Mater Dei College | Tubigon, Bohol | (038)508-8106

College of Accountancy, Business and Management - Business Department

Lesson 7
Course Learning Outcome Apply the cost management techniques in decision-making.

Student Learning Outcomes 1. Compute the initial investment, annual net cash returns/savings of
an investment proposal
2. Apply the techniques in evaluating capital investment projects

Learning Content
CAPITAL BUDGETING: Introduction

Introduction
Implementing long-range plans usually requires capital expenditures. Plans for expansion may call for new
production facilities or new products. Since all firms have limited capital, a manager must often choose
between several competing investments and his skill in selecting investments ultimately determines how
well an organization performs over the long-run.
In this lesson, we will learn what capital budgeting is all about and the factors to be considered in evaluating
capital investment proposals. Later on as we progress, we will learn the various techniques in making
capital investment decisions. Read on to learn more!

Lesson Content
CAPITAL BUDGETING
- is the process of identifying, evaluating, planning and financing capital investment projects of an
organization.
- is the process of deciding whether or not to commit resources to projects whose costs and benefits are
spread over several time periods.
- is used to describe actions relating to the planning and financing capital outlays for such purposes as the
purchase of new machinery, the modernization of plant facilities or the introduction of new product lines.
- is an investment concept, since it involves a commitment of funds now in order to receive some desired
return in the future in the form of additional cash inflows or reduced cash outflows.
- involves:
▪ Preparation of annual budget for capital investment
▪ Assessment of funding capacities and
▪ Allocation of resources to renewal and expansion projects which most clearly conform with the
company’s priorities
Characteristics of Capital Investment Decisions

1. Capital investment decision usually requires large commitments of resources.

2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short-term decisions.
4. Capital investment decisions involve so much risk and uncertainty.

Stages in the Capital Budgeting Process

1. Identification and definition
2. Search for potential investment projects
3. Information gathering- both quantitative and qualitative information
4. Selection- choosing the investment projects after evaluating their proposed costs and benefits
5. Financing
6. Implementation and monitoring

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College of Accountancy, Business and Management - Business Department
Types of Capital Investment
1. Replacement If a piece of equipment breaks down or wears out, whether to replace it may not require
careful analysis. If the expenditure is modest and if not investing has significant implications for production,
operations, or sales, it would be a waste of resources to overanalyze the decision. Just make the replacement.
Other replacement decisions involve replacing existing equipment with newer, more efficient equipment, or
perhaps choosing one type of equipment over another. These replacement decisions are often amenable to
very detailed analysis, and you might have a lot of confidence in the final decision.
2. Expansion Instead of merely maintaining a company’s existing business activities, expansion projects
increase the size of the business. These expansion decisions may involve more uncertainties than
replacement decisions, and these decisions will be more carefully considered.
3. New products and services These investments expose the company to even more uncertainties than
expansion projects. These decisions are more complex and will involve more people in the decision-making
process.
4. Regulatory, safety, and environmental projects These projects are frequently required by a governmental
agency, an insurance company, or some other external party. They may generate no revenue and might not
be undertaken by a company maximizing its own private interests. Often, the company will accept the required
investment and continue to operate. Occasionally, however, the cost of the regulatory/safety/environmental
project is sufficiently high that the company would do better to cease operating altogether or to shut down any
part of the business that is related to the project.

CATEGORIES OF CAPITAL INVESTMENT

1. Independent capital investment projects or Screening decisions

- Are projects which are evaluated individually and reviewed against predetermined corporate standards of
acceptability resulting in an “accept” or “reject” decision.
Examples are:
a. Investment in long-term assets such as property, plant and equipment
b. New product development
c. Undertaking a large scale of advertising campaign
d. Introduction of a computer
e. Corporate acquisitions (such as purchase of shares in subsidiaries or affiliates)

