CAPITAL

BUDGETING
CAPITAL BUDGETING

 Process of identifying, evaluating, planning and

financing capital investment projects of an
organization.

 Process of determining which real investment

projects should be accepted and given an
allocation of funds from the firm.
CAPITAL INVESTMENT DECISIONS

 are concerned with the process of

planning, setting goals, and priorities,
arranging, financing and using certain
criteria to select long-term assets.
CHARACTERISTICS OF CAPITAL
INVESTMENT DECISIONS

 1. Capital Investment Decision usually require relatively large

commitments.
 Large sum of money is involved; it is like a gambling whether you win or lose.

 2. Most Capital Investment involve long-term commitments.

 Lasts more than a normal operating cycle of the business or 20 yrs more.

 3. Capital Investment Decision are more difficult to reverse

than short-term decisions.
CAPITAL BUDGETING PROCESS
 A set of systematic capital budgeting procedures is necessary to ensure that
capital investment proposals are evaluated considering organization’s goals
and policies so that the best alternative is undertaken.

 1. IDENTIFICATION OF POTENTIAL PROJECTS

 2. ESTIMATION OF COST AND BENEFITS
 3. EVALUATION OF PROPOSED PROJECTS
 4. DEVELOPMENT OF CAPITAL EXPENDITURES
 5. REEVALUATION OF PROJECTS
TYPE OF INVESTMENT PROJECTS

 1. REPLACEMENT
 2. IMPROVEMENT
 3. EXPANSION
EVALUATING CAPITAL INVESTMENT
PROJECTS

 Capitalbudgeting process is the

evaluation of the capital investment.
CAPITAL INVESTMENT FACTORS
 1 NET INVESTMENTS
 Defined as the net outflow of cash / a commitment of
cash /a sacrifice of an inflow of cash.

 COSTS/CASH OUT FLOW  SAVINGS/CASH INFLOWS

 Purchase price of the asset
 Trade-in-value of old asset (in
 Accidental projects related costs case of replacement)
(freight, insurance taxes, installations,
etc.)  Proceeds from sale of sold asset
 Working capital required to operate due to acquisition of new project.
the project at the desired level.
 Avoidable cost or immediate
 Market value of an existing, idle repairs on old asset to be
assets which will be transferred or
utilized in the process/ operations of replaced, net of tax.
the proposed capital investment.
ILLUSTRATIVE EXAMPLE
The management of NADULPIT FITNESS CENTER is planning to replace an old
slimming machine which was acquired 5 years ago at a cost of P30,000. The old
machine has been depreciated to its salvage value of P4,000. NADULPIT has found a
buyer who is willing to purchase the old slimming machine for P6,000.
The new machine will cost P50,000. Incidental costs of installation, freight, and
insurance will have to be incurred at a total cost of P10,000.
Should the company decide to retain the old slimming machine (and forget
buying the new one) the same must be upgraded and subjected to major repairs.
The estimated cost of this repairs (which is tax deductible) amounts P8,000. The
income tax rate is 35%.

REQUIRED: Compute the net cost of investment in the new machine for decision
making purposes.
 Purchase price of new machine P 50,000.00
ADD: incidental costs of installation, freight
P 10,000.00
and insurance
TOTAL COST/CASH OUTFLOWS P 60,000.00
LESS: SAVINGS/CASH INFLOWS:
Proceeds from sale of old machine P 6,000.00
LESS: Tax on gain on sale
P 700.00
[( P6,000 proceeds - P4,000 book value) x 35%)]
Proceeds on sale, net of tax P 5,300.00
Avoidable cost of repairs on old machine P 8,000.00
LESS: Applicable tax of 35%
P 2,800.00
(P8,000 x .35)
Avoidable cost of repairs, net of tax P 5,200.00 P 10,500.00
NET COST OF INVESTMENT P 49,500.00
  2 NET RETURNS
 Management will invest in a project if it can expect some Return on
Investment (ROI).

TWO CONCEPTS OF RETURN OR INCOME MAY BE CONSIDERED FOR

PURPOSES OF EVALUATING INVESTMENT PROJECTS:

ACCOUNTING NET INCOME

- Net income (after tax) expected to be earned from the project being evaluated.
- Net income from the proposed project only, and not the total net income earned
from all the operations of the whole firm.

