STRATEGIC COST MANAGEMENT

CAPITAL BUDGETING

CAPITAL INVESTMENT – involves significant commitment of funds to receive a satisfactory return – increase in revenue or reduction
in costs over an extended period of time. Example: purchase of equipment for expansion, replacement of old equipment.

GENERAL CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS

 AS TO COST usually involves large expenditure of resources, relative to business size
 AS TO COMMITMENT usually funds invested are tied up for a long period of time
 AS TO FLEXIBILITY usually more difficult to reverse than short-term decisions
 AS TO RISK usually involves so much risks and uncertainties due to operational and economic changes over an
extended period of time

CAPITAL BUDGETING – is the process by which management identifies, evaluates, and makes decision on capital investment
projects of an organization. It is the process of planning expenditures for assets, the return on which are expected to continue beyond
one-year period.

CAPITAL INVESTMENT FACTORS

Net Investments (for decision-making purposes)

 Costs less savings incidental to the acquisition of the capital investment projects
 Cash outflows less cash inflows incidental to the acquisition of the capital investment projects

Costs or cash outflows

1. Purchase price of the asset, net of related cash discount

2. Incidental project-related expenses such as freight, insurance, handling, installation, test-runs, etc.
CONSIDER ALSO THE FOLLOWING, if any:
 Additional working capital needed to support the operation of the project at the desired level.
 Market value of existing idle assets to be used in the operation of the proposed capital project.
 Training cost, net of related tax

Savings or cash inflows

1. Proceeds from sale of old asset disposed, net of related tax

CONSIDER ALSO THE FOLLOWING, if any:
 Trade-in value of old asset
 Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax

Net Returns
 ACCRUAL BASIS: Accounting net income (after tax)
 CASH BASIS: Net cash inflows
 DIRECT METHOD (Cash inflows – Cash outflows)
 INDIRECT METHOD (Net income after tax + Noncash expenses)

CAPITAL BUDGETING TECHNIQUES IN EVALUATING PROJECTS

 Non-discounted methods – methods that do not consider the time value f money
a. Payback period method c. Bail-out payback method
b. Payback reciprocal method d. Accounting rate of return method

 Discounted methods – methods that consider the time value of money

a. Net present value method c. Internal rate of return method
b. Profitability index method d. Present value payback method

CAPITAL BUDGETING TECHNIQUES

I. NON-DISCOUNTED METHODS:

= Payback Period Method =

Payback period = Net initial cost of investment / Annual net after-tax cash inflows

Advantages:
1. Payback is simple to compute and easy to understand.
2. Payback gives information about the liquidity of the project.
3. It is a good surrogate for risk. A quick or short payback period indicates a less risky project.

Disadvantages:
1. Payback does not consider the time value of money.
2. It gives more emphasis on liquidity rather than on profitability of the project.
3. It does not consider the salvage value of the project.
4. It ignores cash flows that may occur after the payback period (short-sighted)

= Payback Reciprocal =

Payback reciprocal = Net cash inflows / Investment

= 1 / Payback period

= Bail-out Payback Period =

It is a modified payback period method wherein cash recoveries include the estimated salvage value at the end of each year of
the project life.

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 = Accounting Rate of Return Method =

Accounting rate of return (ARR) = Average annual net income / Investment *

* may be based on original or average investment.

Advantages:
1. The ARR closely parallels accounting concepts of income measurement and investment return.
2. It facilitates re-evaluation of projects due to ready availability of data from the accounting records.

Disadvantages:
1. Like traditional payback methods, the ARR method does not consider the time value of money.
2. With the computation of income and book value based on the historical cost accounting data, the effect of inflation is ignored.

Other terms used to denote the ARR:

 Book value rate of return  Approximate rate of return method

 Unadjusted rate of return  Financial statement rate of return method
 Simple rate of return  Average return on investment

II. DISCOUNTED METHODS

The time value of money is an opportunity cost concept. A peso on hand today is worth more than a peso to be received
tomorrow because of interests a peso could earn by putting it in a savings account or placing it in an investment that earns income. The
time value of money is usually measured by using a discount rate that is implied to be the interest foregone by receiving funds at a later
time.

= Net Present Value Method =

Net present value = Present value of cash inflows – Present value of cash outflows

 Cash inflows include cash infused by the capital investment project on a regular basis (e.g., annul cash inflow) and cash
realizable at the end of the capital investment project. (e.g., salvage value, return of working capital requirements)
 The net investment cost required at the inception of the project usually represents the present value of the cash outflows.

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as reinvestment rate

Disadvantages:
1. It requires determination of the costs of the discount rate to be used.
2. The net present values of the different competing projects may not be comparable because of differences in magnitudes or
sizes of the projects.

