TARLAC STATE UNIVERSITY - COLLEGE OF ENGINEERING

MANAGERIAL ACCOUNTING: CAPITAL BUDGETING

Capital Budgeting

Capital assets - are a long-term asset that is used in the production of goods or services. These assets Cash flows from a capital project are received and paid at different points in time over the project's
are typically significant investments for a company and are expected to provide benefits over an life. Some cash flows occur at the beginning of a period, some during the period, and others at the
extended period. Organizations invest in capital assets and these assets can be classified as tangible end.
or intangible assets.
Sample Cash Flow Illustration
Tangible assets - such as machineries, buildings, inventories, supplies and raw materials, and
Assume that various capital projects are being considered by Family One Stop, a retail chain selling
Intangible assets - such as capital lease or renting of an asset for temporary use.
consumer goods in 55 locations throughout the Midwest. One investment being considered by the
Capital budgeting is a systematic approach that businesses use to evaluate, select, and manage future firm is the acquisition of photovoltaic power technology to light all parking lots owned by the chain.
capital investment projects. Managers and accountants apply quantitative and qualitative criteria to In addition to long-term cost savings, this investment would reduce the company's carbon footprint.
evaluate the feasibility of alternative projects. These are:
The expected cost to purchase and install the technology as well as the operating cost savings
Quantitative Criteria Qualitative Criteria appear in the table below. This detailed information can be simplified to a net cash flow for each year.
For Family One Stop, the project generates a net negative flow in the first year and net positive cash
1. Accounting rate of return 1. Employee morale
flows thereafter. This cash flow information can be illustrated using a time line.
2. Payback period 2. Employee safety
3. Discounted payback period 3. Employee responsibility
4. Net present value 4. Corporate image
Cash Outflow Cash Inflows
5. Internal rate of return 5. Social responsibility
6. Profitability index 6. Market share Year 0 $13,500,000 Electricity cost savings:
7. Growth
8. Strategic planning Year 1 500,000 Year 1 $2,700,000
9. Sustainability Year 2 300,000 Year 2 2,900,000
Cash Flows
Year 3 3,200,000
Capital budgeting investment decisions can be based on a variety of quantitative techniques. All these
methods except the internal rate of return focus on cash flows. Year 4 3,900,000

Operating cash flows - represents the cash generated or used by a company's primary business Year 5 4,200,000
activities, such as sales of goods and services.
Year 6 2,100,000
Financing cash flows - represents the cash transactions related to a company's financing activities.
Year 7 1,000,000
These cash flows involve raising capital from investors.

Financing decision - involves choices regarding the method of raising capital to fund an investment.

Investment decision - is a judgment about which assets to acquire to accomplish an entity's mission.
 TARLAC STATE UNIVERSITY - COLLEGE OF ENGINEERING
MANAGERIAL ACCOUNTING: CAPITAL BUDGETING
Time Lines

A time line virtually illustrates the points in time when projected cash flows are received or At the end of the fourth year, all but $1,600,000 of the initial $13,500,000 investment had been
paid, making it a helpful tool for analyzing cash flows of a capital investment proposal. On a time line, covered. The $4,200,000 inflow in the fifth year is assumed to occur evenly throughout the year.
cash inflows are shown as positive amounts and cash outflows are shown as negative amounts. Therefore, it should take approximately 38 percent ($1,600,000 ÷ $4,200,000) of the fifth year to cover
the balance of the original investment, giving a payback period for this project of 4.38 years (or 4 years
The following time line represents the cash flows associated with Family One Stop's potential
and 4.6 months).
photovoltaic technology investment:
When equal periodic cash flows are generated from a project (an annuity), the payback period
End of period 0 1 2 3 4 5 6 7
is determined as follows:
Inflows $0 $2,700 $2,900 $3,200 $3,900 $4,200 $2,100 $1,000 Payback period = Investment ÷ Annuity amount
Outflows $ (13,500) (500) (300) (0) (0) (0) (0) (0) Discounting future cash flows
Net cash flow $(13,500) $2,200 $2,600 $3,200 $3,900 $4,200 $2,100 $1,000 A time value is associated with money because interest is paid or received on money. For example,
$1 received today has more value than $1 received one year from today because money received
Payback Period
today can be invested to generate a return that will cause it to accumulate to more than $1 over time;
Information on the timing of net cash flows is an input to a simple and often used capital budgeting this effect is referred to as the time value of money.
technique called payback period. A project's payback is complete when the organization has
Discounting means reducing future cash flows by removing the portion of the future values
recouped its investment.
representing interest.
The payback period for a project having unequal cash inflows is determined by accumulating cash
A discount rate is used to determine the imputed interest portion of the future cash flows. The
flows until the original investment is recovered. Thus, using the information shown in Exhibit 15.2 and
discount rate should equal or exceed the company's cost of capital (COC).
the time line presented earlier, the photovoltaic technology investment payback period is calculated
using a yearly cumulative total of inflows (in thousands) as follows: Return of capital is the recovery of the original investment (or the return of principal).
Year Annual Cash Flow Cumulative Total Return on capital is income and equals the discount rate multiplied by the investment amount.
0 $(13,500) (13,500) Three discounted cash flow techniques are the net present value method, the profitability index, and
1 2,200 (11,300) the internal rate of return. Each of these methods is defined and illustrated in the following sections.
2 2,600 (8,700)
3 3,200 (5,500)
4 3,900 (1,600)
5 4,200 2,600
6 2,100 4,700
7 1,000 5,700
 TARLAC STATE UNIVERSITY - COLLEGE OF ENGINEERING
MANAGERIAL ACCOUNTING: CAPITAL BUDGETING

