CHAPTER IV

Capital Budgeting

CAPITAL BUDGETING
Is the
process of planning and
controlling long-term investments. It
involves
evaluation
of
capital
investment proposals, allocation of
capital investment funds among
approved projects and programs, and
control of such expenditures.

THE ADMINISTRATIVE PROCESS IN

CAPITAL BUDGETING
The administrative process in capital budgeting
refers to the framework of planning and control
measures which identifies and interrelates the
essential requirements for an effective capital
expenditure program. It consist of the following
steps :
1. Proposal generation
2. Gathering of relevant data on proposal
submitted
3. Evaluation
4. Approval and implementation
5. Control of expenditures and follow-up

WHAT PROBLEMS REQUIRE CAPITAL

BUDGETING
Capital budgeting techniques should be used in all
decision-making problems requiring long-term use of
funds: example are the following :
1. Should an investment be made in a proposed
business venture?
2. Would it be more advantageous for a business
concern to expand or just maintain its current
production/sales capacity?
3. Should existing facilities be maintained, replaced, or
renewed?
4. Which would be more advantageous: continued
ownership or sale leaseback?
5. Should facilities be leased out or used in
operations?

CASH FLOWS IN CAPITAL

BUDGETING

As the word budgeting connotes,

cash flows in different alternatives are
determined and their values are
computed using a common point in
time. The cash flows are investment,
cash returns and terminal values.

INVESTMENTS
This refers to the net outlay of resources
at the inception of a business venture or
special project. This includes the purchase
cost of assets, incidental costs such as
freight in and installation costs. Working
capital requirement, and market value of
asset already owned and to be transferred
to the venture or project.

CASH
RETURNS
This refers to the net cash
inflows expected to be realized
when the business or special
project is already operational.

TERMINAL CASH
FLOWS
This terms refers to cash inflow that
mat be realized upon termination of
business venture or project and
consists of working capital that is
expected to be released there from
and the realizable value of assets
used.

ECONOMIC LIFE
This refers to the length of
period during which economic
benefits can be expected from a
venture or project.

CUT-OFF RATE USED IN EVALUATING

LONG-TERM INVESTMENT PROPOSALS
In
evaluating
investment
proposals,
management adopts standards and one of
these is:
a. The cut-off rate or the lowest acceptable
rate of return.
b. Cost of capital or the opportunity cost of
capital.
c. In some cases, a certain percentage is
added based on risks involved.

Methods of
Evaluating
Capital
Investment
Proposal

A. METHODS OF EVALUATING CAPITAL

INVESTMENT PROPOSAL

1. Payback period. This refers to the

length of period or number of years it
would take to recover an investment.
Formula :
Investment /
Annual cash Returns

2. Payback reciprocal. This indicated

the percentage of investment that is
expected to be recovered in one year.
Formula:
Annual Cash returns / Investment
or
1 / Payback Period

3. Accounting rate of return. It

indicates the amount of net income
realized per peso of investment.
Formula:
Net Income / Investment

4. Average rate of return. It indicates the

amount of net income per peso of average
investment. It is double the accounting rate
of return.
Formula:
Net Income / Average Investment
or
2 ( Accounting rate of return )
Average Investment = Investment / 2

5. Payback bailout period. This

length of period or number
would take to recover an
considering accumulated cash
terminal values.

refers to the
of years it
investment
returns and

Procedure: Accumulate cash returns and

add terminal cash flows at the end of each
year. When the total is equal to investment,
the payback bailout period has been
arrived at.

B. METHODS THAT CONSIDER THE TIME

VALUE OF MONEY:
1. Internal rate of return (IPR). This refers to the rate of
return that a long-term investment earns. It is also
called the discounted or timed adjusted rate of return.
Procedure:
*Compute for payback period
*With the payback period as the present value
factor, locate it an annuity
table considering the
economic life of the investment. The
corresponding
interest rate for the column in which it can be
found is the IRR.

2. Net present value (NPV). This refers to

the excess of the present value of cash
returns discounted at a chosen cut-off rate
over the amount of investment.
Formula:
Present value of annual cash
Discounted at the cut-off rate Investment

returns

3. Profitability index ( benefit / cost ratio or

present value index ). This refers to the
ratio of the present value of cash returns
discounted at a chosen cut-off rate to the
investment requirement.
Formula:
Present value of annual cash
discounted at the cut-off
rate /
Investment

returns

4. Discounted payback period. This refers to

the number of years it would take the present
value of cash returns to equal the investment.
Procedure:
Discount the cash returns at the chosen cut-off
rate and accumulate them. The length of
period or number of years it would require to
make the accumulated figure equal to
investment is the discounted payback period.

