Capital Budgeting

deals with analyzing investment proposal What are the projects that need
1. PPE
What is Capital? A=L+E In Fin Acc, Capital is Equity
But in Financial markets, capital is ASSET
2. Branch operations
Temporary Expense vs Capital Expense Temporary - Nominal Accounts/Expense Account3. Product M
Capital Expenditures-benefits more than 1 accou4. Technolog

Has the following assumptions

Funds are available
Business opportunities exist
Business opportunities are subect to evaluation

The main issues in capital budgeting are

Net Cost of Investment How much is the strategic amount of capital needed?
Net Returns How much would the investment be recovered?
Project Evaluation Techniques Which investment opportunity would provide the highest return?

Net Cost of Investment

Difference between the relevant outflows and inflows of cash
Gains and Losses are ignored, but tax effects are considered

The additional working capital is also a cost of investment

Net Returns
The recovery of investment is measured on the following basis:
Net Cash Inflow or Net Cash Profit
Accounting Profit

Concept of
Model
Net Returns
Project Evaluation Techniques
2 types Traditional Model

Traditional Model we don’t consider time value of money Payback Period NCI
Discounted Model TVOM Payback Reciprocal NCI

Payback Bailout NCi

 Accounting Rate of
Return Net Income

Payback Period
Refers to the length of time before an investment is recovered on a cash basis
Sometimes called breakeven time
Only cashflows are considered
Formula:
Net Cost of Investment / Annual Cash Inflows
Term Formula
Simple Accounting Rate
Accounting Rate of Return of Return NI/Original Investment
Average Accounting Rate
Measures the profitability of a proposed project of Return NI/Ave Investment
Other terms: Average Investment (OI + RV)/2
Return on Investment
Return on Assets NI/Ave Assets If silent? Average

Discounted Model it consideres time value of money

Net Present Value

Difference between present value of cash inflows and present value of cash outflows
Brings the cash values at time zero
There are 2 present value tables that needs to be considered
If the cash flows are even - annuity
If the cash flows are uneven - separate present value table

Cash inflows: Cash Outlflows:

Regular operating cash flow Cost of investment
Residual value that youre going to recover at the end of UL Infusion of working capital
Recovery of working capital

Profitability Index and NPV index

Used to rank projects that are acceptable
Used when evaluating projects that differ in size/amount

What is capital rationing? allocate your resources to the most prioritized investment proposal

Internal Rate of Return

It is called the "breakeven rate of return"
it is where:
 PVCI = PVCO
NPV = ZERO
PI = 1
Other terms: Discounted rate of return
Adjusted rate of return
Discounted minimum required rate of return

Discounted Payback Period

Concept of
Model
Net Returns

Traditional Model

Payback Period NCI

Payback Reciprocal NCI

Payback Bailout NCi

Accounting Rate of
Return Net Income
Discounted Model

NPV Index NCI

NPV NCI

Profitability Index NCI

Discounted Payback NCI

Internal Rate of Return

What are the projects that need capital budgeting analysis?
Acquire or Lease Acquisition Lease
Replace or repair Benefits No Rent Rent
Improve or outsorce Single layoff Staggered payments
. Branch operations Depreciation
introduce a new product or not The lower the profit, the lower the tax
Whether your system or not

Formula:
Outflows Inflows
Purchase Price xxx Proceeds of sale or Trade in xxx

Necessary cost to bring xxx Tax

to its intended use Savings xxx

Savings
xxx from
Additional Tax - Sale and avoided
Disposal / Avoided Cost cost xxx
Additional WC xxx

Formula 1: Formula 2:

Decision
Focus of Measurement
Criterion

Traditional Model

Liquidity Shorter - Better

Liquidity Higher - better

Liquidity Shorter - Better

 Profitability Higher - better

Payback Reciprocal
Represents the rate of cash returns provided by an investment in a given period
Formula:
1/Payback Period

For Example

NI/Original Investment Machine - 1,000,000

NI/Ave Investment Accounting Income - 200,000

Cash Basis Income - 100,000

PB period? 10 yrs

Formula
PVCI
LESS PVCO PVCO - COST OF INVESTMENT
NET PRESENT VALUE

Decision making criteria

if positive - acceptable
if negative - unacceptable

Formula PI PVCI/PVCO
NPVI NPV/PVCO

Decision Making
PI If >= 1, acceptable
NPVI same as npv if positive - acceptable
if negative - unacceptable

Formula Interpolation
 Decision Making:
The higher the better

Decision
Focus of Measurement
Criterion

Traditional Model

Liquidity Shorter - Better

Liquidity Higher - better

Liquidity Shorter - Better

Profitability Higher - better

Discounted Model

liquidity Positive - accept

liquidity Positive - accept

greater or equal
liquidity than 1 - accept

liquidity Shorter - Better

Higher - better,
should be higher
than cost of
liquidity capital
ower the tax
 acceptable
- unacceptable
Net Cost of Investment

The management of Lan Company plans to replace a sorting machine that was acquired several years ago at a cost of P850,00
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 ma
repair the old machine. Gains and losses on the trade-in transactions are not subject to income tax. The cost to repair the old
Income tax rate is at 40%.

