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

 As to COST usually involves large expenditure of resources, relative to business size
 As to COMMITMENT usually funds invested are tied up for a long period of time
 As to FLEXIBILTY usually more difficult to reverse than short-term decisions
 As to RISK usually involves so much risks and uncertainties due to operational and economic
changes over an extended period of time

CAPITAL BUDGETING PROCESS

Identification Evaluation Decision Making

Capital Investment Decisions: FACTORS OF CONSIDERATION

Replacement (Equipment)
Improvement (Products)
Expansion (Facilities) New Investments New Returns Costs of Capital
Addition (Technology)
Reduction (Costs)

Non-discounted methods Discounted methods

Payback period Net present value
Bail-out payback Profitability index
Accounting rate of return Internal rate of return
Payback reciprocal 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

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 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 COSTS
Debt Interest rate (after tax)
Preferred Stock (PS) Dividend yield
Common Stock (CS) Dividend yield plus growth rate
Retained Earnings (RE) Dividend yield plus growth rate

 The after—tax cost debt is computed based on: yield rate (1 – tax rate)
 Dividend yield = dividend per share ÷ price per share

Expected cash dividend per share

Cost of CS and RE = + Dividend growth rate
Market price per common share

 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

Net initial cost of investment

Payback Period = Annual net after-tax cash inflows

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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.

Average annual net income

Accounting rate of return (ARR) =
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 project’s 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  Approximately rate of return method
 Unadjusted rate of return  Financial statement rate of return method
 Simple rate of return  Average return of investment

Payback Reciprocal = Net cash inflows 1

=
Investment 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,

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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.

Present value of cash inflows

Profitability Index =
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:

Net investment cost

PVF for IRR =
Net cash inflows

2. 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.

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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 company’s 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 P 500,000 Income available to common shares
-interests (8%) (48,000) EPS =
Number of outstanding shares
Income before tax P 452,000
-tax (30%) (135,600)
P 306,400
Income after tax P 316,400
= P 30.64
- preferred dividends (5%) (10,000) EPS =
10,000 shares
Income available to common shares P 306,400

SOURCES WEIGHT (%) 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

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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 company’s 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 equipment’s 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 Cash flows Salvage value

1 P 50,000 P 65,000
2 P 50,000 P 50,000
3 P 50,000 P 35,000
4 P 50,000 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.

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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 1’s internal rate of return?
a. 23% c. 25%
b. 27% d. 24%
F) What is project 2’s 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

Mall—Asia 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

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B) ARR (based on original investment)

C) Net present value
D) Profitability
E) 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 Annual Cash Flow Investment Cost of Capital IRR NPV

1 P 45,000 P 188,640 14% (1) (2)
2 P 75,000 (3) 12% 18% (4)
3 (5) P 300,000 (6) 16% P 81,440
4 (7) P 450,000 12% (8) P 115,000

13. CAPITAL RATIONING – RANKING PROJECTS

Case-Zone Corporation is considering five different investment opportunities. The company’s 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 NPV IRR P. Index

1 1st
2 2nd
3 3rd
4 4th
5 5th

***End of the Lecture**