CAPITAL BUDGETING

Capital budgeting - the process of deciding

whether or not to commit resources to
projects whose costs and benefits are spread
over several time periods.
Preparation of annual budget for
capital investment
The assessment of funding capacities
The allocation of resources to renewal
and expansion projects which most
clearly conform with the companies
priorities.
Characteristics of a capital investment
decision
Substantial amount of funds are
required in capital projects
The element of certainty becomes
more critical
The effect of managerial errors will be
difficult to reverse
Success or failure of the Company
may depend upon a single or relatively
few investment decisions.
Categories of capital investments
Independent projects - are projects
whose cash flows are unrelated to (or
independent of) one another; the
acceptance of one does not eliminate
the others from further consideration.
Mutually exclusive projects - are
projects that compete with one
another, so that the acceptance of one
eliminates from further consideration
all other projects that serve a similar
function.
Capital expenditure - is an outlay of funds
by the firm that is expected to produce
benefits over a period of time greater than 1
year.
Operating expenditure - is an outlay of
funds by the firm resulting in benefits
received within 1 year.
Accept/reject approach is the evaluation
of capital expenditure proposals to determine
whether they meet the firms minimum
acceptance criterion.
Ranking approach - is the ranking of
capital expenditure projects on the basis of

some predetermined measure, such as the

rate of return.
Relevant cash flows
Incremental cash outflow
(investment) and resulting
subsequent inflows associated with a
proposed capital expenditure
incremental cash flows
The additional cash flowsoutflows
or inflowsexpected to result from
a proposed capital expenditure.
MAJOR CASH FLOW COMPONENTS

an initial investment,
The relevant cash outflow for
a proposed project at time
zero

operating cash inflows, and

The incremental after-tax
cash inflows resulting from
implementation of a project
during its life.
terminal cash flow.
The after-tax nonoperating
cash flow occurring in the
final year of a project. It is
usually attributable to
liquidation of the project.
Sunk costs cash outlays that have already
been made (past outlays) and therefore have
no effect on the cash flows relevant to a
current decision.
Opportunity costs - cash flows that could
be realized from the best alternative use of
an owned asset.
CHANGE IN NET WORKING CAPITAL
If a firm acquires new machinery to
expand its level of operations, it will
experience an increase in levels of cash,
accounts receivable, inventories,
accounts payable, and accruals. These
increases result from the need for more
cash to support expanded operations,
more accounts receivable and inventories
to support increased sales, and more
accounts payable and accruals to support
increased outlays made to meet
expanded product demand.
The change in net working capital
regardless of whether it is an increase or
a decreaseis not taxable because it
merely involves a net build up or net
reduction of current accounts.

Initial investment - refers to the relevant

cash outflows to be considered when
evaluating a prospective capital expenditure.
The initial investment is calculated by
subtracting all cash inflows occurring at
time zero from all cash outflows occurring
at time zero.

Operating cash inflows - cash inflows

represent dollars that can be spent, not
merely accounting profits.
The basic calculation requires adding
depreciation and any other noncash
charges (amortization and depletion)
deducted as expenses on the firms
income statement back to net profits
after taxes.

Terminal cash flow - the proceeds from

sale of the new and the old asset, often
called salvage value, represent the amount
net of any removal or clean-up costs
expected on termination of the project.

At the end of the projects life, the firm

will dispose of the new asset, so the aftertax proceeds from selling the new asset
represent a cash inflow.

Clemson Software is considering a new

project whose data are shown below. The
required equipment has a 3-year tax life,
after which it will be worthless, and it will be
depreciated by the straight-line method over
3 years. Revenues and other operating costs
are expected to be constant over the
projects 3-year life. What is the projects
Year 1 cash flow?
Equipment cost (depreciable basis)
P65,000
Straight-line depreciation rate
33
and 1/3%
Sales revenues, each year
P60,000
Operating costs (excl. deprec.)
P25,000
Tax rate
35.0%
Answer: P30,333

