CAPITAL BUDGETING

The term capital budgeting is used to describe how managers plan significant cash
outlays on projects that have long-term implications, such as the purchase of new
equipment and the introduction of new products. This chapter describes several tools that
can be used by managers to help make these types of investment decisions.

Capital budgeting analysis can be used for any decision that involves an outlay now in
order to obtain some future return. Typical capital budgeting decisions include:
• Cost reduction decisions. Should new equipment be purchased to reduce costs?
• Expansion decisions. Should a new plant or warehouse be purchased to increase
capacity and sales?
• Equipment selection decisions. Which of several available machines should be
purchased?
• Lease or buy decisions. Should new equipment be leased or purchased?
• Equipment replacement decisions. Should old equipment be replaced now or
later?

Sunk Costs and Opportunity Costs

In capital budgeting analysis, sunk costs are costs which are already incurred and which
need not be reflected in the incremental cash flows used for estimation of net present
value and internal rate of return. Sunk costs are named so because they can’t be
recovered.

Opportunity costs on the other hand are costs which do not necessarily involve any
cash outflows but which need to be considered because they reflect the foregone profit
that could have been elsewhere. Opportunity costs are named so because they reflect
the lost opportunity to earn profit form alternative use of the funds allocated to the project
under consideration.

Capital budgeting decisions are based on current and future incremental cash flows and
not any past cash flows. Therefore, in calculating net initial investment outlay, analysts
need to ignore the sunk costs but include opportunity costs in their analysis.

Time Value of Money

The time value of money concept recognizes that a peso today is worth more than a
peso a year from now. Therefore, projects that promise earlier returns are preferable to
those that promise later returns.

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 The capital budgeting techniques that best recognize the time value of money are those
that involve discounted cash flows.

Net present value (NPV) of a project is the potential change in an investor's wealth
caused by that project while time value of money is being accounted for. The net present
value method compares the present value of a project’s cash inflows with the present
value of its cash outflows. The difference between these two streams of cash flows is
called the net present value.

Net present value calculations take the following two inputs:

▪ Projected net cash flows in successive periods from the project.
▪ A target rate of return i.e. the hurdle rate.
Where,
Net cash flow equals total cash inflow during a period, including salvage value if any, less
cash outflows from the project during the period. Hurdle rate is the rate used to discount
the net cash inflows. Weighted average cost of capital (WACC) is the most commonly
used hurdle rate.

The net present value is interpreted as follows:

If the net present value is positive, then the project is acceptable.
If the net present value is zero, then the project is acceptable.
If the net present value is negative, then the project is not acceptable.

The Internal Rate of Return (IRR) is the rate promised by an investment project over its
useful life. It is sometimes referred to as the yield on a project. The internal rate of return
is the discount rate that will result in a net present value of zero. The internal rate of return
works very well if a project’s cash flows are identical every year. If the cash flows are not
identical every year, a trial-and-error process can be used to find the internal rate of
return. When using internal rate of return, the cost of capital acts as a hurdle rate that a
project must clear for acceptance.

The internal rate of return is interpreted as follows:

If the IRR is equal to or greater than the minimum required rate of return,
then the project is acceptable.
If the IRR is less than the required rate of return, then the project is
rejected.

A Profitability Index can be computed as the net present value of the project divided by
the investment required. The higher the profitability index, the more desirable the project.

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 Profitability index is actually a modification of the net present value method. While present
value is an absolute measure (i.e. it gives as the total peso figure for a project), the
profitability index is a relative measure (i.e. it gives as the figure as a ratio).

Other methods of making capital budgeting decisions

The Payback Method focuses on the payback period, which is the length of time that it
takes for a project to recoup its initial cost out of the cash receipts that it generates. When
the annual net cash inflow is the same every year, the formula for computing the payback
period is the investment required divided by the annual net cash inflow. When the cash
flows associated with an investment project change from year to year, the payback
formula introduced earlier cannot be used. Instead, the un-recovered investment must be
tracked year by year. Accept the project only if its payback period is less than the target
payback period.

Advantages of payback period are:

1. Payback period is very simple to calculate.
2. It can be a measure of risk inherent in a project. Since cash flows that occur later in a
project's life are considered more uncertain, payback period provides an indication of how
certain the project cash inflows are.
3. For companies facing liquidity problems, it provides a good ranking of projects that
would return money early.

