03

Capital Budgeting

Hjalmar C. Rafa
 ➢ What is Capital Budgeting
Topic Contents:
➢ Capital Budgeting Process

➢ Capital Budgeting Techniques

o Payback Period
o Accounting Rate of Return (ARR)
o Net Present Value (NPV)
o Profitability Index
CAPITAL BUDGETING

➢ Capital Budgeting is “a process for evaluating proposed long-range projects or courses of future
activity for the purpose of allocating limited resources.”
- (Barfield, Raiborn, & Kinney)

➢ Capital Budgeting is the process of planning expenditures on assets whose cash flows are expected to
extend beyond one year.
- (Weston & Brigham)
PLANNING

✓ A good plan must be S.M.A.R.T

S pecific to be clear
M easurable to be fair in the evaluation process
A ttainable to elicit outstanding performance
R ealistic to allow people to relate to
T ime bounded to impress urgency and deadline
CAPITAL BUDGETING PROCESS

1. CREATIVE SEARCH FOR INVESTMENT OPPORTUNITIES

2. SCREENING OF INVESTMENT PROPOSALS

3. EVALUATION OF THE PROPOSALS

CAPITAL BUDGETING PROCESS

4. IMPLEMENTATION OF THE PROJECT

5. MANAGEMENT AND CONTROL OF THE PROJECT

6. POST PROJECT EVALUATION AND AUDIT

1. CREATIVE SEARCH FOR INVESTMENT OPPORTUNITIES

Identifying investment opportunities.

2. SCREENING OF INVESTMENT PROPOSALS

Project Classifications—capital budgeting projects usually are classified using the following terms:

✓ Cost Reductions Decision – Should new

equipment be purchased to reduced cost?
2. SCREENING OF INVESTMENT PROPOSALS

Project Classifications—capital budgeting projects usually are classified using the following terms:

✓ Equipment Selection Decision – Which of

several available machines would be the
most effective to purchase?
2. SCREENING OF INVESTMENT PROPOSALS

Project Classifications—capital budgeting projects usually are classified using the following terms:

✓ Lease or Buy Decision - Should new

equipment be leased or purchase?
2. SCREENING OF INVESTMENT PROPOSALS

Project Classifications—capital budgeting projects usually are classified using the following terms:

✓ Replacement decision - a decision

concerning whether an existing asset should
replaced by a newer version of the same
machine or even a different type of machine
that does the same thing as the existing
machine
2. SCREENING OF INVESTMENT PROPOSALS

Project Classifications—capital budgeting projects usually are classified using the following terms:

✓ Expansion decision—a decision concerning

whether the firm should increase operations
by adding new products, additional
machines, and so forth. Such decisions
would expand operations. Should a new
plant, warehouse, or other facility to be
acquired to increase capacity and sales?
2. SCREENING OF INVESTMENT PROPOSALS

Project Classifications—capital budgeting projects usually are classified using the following terms:

✓ Independent project—the acceptance of an

independent project does not affect the
acceptance of any other project—that is, the
project does not affect other projects.
2. SCREENING OF INVESTMENT PROPOSALS

Project Classifications—capital budgeting projects usually are classified using the following terms:

✓ Mutually exclusive projects—in this case,

the decision to invest in one project affects
other projects because only one project can
be purchased.
2. SCREENING OF INVESTMENT PROPOSALS

Project Classifications—capital budgeting projects usually are classified using the following terms:

✓ Vertical Integration Project – expansion

along the same product line.
2. SCREENING OF INVESTMENT PROPOSALS
2. SCREENING OF INVESTMENT PROPOSALS

Ikea buys 83,000 acre forest in

Romania to make furniture
3. EVALUATION OF THE PROPOSALS

Evaluation involves estimating the cash flows of the various

proposals and applying cash flow based criteria for making
a decision to accept or reject the project.
4. IMPLEMENTATION OF THE PROJECT

A project should be implemented according to the plan as

closely as possible.
4. IMPLEMENTATION OF THE PROJECT

GOALS:
1. Attainment of budgeted cost of project investment.
4. IMPLEMENTATION OF THE PROJECT

The projects investment cost should not

exceed the budgeted level. Because
investment is incurred at the start of the
project, an excessive spending level
drastically reduces project viability.
4. IMPLEMENTATION OF THE PROJECT
4. IMPLEMENTATION OF THE PROJECT

GOALS:
2. Completion of the project investment within the timetable
4. IMPLEMENTATION OF THE PROJECT

Attainment of the due to delays in the

timetable for installing the investment is
crucial to the viability of the project.
4. IMPLEMENTATION OF THE PROJECT
4. IMPLEMENTATION OF THE PROJECT

GOALS:
3. Implementation of the project according to technical and operating plans
4. IMPLEMENTATION OF THE PROJECT