Time Value of Money – discounting is mostly used in capital budgeting. The question is when to use 2. Cashflows – these are the expected returns directly attributable to the investment project.
present value factors. Cashflows could be OPERATING CASHFLOWS AFTER TAX or END OF LIFE CASHFLOWS.

● Present value of 1 (PV of 1) – used if the cash flows flow on a lump-sum basis.
OPERATING CASH FLOWS AFTER TAX – the incremental changes in cash arising from cash
Present Value of P1 =
1 flows and cash outflows directly attributable to the project. These cash flows are assumed to
(1+𝑟)𝑛
occur at the end of the year.
● Present value of ordinary annuity – used if the cash flows flow evenly on an annual basis. Incremental – comparison of old new assets.
1 SOLUTION GUIDE
1−(1+𝑟)𝑛
Present Value of Ordinary Annuity of P1 = Cost Savings xxx
𝑟

1−𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃1
Incremental Depreciation (xxx)
Or Cashflow before Tax xxx
𝑟
Incremental tax (xxx)
ELEMENTS OF CAPITAL BUDGETING
Incremental Net Income xxx
These are the factors of capital budgeting used in evaluating capital investment proposals. Add back Incremental Dept. xxx
OPERATING CASHFLOWS AFTER TAX xxx
1. Net Investment – represents the initial cash outlay that is required to obtain future returns
or the net cash outflows to support a capital project.
NOTE: Cash operating income is used if the purpose of the capital project is to increase net
Simply stated, net investment is net cash flows at time zero.
cashflows. On the other hand, cost savings are used if the purpose of the capital project is to
SOLUTION GUIDE reduce the operating cost.

To compute net investment, let us divide in into three (3) parts.
OLD ASSETS
Trade in value (-)
Proceeds from sale (-)
Tax on gain on sale (+)
Tax on loss on sale (-)
Avoidable repairs, net of tax (+)
End of Life Cash Flows
NEW ASSET WORKING CAPITAL These are the net cashflows occurring at the end of the investment projects life.
SOLUTION GUIDE
Acquisition costs (+) Increase in working capital (+)
Operating Cashflows After Tax xxx
Other direct costs (+) Decrease in working capital (-)
Salvage Value xxx
Return to Increase in Working Capital xxx
Return of Decrease in Working Capital xxx
END OF LIFE CASHFLOWS xxx

NOTE: If the decision is an acquisition decision, computation of net investment is limited only to new 3. Discount Rate – is the minimum required rate of return or cut-off rate or target rate. This is
assets and working capital section. If it is a replacement, the three sections are complete. the weighted average cost of capital of long-term funds obtained from different sources.
 TARLAC STATE UNIVERSITY - COLLEGE OF ENGINEERING
MANAGERIAL ACCOUNTING: CAPITAL BUDGETING