NET CASH INFLOW

 It involves only the cash revenues, costs and expenses.
ILLUSTRATIVE EXAMPLE
Pinky Company plans to buy a new machine to increase its plant’s productive
capacity. The new machine’s estimated installed cost is P50,000. It is expected to
have no salvage value at the end of its useful life of 5 years.
Based on Pinky’s projections, the new machine can produce 100,000 units of
product per year. Because of the high demand for this product which the company
sells at P5 each, it is expected that all the units produced will be sold.
Relevant production, selling and administrative costs related to the product
amount of P3 each, exclusive of depreciation. The company pays income tax at the
rate of 35% of taxable income.

REQUIRED:
1. Accounting net income from the new machine
2. The net cash inflows from the project
Accounting Net Income in condensed income statement format:

Sales (100,000 units x P5) P 500,000.00

LESS: costs and expenses:
Production, selling and administration costs
excluding depreciation (100,000 x P3) P 300,000.00
Depreciation of new machine
P 10,000.00 P 310,000.00
(P50,000 / 5yrs)
Income before tax P 190,000.00
LESS: Income tax 35% P 66,500.00
NET INCOME P 123,500.00
2 WAYS OF COMPUTING THE NET CASH INFLOWS:

BY IDENTIFYING ALL CASH INFLOWS AND OUTFLOWS

CASH INFLOWS (SALES) P 500,000.00
LESS: Cash Outflows:
Production, selling and administration costs
excluding depreciation P 300,000.00
LESS: Income tax P 66,500.00 P 366,500.00
NET CASH INFLOW P 133,500.00
2 WAYS OF COMPUTING THE NET CASH INFLOWS:

BY ADDING TO THE NET INCOME FIGURE ALL THE

NON-CASH EXPENSES.

NET INCOME P 123,500.00

ADD: Depreciation P 10,000.00
NET CASH INFLOW 133,500.00
 3 COST OF CAPITAL
 “cut-off rate, minimum desired rate, minimum acceptable
rate, target rate, standard rate and hurdle rate.”
 Serves
as the standard rate with which comparisons are to
be made.
 Cost of using funds: bonds, notes payable, common stocks,
preferred stocks or even from earnings retained in the
business.
Financing can be traced directly to
a specific source:
SOURCE COST OF CAPITAL

Bonds After tax rate of interest

Preferred Stock Dividend per share
Present Market Price of the Preferred Stock
Common Stock and Retained Earnings Earnings per share (after tax and preferred dividends)
Current Market Price of the Common Stock
 When financing comes from a combination of various sources, the weighted
average cost of capital must be computed, the weight being the percentage
component of each item in the firm’s capital structure.

ILLUSTRATIVE DATA
CAPITAL STRUCTURE: % OF TOTAL
Bonds payable, 10% P 500,000.00 50%
Preferred stock, 8% P 100.00 par value P 100,000.00 10%
Common stock, 100,000 shares P 300,000.00 30%
40%
Retained Earnings P 100,000.00 10%
TOTAL P 1,000,000.00 100%
OTHER DATA
Income before tax P 200,000.00
LESS: Tax 35% P 70,000.00
Net Income P 130,000.00
LESS: Preferred dividends
P 8,000.00
PHP 100,000.00 8%
Balance for common stockholders P 122,000.00
÷ # of common shares 100,000 shares 100,000.00 shares
Earnings per share 1.22
CURRENT MARKET PRICES
Common Stock P 5.00
Preferred Stock P 160.00
COMPUTATION OF COST CAPITAL
BONDS = after tax rate of interest = 10% (1 - 0.35) = 6.50%

PREFERRED STOCK DIV. PER SHARE P 100 x 8% P 80

5.0%
PRESENT MARKET P 160 P 160
PRICE

COMMON STOCK AND EPS P 1.22

24.4%
RETAINED EARNINGS PRESENT MARKET P5
PRICE
COMPUTATION OF WEIGHTED
AVERAGE COST OF CAPITAL (WACC)
PROPORTION AFTER TAX WEIGHTED
SOURCE OF FUND
OF FUNDS COST COST
Bonds payable 50 0.065 3.25
Prederred Stock 10 5 0.50
Common stock and retained earnings 40 24.4 9.76
WEIGHTED AVE COST OF CAPITAL 13.51
Methods that
DO NOT
consider the
time value of
money
PAYBACK
BAIL-OUT
ACCONTING RATE OF RETURN
PAYBACK

The length of time required by the project

to return the initial cost of investment.
 ADVANTAGES DISADVANTAGES

Does not consider the time

Simple and easy to understand. value of money.