The project stands the best chances for

operating according to the cost budget if
it had been set up according to the
original design.
5. MANAGEMENT AND CONTROL OF THE PROJECT

Once the project has been set up, operating managers should take over
the project and manage its facilities. Operating managers should use the
capital budget as standard in managing the project.
6. POST PROJECT EVALUATION AND AUDIT

Once the project is completed, management should conduct an

evaluation and audit to ascertain lessons learned from the experience.
Capital Budgeting Techniques

✓ Payback Period

✓ Accounting Rate of Return (ARR)

✓ Net Present Value (NPV)

✓ Profitability Index
Payback Period

✓ Payback period refers to the length of time before an investment is recovered. It is the
time period where the cumulative cash inflows is equal to the cost of investment. It is
otherwise known as the breakeven time.

✓ Net cash inflows may be even or uneven.

Payback Period (Even Cash Inflows)

Payback Period = Cost of investment

Net Cash Inflows

Example : A project requires an investment of P600, 000, with 5 years useful life, no
salvage value, and uses straight line method of depreciation. Other data are:

Expected sales revenue 2, 000, 000

Out-of-pocket costs 1, 600, 000
Tax rate 40%

Compute the Payback Period.

Payback Period (Even Cash Inflows)

First let us determine the net cash inflows:

Sales P 2,000,000.00
Out-of-pocket costs (1,600,000.00)
Depreciation expense (120,000.00)
IBIT 280,000.00
Less: Income Tax (40%) 112,000.00
Net Income 168,000.00
Add: Depreciation expense 120,000.00
Net Cash Inflows 288,000.00
Payback Period (Even Cash Inflows)

Therefore:

Payback Period = P 600, 000 / P 288, 000

= 2.08 yrs.

Assume an investor wants a payback period of 3 years, the proposed project is acceptable
because its expected payback period is 2.08 years which is shorter than 3 years. This
means that the proposed project shall be recovered faster than the 3-year recoverability
standard set by the business.
Payback Period (Uneven Cash Inflows)

Payback period is where :

Cash to date = Cost of investment

Payback Period (Uneven Cash Inflows)

Example :

An investment of P400,000 can bring in the following annual cash income, net of tax :

1st year, P40,000; 2nd year, P95,000; 3rd year, P85,000; 4th year, P160,000, 5th year, P86,000,
6th year, P70,000.
Payback Period (Uneven Cash Inflows)

The payback period is determined as follows:

Year Net Cash Inflows Cash to date Payback Period

1 P40, 000 P40, 000 1

2 95, 000 135, 000 1

3 85, 000 220, 000 1

4 160, 000 380, 000 1

5 86, 000 400, 000 .23 (20,000/86,000)

6 70,000 4.23
Payback Reciprocal

Payback reciprocal is one over payback period. It represents the percentage of annual net cash returns
provided by an investment. Say, a project has a payback period of 3.75 years, then the payback
reciprocal is:

Payback reciprocal = 1/Payback period

= 1/3.75
= 26.67%

The higher the payback reciprocal, the better.

Payback Bailout Period

There are times where a project could be terminated anytime during its life such as projects funded by
government money where the budget depends on congress approval and projects where there
continuity depends on the approval of funding (or mother) agency. In this case, the salvage value is
considered in determining the total cash provided by the project.
It is the basis of using the payback bailout period.
Payback Bailout Period

Payback bailout period also determines the number of years to recoup the investment where total cash
includes the regular net cash inflows plus the salvage value. If there is a fraction of a year, it is
determined as follows:

1. Compute how much more cash is needed to recover the cost of investment (i.e., cost of investment
less cash to date).

2. Deduct the salvage from the amount computed in letter “a” above.

3. Divide the amount determined in letter “b” over the net cash inflows for the year.

The shorter the payback period, the better!

Payback Bailout Period

Sample Problem

An investment of P500, 000 can bring in the following annual cash inflows and salvage values:
Net cash inflows Salvage values, end of year

First year P130, 000 P 230, 000

Second year 90, 000 100, 000

Third year 85, 000 40, 000

Fourth year 160, 000 20, 000

Fifth year 75, 000 10, 000

Sixth year 70, 000 5, 000

Determine the payback bailout period.

Payback Bailout Period

Solutions/Discussions:
The payback bailout year is computed below:
Year Net Cash Inflows Cash to Date Salvage Values Total Cash to date Payback bailout period

1 P130, 000 P130, 000 P 230, 000 P360, 000 1

2 90, 000 220, 000 100, 000 320, 000 1

3 85, 000 305, 000 40, 000 345, 000 1

4 160, 000 465, 000 20, 000 485, 000 1

5 75, 000 500, 000 10, 000 500, 000 0.33 (35,000 - 10,000/75,000)

TOTAL 4.33 yrs.