= Profitability Index Method =

Profitability index = Present value of cash inflows / Present value of cash outflows
NPV index = NPV / Investment

The profitability index method is designed to provide a common basis of ranking alternatives that require different amounts of
investment.

Note: Profitability index method is also known as desirability index, present value index and benefit-cost ratio.

= Internal Rate of Return Method =

IRR is the rate of return that equates the present value of cash inflows to present value of cash outflows. It is also known as
discounted cash flow rate of return, time-adjusted rate of return or sophisticated rate of return.

Guidelines in determining IRR:

1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of the following formula:

PVF for IRR = Net investment cost / Net cash inflows

2. Using the present value annuity table, find on line ‘n’ (economic life) the PVF obtained in No. 1. The corresponding rate is the
IRR. If the exact rate is not found on the PVF table, ‘interpolation’ process may be necessary.

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes the true return of project

Disadvantages:
1. Assumes that IRR is the re-investment rate.
2. When project includes negative earnings during its life, different rates of return may result.

ILLUSTRATIVEE PROBLEMS:

PROBLEM 1: Net Investments for Decision-Making

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 Bicol Company plans to replace a unit of equipment that was acquired three (3) years ago and is now recorded at a book
value of P65,000. This equipment can be sold now for P75,000. Tax rate is 25%.

New equipment can be acquired from Baguio Company at a list price of P200,000. Baguio will grant a 2% cash discount if the
equipment is paid for within 30 days from acquisition date. Shipping, installation and testing charges to be paid are estimated at
P14,000.
Other assets with a book value of P12,000 that are to be retired as a result of the acquisition of the new machine can be
salvaged and sold for P10,000.

Additional working capital of P18,000 will be needed to support operations planned with the new equipment.

The annual cash flow after income tax from the operation of the new equipment has been estimated at P50,000. The
equipment is expected to have a useful life of 5 years with a salvage value of P4,000 at the end of 5 years.

Required: What is the initial cost of investments for decision-making purposes?

PROBLEM 2: Capital Budgeting Techniques

CORONA Company considers the replacement of some old equipment. The cost of the new equipment is P90,000, with a useful life
estimate of 8 years and a salvage value of P10,000. The annual pre-tax cash savings from the use of the new equipment is P40,000.
The old equipment has zero market value and is fully depreciated. The company uses a cost of capital of 25%.

Required: Assuming that the income tax rate is 40%, compute for the following:
1. Payback period
2. Payback reciprocal
3. Accounting rate of return on original investment
4. Accounting rate of return on average investment
5. Net present value
6. Profitability index
7. Internal rate of return (ignoring the cash inflow at the end of the asset’s life from salvage value)
8. Present value payback
9. Bailout payback assuming the following salvage values at the end of each year:
Year 1: P50,000; Year 2: P40,000; Year 3: P35,000; Year 4: P30,000; Year 5: 25,000; Year 6: P15,000; Year 7: P12,000; Year
8: P10,000
10. Payback period assuming that the annual post-tax net cash flow is expected to increase by P5,000 per year.

EXERCISES
I. PROBLEM-SOLVING

PROBLEM 1: Pole Company has an investment opportunity costing P90,000 that is expected to yield the following cash flows over the
next five years: (assume a cut-off rate of 30%)
Year 1: P40,000 Year 2: P35,000 Year 3: P30,000 Year 4: P20,000 Year 5: P10,000

Required:

1. Payback period in months

2. Book rate of return

PROBLEM 2: A project costing P180,000 will produce the following annual cash flows an salvage value:

Year Cash Flows Salvage Value

1 P 50,000 P 65,000
2 P 50,000 P 50,000
3 P 50,000 P 35,000
4 P 50,000 P 20,000

Required: Compute for the bail-out payback period.

PROBLEM 3: Can Company plans to buy a new machine costing P28,000. The new machine is expected to have a salvage value of
P4,000 at the end its life of 4 years. The annual cash inflows before income tax from this machine have been estimated at P11,000.
The tax rate is 20%. The company desires a minimum return of 25% on invested capital.

Required: Determine the net present value. (Round-off factors to three decimal places)

PROBLEM 4: Zone Corp. is considering five different investment opportunities. The company’s cost of capital is 12%. Data on these
opportunities under consideration are given below:

Project Investment PV – Cash Flow NPV IRR (%) P. Index

1 P35,000 P39,325 P4,325 16 1.12
2 20,000 22,930 2,930 15 1.15
3 25,000 27,453 2,543 14 1.10
4 10,000 10,854 854 18 1.09
5 9,000 8,749 (251) 11 0.97

Required:
1. Rank the projects in descending order of preference according to NPV, IRR and benefit/cost ratio.
2. If only a budget of P55,000 is available, which projects should be chosen?

