Capital BudgetingCHAPTER IV

Is the process of planning and controlling long-term investments. It involves evaluation of capital investment proposals, allocation of capital investment funds among approved projects and programs, and control of such expenditures.

CAPITAL BUDGETING

The administrative process in capital budgeting refers to the framework of planning and control measures which identifies and interrelates the essential requirements for an effective capital expenditure program. It consist of the following steps :1. Proposal generation2. Gathering of relevant data on proposal

submitted3. Evaluation4. Approval and implementation5. Control of expenditures and follow-up

THE ADMINISTRATIVE PROCESS IN CAPITAL BUDGETING

Capital budgeting techniques should be used in all decision-making problems requiring long-term use of funds: example are the following :

1. Should an investment be made in a proposed business venture?

2. Would it be more advantageous for a business concern to expand or just maintain its current production/sales capacity?

3. Should existing facilities be maintained, replaced, or renewed?

4. Which would be more advantageous: continued ownership or sale leaseback?

5. Should facilities be leased out or used in operations?

WHAT PROBLEMS REQUIRE CAPITAL BUDGETING

As the word budgeting connotes, cash flows in different alternatives are determined and their values are computed using a common point in time. The cash flows are investment, cash returns and terminal values.

CASH FLOWS IN CAPITAL BUDGETING

This refers to the net outlay of resources at the inception of a business venture or special project. This includes the purchase cost of assets, incidental costs such as freight in and installation costs. Working capital requirement, and market value of asset already owned and to be transferred to the venture or project.

INVESTMENTS

This refers to the net cash inflows expected to be realized when the business or special project is already operational.

CASH RETURNS

This terms refers to cash inflow that mat be realized upon termination of business venture or project and consists of working capital that is expected to be released there from and the realizable value of assets used.

TERMINAL CASH FLOWS

This refers to the length of period during which economic benefits can be expected from a venture or project.

ECONOMIC LIFE

In evaluating investment proposals, management adopts standards and one of these is:a. The cut-off rate or the lowest acceptable

rate of return.b. Cost of capital or the opportunity cost of

capital.c. In some cases, a certain percentage is

added based on risks involved.

CUT-OFF RATE USED IN EVALUATING LONG-TERM INVESTMENT PROPOSALS

Methods of Evaluating

Capital Investment

Proposal

1. Payback period. This refers to the length of period or number of years it would take to recover an investment.

Formula : Investment /

Annual cash Returns

A. METHODS OF EVALUATING CAPITAL INVESTMENT PROPOSAL

2. Payback reciprocal. This indicated the percentage of investment that is expected to be recovered in one year.

Formula: Annual Cash returns / Investment

or 1 / Payback Period

3. Accounting rate of return. It indicates the amount of net income realized per peso of investment.

Formula:Net Income / Investment

4. Average rate of return. It indicates the amount of net income per peso of average investment. It is double the accounting rate of return.

Formula:Net Income / Average Investment

or2 ( Accounting rate of return )

Average Investment = Investment / 2

5. Payback bailout period. This refers to the length of period or number of years it would take to recover an investment considering accumulated cash returns and terminal values.

Procedure: Accumulate cash returns and add terminal cash flows at the end of each year. When the total is equal to investment, the payback bailout period has been arrived at.

1. Internal rate of return (IPR). This refers to the rate of return that a long-term investment earns. It is also called the discounted or timed adjusted rate of return.

Procedure:

*Compute for payback period

*With the payback period as the present value factor, locate it an annuity table

considering the economic life of the investment. The corresponding interest rate for the

column in which it can be found is the IRR.

B. METHODS THAT CONSIDER THE TIME VALUE OF MONEY:

2. Net present value (NPV). This refers to the excess of the present value of cash returns discounted at a chosen cut-off rate over the amount of investment.

Formula:Present value of annual cash returns

Discounted at the cut-off rate -Investment

3. Profitability index ( benefit / cost ratio or present value index ). This refers to the ratio of the present value of cash returns discounted at a chosen cut-off rate to the investment requirement.

Formula:Present value of annual cash returns

discounted at the cut-off rate /Investment

4. Discounted payback period. This refers to the number of years it would take the present value of cash returns to equal the investment.