Gives information about liquidity Gives more emphasis on

of the project. liquidity rather than profitability.

Does not consider the salvage

A good surrogate for risk. value of the project.
Ignores cash flows that may
occur after the payback
period.
PAYBACK PERIOD = Net Cost of INITIAL Investment
Annual Net Cash Inflows
ILLUSTRATIVE EXAMPLE:

If a company plans to buy an equipment for P50,000 and the

equipment is expected to generate after tax net cash inflows of
P10,000 per year, what is the payback period?

Payback period = Net cost of initial investment / Annual Net Cash

Inflows
= 50000/10000
= 5 years
Net Cost of Investment 50,000

Year Net Cash Inflows

1 18,000
2 14,000
3 12,000
4 8,000
5 6,000
AMOUNT TO BE NET CASH PAYBACK
RECOVERED YEAR INFLOWS PERIOD

50,000 1 18,000 1
32,000 2 14,000 1
18,000 3 12,000 1
6,000 4 8,000 0.75
3.75
BAIL - OUT

Cash recoveries include not only the operating net cash inflows but
also the estimated salvage value or proceeds from sale at the end of
each year of the life of the project.
ILLUSTRATIVE EXAMPLE:

Cost of Investment P150,0000

Year Net Cash Inflow Salvage Value
1 40,000 100,000
2 30,000 70,000
3 25,000 60,000
4 20,000 50,000
5 20,000 30,000
 Total
Amount to be Net Cash Salvage Cash Bail-out
recovered Year Inflows Value Inflows Period

150,000.00 1 40,000.00 100,000.00 140,000.00 1

110,000.00 2 30,000.00 70,000.00 100,000.00 1

80,000.00 3 25,000.00 60,000.00 85,000.00 0.8

2.8
ACCOUNTING RATE OF RETURN

Also called book value rate of return, financial statement method,

average return on investment and unadjusted rate of return.
 ADVANTAGES DISADVANTAGES

Closely parallels accounting

concepts of income measurement Does not consider the time
and investment return value of money.
Facilitates re - evaluation of
projects. Effect of inflation is ignored.

Considers income over the entire

life of the project.
Indicates the project's profitability.
To compute for ARR:

A.Original or Initial Investment : Net Income / Original Investment

B. Average Investment : Net Income / *Average Investment

*(Original Investment + Salvage Value) / 2
ILLUSTRATIVE EXAMPLE
A company is planning to acquire a new machine that will cost 60,000. This
machine is expected to generate net income of 12,000 per year. No
salvage value is expected to be recovered at the end of its useful life of 10
years. What is the ARR for this project?

A. ARR = Net Income / Original Investment

= 12,000 / 60,000
= 20%
B. ARR = Net Income / *Average Investment
= 12,000 / {(60,000 + 0) /2}
= 12,000 / (60,000/2)
= 12,000 / 30,000
= 40%
 Methods that DO
NOT consider the
time value of money
• PAYBACK
• BAIL-OUT
• ACCONTING RATE OF RETURN
PAYBACK

The length of time required by the project to return

the initial cost of investment.
 ADVANTAGES DISADVANTAGES

Does not consider the time value of

Simple and easy to understand. money.

Gives information about liquidity of the Gives more emphasis on liquidity

project. rather than profitability.

Does not consider the salvage value of

A good surrogate for risk. the project.

Ignores cash flows that may occur after

the payback period.
PAYBACK PERIOD = Net Cost of INITIAL Investment
Annual Net Cash Inflows
ILLUSTRATIVE EXAMPLE:

If a company plans to buy an equipment for P50,000 and the equipment is expected to
generate after tax net cash inflows of P10,000 per year, what is the payback period?

