SAN PEDRO COLLEGE

12 C. Guzman Street, 8000 Davao City, Philippines

Master of Arts in Hospital Administration

Third Trimester, SY 2019-2020

ACCOUNTING & FINANCIAL MANAGEMENT

LESSON 5 – CAPITABL BUDGETING

CAPITAL BUDGETING DEFINED

It is the process of evaluating and prioritizing long-term capital investment projects of

an organization and their financing.

Financing decision – involves judgment regarding the method of raising capital to

fund an investment project.

Capital Investment decision – involves judgment about which capital assets to

acquire or lease to achieve the organization objectives.

CHARACTERISTICS OF CAPITAL INVESTMENT DECISION

1. Significant outlay of resources

2. Involvement of long-term financing
3. Difficulty to reverse compared to short-term decisions
4. Much risk and uncertainty

CATEGORIES OF CAPITAL INVESTMENT

1. Replacement
2. Improvement
3. Expansion

ELEMENTS OR FACTORS OF CAPITAL BUDGETING

1. Net investment
2. Net returns:
a. Accounting Rate of Return; or
b. Net Cash Inflows.
3. Cost of capital
NET INITIAL INVESTMENT (OR PROJECT COST)

NET INVESTMENT – refers to the initial outlay of funds required to acquire long-
term investment projects.

Costs or Cash Outflows:

Purchase price and incidental costs xx
Working capital requirements xx
Fair market value of existing or
currently idle assets to be used
in the investment project xx xx
Less: Savings or Cash Inflows:
Trade-in value of old assets
(in case of replacements) xx
Proceeds from sale of old assets
due to purchase of new projects,
net of tax xx
Avoidable cost of immediate
repairs on old assets to be
replaced, net of tax xx (xx)
Net investment or Project cost xx

Illustration:

A project investment proposal has been made to effect the replacement of a

machinery equipment and the following data are given:
Book value of old machine P6,000,000
Sales price of old machine 4,000,000
Income tax rate 30%
Purchase price of new machine 8,500,000
Freight-in, installation cost, cost of test runs 500,000
Immediate repairs needed on old machine 800,000

Required:
Compute the net investment.

Answer – P3,125,900
Solution –

Costs or Cash Outflows:

Purchase price P8,500,000
Installation costs 500,000
 Less: Savings or Cash Inflows:
Proceeds from sale of old assets, net of tax
Sales price of old machine P4,000,000
Add: Tax savings on loss
(2,000,000 x 30%) 600,000 (4,600,000)
Avoidable cost of immediate repairs
Repairs P 800,000
Less: Tax savings (30%) 240,000 ( 560,000)
Net investment P3,840,000

NET CASH RETURNS (OR INFLOWS)

NET CASH RETURNS – refer to the cash inflows less cash outflows from business
operations.

Direct Method:
Cash Inflows xx
Less: Cash outflows (xx)
Net Cash Inflows xx

Indirect Method:
Net income xx
Add: Non-cash items (depreciation) (xx)
Net Cash Inflows xx

Illustration:

An investment proposal is expected to enable a company to make sales of

P5,000,000 per annum. Cost of sales and operating expenses requiring
disbursements are estimated at P1,497,000 per annum. The fixed assets that must
be acquired cost P6,738,000 and have an estimated life of three years. Income tax
rate is 30%.

Required:
Compute the annual net cash return or net cash inflow:

Answer – P3,125,900
Solution –
Sales P5,000,000
Less: Cost of sales and operating expenses 1,497,000
Gross profit P3,503,000
Less: Depreciation 2,246,000
Net income before tax P1,257,000
 Less: Income tax (30%) 377,100
Net income after tax P 879,900

Net income after tax P 879,900

Add: Depreciation 2,246,000
Annual net cash return or net cash inflow P3,125,900

COST OF CAPITAL/ MINIMUM OR LOWEST ACCEPTABLE RATE OF RETURNS

COST OF CAPITAL – is the weighted-average rate of return the organization must

pay to its long-term creditors and shareholders for the use of their funds. It is
otherwise known as hurdle rate, required rate of return, or cut-off rate.

