Professional Documents
Culture Documents
CAPBUD
CAPBUD
CAPITAL BUDGETING
Reviewer: Noelen Monarca Carreon, CPA, MBA
Topic Outline
● Basic Concepts
● Elements of capital budgeting
● Techniques in capital budgeting
● Investment decisions
I. Basic concepts
Capital Budgeting is a process of identifying, evaluating, planning and financing capital investment
projects of an organization.
Receive Returns
Additional
Invest or commit cash inflows
funds Reduced
cash outflows
TODAY FUTURE
High Risk and Uncertainty
Note:
You are investing funds today with an expectation to receive returns in the future. Expected
returns may come either in additional cash inflows or reduced cash outflows.
Capital budgeting involves investment in LONG TERM ASSETS. These type of investments have
high risk and uncertainty as it requires longer period for the returns to be realized.
Types of Projects
a. Independent projects
b. Mutually exclusive projects
These are the factors of capital budgeting used in evaluating capital investment proposals.
● Net Investment
● Cash Flows or Net returns
● Discount Rate
a. NET INVESTMENT
Net investments represent the initial cash outlay that is required to obtain future
returns or the net cash outflows to support a capital project.
Simply stated, net investment is net cash flows at time zero.
NET INVESTMENT
WORKING
OLD ASSET NEW ASSET
CAPITAL
b. Cash flows
These are the expected returns directly attributable to the investment project
Cash flows could be operating cash flows after tax or end of life cashflows.
2
EXAMPLE:
Operating Cash-flows after tax
Cost savings/ Cash operating income 100
Incremental depreciation (20)
Cash Inflow before tax 80
Incremental Tax (30%) (24)
Incremental net income 56
Add back incremental depreciation 20
OPERATING CASH FLOWS AFTER TAX 76
Note:
In Replacement decision, compare the depreciation of the new asset against the depreciation of
the old asset. The incremental depreciation is the difference in the depreciation between the old
asset and the new asset. However, in an Acquisition decision only the depreciation of the new
asset is incremental depreciation.
c. Discount Rate
This is the weighted average cost of capital of long term funds obtained from different sources.
A.K.A minimum required rate of return or cut off rate or target rate or desired rate of return or
hurdle rate.
SAMPLE EXERCISE 1.
During the current year, 2020, HANZO CORP. is planning to replace an old machine with the
following information:
Carrying amount P600,000
Useful life 5 years
Current market value 300,000
The new equipment could be purchased at a cost of P1,000,000 excluding payments for shipping
and installation for a total amount of P100,000. Other assets that are to be retired as a result of the
acquisition of the new machine can be salvaged for P40,000. The gain on the retirement of these
assets is P10,000, which will increase income taxes by P2,500.
Should the company decide not to acquire the new machine, it needs to repair the old one at a cost
of 100,000. Otherwise, additional cost of removing the unit is estimated at P20,000. Additional gross
working capital of P30,000 will be needed to support operation planned with the new equipment.
3
REQUIREMENT 1: How much is net investment?
Solution:
New Asset
Acquisition Cost 1,000,000
Directly Attributable costs 100,000___
Total 1,100,000
Old Asset
Market Value- Old Asset P(300,000)
Proceeds from sale- other assets (40,000)
Tax on gain-other assets 2,500
Tax on loss- Old asset (300k x 25%) (75,000)
Avoidable repairs, net of tax (P100,000 x 75 %) (75,000)
Removal cost, net of tax (20,000 x 75%) 15,000___
Total (472,500)
Working Capital
Increase in WC 30,000__
NET INVESTMENT P657,500
REQUIREMENT 2: What is the increase in annual net cash flows if the company replaces the
machine?
Solution:
Alternative solution:
Ignores Time
value of money Discounted Payback period
Cash flows
Net Present Value
Considers Time
value of money
Internal Rate of Return
(IRR)
Profitability Index
4
Accounting Rate of Return
● Type: Non discounting method
● Basis: Accounting Net income
● Purpose: tells managers how much net income a potential project is expected to generate
as a relative percentage of the investment required
● How used: compare ARR to the hurdle rate (minimum rate of return)
Accept: ARR > Hurdle rate
Reject: ARR < Hurdle rate
ADVANTAGES DISADVANTAGES
ARR emphasizes
profitability rather than Ignores the time value of
liquidity money
The computation of
ARR considers income
income and book value based
over the entire life of the on historical cost accounting
project. data, the effect of inflation is
Availability of data from ignored.
the accounting records
Payback Period
● Type: Non-discounting method
● Basis: Cash flows
● Purpose: It shows the amount of time it takes for a capital investment to be recovered by
the company using the cash inflows from investment.