Required: The net investment assigned to the new machine for decision analysis

Outflows Inflows
Purchase Price 2851800 Trade in allowance
Additional Tax 298000 Savings from Repairs

3149800
Net Investment 2,228,800
 ago at a cost of P850,000. The machine has been depreciated to its residual value of P90,000. A
P176,000 on the old machine. If a new machine is not purchased, Lan will spend P745,000 to
he cost to repair the old machine can be deducted in the first year for computing income tax.

176000
745000

921000
Net Cost of Investment

Sunshine Corporation is planning to purchase a new machine costing P2,800,000, with freight and installation cost amounting
P260,000. Other assets that are to be retired as a result of the acquisition of the new machine can be residuald and sold for P5
by P20,000. If the new machine is not purchased, extensive repairs on the old machine will have to be made at an estimated c
Additional gross working capital of P350,000 will be needed to support operations planned with the new machine.

Required: The net investment assigned to the new machine for decision analysis

Outflows Inflows
PP 2,800,000 Trade in allowance
Other Cost 135,000 Other Assets
Addl WC 350,000 Tax Savings
Additional Tax 160,000 Savings from repairs

3,445,000
Net Investment 2,713,000
nd installation cost amounting to P135,000. The old unit to be traded in will be given a trade in allowance of
an be residuald and sold for P52,000. The loss on retirement of these assets is P50,000 and will reduce taxes
to be made at an estimated cost of P400,000. This cost can be avoided by purchasing the new machine.
the new machine.

Tax Rate
260,000 Tax savings 20,000
52,000 Losses 50,000
20,000 Tax rate 0.4
400,000

732,000
Net cost of Investment

The Mabuhay Corporation plans to acquire a new equipment costing P1,340,000 to replace the equipment that is no being use
to install. Special attachments to be used with this unit ill be needed and will cost P64,000. If the new equipment is acquired, o
old equipment had a net book value of P45,000 and will be sold for P25,000. If the new equipment is not purchased, the old e
in the year incurred. Tax rate is 30%.

Required: The net investment assigned to the new machine for decision analysis

Outflow Inflow
Pp 1,340,000 Sale of Old Equipmen 25,000
Freight 75,000 Savings from Repairs 320,000
IC 90,000 Tax Savings 6,000
Special 64,000
Attachment
Additional
WC 310,000
Additional Tax 96000

1,975,000 351,000
Net Investment 1,624,000
pment that is no being used. Freight charges on the new equipment are estimated at P75,000 and it will cost P90,000
w equipment is acquired, operations will be expanded and this will require additional working capital of P310,000. The
s not purchased, the old equipment must be overhauled at a cost of P320,000. This cost is deductible for tax purposes

Loss 20,000
Tax Consequence 6000 Tax Savings
Net Cost of Investment

The JT Company plans to open a new branch office wherein the company shall invest P2,500,000 in furnishings and equipmen
branch are estimated at P9,000,000 a year. One-third of these sales will be in the form of accounts receivable at any given tim
inventory is approximately P400,000 at any time during the year. Cash of P120,000 will be needed to meet payments for oper
of sales.

Required: The net investment assigned to the new machine for decision analysis

Outflows Inflows
PP 2,500,000 AP 450000
Construction 4,550,000
Cash 120,000
AR 1,800,000
Inventory 400,000

9,370,000

Net Investment 8,920,000

 nishings and equipment. Constructin and other related outlays are estimated at P4,550,000. Sales from this new
eivable at any given time. Cost of goods sold is estimated to be sixty percent of sales. The investment in merchandise
meet payments for operating expenses. Accounts payable and other current liabilities are expected to increase by 5%

Working Capital CA-CL

CA
Cash 120,000 Increase Outlflow Decrease Inflow
AR 3,000,000 Increase Outlflow Decrease Inflow
Inventory 400,000 Increase Outlflow Decrease Inflow
Prepayments Increase Outlflow Decrease Inflow

CL
AP Increase Inflow Decrease Outflow
Accruals Increase Inflow Decrease Outflow

Before you can sell 3,000,000 you need to purchase 1,800,000 of inventory
that is 3,000,000 * 60%(Cogs ratio)
Payback period, payback reciprocal, and accounting rate of return, even cash flows.
Diamond Company is planning to buy a new machine costing P2,600,000 with a useful life of five years, and P100,000 residual