Accounting Rate of Return

Accounting rate of return (ARR) measures the profitability of a proposed project. ARR may be
computed based on original or average investment. Average investment is the sum of original
investment plus salvage value divided by 2. It is the average investment balance over the entire life of
the investment.

ARR (original) = Net income / Original Investment

ARR (average) = Net income / Average Investment

= Net income / [(Original Investment + Salvage value)/2]

The higher the ARR, the better!

Accounting Rate of Return

Sample Problem

The Tarlac Company is considering the production of a new product line which will require an
investment of P3,000,000, with P200,000 salvage value. The investment will have a useful life of ten
years during which annual cash inflows before income taxes of P1,400,000 are expected. The income
tax rate is 40%.

Required:

Annual net income

ARR based on original and average investment balances.
Accounting Rate of Return

Solutions/Discussions:

The accounting net income is determined below:

Cash flows before taxes P1,400,000

Less: Depreciation expense
[(P 3 million – P200,000)/10 yrs.] 280,000
Income before income tax 1,120,000
Less: Tax (40%) 448,000
Net income P 672,000
Accounting Rate of Return

Solutions/Discussions:

ARR (original) = P 672,000/P3 million

= 22.45%

ARR (average) = P 672,000 / [(3million + P 200,000)/2]

= P 672,000 / P 1,600,000
= 42%

ARR based on average investment is always greater than ARR based on original investment. ARR
based on average investment is twice as much as the ARR based on original if there is no salvage
value.
The Profitability Index and the NPV Index

The indexes are normally used to rank projects that are acceptable (say, several projects have positive
NPVs). The ranking of acceptable projects is done when there is a constraint on resources such as
money, manpower, and materials. The process of allocating available money to the most prioritized
investment proposals is known as “capital rationing”. In the ranking process, the project that has the
highest index has the highest priority.
The Profitability Index and the NPV Index

The profitability index and NPV index are computed as follows:

Profitability Index = PVCI / COI

NPV Index = NPV / COI

Payback Period (Uneven Cash Inflows)

Sample Problem
Millennium Corporation has P12 million available money for investment. It has already evaluated
several project proposals and now considers the following acceptable projects:
Project COI PVCI NPV

A P 5,000,000 5,500,000 P 500,000

B 6,000,000 6,900,000 900,000

C 4,000,000 4,850,000 850,000

D 3,000,000 3,470,000 470,000

Which project should the company invest?

Payback Period (Uneven Cash Inflows)

Solutions / Discussions :

The indeces, project ranking, and project investments are determined as follows:
Project PVCI NPV Profitability NPV Rank Investment shall be
COI Index Index made to project

A 5 million 5,500,000 500,000 1.10 0.10 04

B 6 million 6,900,000 900,000 1.20 0.20 02

C 4 million 4,850,000 850,000 1.21 0.21 01

D 3 million 3,470,000 470,000 1.16 0.16 03

Profitability index = PVCI / COI

NPV index – NPV / COI
Thank you for listening
TASK 3 ( 70 points)
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 1. Define Capital Budgeting?
TASK 3
2. Discuss the Capital Budgeting Process.

3. Problem Solving.
Problem 1

Diamond Corp. is planning to buy a new machine costing 500,000 with a useful life of 5 yrs, no
salvage value. Other data were made available:

Expected Annual Sales Revenue 600,000

Annual-out-of-pocket cost 450,000
Interest rate 40%
Depreciation method Straight line

Required: PP,PR,ARRi,ARRa
Problem 2

An investment of 400,000 can bring in the following annual cash income, net of tax.

1 - 70,000
2 - 90,000
3 - 85,000
4 - 160,000
5 - 75, 000
6 - 70,000

Required: Payback period

Problem 3

An equipment costing 1,000,000 is expected to yield the following net cash inflows and salvage
values.

Year Net Cash Inflows Salvage Value, net of tax

1 300,000 200,000

2 400,000 100,000

3 200,000 50,000

4 150,000 20,000

Required:
Determine the payback period
Problem 4

Citizen Company is considering the purchase of a P40,000 machine, which will be depreciated on the
straight-line basis of 8-year period with no salvage value for both book and tax purposes. The
machine is expected to generate an annual pretax cash inflow of P15,000. The income tax rate is 40%.

Required:

Determine the payback period.

Compute the accounting rate of return of original investment.
Problem 5

The RT Company is considering the production of a new product line which will require an
investment of 1,000, 000 with no scrap value. The investment will have a useful life of 10 years,
during which annual net cash inflows before taxes of 200,000 are expected, the income tax rate is
40%.

Required: Annual net income, ARRi, ARRa