Type of Financing Cost of Capital Calculation

Debt Interest rate x (100% - Tax Rate)

Preference share Dividend per share

Market price per share

Ordinary share Earnings per share

Market price per share

Steps to compute the average cost of capital:

1 – Determine the cost of each component (or specific cost) in the capital structure.
2 – Determine the respective weights of the different components (or component
percentages) in the capital structure.
3 – Multiply and add the products to arrive at the weighted average cost of capital.

Illustration:

The following data are given on the capital of Prince Corporation:

15% loans payable P350,000
12% preferred share, par P100 200,000
Ordinary share, par P100 300,000
Retained earnings 150,000
Market price per share – ordinary 150
Earnings per share of ordinary share 21
Corporate income tax 30%
Required:
Compute the cost of capital

Answer – 12.4%
 Solution –
Specific Component Weighted
Cost x Percentage = Cost
Loans payable 10.5% 35% 3.7%
Preferred share 12% 20% 2.4%
Ordinary share 14% 45% 6.3%
100% 12.4%

The specific costs and component percentages are computed as:

Cost of each component Balances %
Loans payable 15% x (1-30%) = 10.5% P350,000 35%
Preferred share (12% x 100)/100 = 12.0% 200,000 20%
Ordinary share 21/ 150 = 14.0% 450,000 45%
P1,000,000 100%

PROCESS OF CAPITAL BUDGETING

1. Identification of investment opportunities

2. Information gathering – both quantitative and qualitative
3. Evaluation of project costs and benefits
4. Selection of the best investment
5. Financing
6. Implementation and monitoring

CATEGORIES OF PROJECT CASH FLOW

1. INITIAL CASH FLOWS – refer to the amounts paid out or received at the start of a
project or investment. This is usually a negative figure since capital investments
require a large initial capital investment by a company at the outset of a project that
will generate positive cash flow over time.

2. OPERATING CASH FLOWS – refer to the amounts of cash generated by the

organization's normal business operations. These indicate whether a company can
generate sufficient positive cash flow to maintain and grow its operations, or it may
require external financing for capital expansion.

3. TERMINAL CASH FLOWS – refer to the amounts realizable at the end of the
economic life of a project investment or end of its project life.
CAPITAL INVESTMENT EVALUATION METHODS

Methods that do not consider Time Value of Money:

Formula
1. Payback period Net Investment
Annual Net Cash Returns

2. Accounting rate of return Net Income

Net Investment

Methods that consider Time Value of Money:

(Discounted Cash Flows Techniques)

1. Discounted payback period same with Payback Period

above but using present
values for net cash returns

2. Discounted (or internal) rate of return use of Present Value (PV)

annuity table

3. Net present value PV of cash inflows minus

PV of cash outflows*

4. Profitability index PV of cash inflows

PV of cash outflows*

* equal to Net Investment

PAYBACK PERIOD – is the length of time required for a project to recover its net
investment from the net cash returns it generates.

Decision Rule:
The project investment is desirable if it can be recovered more quickly.

Illustration 1:

An investment of P6,738,000 is expected to bring in annual cash returns of

P3,000,200, during its economic life of three years.

Required:
Compute the payback period.
 Answer – 2.246 years
Solution –
Payback period = P6,738,000 / P3,000,200 = 2.246 years

Illustration 2:

An investment of P10,000,000 can bring in following annual cash returns of:

First year P1,500,000
Second year 3,500,000
Third year 3,000,000
Fourth year 2,000,000
Fifth year 2,400,000
Sixth year 2,200,000

Required:
Compute the payback period.

Answer – 4 years*
Solution –
Investment P10,000,000
First year ( 1,500,000)
Second year ( 3,500,000)
Third year ( 3,000,000)
Fourth year ( 2,000,000)

* The payback period is computed by adding the net cash returns

until the total amounts to P10,000,000.