Disadvantages of payback period are:

1. Payback period does not take into account the time value of money which is a serious
drawback since it can lead to wrong decisions. A variation of payback method that
attempts to remove this drawback is called discounted payback period method.
2. It does not take into account, the cash flows that occur after the payback period.

The Accounting Rate of Return (ARR) Method (also known as the simple rate of return
or the unadjusted rate of return) does not focus on cash flows; rather it focuses on
accounting net operating income. It is the ratio of estimated accounting profit of a project
to the average investment made in the project. Accept the project only if its ARR is equal
to or greater than the required accounting rate of return. In case of mutually exclusive
projects, accept the one with highest ARR.

Advantages of Accounting Rate of Return

1. Like payback period, this method of investment appraisal is easy to calculate.
2. It recognizes the profitability factor of investment.

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 Disadvantages of Accounting Rate of Return
1. It ignores time value of money. Suppose, if we use ARR to compare two projects having
equal initial investments. The project which has higher annual income in the latter years
of its useful life may rank higher than the one having higher annual income in the
beginning years, even if the present value of the income generated by the latter project
is higher.
2. It can be calculated in different ways. Thus there is problem of consistency.
3. It uses accounting income rather than cash flow information. Thus it is not suitable for
projects which having high maintenance costs because their viability also depends upon
timely cash inflows.

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Table Factor for Present Value of P1 = (1 + i)-n

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5 prohibited”
Table Factor for Future Value of P1 = (1 + i)n

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6 prohibited”
 1 − (1 + i)-n
Table Factor for Present Value of an Ordinary Annuity of P1=
i

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7 prohibited”
 (1 + i)n − 1
Table Factor for Future Value of an Ordinary Annuity of P1 =
i

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8 prohibited”
 PROBLEMS

1. The following data concern an investment project:

Investment in equipment P16,000
Annual Net cash inflows P3,600
Working capital required P4,500
Salvage value of the equipment P2,000
Life of the project 12 years
Discount rate 14%

The working capital will be released for use elsewhere at the conclusion of the
project.

Required:
Compute the project's net present value.

2. The management of Sem Corporation is considering the purchase of a machine

that would cost P41,110 and would have a useful life of 6 years. The machine
would have no salvage value. The machine would reduce labor and other operating
costs by P10,000 per year.

Required:
Determine the internal rate of return on the investment in the new machine.

3. XY Company is considering the purchase of a machine that promises to reduce

operating costs by the same amount for every year of its 6-year useful life. The
machine will cost P83,150 and has no salvage value. The machine has a 20%
internal rate of return.

Required:
What are the annual cost savings promised by the machine?

4. The management of an amusement park is considering purchasing a new ride for

P40,000 that would have a useful life of 15 years and a salvage value of P6,000.
The ride would require annual operating costs of P22,000 throughout its useful life.
The company's discount rate is 12%. Management is unsure about how much
additional ticket revenue the new ride would generate-particularly since customers
pay a flat fee when they enter the park that entitles them to unlimited rides.
Hopefully, the presence of the ride would attract new customers.

Required:
How much additional revenue would the ride have to generate per year to make it
an attractive investment?

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 5. The management of Cont Corporation is considering the following three investment
projects:
Project A Project B Project C
Investment required P34,000 P60,000 P81,000
Present value of cash inflows P37,060 P61,800 P85,050

The only cash outflows are the initial investments in the projects.

Required:
Rank the investment projects in terms of preference.

6. The Company has an old machine that is fully depreciated but has a current
salvage value of P5,000. The company wants to purchase a new machine which
would cost P60,000 and have a 5-year useful life and zero salvage value. Expected
changes in annual revenues and expenses if the new machine is purchased are:
Increased revenues P63,000
Increased expenses:
Salary of additional operator P20,000
Supplies 9,000
Depreciation 12,000
Maintenance 4,000 (45,000)
Increased net operating income P 18,000

Required:
a. Compute the payback period on the new equipment.
b. Compute the simple rate of return on the new equipment.

7. The Company is considering purchasing a machine that would cost P436,800 and
have a useful life of 5 years. The machine would reduce cash operating costs by
P132,364 per year. The machine would have no salvage value.

Required:
a. Compute the payback period for the machine.
b. Compute the simple rate of return for the machine.

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 8. The management of Unt Company is considering an investment with the following
cash flows:
Year Investment Cash Inflow
1 P 150,000 P 10,000
2 80,000 20,000
3 25,000
4 40,000
5 50,000
6 60,000
7 50,000
8 40,000
9 30,000
10 20,000

Required:
Compute the payback period of the investment.

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