● How used: Generally, projects with shorter payback periods are safer investments than
those with longer payback periods.
Payback period is the length of time required for a project's cumulative cash flows to equal its net
investment.
5
ADVANTAGES DISADVANTAGES
Payback gives
information about the Ignores time value of
projects liquidity money. After reaching
Payback is simple to the payback period
compute and easy to subsequent cash flows
understand are ignored
SAMPLE EXERCISE 2:
BANE BUS COMPANY INC. is planning to install vending machines with a cost of P
300,000. It is estimated that this vending machines will generate annual sales of 20,000 cups with
a price of P10 per cup. Cash variable costs are P4 per cup while cash fixed costs are expected to
be P50,000 per year. The vending machine’s estimated economic life would be 5 years with a
salvage value of P50,000 and depreciated using the straight line method. Bane is subject to a
35% income tax rate.
Requirements:
(a) Determine the payback period.
(b) Determine the accounting rate of return based on original investment;
( c) Determine the accounting rate of return based on average investment.
Solution:
Net investment P300,000
Alternative solution:
Cash operating income after tax (P70,000 x 65%) P45,500
Tax shield on depreciation (P50,000 x 35% 17,500
Operating cash flow after tax 63,000
6
Bail-out Period
Is a variation of payback period where cash recoveries include not only the operating net
cash inflows but also the estimated salvage value at the end of each year of the life of the project.
SAMPLE EXERCISE 3:
A Company purchased a new machine on January 1 of this year for P180,000 with an
estimated useful life of 5 years and a salvage value of P10,000. The machine will be depreciated
using the straight line method. The machine is expected to produce the following cash flow from
operations, net of income taxes:
Year Amount
1 60,000
2 70,000
3 80,000
4 70,000
5 60,000
The new machine’s salvage value is P20,000 in years 1 and 2, and P15,000 in years 3 and 4.
Payback period
1 60,000 = 1
2 70,000 = 1
3 50,000 = .625 (50,000/ 80,000)
180,000 2.625
Answer = 2.625 years
Bailout period
Year 1:
Salvage value P20,000
Cash flow after tax (current) 60,000
Total P80,000
Year 2:
Salvage value P20,000
Cash flow after tax (prior) 60,000
Cash flow after tax (current) 70,000
Total P150,000
Year 3:
Salvage value P20,000
Cash flow after tax (prior) 130,000
Cash flow after tax (current) 35,000
Total P180,000
7
Answer: 2 years + (35,000/80,000) = 2.4375
Discounted Payback
It is the period required for the discounted cumulative cash inflows on a project to equal
the discounted cumulative cash outflows (usually the initial cost). It is the same concept as
payback period except that cash flows should be discounted.
NPV is the excess of the present value of the cash inflows over present value of cash
outflows generated by the project throughout its life.
PV of inflows:
CFAT xxx
Salvage value xxx
Working capital xxx
PV of Outflows:
Net investment (xxx)
NET PRESENT VALUE xxx
This is the rate which equates the present value of cash inflows to the present value of
cash outflows. Simply stated, it is the rate where present value is zero.
A.K.A Discounted cash flow rate of return, time adjusted rate of return or sophisticated rate of
return.
Present value Factor = Cost of investment/ annual cash inflow
Profitability Index
● Type: Discounting method
● Basis: Cash flows
● Purpose:The ratio of the project’s benefit ( measured by the Pv of the future cash flows)
to its cost (or required investment).
● How used:
Accept: PI > 1
Reject: PI < 1
8
Profitability Index is designed to provide a common basis of ranking alternatives that require
different amounts of investment.
b. Mutually exclusive Projects- competing alternatives where investing in one removes the
possibility of investing in another.
SAMPLE EXERCISE 4:
Two independent proposals are under consideration by ALUCARD INC. during the current year:
9
(b.) @ Internal Rate of Return
Cash Inflows after tax (200,000 x 3) 600,000
Net investment (600,000)
Net present Value -0-
Internal Rate of Return 12.59%
TECHNIQUE DECISION
Net present value Accept
Internal rate of return Accept
Profitability Index Accept
Payback period Reject
Accounting rate of return Accept
TECHNIQUE DECISION
Net present value Reject
Internal rate of return Reject
Profitability Index Reject
Payback period Reject
Accounting rate of return Reject
If the projects are MUTUALLY-EXCLUSIVE, the company should accept PROJECT ABC only.
10