BAIL-OUT PERIOD – considers the salvage value or proceeds from sale at the end of
each year of the life the project investment.

Decision Rule:
The project investment is desirable if it can be recovered more quickly.

Illustration:

An equipment costing P30,000,000 with the following cash returns expected

from its use.
Scrap value
Cash returns End of year
First year P6,000,000 P15,000,000
Second year 9,000,000 10,000,000
Third year 10,000,000 5,000,000
Fourth year 8,000,000 1,000,000
Required:
Compute the payback bail-out period.
 Answer – 3 years
Solution –
Net cash
returns Scrap value Total
End of first year P6,000,000 P15,000,000 P21,000,000
End of second year 15,000,000 10,000,000 25,000,000
End of third year 25,000,000 5,000,000 30,000,000

ACCOUNTING RATE OF RETURN (ARR) – is the return on investment based on

accounting net income rather than net cash returns.

Decision Rule:
The project investment is desirable if it has a higher positive ARR.

Illustration:

Big League, Inc. is a processor of low-acid tea. The company is contemplating

purchasing equipment for an additional processing line. The additional
processing line would increase revenues by P90,000,000 per year. Incremental
operating expenses would be P40,000,000 per year. The equipment would cost
P180,000,000 and have a nine-year life with no salvage value.

Required:
Compute the accounting rate of return.

Answer – 16.7%
Solution –
Accounting rate of return = P30,000,000*/ P180,000,000
= 16.7%
* Revenues P90,000,000
Less: Operating expenses P40,000,000
Depreciation
(180,000,000/ 9) 20,000,000 (60,000,000)
Net accounting income P30,000,000

Note: The depreciation method used is assumed to be straight line.

Thus, any salvage value must be deducted to determine the depreciable
value before allocating it its useful life.

DISCOUNTED PAYBACK PERIOD – is the length of time required for the discounted
cumulative cash inflows on a project to equal the discounted cumulative cash
outflows (net investment).

Decision Rule:
The project investment is desirable if it can be recovered more quickly.
 Illustration:

An investment of P5,876,000 will bring in cash returns as follows:

First year P2,000,000 Fourth P2,500,000
Second year 3,000,000 Fifth 2,000,000
Third year 3,000,000
Required rate of return is 25%.

Required:
Compute the discounted payback period.

Answer – 3.80 years

Solution –
Annual Present Value No. of
Cash Returns PVF Cash Returns Yrs.
1 P2,000,000 0.800 P1,600,000 1
2 3,000,000 0.640 1,920,000 1
3 3,000,000 0.512 1,536,000 1
4 2,500,000 0.410 1,025,000 0.80 (820/1,025)
3.80

DISCOUNTED (OR INTERNAL) RATE OF RETURN – is the adjusted rate of return

which equates the present value of cash inflows to present value of cash outflows.
It can be determined by:
a. Ascertaining the present value factor (PVF) for internal rate of return (IRR)
using:
PVF for IRR = Net investment
Net cash returns
b. Determining on line n (economic life) the PVF obtained in the above step
using the present value annuity table. The corresponding rate is the IRR.

Decision Rule:
The project investment is desirable if it has a higher positive IRR.

Illustration:

Investment of P15,000,000 and annual cash returns for 5 years us P5,000,000.

Required:
Compute the discounted (or internal) rate of return.

Answer – 19.9%
Solution –
 Payback period = 15,000,000/ 5,000,000 = 3 years
Referring to the annuity table:
At 18% 3.127 0.127
3.0
At 20% 2.991 0.009
2% 0.136
The exact time adjusted rate of return is equal to:
18% + 0.127 x 2% = 19.9%
0.136
or:
20% + 0.009 x 2% = 19.9%
0.136
Note: When cash inflows from operations are uneven, the time adjusted
rate of return is based on average annual cash returns.

NET PRESENT VALUE – is the difference between the total present value of the net
cash inflows and the net cost of investment.

Decision Rule:
The project investment is desirable if it has a positive net present value
which means that the investment is to provide a rate of return greater than the
discount rate.

