CAPITAL INVESTMENT

DECISIONS (CAPITAL
BUDGET)
Toby Cabug
CAPITAL BUDGETING

•Capital budgeting is the process a business

undertakes to evaluate potential major projects or
investments.
•The process involves analyzing a project’s cash
inflows and outflows to determine whether the
expected return meets a set benchmark.
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QUESTION:

Net Investment:
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Capitalized amount P(550,000)
Increase in NWC - 0 -
Sale of Replaced Mach. P400,000
Tax impact (P400k – P400K) x 40% - 0 - 400,000
Other savings (during invest. point) - 0 -
Net investment P(150,000)
Net Investment:
Capitalized amount ($250k + $25k) $(275,000)
Increase in NWC ($30k - $15k) ( 15,000)
Sale of Replaced Mach. $80,000
Tax impact (P80k – P100K) x 40% $8,000 88,000
Other savings (during invest. point) - 0 -
Net investment $(202,000)
Net Investment:
Capitalized amount ($250k + $15k + $25k) $(290,000)
Increase in NWC () - 0 -
Sale of Replaced Mach. $7,500
Tax impact ($7.5k – P10K) x 25% 625 8,125
Other savings (during invest. point) - 0 -
Net investment $(281,875)
After-tax cash flows After-tax cash flows
Δ in Sales -0- = BTCF x (1 – T %)
Δ in Cash expenses 50,000 + Depr. x T%
Δ in BTCF 50,000
Δ in Depreciation = P50,000 x (1 – 40%)
(20,000) + P2o,000 x 40%
Δ in Profit bef. tax 30,000
Δ in income tax (12,000) = P30,000 + P8,000
Δ in Profit after tax 18,000
Δ in Depreciation = P38,000
20,000
Δ in ATCF 38,000
After-tax cash flows
= BTCF x (1 – T %)
+ Depr. x T%

= P75,000 x (1 – 40%)
+ P55,000 x 40%

= P45,000 + P22,000

= P67,000
PROJECT EVALUATION
TECHNIQUES
Accounting
Profitability
Rate of
Index
Return

Payback Internal Rate

Period of Return

Net Present
Value
PROJECT EVALUATION
TECHNIQUES
Accounting
Profitability
Rate of
Index
Return

Payback
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Internal Rate
Period of Return

Net Present
Value
PROJECT EVALUATION
TECHNIQUES
Based on
Accounting Profit
Accounting
Profitability
Rate of
Index
Return
Based on Cash flows
Payback Internal Rate
Period of Return

Net Present
Value
PROJECT EVALUATION
TECHNIQUES
Accounting
Profitability
Rate of
Index
Return

Payback Internal Rate

Period of Return

Net Present
Value
ACCOUNTING RATE OF RETURN
This is the Accounting Profit generated by a project,
expressed as a percentage of the investment in that project.

Initial
Investment

Average
Investment
SAMPLE CASE
A new investment in machinery made by Jupert Corp. costs P800
000 which is expected to be in use for four years. Jupert uses the
straight-line method to depreciate assets. The cash flows expected
for this project are as follows:
Year Cash flows Year Cash flows
1 P340,000 3 P380,000
2 P380,000 4 P300,000
 SAMPLE CASE
A new investment in machinery made by Jupert Corp. costs P800 000 which is expected to be in use
for four years. Jupert uses the straight-line method to depreciate assets. The cash flows expected for
this project are as follows:
Year Cash flows Year Cash flows
1 P340,000 3 P380,000
Depr. Exp = P800K
4y 2 P380,000 4 P300,000

= P200K /y ARR
=
Profit
P150K
Year 1 P340K - P200K =
P800K
P140K
P150,000 =
Year 2 P380K - P200K =
18.75%
P180K
Year 3 P380K - P200K =
=
P180K
P150K
DRAWBACKS OF A.R.R.

•It is based on Accounting Profit (instead of cash

flows)
WEAKEST
•It does not account for the time value of money
PROJECT EVALUATION
TECHNIQUES
Accounting
Profitability
Rate of
Index
Return

Payback Internal Rate

Period of Return

Net Present
Value
 PAYBACK PERIOD
This is the time period needed to recover the
investment.
It is a measure of a project’s liquidity (i.e. cash
convertibility).
SAMPLE CASE
A new purchase of machine to be made by Marsma Corp. costs
P500 000 which is expected to be in use for four years. Marsma
uses the straight-line method to depreciate assets. The profits to
be earned from this machine are as follows:
Year Profits Year Profits
1 P100,000 3 P75,000
2 P130,000 4 P65,000
 SAMPLE CASE A new purchase of machine to be made by Marsma Corp. costs P500 000 which is expected to be
in use for four years. Marsma uses the straight-line method to depreciate assets. The profits to be
earned from this machine are as follows:
Year Profits Year Profits
1 P100,000 3 P75,000
Depr. Exp = P500K
2 P130,000 4 P65,000
4y
= P125K /y Payback period PBP
Cash flows Net investment P(500,000) = 2Yrs + P20K
Year 1 P100K + P125K Year 1 225,000 P200K
Year 2 P130K + P125K P(275,000) = 2 + 10% of 1 ye
Year 3 P 75K + P125K Year 2 255,000 = 2.10 years
Year 4 P 65K + P125K P( 20,000)
Year 3 200,000
VARIANTS OF THE PAYBACK PERIOD