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PROBLEM 5: Mall Company is considering buying a new machine, requiring an immediate P400,000 cash outlay. The new machine is
expected to increase annual net after-tax cash receipts by P160,000 in each of the next five years of its economic life. No salvage value
is expected at the end of 5 years. The company desires a minimum return of 14% on invested capital.

Required: Round-off factors to three decimal places in all cases.

1. Payback period 4. Profitability index
2. ARR (based on original investment) 5. Internal rate of return
3. Net present value

PROBLEM 6: Fill in the blanks for each of the following independent cases. In all cases, the investment has a useful life of 10 years
and no salvage value. Round off factors to three decimal places.

Project Annual Cash Flow Investment Cost of Capital IRR NPV

1 P45,000 P188,640 14%
2 P75,000 12% 18%
3 P300,000 16% P81,440
4 P450,000 12% P115,000

PROBLEM 7: Moon Corporation is planning to buy cleaning equipment that can reduce service cost and other cash expenses by an
average of P70,000 per year. The new cleaning equipment will cost P100,000 and will be depreciated for 5 years on a straight-line
basis. No salvage value is expected at the end of the equipment’s life. Income tax is estimated at 32%.

Required: Determine the net cash inflows that will be generated by the project.

PROBLEM 8: The management of Star Cinema plans to install coffee vending machines costing P200,000 in its movie house. Annual
sales of coffee are estimated at 10,000 cups at a price of P15 per cup. Variable costs are estimated at P6 per cup, while incremental
fixed cash costs, excluding depreciation, at P20,000 per year. The machines are expected to have a service life of 5 years, with no
salvage value. Depreciation will be computed on a straight-line basis. The company’s income tax rate is 30%.
Required: Assuming that the vending machines are installed, determine:
a. The increase in annual net income
b. The annual cash inflows that will be generated by the project.

II. TRUE OR FALSE; MULTIPLE-CHOICE

1. A project’s salvage value, realizable at the end of life of the project, is considered in the computation of the net investments for
decision-making purposes.
2. The payback period emphasizes the profitability of a capital project while the accounting rate of return, on the other hand,
emphasizes the project’s liquidity.
3. Annual cash inflows from the capital projects are measured in terms of
a. Income before depreciation and taxes c. Income before depreciation but after taxes
b. Income after depreciation and taxes d. Income after depreciation but before taxes
4. When computing for the accounting rate of return (ARR), which of the following is used?
a. Income before depreciation and taxes c. Income before depreciation but after taxes
b. Income after depreciation and taxes d. Income after depreciation but before taxes
5. The technique that does not use cash flow for capital investment decisions.
a. Payback b. NPV c. ARR d. IRR
6. Which of the following groups of capital budgeting techniques uses the time value of money?
a. Book rate of return, payback and profitability index c. IRR, ARR and PI
b. IRR, payback and NPV d. IRR, NPV and PI
7. Cost of capital is 3%; economic life in years = 4 years; simple PV factor for year 4 is
a. 0.915 b. 0.888 c. 0.455 d. 0.350
8. Discount rate is 11%; economic life in years = 3 years; PV annuity factor for 3 years is
a.0.731 b. 1.713 c. 2.444 d. 3.102
9. As the discount rate increases,
a. Present value factors increase c. Present value factors remain constant
b. Present value factors decrease d. It is impossible to tell what happens to the factors
10. The PVF of any amount at year zero or zero percent is always equal to
a. Zero b. 0.50 c. 1.00 d. cannot be determined
11. The present value of P50,000 due in five years would be highest if discounted at a rate of
a. 0% b. 10% c. 15% d. 20%
12. An investment with a positive NPV also has
a. A positive PI b. A PI of one c. A PI less than one d. A PI greater than one
13. A company is considering the purchase of an investment that has a positive NPV based on a 12% discount rate of. What is the
IRR?
a. Zero b. 12% c. Greater than 12% d. Less than 12%
14. Which of the following combinations is possible?
Profitability index NPV IRR
a. >1 Positive = cost of capital
b. >1 Negative < cost of capital
c. <1 Negative < cost of capital
d. <1 Positive < cost of capital
15. The NPV method assumes that the project’s cash flows are reinvested at the
a. Internal rate of return b. Simple rate of return c. Cost of capital d. Payback period

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16. The internal rate of return method assumes that the project’s cash flows are reinvested at the
a. Internal rate of return b. Simple rate of return c. Required rate of return d. Payback period
17. Which one of these methods is a project ranking method rather than project screening method?
a. NPV method b. Simple rate of return c. Profitability index d. Sophisticated rate of return
18. If the IRR on an investment is zero,
a. Its NPV is positive c. It is generally a wise investment
b. Its annual cash flows equal its required investment d. Its cash flows decrease over its life