD: Additional Working Capital 50,000
TOTAL 146,000
LESS: Trade in allowance of old machine P16,000
Avoidable Repairs cost of old machine
(net of increase of income taxes of P4,000) 6,000 22,000
NET INVESTMENT P124,000

NET OPERATING CASH FLOWS OR RETURN

-OR Annual Net Cash Returns are the incremental changes in a firm's cash flows that result from investing in a project.
-Net operating cash flows may vary over the project's life and the timing of these varying flows may also vary during the
year. However, operating cash flows are generally assumed to occur at the end of a given year

The cash returns are the inflows of cash expected from a project reduced by the cash cost that can be directly attributed to
the project. This is computed as follows:

Annual incremental revenue from the project Pxx

Less: Incremental cash operating costs xx
Annual cash inflow before taxes Pxx
Less: Taxes
[Tax rate (Annual cash inflow before taxes - Depreciation)) xx
Annual net cash inflow after taxes Pxx
or
Annual incremental revenue from the project Pxx
Less: Incremental cash operating costs xx
Annual cash inflow before taxes Pxx
Less: Incremental depreciation xx
Net income before taxes Pxx
Less: Income taxes xx
Net income after taxes Pxx
Add: Incremental depreciation xx
Annual net cash inflow after taxes Pxx
Some projects however are expected to produce an inflow of cash but will yield returns in the form of cash savings. This
is determined as follows:

Annual cash operating costs (if the old asset or method is used) Pxx
Less: Annual cash operating costs (if the new asset or method is used) xx
Annual cash savings before taxes Pxx
Less: Taxes
[Tax Rate(Annual cash flows before taxes–Incremental Depreciation)] xx
Annual cash saving after taxes Pxx

or

Cash operating costs (if the old asset or method is used) Pxx
Less: Annual cash operating costs (if the new asset or method is used) xx
Cash savings before taxes Pxx
Less: Incremental depreciation xx
Increase in income before taxes Pxx
Less: Income taxes xx
Increase in income after taxes Pxx
Add: Incremental depreciation xx
Net cash savings after taxes Pxx

Determination of Annual Cash Savings

The Group 2 Supply Company has been considering a new production method that can reduce materials costs by an
estimated amount of P52, 000 a year. The new method is also expected to result in an annual savings of labor and
overhead method is estimated at P40, 000 a year over the period of ten years. Income taxes are estimated at 30% of
income before income taxes. What are the annual net returns (or savings) expected from the new production method?
Solution:
Annual savings in direct material costs P 52,000
Annual savings labor and overhead costs 64,000
Total savings before depreciation P 116,000
Less: Depreciation 40,000
Savings after depreciation P 56,000
Less: Incremental income taxes (30%) 16,800
Net increase in income P 39,200
Add: Depreciation 40,000
Net cash returns (savings) P 79,200

Step 4. EVALUATING PROJECT PROPOSALS

After the cash flow projected, capital investments are evaluated under certainty or risk. There are numerous techniques
that may be used to evaluate both individual and multiple projects under conditions of certainty and risk.

Step 5. SELECTING PROJECTS

In theory, the firm should invest in new projects up to the point where the rate of return from the last project is equal to
the firm’s marginal cost of capital.
The final selection of projects depends on three major factors:
1. Project type
2. Availability of funds
3. Decision Criteria

Step 6. IMPLEMENTING AND REVIEWING PROJECTS

The implementation stage involves developing formal procedures for authorizing the expenditures of funds for capital
projects
The review stage involves analyzing projects that have been adopted in order to determine if they should be continued,
modified or terminated.

After the project was completed, POST AUDIT is conducted in which comparisons are made earlier estimates and actual
data
2 MAIN PURPOSES
1. Improve forecast
- Forecasting is a way to predict future outcomes. Once it is been done there is a possibilty of improvements.
Thereby, seeking for a new forecasting method can help to observed biases and these biases can be eliminated.
2. Improve Operation
- In line with forecasting, if the expenses are above the predicted sales level then people in the production, marketing or
in any other areas should improve operations and bring results aligned with forecasting.