Sample Problem 1:

UNIVERSITY OF SAINT LOUIS The management of BIGBOY Company plans to replace a weaving machine that was acquired several
Tuguegarao City years ago at a cost of P50,000. The machine has been depreciated to its salvage value of P5,000, and it
can be sold now for P6,000. A new weaving machine can be purchased for P80,000. If a new machine is
SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY not purchased, BIGBOY Company will spend P10,000 to repair the old machine. The cost to repair the old
SHORT TERM S.Y. 2021-2022 machine can be deducted in the first year to compute income tax. Income tax is estimated at 30% of the
income subject to tax. The acquisition of the new machine will require additional investment in working
COURSE LEARNING MODULE capital of P4,000. What is the NET COST OF INVESTMENT for decision making purposes?
MGMT 1033 – STRATEGIC COST MANAGEMENT
Solution:
+ Acquisition cost (new weaving machine) P80,000
Lesson 5: Capital Budgeting + Tax on gain on sale [(6,000 – 5,000)*30%] 300
+ Increase in working capital 4,000
- Proceeds from sale of old machine (6,000)
LEARNING CONTENT - Avoidable repairs, net of tax (10,000*70%) (7,000)
NET COST OF INVESTMENT P71,300
Our last topic – Short-term Non-Routine Decisions, i.e., Differential Analysis – delved on short-term
management decisions. In this current topic – CAPITAL BUDGETING - we are not planning for short term 2. Returns
purposes but we are planning for the long term. In accounting we have the so called revenue expenditures, - This refers to the expected income from the investment. This could be monetary or
which are expensed as incurred and we have these capital expenditures, which are capitalized as asset nonmonetary. There are also two types of monetary returns. The first one is the Accounting Net
because these expenditures will benefit the company in more than one period. In short, these are long- Income (which is geared towards profitability) and net cash inflows (which is geared towards
term assets. liquidity).
- Accounting Net Income is the amount that you’ve learned to compute since you were in your
Capital Budgeting also involves decision making; decision making in the sense that the company needs Senior High School years. However, for Finance purposes, it is but proper to use the net cash
to evaluate alternatives whether to invest or not in a new asset, expand or not their current plant or flows in evaluating capital decision projects.
to incur large amount of renovations to their currently available property, plant and equipment.
- Please refer to Key Formula No. 2 for the computation of your net cash flows. Remember that
However, not like short-term decision making, we should be very careful in evaluating capital investment
net cash flows can be NET OPERATING CASH FLOW AFTER TAX or END OF LIFE CASH
decisions. Why? Because of the following characteristics: FLOWS. Operating cash flows after tax are returns which arise from in and out of cash that is
directly attributable to the capital investment. Normally, these cash flows are ASSUMED to
1. Capital investment projects involves HUGE amount of money and resources – If you make a
occur at the end of each period. On the other hand, end of life cash flows are the net cash flow
wrong decision, big amount money would be lost. If you recommended to the company the
that are realized at the end of the project’s life.
purchase of an equipment worth P10M for the reason that it can generate a reasonable amount of
return but failed to achieve it, it is difficult to return the company investment of P10M.
2. Capital investment projects involve long-term commitments – any defective company decision
would result in a long-term sacrifice
3. Capital investment projects are more difficult to reverse than short-term decision – you cannot
reverse any wrong decision at a click of a finger. Example, the company made a wrong decision
of investing P10M. The entity cannot just make a reversing entry of Dr. Loss, Cr. Building.
4. Capital investment projects involves much risk and uncertainty – during the course of investing
or building the project, some uncertainties may happen which may cause the company losses.

After knowing the characteristics of capital investment projects, we should learn the different factors that
we need to consider in evaluating it. The following are the capital investment factors that we should
consider:

1. Net cost of investment

- This includes all cost or cash outflows net of inflows or savings that is incidental to the fulfillment
of capital investment projects.
- THIS IS THE AMOUNT OF NET CASH FLOWS @ TIME ZERO.

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 3. Cost of Capital
- This refers to the cost of obtaining funds or using funds for any investment.
- This is also taken into consideration in coming up in a decision in capital budgeting. For
terminology purposes, cost of capital is also called hurdle rate, required rate of return, cut-off
rate, opportunity cost of capital, minimum rate of return, target rate of return or desired rate of
return.

Now that we have a grasp on the different concepts and factors that we will be needing in evaluating
capital investment projects, we are now ready to do CAPITAL BUDGETING

EVALUATING CAPITAL INVESTMENT PROJECTS

There are two broad types of capital budgeting techniques. First is those who are NOT considering the
time value of money (non-discounted cash flow methods) and those who are considering the time value
of money (discounted cash flow methods). We are going to discuss first the methods that do not consider
the time value of money

NON-DISCOUNTED CASH FLOW TECHNIQUES

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DISCOUNTED CASH FLOW TECHNIQUES
These are the capital investment techniques that considers the TIME VALUE OF MONEY in decision
making. Because we consider time value of money in these techniques, only NET CASH FLOWS will
be considered as our returns here.

CAPITAL RATIONING
Capital rationing is a situation in which management places a constraint on the total size of the firm’s
capital budget during a particular period. It is also described as the selection of the investment proposals
in a situation of constraint on availability of capital funds to maximize the wealth of the company by
selecting those projects which will maximize overall NPV.

STEPS IN CAPITAL RATIONING

(1) Rank the projects according to their profitability index
(2) Choose the combination of projects with the highest total NPV

***END of LESSON 5***

REFERENCES

Textbooks
1. Agamata, F. (2011), Management Advisory Services, GIC Enterprises Inc.
2. Brigham, E., Houston, J. (2013), Fundamentals of financial management. Cengage Learning Asia
Pte. Ltd
3. Cabrera, E.(2015) Financial Management: Principles and Applications, GIC Enterprises & Co., Inc.,
Manila
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WARNING: No part of this E-module or LMS content can be reproduced or transported or WARNING: No part of this E-module or LMS content can be reproduced or transported or
shared to others without permission from the University of Saint Louis. Unauthorized use of shared to others without permission from the University of Saint Louis. Unauthorized use of
the materials, other than personal learning use, will be penalized. Please be guided the materials, other than personal learning use, will be penalized. Please be guided
accordingly. accordingly.
 4. Salvador, S., Baysa, G, Gamboa, D., Geronimo, E. (2012) Fundamentals and applications of
financial management, Allan Adrian Books Inc.
5. William, J. (2015), Financial Management

Online Reference

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shared to others without permission from the University of Saint Louis. Unauthorized use of
the materials, other than personal learning use, will be penalized. Please be guided
accordingly.