2. Mutually exclusive capital investment projects or Preference decisions

- Are projects which require the company to choose from among specific alternatives. The project to be
acceptable must pass the criteria of acceptability set by the company and be better than the other investment
alternatives.
Examples are:
a. Replacement against renovation of equipment or facilities
b. Rent or lease against ownership of facilities
c. Manual bookkeeping system against computerized system
d. Preventive maintenance against periodic overhaul of machineries
e. Purchase of machinery from an outside supplier against assembly of the machinery by the company’s
own staff

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 Mater Dei College | Tubigon, Bohol | (038)508-8106
College of Accountancy, Business and Management - Business Department
CAPITAL BUDGETING ELEMENTS

1. Net investment cost of cash outflows less cash inflows or savings incidental to the acquisition of the
investment
Net Investment = Cash outflows – Cash inflows
2. Costs or cash ▪ The initial cash outlay covering all expenditures on the project up to the time
outflows when it is ready for use or operation. Example: Purchase price of the asset;
incidental project-related costs such as freight, insurance taxes, handling,
installation, test-runs, etc.
▪ Working capital requirement to operate the project at the desired level.
▪ Market value of an existing, currently idle asset, which will be transferred to or
utilized in the operations of the proposed capital investment project.
3. Savings or cash ▪ Trade-in value of old asset (in case of replacement).
inflows ▪ Proceeds from sale of old asset to be disposed due to the acquisition of the
new project
less applicable tax, in case there is gain on sale
or add tax savings, in case there is loss on sale
▪ Avoidable cost of immediate repairs on old asset to be replaced, net of tax.
4. Cost of capital the cost of using funds;
also known as the hurdle rate.

NET INVESTMENT
Illustration 7-1. Net Investment
ABC Company is considering the purchase of a new machine to replace an old one used in production. The new
machine would cost P 2,480,000. Details regarding the old machine were provided for decision-making:
▪ The cost of the machine was P1,488,000 which had a useful life of 10 years and was already used for 7 years;
▪ Much needed repairs amounting to P310,000 will be incurred if the company does not sell; and
▪ If the machine is sold, proceeds would amount to P446,400. The company is subject to income tax of 30%.
Required:
a) What is the net cost of investment for decision-making purposes?
Answer: P 1,816,000
Solution:
Carrying amount of old machine (P1,488,000 x 3/10 remaining life) P 446,400
Proceeds from sale 446,400
Gain (loss) P 0

No tax adjustment since there is no gain nor loss.*

Cash outflows
Cost of new machine P 2,480,000
Cash inflows
Proceeds from sale of old machine (no tax adj.*) 446,400
Avoidable cost of repairs, net of tax (P310,000 x 70%) 217,000 663,400
Net Investment P 1,816,600

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 Mater Dei College | Tubigon, Bohol | (038)508-8106
College of Accountancy, Business and Management - Business Department
b) Assume that the proceeds from the sale would only amount to P300,000, determine the net cost of
investment for decision-making.
Answer: P 1,919,080

Solution:

Carrying amount of old machine (P1,488,000 x 3/10 remaining life) P 446,400

Proceeds from sale 300,000
Loss from sale (P 146,400)
x Tax rate 30%
Tax savings P 43,920
Add to proceeds from sale 300,000
Net proceeds from sale of old machine P 343,920**

Cash outflows
Cost of new machine P 2,480,000
Cash inflows
Net Proceeds from sale of old machine 343,920**
Avoidable cost of repairs, net of tax (P310,000 x 70%) 217,000 560,920
Net Investment P 1,919,080

Illustration 7-2. Net Investment

The management of Maingat Company plans to replace a sorting machine that was acquired several years ago at
a accost of P60,000. The machine has been depreciated to its residual value of P10,000. A new sorter can be
purchased for P96,000. The dealer will grant a trade-in allowance of P16,000 on the old machine. If a new machine
is not purchased, Maingat Company will spend P10,000 to repair the old machine. Gains and losses on trade-in
transactions are not subject to income taxes. The cost to repair the old machine can be deducted in computing
income taxes. Income taxes are estimated 40% of the income subject to tax. Additional working capital is required
is P50,000.

Required: Compute the net initial investment in this project.