Solution:
Sales revenues
P60,000
Basis rate = depreciation
21,667
Operating costs (excl. deprec.)
25,000
Operating income (EBIT)
P13,333
Taxes
Rate = 35.0%
4,667
After-tax EBIT
P
8,667
+ Depreciation
21,667
Cash flow, Year 1
P30,333
Liberty Services is now at the end of the final
year of a project. The equipment originally
cost P22,500, of which 75% has been
depreciated. The firm can sell the used
equipment today for P6,000, and its tax rate
is 40%. What is the equipments after-tax
salvage value for use in a capital budgeting
analysis? Note that if the equipments final
market value is less than its book value, the
firm will receive a tax credit as a result of the
sale.
Answer: P5,850

PROBLEMS:

Solution:
Equipment cost
P22,500

 Accumulated deprec.
16,875
Current book value of equipment
P
5,625
Market value of equipment
6,000
Gain
P
375
Taxes paid on gain
-150
AT salvage value =
P 5,850
Poulsen Industries is analyzing an averagerisk project, and the following data have
been developed. Unit sales will be constant,
but the sales price should increase with
inflation. Fixed costs will also be constant,
but variable costs should rise with inflation.
The project should last for 3 years, it will be
depreciated on a straight-line basis, and
there will be no salvage value. This is just
one of many projects for the firm, so any
losses can be used to offset gains on other
firm projects. The marketing manager does
not think it is necessary to adjust for inflation
since both the sales price and the variable
costs will rise at the same rate, but the CFO
thinks an adjustment is required. What is the
difference in the expected NPV if the inflation
adjustment is made vs. if it is not made?
WACC
10.0%
Net investment cost
(depreciable basis)
P200,000
Units sold
50,000
Average price per unit, Year 1
P25.00
Fixed op. cost excl. deprec.
(constant)
P150,000
Variable op. cost/unit, Year 1
P20.20
Annual depreciation rate
33.333%
Expected inflation
4.00%
Tax rate
35.0%
Answer: P14,721
Your company, RMU Inc., is considering a
new project whose data are shown below.
What is the projects Year 1 cash flow?
Sales revenues
P22,250
Depreciation
P 8,000
Other operating costs
P12,000
Tax rate
35.0%
Answer: P9,463

Solution:
Sales revenues
P22,250
Operating costs (excl. deprec.)
12,000
Depreciation
8,000
Operating income (EBIT)
P
2,250
Taxes Rate = 35%
788
After-tax EBIT
P
1,463
+ Depreciation
8,000
Cash flow, Year 1
P 9,463
Marshall-Miller & Company is considering the
purchase of a new machine for P50,000,
installed. The machine has a tax life of 5
years, and it can be depreciated according to
the following rates. The firm expects to
operate the machine for 4 years and then to
sell it for P12,500. If the marginal tax rate is
40%, what will the after-tax salvage value be
when the machine is sold at the end of Year
4?
Year Depreciation Rate
1
0.20
2
0.32
3
0.19
4
0.12
5
0.11
6
0.06
Answer: P10,900
Solution:
Gross sales proceeds (Market value)
P12,500
Book value, end of Year 4
8,500
Profit
P 4,000
Tax on profit Rate = 40%
1,600
AT salvage value =
P10,900
CAPITAL BUDGETING TECHNIQUES
Process of capital budgeting
1. Finding Investment Opportunities
2. Collect relevant information about
Opportunities
3. Select Discount Rate
4. Financial Analysis of Cash Flows

5. Decision
6. Project Implementation
Net cost of investment
Cash Outflows
Net purchase price of the new asset (net
of discount), whether take or not.
Additional or incidental costs paid or
incurred to prepare the asset for use
Additional taxes paid or incurred in case
of gain on disposal of old asset.
Additional taxes paid from savings on
avoided cost of repairs, if the old asset is
replaced.
Increase in working capital base
Cash Inflows
Proceeds from sale or trade-in allowance
from disposal of old asset.
Tax savings from loss on sale of old asset
Savings from avoided repairs and
maintenance, if the old asset is replaced.
The management of X Company plans to
replace a sorting machine that was acquired
several years ago at a cost of P850,000. The
machine has been depreciated to its salvage
value of P90,000. A new sorter can be
purchased for P2,940,000, 3/10, n/30. The
dealer will grant a trade-in allowance of
P176,000 on the old machine. If a new
machine is not purchased, X will spend
P745,000 to repair the old machine. Gains
and losses on trade-in are not subject to
income tax. The cost to repair can be
deducted for tax purposes. Income tax rate
is 40%. What is the net cost of investment?
Answer: P2,228,800
Payback period - the amount of time
required for a firm to recover its initial
investment in a project, as calculated from
cash inflows.
Decision criteria:
The length of the maximum acceptable
payback period is determined by
management.
If the payback period is less than the
maximum acceptable payback period,
accept the project.
If the payback period is greater than the
maximum acceptable payback period,
reject the project.