Procedure:Discount the cash returns at the chosen cut-off rate and accumulate them. The length of period or number of years it would require to make the accumulated figure equal to investment is the discounted payback period.

ILLUSTRATIVEPROBLEM

An investment proposal is expected to enable a company to make sales of P5, 000 per annum. Cost of sales and operating expenses requiring disbursements are estimated at P1, 497 per annum. The fixed assets that must be acquired cost P6,738 and have estimated useful life of three years. Income tax rate is 40%. Determine the annual cash return.

1. ANNUAL CASH RETURNS

ACR = net income+ Dept exp.

Net income=

sales 5000

Less OE 1497

Dept ( 6738/ 3) 2246 3743

Net income before tax 1257

Tax( 1257*.40) 502.80

754.20

ACR = NET INCOME + DEPRECIATION EXPRENSE

754.20 + 2246 = 3,000.20

An investment of P6, 738 is expected to bring in annual cash returns of P3, 000.20 during is economic life of three years. Determine the payback period and payback reciprocal.PAYBCK PERIOD 6738/ 3000.20 =2.2459 YEARSPAYBACK RECIPROCAL3000.20/ 6738 = 44.53%

2. PAYBACK PERIOD AND PAYBACK RECIPROCAL

A machine costing P6, 738 is expected to enable the company to realize an annual net income of P754.20 throughout its life of three years. Determine the accounting rate of return and the average rate of return. ARR- NI/ INVESTMENT754.20/6738= 11.20%AVERAGE RR6738/2 =3369 OR 2(ARR)= 2(11.20%)= 22.40

3. ACCOUNTING RATE OF RETURN AND AVERAGE RATE

OF RETURN

An equipment costing P30, 000 with the following cash returns expected from its use; determine the payback bailout period.

4. PAYBACK BAILOUT PERIOD

Cash Returns Scrap Value End of Year

First year 6, 000 15, 000

Second year 9, 000 10, 000

Third year 10, 000 5, 000

Forth year 8, 000 1, 000

A machine costing P1, 366.40 has estimated economic life of three years without scrap value. Annual cash returns have been estimated at P700. Determine the internal rate of return.

5. INTERNAL RATE OF RETURN

First compute the payback period.

payback period = investment/ annual cash return

Given : P. 1,366.40- investment

P 700 – annual cash return

3 years economic life

Solution :

=P1,366.40 / P700

= 1.952 years

then locate 1952 at annuity table . Row of 3 years, since the economic life is 3 years.

1.952 is at 25%, so that 25 % is the IRR.

A proposal investment of P1, 366.40 annual returns of P700 per annum are expected during its economic life of three years. Management has adopted the policy of approving project proposals if the rate of return is 20% or higher. Determine the Net Present value.

6. NET PRESENT VALUE

First, look at annuity table, since economic life is 3 years, look at the row of 3 years then look at the corresponding value at 20%. 20 % is the rate of return in the problem.• 3 years at 20% is 2,106

Formula:

Present value of annual cash returns Discounted at the cut-off rate – Investment.

Solution: ( 700 * 2.106) = 1474.20LESS: Investment=(1366.40)NET PRESENT VALUE = 107.80

A proposed investment of P1, 366.40 annual returns of P700 per annum are expected during its economic life of three years. Management has adopted the policy of approving project proposals if the rate of return is 20% or higher. Determine the Profitability Index.

7. PROFITABILITY INDEX

PROFITABLE INDEX =PV OF ACR/ INVESTMENT

= 1474.20/1366.40= 1.078 OR 107.80%

An investment of P5, 876 will bring in cash returns as follows:

Required rate of return is 25%. Determine the discounted payback period.

8. DISCOUNTED PAYBACK PERIOD

First year 2, 000

Second year 3, 000

Third year 3, 000

Forth year 2, 500

Fifth year 2, 000

YEAR ARC PV@25% PV ACCUM. OF PV @25%

1 2,000 .800 16000 16000

2 3,000 .640 1920 3520

3 3,000 .512 1536 5056

4 2,500 .409 1022.50 8205876

5 2,000 .328 656

820/ 1022.50

= 3.80 YEARS