CAPITAL BUDGETING

Capital Budgeting
It is long-term Planning Process
It involves making and financing
investments
It affects financial results over a
number of year.
Capital Budgeting
It is a process of making capital
expenditures decisions.
Decisions to exchange current cash
outflows for the promise of receiving
future cash inflows.
Net Investment
 Cash Outflows minus Cash inflows
 Cash Outflows:
 The initial cash outlays covering all expenditures on the project
up to the time when it is ready for use.
 Additional Working Capital Requirement
 Market value of an existing, currently idle asset which will be
transferred or utilized in the operations of the proposed capital
investment project.
 Cash Inflows:
 Trade-in value of old assets (in case of replacement)
 Proceeds from sale of old asset to be disposed (consider tax
effect of losses and gains)
 Avoidable cost of immediate repairs on old assets to be
replaced, net of tax
Cash Flow from Sale of Old
Machine
Hoff is considering the sale of a machine with
a book value of $80,000 and 3 years
remaining in its useful life. Straight-line
depreciation of $25,000 annually is available.
The machine has a current market value of
$50,000. What is the cash flow from selling
the machine if the tax rate is 40%?
Cash Flow from Sale of Old
Machine
Acme is considering the sale of a machine
with a book value of $80,000 and 3 years
remaining in its useful life. Straight-line
depreciation of $25,000 annually is
available. The machine has a current
market value of $100,000. What is the
cash flow from selling the machine if the tax
rate 40%.
Cash Flow from Sale of Old
Machine
Eyring Industries has a truck purchased
seven years ago at a cost of $6,000. At the
time of purchase, the ultimate salvage
value was estimated at $500, but salvage
value was ignored in depreciation
deductions. The truck is now fully
depreciated. Assuming a tax rate of 40%, if
the truck is sold for $500, the after-tax cash
inflow for capital budgeting purposes will
be?
Initial Net Cash Investment
 Hatchet Company is considering replacing a
machine with a book value of $400,000, a
remaining useful life of 5 years, and annual
straight-line depreciation of $80,000. The existing
machine has a current market value of $400,000.
The replacement machine would cost $550,000,
have a 5-year life, and save $75,000 per year in
cash operating costs. If the replacement machine
would be depreciated using the straight-line
method and the tax rate is 40%, what would be the
net investment required to replace the existing
machine?
Initial Net Cash Investment
 Regal Industries is replacing a grinder purchased 5
years ago for $15,000 with a new one costing
$25,000 cash. The original grinder is being
depreciated on a straight-line basis over 15 years
to a zero salvage value. Regal will sell this old
equipment to a third party for $6,000 cash. The
new equipment will be depreciated on a straight-
line basis over 10 years to a zero salvage value.
Assuming a 40% marginal tax rate, Regal’s net
cash investment at the time of purchase if the old
grinder is sold and the new one is purchased is
Initial Net Cash Investment
Superstrut is considering replacing an old
press that cost $80,000 six years ago with
a new one that would cost $245,000. The
old press has a net book value of $15,000
and could be sold for $5,000. The
increased production of the new press
would require an investment in additional
working capital of $6,000. The company's
tax rate is 40%. Superstrut's net investment
now in the project would be
Initial Net Cash Investment
 Old Machine Traded-in

A machine that cost $50,000 and is fully

depreciated is allowed as a $10,000
trade-in on a machine costing $75,000.
Assuming a 40% tax rate, the out-of-
pocket cost of the new machine is:
Initial Net Cash Investment
 Old Machine Traded-in, Avoidable Cost

 Key Corp. plans to replace a production machine that was

acquired several years ago. Acquisition cost is P450,000
with salvage value of P50,000. The machine being
considered is worth P800,000 and the supplier is willing to
accept the old machine at a trade-in value of P60,000.
Should the company decide not to acquire the new
machine, it needs to repair the old one at a cost of
P200,000. Tax-wise, the trade-in transaction will not have
any implication but the cost to repair is tax-deductible. The
effective corporate tax rate is 35% of net income subject to
tax. For purposes of capital budgeting, the net investment
in the new machine is
 Initial Net Cash Investment
 Old Machine Traded-in, Other Assets Written Off, Avoidable Cost, Additional
Working Capital
 Great Value Company is planning to purchase a new machine
costing P50,000 with freight and installation costs amounting to
P1,500. The old unit is to be traded-in will be given a trade-in
allowance of P7,500. Other assets that are to be retired as a
result of the acquisition of the new machine can be salvaged and
sold for P3,000. The loss on retirement of these other assets is
P1,000 which will reduce income taxes of P400. If the new
equipment is not purchased, repair of the old unit will have to be
made at an estimated cost of P4,000. This cost can be avoided
by purchasing the new equipment. Additional gross working
capital of P12,000 will be needed to support operation planned
with the new equipment. The net investment assigned to the new
machine for decision analysis is
PAYBACK PERIOD
 For Uniform or Even Cash flows:
𝑁𝑒𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

 For Non-uniform or Uneven Cash Infows:

 No. of Years for the accumulated estimated Annual
Cash Inflows + Fractional Year
𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
 Fractional Year =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
Annual Net Cash Inflows after
Taxes
Incremental Revenue from the Project xxx
Less: Incremental Cash Operating Costs xxx
Cash inflow before taxes xxx
Less: Incremental Depreciation xxx
Net Income before Taxes xxx
Less: Income Taxes xxx
Net Income after tax xxx
Add: Incremental Revenue xxx
Net Cash inflows after tax xxx