Illustration:

Sun Company is considering purchasing new equipment costing P350,000. Sun's

management has estimated that the equipment will generate cash inflows as
follows:

Year 1 P100,000
Year 2 P100,000
Year 3 P125,000
Year 4 P125,000
Year 5 P75,000

Required:
Using the factors in the table below, please calculate the net present value of the
investment project (including initial investment plus the NPV of the net cash inflows
above) using a discount rate of 10%. Please round all calculations to the nearest
whole dollar.

Present
Value of P1
5% 6% 7% 8% 9% 10%
1 0.952 0.943 0.935 0.926 0.917 0.909
2 0.907 0.890 0.873 0.857 0.842 0.826
3 0.864 0.840 0.816 0.794 0.772 0.751
 4 0.823 0.792 0.763 0.735 0.708 0.683
5 0.784 0.747 0.713 0.681 0.650 0.621

Answer – P49,325
Solution –

Net Cash Flows Factors Net Present Value

P100,000.00 0.909 P90,900
P100,000.00 0.826 P82,600
P125,000.00 0.751 P93,875
P125,000.00 0.683 P85,375
P75,000.00 0.621 P46,575
PV of Cash Inflows P399,325
Investment (P350,000)
NPV of project P49,325

PROFITABILITY INDEX – is the ratio of the present value of the net cash inflows over
the net cost of investment.

Decision Rule:
The project investment is desirable if it has a higher profitability index.

Illustration:

Please review the information on 4 potential investments:

Project A Project B Project C Project D

Initial investment P200,000 P250,000 P300,000 P90,000
PV of cash inflows P285,000 P295,000 P420,000 P94,000
Payback period (years) 7.2 6.0 9.5 2.0
NPV of project P85,000 P45,000 P120,000 P4,000

Required:
Compute the profitability index for each project.

Answer – Project A = 1.43, Project B = 1.18,

Project C = 1.40, Project D = 1.04.
Solution –

Project A Project B Project C Project D

PV of Cash Inflows = 285,000 295,000 420,000 94,000
Investment 200,000 250,000 300,000 90,000
= 1.43 1.18 1.40 1.04
COMPREHENSIVE ILLUSTRATION:

Brave Company is considering a project that would have a five-year life and require
a P2,400,000 investment in equipment. At the end of five years, the project would
terminate and the equipment would have no salvage value. The project would
provide net operating income each year as follows:

Sales P3,200,000
Variable costs 1,800,000
Contribution margin P1,400,000
Fixed costs:
Advertising, salaries, and other
fixed out-of-pocket costs 700,000
Depreciation 300,000
Net operating income P 400,000
The company’s discount rate is 12%.

Required:
1. Compute the annual net cash inflow from the project.

Answer – P700,000
Solution –
Sales P3,200,000
Less: Variable costs 1,800,000
Contribution margin P1,400,000
Less: Advertising, salaries, and other
fixed out-of-pocket costs 700,000
Annual net cash inflow P 700,000
Or
Net operating income P 400,000
Add: Non-cash item (Depreciation) 300,000
Annual net cash inflow P 700,000

2. Compute the project’s net present value. Is the project acceptable?

Answer – P123,500. The project is acceptable because it has a positive

net present value.

Solution –
PV of cash inflows (700,000 x 3.605) P2,523,500
Less: PV of cash outflows 2,400,000
Net present value P 123,500

3. Find the project’s internal rate of return to the nearest whole percent.

Answer – P123,500
Solution –
 Ascertaining the present value factor (PVF) for internal rate of return (IRR) using:
PVF for IRR = P2,400,000 = 3.429
P700,000
Determining on line n (economic life) the PVF obtained in the above step using
the present value annuity table. The corresponding rate is the 14%.

