CAPITAL

BUDGETING
Major Accounting Concerns:
 Net Cost of Investment
 Cost of Capital
 Net Returns
 Project Evaluation Techniques (PETs)
What is Capital Budgeting?
Isit worth it to put money
or “capital” into this
project?

Isit worth it to use money

to buy this machine?

Is it worth it to put money

in this business?
What is Capital Budgeting?
Basic Example:
Let’s say you’re thinking of borrowing
$1,000 from the bank at 5% interest to
buy a new machine for $1,000.
It will earn $400/year for 2 years.
It will break-down after 2 years, but
you can sell it for scrap at $300.
Will you win or lose money in this
project?
What is Capital Budgeting?
 Definition:
It deals with analyzing the long-term potential
(profitability) and cash-generating capability (liquidity) of a
given investment/project proposal.

 It is premised on the following assumptions:

1. Funds are available
2. Business opportunities (project proposals) awaiting to
be tapped
3. Business opportunities are subject to quantitative
evaluation.

 2 Characteristics of capital expenditure projects:

1. The amount involve is material (huge amount)
2. The project life-cycle extends beyond 1 year
What is Capital Budgeting?
Example Projects that need capital budgeting analyses:

 Replacement or Expansion Decisions:

1. Establish a branch or not
2. Purchase or lease a long-term asset
3. Introduce a new product or not
4. Develop a new channel of distribution or establish alliance woth existing
distribution channel

 Improvement or Retention Decisions:

1. Retain the old technology or introduce a new/modern technology
2. Improve channel of distribution or not

 Others:
1. Research and development
2. Exploration
3. New Projects
4. Internally develop a major marketing program or outsource services from
available service contractors
5. Similar strategic decisions
 Main Issues in Capital
Budgeting
 Net Cost of Investment
 Cost of Capital
 Net Returns
 Project Evaluation Techniques
(PETs)
NET COST OF INVESTMENT
 How much money is needed?
 Refers to the net cash outflows, after tax
considerations, that are paid by investors in
relation to the investing transaction
(Net COI = Cash Outflows – Cash Inflows)

 It includes opportunity costs such as

possible savings and tax effects on
possible gain, loss or savings on related
transactions
 NET COST OF INVESTMENT
1. +Net purchase price of the new asset
(net of discount, whether taken or not) P xx
2. +Directly attributable/incidental costs
to prepare (ready) the asset for use xx
3. +Increase in working capital base xx
4. -Proceeds from sale/trade-in allowance
from disposal of old asset (xx)
+ Tax effect on (+)gain or (-)loss on sale xx
5. –Savings from avoided repairs and maintenance
if the old asset is replaced (net of tax) (xx)
Net cost Of Investment P xx
 NET COST OF INVESTMENT
PROBLEM 1. Diliman Republic Publishers, Inc. is
considering replacing an old press that cost P800,000
six years ago with a new one that would cost
P2,250,000. Shipping and installation would cost an
additional P200,000. The old press has a book value
of P150,000 and could be sold currently for P50,000.
The increased production of the new press would
increase inventories by P40,000, accounts receivable
by P160,000 and accounts payable by P140,000.
Diliman Republic’s net initial investment for analyzing
the acquisition of the new press assuming a 35%
income tax rate would be
ANSWER: P2,425,000
 NET COST OF INVESTMENT
PROBLEM 2. Key Corp. plans to replace a production
machine that was acquired several years ago.
Acquisition cost is P450,000 with salvage value of
P50,000. The machine being considered is worth
P800,000 and the supplier is willing to accept the old
machine at a trade-in value of P60,000. Should the
company decide not to acquire the new machine, it
needs to repair the old one at a cost of P200,000. Tax-
wise, the trade-in transaction will not have any
implication but the cost to repair is tax-deductible. The
effective corporate tax rate is 35% of net income
subject to tax. For purposes of capital budgeting, the
net investment in the new machine is
ANSWER: P610,000
 NET COST OF INVESTMENT
PROBLEM 3. The Mabuhay Corporation plans to acquire a
new equipment costing P1,340,000 to replace the
equipment that is now being used. Freight charges on the
new equipment are estimated at P75,000 and it will cost
P90,000 to install. Special attachment to be used with this
unit will be needed and will cost P64,000. If the new
equipment is acquired, operations will be expanded and
will require additional working capital of P310,000. The old
equipment had a carrying amount of P45,000 and will be
sold for P25,000. If the new equipment is not purchased,
the old equipment must be overhauled at a cost of
P320,000. This cost is deductible for tax purposes in the year
incurred. Tax rate is 30%. Compute the net cot of
investment.
ANSWER: P1,624,000
 NET COST OF INVESTMENT
PROBLEM 4. Great Value Company is planning to purchase a
new machine costing P50,000 with freight and installation
costs amounting to P1,500. The old unit is to be traded-in will
be given a trade-in allowance of P7,500. Other assets that
are to be retired as a result of the acquisition of the new
machine can be salvaged and sold for P3,000. The loss on
retirement of these other assets is P1,000 which will reduce
income taxes of P400. If the new equipment is not
purchased, repair of the old unit will have to be made at an
estimated cost of P4,000. This cost can be avoided by
purchasing the new equipment. Additional gross working
capital of P12,000 will be needed to support operation
planned with the new equipment. The net investment
assigned to the new machine for decision analysis is
ANSWER: P50,200
Thank You!!!