Solution:

Purchase price of new sorter P96,000

Add: Additional working capital 50,000
Total P 146,000
Less: Trade-in allowance on old sorter 16,000
Avoidable repairs cost on old sorter (net of increase in income taxes of
P4,000) 6,000 22,000
Net investment P 124,000

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 Mater Dei College | Tubigon, Bohol | (038)508-8106
College of Accountancy, Business and Management - Business Department

CASH FLOWS

Categories of Project Cash Flows

Cash inflows Additional information

▪ Periodic cash inflows from positive cash flows from revenue generating activities or from cost-saving programs
operations, net of taxes
▪ Investment tax credit allows a credit against a company’s income tax liability based on the cost of an
acquired asset. If the present income tax laws allow investment tax credit, it would
reduce the cost of making investments by giving companies a credit against their
corporate income taxes equal to (say) 10% of the costs of assets.

▪ Proceeds from sale of old asset treated as a reduction from cost of initial investment. If the old asset is sold at a gain,
being replaced or, net of taxes the incremental income tax should be deducted from the proceeds. If the old asset
is sold at a loss that is, its book value exceed the selling price, the tax savings will
be added to the proceeds.

▪ Trade-in allowance from disposal of

asset
▪ Avoidable costs, net of taxes In some instances, purchase of new asset may result to the avoidance of incurring
expenses to repair the old asset. The avoidable repair cost, net of incremental tax
will be treated as a deduction in computing the cost of initial investment.

▪ Return of some working capital When a project ends, there are usually some leftover inventory, cash or other
invested in the project* working capital items that were used to support operations. These working capital
items are then freed for use elsewhere and treated as cash inflow.

▪ Cash inflow from salvage of the new Ending a project will usually require disposal of its assets. In some cases, more
long-term asset at the end of its money is spent in disassembling the assets and disposing these than is gained from
their sale. Any net outflows from the disposal of a project’s assets become tax
useful life. This will be net of tax deductions in the year of disposal. The net salvage value of an asset is listed as a
consequence.* cash inflow at the time it is expected to be realized. If the net salvage value of the
asset is negative, then it is listed as cash outflow also at the time it is expected to be
incurred.

*The end of a project’s life will usually result in some cash flows. These cash flows are referred to as disinvestment flows.
Cash outflows
▪ Acquisition cost of purchasing and represent the primary outflows for most capital investments. They are listed as cash
installing assets (discounts are outflows in the years in which they are incurred.
deducted whether taken or not
taken)
▪ Additional working capital Many projects require fund for working capital needs (for example, to build up
inventories, additional cash balance to handle increased level of activities). These
cash flows often occur before the project is in operation. Working capital investments
shall be recovered entirely at the end of the project life.

▪ Other cash flows such as severance

payments, relocation costs and
similar costs
▪ Additional tax paid or incurred in the
case of gain from sale or disposal of
old asset
▪ Additional tax paid from savings on
avoided cost of repairs, if the old
asset is replaced

➢ Operating transactions are made on cash basis except for depreciation expense.
➢ Gain or loss on disposal of old assets have no direct effect in the computation of the net cost of investment.
However, the tax effects of the gain or loss on disposal of old asset affect the cost of investment.

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College of Accountancy, Business and Management - Business Department

Formulas:
Computation Of Cash Inflows:

Annual incremental revenue from the project P xx or Annual incremental revenue from the project P xx
Less: incremental cash operating costs xx Less: incremental cash operating costs xx
Annual cash inflow before taxes xx Annual cash inflow before taxes xx
Less: taxes Less: incremental depreciation xx
[tax rate x (annual cash inflow before taxes – depn.)] xx Net income before taxes xx
Annual Net Cash Inflow After Taxes xx Less: income taxes xx
Net income after taxes xx
Add: incremental depreciation xx
Annual Net Cash Inflow After Taxes xx
Computation Of Cash Savings:

Annual cash operating costs (if the old asset or or Cash operating costs
method is used) P xx (if the old asset or method is used) P xx
Less: annual cash operating costs (if the new asset Less: annual cash operating costs (if the new
or method is used) xx asset or method is used) xx
Annual cash savings before taxes xx Cash savings before taxes xx
Less: taxes Less: incremental depreciation xx
[tax rate x (annual cash inflow- incremental depn)] xx Increase in income before taxes xx
Annual Cash Savings After Taxes xx Less: income taxes xx
Increase in income after taxes xx
Add: incremental depreciation xx
Annual Cash Savings After Taxes xx
Illustration 7-3. Annual Cash Returns

Alalay Company is considering the acquisition of a machine which will cost P120,000. It has an expected useful
life of five years at the end of which its scrap value will be P20,000. The company expects to be able to generate
annual cash flow before taxes of P40,000. Estimated income tax rate is 30%. What is the annual cash flow after
taxes on this investment?
Solution:
Annual cash inflow before taxes P40,000
Less: incremental depreciation (P120,000 – 20,000)÷5 years 20,000
Net income before taxes 20,000
Less: income taxes (30%) 6,000
Net income after taxes 14,000
Add: incremental depreciation 20,000
Annual Net Cash Inflow After Taxes P34,000

Illustration 7-4. Annual Cash Savings

The Visayan Division of Marlow Supply Company has been considering a new production method that can reduce
materials costs by an estimated amount of P52,000 a year. The new method is also expected to result in an annual
savings of labor and overhead methods is estimated at P40,000 a year over a period of ten years. Income taxes
are estimated at 30% of income before income taxes. What are the annual net returns (or savings) expected from
the new production method?
Solution:
Annual savings in direct materials costs P 52,000
Annual savings in direct labor and overhead costs 64,000
Total savings before depreciation 116,000
Less: Depreciation 40,000
Savings after depreciation 56,000
Less: Incremental income taxes (30%) 16,800
Net increase in income 39,200
Add: Depreciation 40,000
Net Cash Savings After Taxes 79,200

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Simplified Notes in Strategic Cost Management 2023 Edition
 Mater Dei College | Tubigon, Bohol | (038)508-8106
College of Accountancy, Business and Management - Business Department

COST OF CAPITAL

The minimum or lowest acceptable rate of return or opportunity cost may equal the average rate of return that the
company will earn from alternative investment opportunities or the cost of capital which is the average rate of return
that the firm must pay to attract investment fund. The cost of capital according to source may be computed as
follows:

Cost of debt =Interest rate x (1- Corporate tax rate)

Cost of Preference shares (PS): 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
=
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑃𝑆
Cost of Ordinary share (OS): 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
a) Stock price-based = + 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑂𝑆

b) Book value-based* 𝑁𝑒𝑥𝑡 𝑦𝑒𝑎𝑟′ 𝑠 𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑂𝑆
Cost of Retained Earnings Same as cost of ordinary equity
*used when dividend growth rate is not known

WEIGHTED AVERAGE COST OF CAPITAL

To compute for the overall weighted average cost of capital (WACC), multiply the cost of each type of capital by
their respective weights (percentage of each source to the firm’s total capital structure) and add up the individual
weighted cost of capital.

Illustration 7-5. Weighted Average Cost of Capital

The following information on Bettina Corporation’s capital structure is available from the latest financial
statement:
Source Amount Proportion
6% Bank Loan P 300,000 30%
5% Preference shares 100,000 10%
Ordinary shares 200,000 20%
Retained earnings 400,000 40%
Total P1,000,000 100%
Required: Compute for the following:
a) Individual cost of capital
b) Weighted average cost of capital

Solution:
a) Individual cost of capital
Source Cost of capital
6% Bank Loan = 6% x (1-32%) = 4.08%