4. Compute the project’s payback period.

Answer – 3.4 years

Solution –
Payback period = P2,400,000 = 3.4 years
P700,000

5. Compute the project’s accounting rate of return.

Answer – 16.7%
Solution –
Accounting rate of return = P400,000 = 16.7%
P2,400,000

2.11 Preference Decisions – The Ranking of Investment Projects

Either the Internal Rate of Return (IRR) or the Net Present Value can be used in making
preference decisions. If these methods are in conflict, the Net Present Value is
desirable to use. However, profitability index is much better for multiple investment
projects as it shows the percentage/ ratio of return on the investments.

INFLATION AND CAPITAL BUDGETING

• Inflation has consequences on the amount realizable of a capital investment project.

• Real cash flows are based on purchasing power at the time the decision to invest would
be made.
• Market cost of capital is not completely representative of the real cost of borrowing
funds.
• As the rate of inflation increases, investors require a higher real rate of return to
compensate, which makes many investment projects very expensive.
Present Value of an Annuity of 1 to be Received for ‘n’ Years
Present Value of 1 to be Received for ‘n’ Years
QUIZ – OPERATIONAL BUDGETING

Multiple Choice:

1. Which of the following is a common capital budgeting method?

a. Return on assets
b. Net present value
c. Inventory turnover
d. Debt-to-equity ratio

2. Which of the following is TRUE of discounted cash flow methods like NPV and IRR?
a. They use simple interest calculations.
b. They use net income amounts rather than cash flows.
c. They focus on the payback period.
d. They incorporate compound interest calculations.

3. Cash flows used in NPV and IRR analyses include all of the following EXCEPT:
a. future increased sales.
b. future cost savings.
c. depreciation expense.
d. residual value.

4. An investment would be considered a good prospect under which of the following

conditions?
a. The present value of the cash flows exceeds the initial investment.
b. The IRR is lower than the hurdle rate.
c. The cash inflows are greater than the initial investment.
d. It has a residual value.

5. Which of the following most accurately describes the discount rate used in NPV and IRR
analyses?
a. The rate of inflation
b. The rate of interest earned on a savings account
c. The required rate of return, also known as the "hurdle rate"
d. The rate of interest charged for debt financing of an investment
CASE PROBLEMS

1. The following data pertains to a project being proposed:

Cash purchase price of machinery and equipment P300,000
Freight in 3,000
Installation cost 4,000
Cost of labor and materials to be used in test runs 62,000
Working capital requirements 50,000

Required: Net cost of investment is _____________.

2. The following data pertains to a project being proposed:

Investment P100,000
Cash returns Scrap
First year P40,000 P30,000
Second year 26,000 20,000

Third year 20,000 10,000

Fourth year 10,000 4,000
Fifth year 6,000 1,000

Required:
a. Payback period_________
b. Payback bail-out period___________

3. The following data pertains to a project being proposed:

Investment P60,000,000
Annual revenue 22,000,000
Annual out-of-pocket operating expenses 15,000,000
Income tax rate 30%
Economic life of asset 10 years

Required:
a. Compute the net accounting income____________
b. Compute the net cash inflows.____________
c. Compute the accounting rate of return.__________
d. Compute the payback period.___________

4. The following are extracted for two investment projects:

Case A Case B
Investment P50,000,000 P65,000,000
Cash returns:
Year 1 30,000,000 40,000,000
Year 2 40,000,000 38,000,000
Year 3 35,000,000 26,000,000
 Year 4 22,000,000 25,000,000
Cost of money 18% 20%

Required: Compute the discounted payback period._____________

5. Brand Corporation is considering five different investment opportunities. The

company’s cost of capital is 12%. Data on these opportunities under consideration are
given below: Profitability
Project Investment PV at 12% NPV IRR Index
A P35,000,000 P39,325,000 P4,325,000 16% 1.12
B 20,000,000 22,930,000 2,930,000 15% 1.15
C 25,000,000 27,453,000 2,453,000 14% 1.10
D 10,000,000 10,854,000 854,000 18% 1.09
E 9,000,000 8,749,000 (251,000) 11% 0.97
Required:
1. Rank these five projects in order of preference, according to:
- Net present value
- Internal rate of return
- Profitability index

2. Which ranking would you prefer?