Advantages:
It is easy to compute and understand
It is used to measure the degree of risk
associated with a project
Generally, the longer the payback period,
the higher the risk
It is used to select projects which provide
a quick return of invested funds.
Disadvantages:
It does not recognize the time value of
money
It ignores the impact of cash flows after
the payback period
It does not distinguish between
alternatives having different economic
lives
The conventional payback computation
fails to consider salvage value, if any
It does not measure profitability only
the relative liquidity
There is no necessary relationship
between a given payback and investor
wealth maximization so an investor would
not know what an acceptable payback is.
Taggart Inc. is considering a project that has
the following cash flow data. What is the
project's payback?
Year
0
1
2
3
Cash flows -P1,150
P500 P500 P500
Answer: 2.30 years
Payback Reciprocal = 1 / payback period
(using the same problem)
= 1 / 2.30
= 43.48%
The higher, the better
Payback bailout period
Year
0
1
2
3
Cash flows -P1,150
P500 P500 P500
Salvage Value
P400 P200 P150
Answer: 1.90 years
Accounting rate of return
Matchi Corporation is considering the
production of a new product line which will
require an investment of P10,000,000, no
scrap value. The investment will have a
useful life of 5 years, during which annual

net cash flows before taxes of P3,500,000

are expected. The income tax rate is 40%.
A) Annual net income for purposes of
computing ARR:
B) Accounting Rate of Return (original and
average investment):
Solution:
Cash inflows before tax
P3,500,000
Depreciation expense(10M / 5)
2,000,000
EBIT
Tax(40% x 1,500,000)
600,000
Net Income

1,500,000
P 900,000

ARR (Original) 900,000 / 10,000,000 =

9%
ARR (Average) 900,000 / (10,000,000 / 2) =
18%

Requires detailed long-term forecasts of

incremental cash flow data
Requires pre-determination of the cost of
capital or the discount rate to be used.

Net present value - a sophisticated capital

budgeting technique; found by subtracting a
projects initial investment from the present
value of its cash inflows discounted at a rate
equal to the firms cost of capital.
NPV = Present value of cash inflows
Initial investment
Decision criteria:
If the NPV is greater than P0,
accept the project.
If the NPV is less than P0, reject the
project.
Warnock Inc. is considering a project that has
the following cash flow and WACC data.
What is the project's NPV?

ARR Advantages
Easily understood by investors
acquainted with financial statements
Used as a rough preliminary screening
device of investment proposals

WACC: 10.00%
Year
0
1
2
3
Cash flows -P950 P500 P400 P300

ARR Disadvantages
Ignores time value of money
Does not consider the timing component
of cash flows
Different averaging techniques yield
inaccurate answers
Utilizes the concepts of capital and
income primarily designed for the
purposes of financial statements
preparation and which may not be
relevant to the evaluation of investment
proposals.

Profitability index = PV of Cash Flows /

Cash Outlay

Discounted Cash Flow Techniques

Advantages
More reliable (time value of money is
considered)
Income over the entire life of project is
considered
More objective and relevant because it
focuses on cash flows
Discounted Cash Flow Techniques
Disadvantages
Not easily understood
More complex and difficult to apply

Answer:P60.52

WACC: 10.00%
Year
0
1
2
3
Cash flows -P950 P500 P400 P300
P1,010.52 / P950
Answer: 1.06
Internal rate of return - the breakeven
rate of return, where PV of Cash flows = Cost
of investment
NPV = P0, PI = 1.00
Using the same given, solve for IRR:
WACC: 10.00%
Year
0
1
2
3
Cash flows -P950 P500 P400 P300
Answer: 13.92%
Discounted payback period - computes
for number of years before an investment is
recouped.
Time Value of Money is considered in
DPP.

WACC: 10.00%
Year
0
1
2
3
Cash flows -P950 P500 P400 P300

Answer: 2.73 years