Payback period = Net cost of initial investment / Annual Net Cash Inflows
= 50000/10000
= 5 years
Net Cost of Investment 50,000

Year Net Cash Inflows

1 18,000
2 14,000
3 12,000
4 8,000
5 6,000
AMOUNT TO BE NET CASH PAYBACK
RECOVERED YEAR INFLOWS PERIOD

50,000 1 18,000 1
32,000 2 14,000 1
18,000 3 12,000 1
6,000 4 8,000 0.75
3.75
BAIL - OUT
Cash recoveries include not only the operating net cash inflows but also the
estimated salvage value or proceeds from sale at the end of each year of the life
of the project.
ILLUSTRATIVE EXAMPLE:

Cost of Investment P150,0000

Year Net Cash Inflow Salvage Value
1 40,000 100,000
2 30,000 70,000
3 25,000 60,000
4 20,000 50,000
5 20,000 30,000
Amount to be Net Cash Salvage Total Cash Bail-out
recovered Year Inflows Value Inflows Period

150,000.00 1 40,000.00 100,000.00 140,000.00 1

110,000.00 2 30,000.00 70,000.00 100,000.00 1

80,000.00 3 25,000.00 60,000.00 85,000.00 0.8

2.8
ACCOUNTING RATE OF RETURN
Also called book value rate of return, financial statement method, average
return on investment and unadjusted rate of return.
 ADVANTAGES DISADVANTAGES

Closely parallels accounting concepts of

income measurement and investment Does not consider the time value
return of money.
Facilitates re - evaluation of projects. Effect of inflation is ignored.

Considers income over the entire life of the

project.
Indicates the project's profitability.
To compute for ARR:

A.Original or Initial Investment : Net Income / Original Investment

B. Average Investment : Net Income / *Average Investment

*(Original Investment + Salvage Value) / 2
ILLUSTRATIVE EXAMPLE
A company is planning to acquire a new machine that will cost 60,000. This
machine is expected to generate net income of 12,000 per year. No salvage
value is expected to be recovered at the end of its useful life of 10 years. What
is the ARR for this project?

A. ARR = Net Income / Original Investment

= 12,000 / 60,000
= 20%
B. ARR = Net Income / *Average Investment
= 12,000 / {(60,000 + 0) /2}
= 12,000 / (60,000/2)
= 12,000 / 30,000
= 40%
Methods that consider the time value of
money
(DISCOUNTED CASH FLOW METHODS)
Discounted Cash Flow Method

 is a valuation method used to estimate the attractiveness of an investment

opportunity.

 It analyses use future free cash flow projections and discounts them, using
a required annual rate, to arrive at present value estimates.
Discounting Process

 Compounding – involves conversion of present value to future value

by considering the interest earning given a period of time
Formula: FV = PV (1 + i )^n

 Discounting – involves conversion of future value to present value

by removing or discounting the assumed interest earnings included
in the future value.
Formula: PV = FV__ or PV = FV x 1 1
(1 + i )^n (1 + i )^n
Net Present Value

 all cash inflows and outflows related to the investment project

are discounted at a minimum acceptable rate of return which,
in most cases, is the firms cost of capital.
 The project is acceptable if the present value of cash inflow is
greater than the present value cash outflow.
 The difference between the two present values are called net
present value.
NPV > 0, accept the investment.
NPV < 0, reject the investment.
NPV = 0, the investment is marginal
Net Present Value Formula

The Net Present Value Formula for a single investment is: NPV = PV less I
Where: PV = Present Value
I = Investment
NPV = Net Present Value

The Net Present Value Formula for multiple investments is: The sum of all terms of:
CF (Cash flow)/ (1 + r)t
Where: CF = A one-time cash flow
r = the Discount Rate
t = the time of the cash flow
Jody is the owner of a debt collections firm called Collectco. Jody has been working on his
company for several years. As the years have piled up on Jody so has the urge to retire and
live a simpler life. Finally reaching the end of his rope, Jody is ready to move on and spend
more time with his children. In order to do this Jody must sell his company. Adding to this,
Jody must first make sure his company is up to date with industry standards. If Jody’s
company is not performing to the same efficiency as the industry standard he will loose
some of it’s value in negotiations with a buyer. Jody begins by having his company audited
by an expert consultant in the industry. The audit turned out to be much better than Jody
expected. Despite this, Jody must update his collections software as it is no longer
supported by technical assistance from the creator. Jody performs the net present value
calculation to evaluate this investment.