CAPITAL BUDGETING TECHNIQUES

DISCOUNTED TECHNIQUES
NON-DISCOUNTED TECHNIQUES 1. NET PRESENT VALUE (NVP) – is the excess of the present value of cash inflows over present
value of cash outflows generated by the project throughout its life.
1. ACCOUNTING RATE OF RETURN (ARR) – also called the book rate of return (BRR). This is
a conventional or traditional technique of measuring profitability by relating the SOLUTION GUIDE
required investment to its incremental net income. Present Value of Cash Inflows xxx
Present Value of Cash Outflows (xxx)
ADVANTAGES DISADVANTAGES NET PRESENT VALUE xxx
ARR closely parallels accounting concepts of
Ignores time value money
income measurement and investment return. 2. INTERNAL RATE OF RETURN - this is the rate which equates the present value of cash inflows
With the computation of income and to present value of cash outflows. Simply put, it is the rate where the present value is zero.
It facilities re-evaluation of projects due to the
book value based on the historical cost
ready availability of data from the accounting
accounting data, the effect of inflation Guidelines in determining IRR:
records.
is ignored.
a) Determining the present value factor of IRR with the use of the formula below:
ARR considers income over the entire life of the 𝑛𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
project. IRR =
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑎𝑓𝑡𝑒𝑟−𝑡𝑎𝑥
ARR emphasizes profitability rather than liquidity b) Using the present value annuity table, find the line “n” (economic life) the factor
computed in the corresponding rate is the IRR.
SOLUTION GUIDE
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 3. PROFITABILITY INDEX – is designed to provide a common basis of ranking alternatives that
ARR = require differences in amounts of investment.
𝑛𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

NOTE: Net investment could be based on original investment or average investment. Average SOLUTION GUIDELINES
investment is computed as original investment plus salvage value divided by two.
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
Profitability Index =
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
2. PAYBACK PERIOD – it is the measurement of time project to break even. With that,
PAYBACK PERIOD is a measurement of LIQUIDITY rather than PROFITABILITY. 𝑁𝑃𝑉
Profitability Index = +1
𝑛𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
The solution below is a guide only if the operating cash flow after tax is even. Otherwise,
payback period computation is done manually. 𝑃𝑉 𝑓𝑎𝑐𝑡𝑜𝑟 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒
Profitability Index =
𝑃𝑉 𝑓𝑎𝑐𝑡𝑜𝑟 𝐼𝑅𝑅
𝑛𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Payback Period =
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑎𝑓𝑡𝑒𝑟−𝑡𝑎𝑥
 TARLAC STATE UNIVERSITY - COLLEGE OF ENGINEERING
MANAGERIAL ACCOUNTING: CAPITAL BUDGETING

INVESTMENT DECISION SAMPLE PROBLEMS (FROM TEST BANK)

Management must identify the best asset to acquire for fulfilling the company’s goals and objectives.
Screening Decisions - determines whether a capital project is desirable based on some previously
established minimum criteria. A project that does not meet the minimum standard is excluded from
further consideration.
Preference Decision – ranks project according to their impact on the achievement of company
objectives.
JUDGEMENT METHOD – the judgement method of risk adjustments allows decision makers to use
logic and reasoning when deciding whether a project provides rate of return in relation to its risks.
RISK ADJUSTED DISCOUNT RATE METHOD – the decision maker increases the rate used for
discounting future cash inflows and decreases the rate used for discounting future cash outflows to
compensate for increased risks.
1. A company has a minimum required rate of return of 9%. It is considering investing in a project
that costs $210,000 and is expected to generate cash inflows of $84,000 at the end of each
year for three years. What is the net present value of this project?
2. The net initial investment for a piece of construction equipment is $1,000,000. Annual cash
inflows are expected to increase by $200,000 per year. The equipment has an 8-year useful
life. What is the payback period?
3. Gray Corporation recently purchased a new machine for $339,013.20 with a ten-year life. The
old equipment has a remaining life of ten years and no disposal value at the time of
replacement. Net cash flows will be $60,000 per year. What is the internal rate of return?
4. Investment Y requires a net investment of $800,000. The required rate of return is 12% for
the four-year annuity. What are the annual cash inflows if the net present value equals 0?
(rounded)

5. The following information is available for a potential investment for LY Company:

Initial investment $95,000

Net annual cash inflow 20,000
Net present value 36,224
Salvage value 10,000
Useful life 10 years

The potential investment’s profitability index is _____.