Expected annual sales revenue 4,600,000 Annual Cash Inflow Computation

Annual out of pocket cost 2,450,000 Sales 4,600,000
Income Tax Rate 40% Expenses 2,450,000
Working Capital 500,000 Depreciation 500,000
Depreciation Straight Line PBIT 1,650,000
Tax 660000
Profit 990,000
Depreciation 500,000
Annual Cash Inflow 1,490,000

Depreciation 500

Required: Determine the following

Payback Period
Payback Reciprocal Beg
Accounting rate of return base on: Original Investment End
Average Invesment
Average book value during the first year of operations

Net Returns Cash Basis Income Accounting Income

Sales
Expenses
Depreciation
PBIT
Tax
Profit 1 1
Add: Non Cash Expenses
Depreciation
Amortization
Losses
Less: Non Cash Income
Gains
Cash Basis Inc 2 2
years, and P100,000 residual value. Other data were made available:

A. Payback Period B. Payback Reciprocal

Formula OI/ACI Formula 1/pb
1.744966 57%
1.74 yrs

C. ARR
Orginal Invesment 38%

Average investment 73%

AI 1350000

Average BV 42%
BV of beg and end balance in y1
Y0 BV 2,600,000
Y1 BV 2100000
Average 2350000
Net Present Value, Profitability Index, NPV Index, even cash flows

An equipment costing P1,200,000 will produce annual cash inflows of P500,000. At the end of of its useful life of 5 years, the e
capital needed to operate this equipment is P250,000 at time zero and P150,000 at the end of year 2. The desired rate of retu

Required:
Net present value
Profitability Index
NPV index
a. npv
Cash Inflows
Important note: COC is 18% Base PV Factor
Annual Cash Inflows 500,000 3.127
Residual Value 20,000 0.437
Recovery of Working Capital 400,000 0.437

PVCI 1,747,050
PVCO/COI 1,557,700
NPV 189,350 Acceptable

b. profitability index
PVCI 1,747,050 Formula = pvci/pvco
PVCO/COI 1,557,700 1.121557
 its useful life of 5 years, the equipment will have a residual value of P20,000. Additional working
ear 2. The desired rate of return is 18%.

Cash Outflows
PV Base PV Factor PV
1563500 Cost of Investment 1,450,000 1,450,000
8740 Year 2 working capita 150,000 0.718 107700
174800 1,557,700
1,747,040

Acceptable

c. npv index formula = npv/pvco

Formula = pvci/pvco PVCI 1,747,050 0.121557
Acceptable PVCO/COI 1,557,700 Acceptable
npv 189,350
Net present value, uneven cash inflows
An equipment costing P500,000 with a residual value of P30,000 at its useful life of five years is expected to bring the followin

Year
1 350,000
2 250,000
3 150,000
4 100,000
5 50,000

The company uses a 12% discount rate. The company expects to spend 200,000 for major repairs of the equipment at the beg
Required:
Net present value
Profitability Index A. NPV
NPV Index Year ACI PVF PVCI Cash outflows
1 350,000 0.893 312,550 Year 0
2 250,000 0.797 199,250 Year 2
3 150,000 0.712 106,800
4 100,000 0.636 63,600
5 50,000 0.567 28,350
RV 30,000 0.567 17,010 PVCI
WC 200,000 0.567 113,400 PVCO
840,960 NPV
Acceptable
expected to bring the following net cash inflows.

s of the equipment at the beg of year 3.

B. PI C. NPVI
Cash outflows PVCO 1.275341 0.275341
500,000 500,000 Acceptable
200,000 0.797 159400
659,400

840,960
659,400
181,560
Acceptable
Net Present Value
Oblivion Corporation is considering the following investment alternatives:

Project 1 Project 2 Project 3

Year 0 -5,000,000 -8,000,000 -1,400,000 PVCI
Year 1 2,400,000 5,500,000 200,000 PVCO
Year 2 2,200,000 2,600,000 600,000 NPV
Year 3 1,800,000 700,000 1,000,000 P.Index
Year 4 1,100,000 200,000 800,000 Rank
Residual
200,000 200,000 80,000
Value

The company has 13,500,000 available money for investment. The company’s
required market rate of return is 12%.