•Traditional payback period (as discussed)

•Bail-out period
•Assumes that the project is terminated if all
invested cash flows are recoverable.
•Discounted payback period
•Accounts for the time value of money in
calculating the payback period.
DRAWBACKS OF PAYBACK PERIOD

•It ignores the profitability of the

project.
 QUESTION:
PBP
= 3 Yrs + P20K
P130K
= 3 + 15% of 1 year
= 3.15 years

Payback period
Net investment P(300,000) Accounting Rate of Return ARR
Year 1 75,000 Y BTCF Depreciation Profit = P50K
P(225,000) 1 P75,000 P50,000 P25,000 P300K
Year 2 90,000 2 90,000 50,000 40,000 = 16.67%
P(135,000) 3 115,000 50,000 65,000
Year 3 115,000 4 130,000 50,000 80,000 P50,000 = P50K
(20,000) 5 100,000 50,000 50,000 P150K
P130,000 6 90,000 50,000 40,000 = 33.33%
Net investment $(400,000)
Year 1 160,000
$(240,000)
Year 2 140,000
$(100,000)
Year 3 100,000
–
PBP = $175K
$ 35K

= 5 years
 Net investment $ (550,000)
Year 1 (500,000)
$(1,050,000)
Year 2 450,000
$ (600,000)
Loading… Year 3 350,000
$ (250,000)
Year 4 250,000
X (10K) 5K 5K 2 Years

Y (10K) 4K 4K 4K 4K 4K 2.5 Years

Net investment $(6,000)
Year 1 $3,000 x .9091 2,727
$(3,273)
Year 2 $2,250 x .8264 1,859
$(1,414)
Year 3 $1,750 x .7513 1,315

$ ( 99)
Year 4 $1,500 x .6830 1,025

DPBP = 3 + $99/$1,025
= 3.10 years
PROJECT EVALUATION TECHNIQUES

Non Discounting
Accounting
Techniques Profitability
Rate of
Return Discounted Cash Index
Flow Techniques
Payback Internal Rate
Period of Return

Net Present
Value
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
P(300,000) P75,000 P90,000 P115,000 P130,000 P100,000 P90,000
x 0.9091 x 0.8264 x 0.7513 x 0.6830 x 0.6209 x 0.5645
P68,183 P74,376 P86,400 P88,790 P62,090 P50,805
P 430,644
P 130,644
ATCF Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
= BTCF x (1-T)
+ Depr x T P(100K) P38K P38K P38K P38K
P38K
= P50,000 x .60
+ P20,000 x .40 <
12%
= P38,000 P 136,982 (38,000 x 3.6048)
P 36,982
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
$(116,000) $27,000 $27,000 $27,000 $27,000 $27,000
20,000 (1-50%)
< 9%
$ 111,529 ($27,000 x 3.8900 + $10,000 x 0.6499)
$ (4,471) NPV
 After-tax cash flows
After-tax cash flows

Δ in Sales ($80 x 100K) $8,000,000 = BTCF x (1 – T %)

Δ in Cash expenses ($65 x 100K) + $500k + Depr. x T%
(7,000,000)
Δ in BTCF $1,000,000 = $1,000,000 x (1 – 40%)
Δ in Depreciation + 0 x 40%
Δ in Profit bef. tax $ 1,000,000
Δ in income tax 40% ( 400,000) = $600,000 + 0
Δ in Profit after tax $ 600,000
Δ in Depreciation -0 - = $600,000
 After-tax cash flows

After-tax cash flows = BTCF x (1 – T %)

from operations $ 600,000 + Depr. x T%
Salvage value of equipment
($300,000 - $100,000) x (1 -40%) 120,000 = $1,000,000 x (1 – 40%)
Recovery of Working capital 400,000 + 0 x 40%
Total ATCF $1,120,000
= $600,000 + 0

= $600,000
Year 0 Year 1 Year 2 Year 3 Year 4
P(14,000) P14,000
<
10 %
P 9,562 (P14,000 x 0.6830)
P( 4,438)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
P(1,500,000) P400,000 P400,000 P400,000 P400,000 P400,000
<
10.4248%
P1,500,000 (P400,000 x 3.7500)
P - 0 -
 Profitability Index = Project Value
Net Investment Cost

Profitability Index = $130,000

$100,000
Value $130,000
= 1.30
Net Inv. (100,000)
NPV $ 30,000
 Independent (unlimited funds)
Any Project:
NPV > 0 ;
IRR > Hurdle rate ;
PI > 1

Mutually Exclusive Projects Independent (capital rationing)

Choose many that fits the budget
You can choose only one!

One with the highest NPV! Rank According to PI

 Capital
Available P1,500,000
III 650,000
850,000
IV 750,000
100,000
 Capital Available P100,000
1.5 S 5,000
P 95,000
2.0
R 10,000
1.2 P 85,000
1.25 U 60,000
1.2 P 25,000
1.2 W 15,000
P 10,000