5% Preference shares 5
=62.50 = 8%
2
Ordinary shares =40 + 4% = 9%
Retained earnings Same as ordinary shares

b) Weighted average cost of capital

Source Amount Proportion Cost Weighted cost

6% Bank Loan P 300,000 30% 4.08% 1.22%
5% Preference shares 100,000 10% 8.00% 0.80%
Ordinary shares 200,000 20% 9.00% 1.80%
Retained earnings 400,000 40% 9.00% 3.60%
Total P1,000,000 100% 7.42%
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Simplified Notes in Strategic Cost Management 2023 Edition
 Mater Dei College | Tubigon, Bohol | (038)508-8106
College of Accountancy, Business and Management - Business Department

Exercises
Exercise 7-1. Net Cash Flows
Acme is considering the sale of a machine with a book value of P200,000 and 4 years remaining in its useful life.
Straight-line depreciation of P50,000 annually is available. The machine has a current market value of P160,000.
What is the cash flow from selling the machine if the tax rate is 30%?

Exercise 7-2. Net Cost of Investment

ABC Company is deciding whether to purchase a new equipment costing P200,000 and replace an old one
purchased 5 years ago. The old equipment had a cost of P240,000 and has remaining life of 3 years. Based on
market studies, the old equipment can be sold for P50,000. ABC Company pays a tax rate of 30% of income before
tax. What is the net cash investment at the time of purchase of the new equipment?

Exercise 7-3. Net Cost of Investment

Pepin Company is considering replacing a machine that has the following characteristics.
Book value P 100,000
Remaining useful life 5 years
Annual straight-line depreciation P?
Current market value P 60,000

The replacement machine would cost P150,000, have a five-year life, and save P50,000 per year in cash operating
costs. It would be depreciated using the straight-line method. The tax rate is 40%.
Required:
a. Find the net investment required to replace the existing machine.
b. Compute the increase in annual income taxes if the company replaces the machine.
c. Compute the increase in annual net cash flows if the company replaces the machine.

Exercise 7-4. Net cost of investment

The management of ABC Company plans to replace a sorting machine that was acquired several years ago at a
cost of P925,000. The machine has been depreciated to its residual value of P90,000. A new sorter can be
purchased for P3,194,000, 3/10, n/30. The dealer will grant a trade-in allowance of P76,000 on the old machine.
If a new machine is not purchased, Dawn will spend P745,000 to repair the old machine. Gains and losses on
trade-in transactions are not subject to income tax. The cost to repair the old machine can be deducted in the
first year for computing income tax. Income tax is 30% of the income subject to tax. Compute the net
investment.

Exercise 7-5. Annual profits and net cash flow after tax

The CDE Company is planning to add a new product line to its present business. The new product will require a
new equipment costing P12,000,000, having a five-year useful life with no residual value. The following estaimes
are made available:

Annual Sales P20,000,000

Annual costs and expenses:
Materials 4,800,000
Labor 6,200,000
Factory overhead (excluding depreciation on new 2,540,000
equipment)
Distribution and administrative expenses 1,700,000
Income tax rate 30%

Required: Determine the following:

a. Annual profit after tax

b. Annual net cash flow after tax

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College of Accountancy, Business and Management - Business Department

Exercise 7-6. Incremental Cash Inflows

ABC Inc. currently has annual cash revenues of P2,400,000 and annual operating costs of P1,850,000 (all cash
items except depreciation of P350,000). The company is considering the purchase of a new machine costing
P1,200,000 that would increase cash revenues to P2,900,000 and operating costs (including depreciation) to
P2,050,000. The new machine would increase depreciation to P500,000 per year. Revenues are expected to
increase to P2,900,000 and assuming a 35% tax rate, ABC’s incremental after cash flows from the machine would
be _______________.

Exercise 7-6. Operating cash savings

XYZ Company is considering the acquisition of a new, more efficient press. The cost of the press is P360,000
and the press has an estimated 6-year life with zero residual value. XYZ uses straight-line depreciation for both
financial reporting and income tax reporting purposes and has a 40% corporate income tax rate. In evaluating
equipment acquisitions of this type, XYZ uses a goal of a 4-year payback period. To mee XYZ desired payback
period, the press must produce a minimum annual before-tax operating cash savings of ______________>

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Simplified Notes in Strategic Cost Management 2023 Edition