Required: Using the profitability Index model, determine in which project should to compay invest its money
 Project 1 Project 2 Project 3
5,686,200 7,736,500 1,928,480
5,000,000 8,000,000 1,400,000
686,200 -263,500 528,480
1.13724 0.9670625 1.377485714
2 Unacceptable 1

vest its money

Discounted Payback period, even and uneven cash flows
ZXC Corporation is considering to invest in the following project opportunities:

X Y
Cost of Investment 5,000,000 5,000,000
Net Cash Savings after tax
Year
1 2,000,000 3,500,000
2 2,000,000 2,500,000
3 2,000,000 1,500,000
4 2,000,000 500,000
Total 8,000,000 8,000,000

Required:
Normal Payback Period
Discounted Payback Period for each proposed project using a different discount rate of 16%

Less y1
Less y2
Less y3

Residual
Answer is 3 years + 0.46 mon
 X Y
N / YEAR PVF
1 0.862 1,724,000 3,017,000
2 0.743 1,486,000 1,857,500
3 0.641 1,282,000 961,500
4 0.552 1,104,000 276,000
5,596,000 6,112,000

Payback computation
For X For Y
5,000,000 5,000,000
1724000 3,276,000 Less y1 3017000 1,983,000
1486000 1,790,000 Less y2 1857500 125,500
1282000 508,000

0.460145 Residual 0.130525

Answer is 3 years + 0.46 months Answer is 3 years + 0.12 months
3 years and 6 months 3 years and 2 months
3.46 years 3.13 years
Internal Rate of Return, even cash flows

Great Corporation has the opportunity to buys new machine at P2,520,000. This machine is expected to have a useful life of 4
yield an annual net cash inflow after tax of P950,000 during its economic life. The company has a cost of capital of 10%.

Required: IRR What is IRR again? Things that need to be considered when solving using interpolation
PVCI=PVCO 1. Higher rate - lower present value
NPV = 0 2. Lower rate - higher present value
P.INDEX = 1 3. You need to find to amounts that will be so close to the base (2,520,0
Formula: (𝐵𝑎𝑠𝑒 −𝐿𝑜𝑤𝑒𝑟 𝑎𝑚𝑜𝑢𝑛𝑡)/(𝐻𝑖𝑔ℎ𝑒𝑟
𝑎𝑚𝑜𝑢𝑛𝑡 −𝐿𝑜𝑤𝑒𝑟 𝐴𝑚𝑜𝑢𝑛𝑡)

Then Higher rate less answer

Where: Lower amount is the higher interest

Higher amount is the lower interest

Step 1: What is the target amount? Step 5

2,520,000 (2,520,000−2,506,100)
Step 2: What is the annual net cash inflow? /
950,000 (2,555,500−2,506,100)
Step 3: at 19% Answer 0.28
PVF 2.638
PVCI 2,506,100 Step 6
Step 4 at 18% Higher rate less answer
PVF 2.69 That is:
PVCI 2,555,500 19-0.28 18.72
ected to have a useful life of 4 years, no residual value and will
a cost of capital of 10%.

olving using interpolation

e so close to the base (2,520,000) where one is lower and the other is higher

higher interest
e lower interest

Proving: at 18.72%
PVF 2.653
PVCI 2,520,350
IRR, uneven cash flows
A new equipment costing P800,000 with five years useful life and P40,000 residual value at the end of five years, is expected t

Year Net Cash Inflows Step 1 What is the target amount?

1 350,000 800,000
2 300,000 Step 2 What is the annual cash inflow?
3 250,000 1,170,000
4 150,000 Step 3 at 18%
5 80,000 year PVF Cash Inflow
RV 40,000 1 0.847 296450
ACI 1,170,000 2 0.718 215400
3 0.609 152250
4 0.516 77400
Requried: IRR 5 0.437 34960
rv 0.437 17480
793,940

Step 4 at 17%
1 0.855 299250
2 0.731 219300
3 0.624 156000
4 0.534 80100
5 0.456 36480
rv 0.456 18240
809,370
e end of five years, is expected to bring the ff cash inflows (after tax):

Step 5
(800,000−793,940)/
(809,370−793,940)

Answer 0.39

Step 6

18-0.39 17.61

Prove PVF of 17.61%

year
1 0.85 297500
2 0.723 216900
3 0.615 153750
4 0.523 78450
5 0.444 35520
rv 0.444 17760
799880
Discounted tax benefits on varrying depreciation expense models

Jamaica Company acquired a plant asset at a cost of P8,000,000. The estimated useful life was 4 years, and there was no estim
rate of 8% and an income tax rate of 40%

Required
The present value of the income tax benefit resulting from using the SYD of depreciation as opposed to straight line depreciati

Depreciation Expense Profit Tax Effect PVF PV of tax savings

N SYD SL Difference
1 3,200,000 2,000,000 1,200,000 -1,200,000 -480,000 0.926 -444,480
2 2,400,000 2,000,000 400,000 -400,000 -160,000 0.857 -137,120
3 1,600,000 2,000,000 -400,000 400,000 160,000 0.794 127,040
4 800,000 2,000,000 -1,200,000 1,200,000 480,000 0.735 352,800
-101,760

By using SYD, you will have additional tax savings of 101,760 as compared to using straight line
s, and there was no estimated residual value. Assume a relevant interest

to straight line depreciation on this asset

using straight line