ILLUSTRATIVE
PROBLEM

1. ANNUAL CASH RETURNS

An investment proposal is expected to
enable a company to make sales of P5, 000
per annum. Cost of sales and operating
expenses requiring disbursements are
estimated at P1, 497 per annum. The fixed
assets that must be acquired cost P6,738
and have estimated useful life of three
years. Income tax rate is 40%. Determine
the annual cash return.

ACR = net income+ Dept exp.

Net income=
sales
5000
Less OE
1497
Dept ( 6738/ 3) 2246

3743

Net income before tax 1257

Tax( 1257*.40)
754.20

502.80

ACR = NET INCOME + DEPRECIATION

EXPRENSE

754.20 + 2246 = 3,000.20

2. PAYBACK PERIOD AND

PAYBACK RECIPROCAL
An investment of P6, 738 is expected
to bring in annual cash returns of P3, 000.20
during is economic life of three years.
Determine the payback period and payback
reciprocal.
PAYBCK PERIOD
6738/ 3000.20 =2.2459 YEARS
PAYBACK RECIPROCAL
3000.20/ 6738 = 44.53%

3. ACCOUNTING RATE OF
RETURN AND AVERAGE RATE OF
RETURN
A machine costing P6, 738 is expected to
enable the company to realize an annual net
income of P754.20 throughout its life of three
years. Determine the accounting rate of return
and the average rate of return.
ARR- NI/ INVESTMENT
754.20/6738= 11.20%
AVERAGE RR
6738/2 =3369 OR 2(ARR)= 2(11.20%)= 22.40

4. PAYBACK BAILOUT
PERIOD
An equipment costing P30, 000 with the
following cash returns expected from its use;
determine the payback bailout period.
Cash Returns

Scrap Value
End of Year

First year

6, 000

15, 000

Second year

9, 000

10, 000

Third year

10, 000

5, 000

Forth year

8, 000

1, 000

5. INTERNAL RATE OF RETURN

A machine costing P1, 366.40 has
estimated economic life of three years
without scrap value. Annual cash returns
have been estimated at P700. Determine
the internal rate of return.

First compute the payback period.

payback period = investment/ annual cash return
Given : P. 1,366.40- investment
P 700 annual cash return
3 years economic life

Solution :
=P1,366.40 / P700
= 1.952 years
then locate 1952 at annuity table . Row of 3 years, since
the economic life is 3 years.
1.952 is at 25%, so that 25 % is the IRR.

6. NET PRESENT
VALUE
A proposal investment of P1, 366.40
annual returns of P700 per annum are
expected during its economic life of three
years. Management has adopted the policy
of approving project proposals if the rate of
return is 20% or higher. Determine the Net
Present value.

First, look at annuity table, since economic life is 3 years,

look at the row of 3 years then look at the corresponding
value at 20%. 20 % is the rate of return in the problem.
3 years at 20% is 2,106
Formula:
Present value of annual cash
cut-off
rate Investment.

returns Discounted at the

Solution:
( 700 * 2.106)
= 1474.20
LESS: Investment=(1366.40)
NET PRESENT VALUE = 107.80

7. PROFITABILITY INDEX
A proposed investment of P1, 366.40
annual returns of P700 per annum are
expected during its economic life of three
years. Management has adopted the policy
of approving project proposals if the rate of
return is 20% or higher. Determine the
Profitability Index.

PROFITABLE INDEX =
PV OF ACR/ INVESTMENT
= 1474.20/1366.40
= 1.078 OR 107.80%

8. DISCOUNTED PAYBACK PERIOD

An investment of P5, 876 will bring in cash returns as
follows:
First year

2, 000

Second year

3, 000

Third year

3, 000

Forth year

2, 500

Fifth year

2, 000

Required rate of return is 25%. Determine the

discounted payback period.

YEAR
1

ARC
PV@25% PV ACCUM. OF
PV @25%
2,000
.800
16000 16000

2
3
4
5

3,000
3,000
2,500
2,000

820/ 1022.50
= 3.80 YEARS

.640
.512
.409
.328

1920 3520
1536 5056
1022.50 820
656

5876