Where:
PV = The yearly income of Collectco = $120,000
I = The cost of the new collections software = $5,000
NPV = $115,000
Net Present Value Calculation:

For a single investment:

$120,000 – $5,000 = $115,000

Where:
PV = $120,000
I = $5,000
NPV = $115,000
Now Jody can begin the process of finding a buyer for his company. His
consultant, an expert in the business dealings of collections firms, tells him
that it is in his best interest to know the Net Present Value of his company
before he begins negotiations. Jody starts this process by attempting to find
the easiest way to perform this calculation. After finding few relevant online
results for the search “net present value calculator”, Jody happens to find
the NPV formula. Jody then performs this calculation:

Where:
CF = Collectco yearly cashflow = $120,000
r = 10%
t = Year 1
NPV = $109,091
For multiple investments:

$120,000 / (1 + 10%)1 = $109,091

Where: CF = $120,000
r = 10%
t = Year 1
NPV = $109,091
Net Present Value Advantages
 Uses cash flow not earnings
 Eliminates time component
 Results in investment decisions that add value
 Net Present Value Limitations

Net present value disadvantages include:

 Difficult to predict cash flows
 Assumes a constant discount rate over life of investment
Present Value Index (Profitability Index)

 attempts to identify the relationship between the costs and benefits

of a proposed project.
 The profitability index is calculated by dividing the present value of
the project's future cash flows by the initial investment
 A PI (Profitability Index) greater than 1.0 indicates that profitability is
positive, while a PI of less than 1.0 indicates that the project will
lose money.
 As values on the profitability index increase, so does the financial
attractiveness of the proposed project.
 The PI ratio is calculated as follows:
PV of Future Cash Flows
Initial Investment
 Project Sapphire Project Diamond PVF
Cost of Investment 50,000.00 80,000.00 1 0.909091
Annual Net Cash Inflows 20,000.00 40,000.00 2 0.826446
Economic Life 5 Years 5 Years 3 0.751315
Cost of Capital 10% 4 0.683013
5 0.620921
3.790787
Present Value of Cash Inflows (i.e. 20K x 3.79078) 75,815.74 151,631.47
Less: Cost of Investment 50,000.00 80,000.00
Net Present Value 25,815.74 71,631.47

Profitability Index = PV Cash Inflow 75,815.74 151,631.47

Invesment 50,000.00 80,000.00

1.52 1.90
Present Value Payback Method

 The cash flows to be used in computing the payback period

are converted to their present values.

Cost of Investment 750,000.00

Example: Net Cash inflows:
Year 1 250,000.00
2 300,000.00
3 320,000.00
4 350,000.00
5 420,000.00
Cost of Capital 25%
To Present value payback period

Present
Investment cost to be Net cash PV of Cash
Year x PVF = Balance Value
recovered Inflow inflow
Payback
1 750,000.00 250,000.00 0.8000 200,000.00 550,000.00 1
2 550,000.00 300,000.00 0.6400 192,000.00 358,000.00 1
3 358,000.00 320,000.00 0.5120 163,840.00 194,160.00 1
4 194,160.00 350,000.00 0.4096 143,360.00 50,800.00 1
5 50,800.00 420,000.00 0.4096 172,032.00 (121,232.00) 0.30

Total Present Value Payback Year 4.30

PVF = 1/(1.25)^n
PV Cash inflow = Net Cash Inflow x PVF
Total PVPY = Investment cost to be recovered / PV Cash Inflow
Discounted Cash Flow Rate of Return
 This method involves the computation of the Time adjusted rate of return aka
“adjusted rate of return” “internal rate of return (IRR)” or DCFRR.
 This refers to the interest or discount rate that equates the present value of the
return or net cash inflows with the investment.
 In a nutshell, when DCFRR is used as the discount rate, the present value of cash
inflows will be equal to the present value of cash outflow, so that the net present
value will set back to nil.
 This provides a measure of profitability that can be compared at a minimum
acceptable rate of return.
 This method can be used to evaluate the attractiveness of the proposal that will give
a greater yield.

or Cash Inflow x PVF = Cost of Investment

PV of Cash Inflows = Cost of Investment
where n = years
where I = DCFRR when I = DCFRR