AE24 Lesson 6: Analysis of Capital Investment Decisions

AE24
LESSON 6
Analysis of Capital Investment Decisions
November 16, 2020

Capital Budgeting Process
 Capital budgeting process – is a system of interrelated steps for
making long term investment.
Step 1 – Generating Project Proposals
 Capital Investment Decision

 A decision that involves an outlay in order to obtain a future return.
 Capital Investment Decision includes:

1. Replacement decisions to continuous current operations.
2. Replacement to effect cost reduction
3. Expansion into new products or market
4. Expansion of existing products or market
5. Equipment selection decisions
6. Safety and/or environmental projects
7. Mergers
8. Other projects
Categories of Capital Investment Decision
 Capital investment decisions fall into two broad categories:
1. Independent Capital investment projects or screening decisions
Examples:
o Investment in long-term assets such as property, plant and equipment
o New Product Development
o Undertaking a large scale advertising campaign
o Introduction of a computer
o Corporate Acquisition
2. Mutually exclusive capital investment projects of preference decisions.
 Replacement against renovation off equipment or facilities
 Rent or Lease against ownership facilities
 Manual bookkeeping system against computerized
 Preventive maintenance against periodic overhaul of machineries
Step 2 – Collecting Relevant Information about opportunities
 Capital Budgeting is a dynamic process because the firm’s changing
environment may affect the desirability of current or proposed
investment. Information is needed throughout the entire capital
budgeting process.
Step 3- Estimating Cash Flows

 Net Cash Flow is the difference between inflows and outflows of
cash that result from a firm undertaking a project.
 Cash Flows of a project fall into 3 categories:
1. Net Initial Investment
2. Net Operating Cash Flows or Returns
3. Net Terminal Cash Flow
Net Initial Investment
• Net investment is the net initial cash outlay needed to acquire a
specific investment project.
• General format for computing net investment follows:
Purchase Price of New Asset

+ Installation and transportation costs
+ Additional net working capital
- Proceeds from sale of old asset
+/- Tax effects on disposal of old asset
and/or purchase of new one
Net Investment
 Illustration 1.
Kiara Enterprises plans to add a new machine to increase
production capacity. The machine cost ₱180,000 plus ₱20,000
for installation and transportation costs and requires ₱40,000
additional working capital.
Required: Calculate the Net Investment.
 Illustration 2.
The management of Green Company plans to replace a sorting
machine that was acquired several years ago at a cost of ₱60,000.
The machine has been depreciated to its residual value of
₱10,000.
A new sorter can be purchased for ₱96,000. The dealer will grant a
trade-in allowance of ₱16,000 on the old machine. If a new
machine is not purchased Green Company will spend ₱10,000 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 at 40% of the income subject to tax.
Additional working capital required is ₱50,000
Required: Compute the net initial investment in this project.

Net operating Cash Flows or Returns
 Net Operating Cash flows are the incremental changes in a firm’s
cash flows that result from investing in a project.
 The cash returns are the inflows of cash expected from a project
reduced by the cash cost that can be directly attributed to the
project.
 This can be computed as follows:
Annual Incremental Revenue from the

project XX
Less: Incremental Cash Operating Costs XX
Annual Cash Inflow before taxes XX
Less: Taxes {Tax Rate x (Annual Cash Inflow
before taxes – Depreciation)} XX
Annual Net Cash Infow after taxes XX
Annual Incremental Revenue from the project XX
Less: Incremental Cash Operating Costs XX
Annual Cash Inflow before taxes XX
Less: Incremental Depreciation XX
Net Income Before Taxes XX
Less: Income Taxes XX
Net Income After Tax XX
Add: Incremental Depreciation XX
Annual Net Cash Infow after taxes XX
Illustration:
The Cagayan Division of Marilou Supply Company has been
considering a new production method that can reduce material costs
by an estimated amount of ₱52,000 a year. The new method is also
expected to result in an annual savings of labor and overhead
amounting to ₱40,000. Depreciation is estimated at ₱20,000 a year
over a period of 10 years. Income taxes are estimated at 30% of
income before taxes. What are the annual net returns expected from
the new production method?
Solution:
Savings on Material Cost 52,000
Savings on Labor and Overhead 40,000
Total Savings 92,000
Less: Depreciation 20,000
Net Income After Depreciation 72,000
Less: Income Tax – 30% 21,600
Net Income After Tax 50,400
Add: Depreciation 20,000
Annual Net Cash Inflow After Taxes 70,400
Step 4. Evaluating project proposals
 Capital investments are evaluated under certainty or risk.
 Under Certainty , the exact values are associated with the investment,
such as the cash flows, and the required rate of return, are known in
advance.
 Under Risk, variables required for evaluating investment proposals are not
certain and involve a margin of error.
Step 5. Selecting Project

 In theory, the firm should invest in new projects up to the point where the
rate of return from the last project is equal to the firm’s marginal cost of
capital.
 In practice, many factors, quantitative as well as qualitative, should be
given consideration before the final decision is made as to the selection of
a particular investment.
 The final selection of projects depends on 3 major factors:
1. Project type
2. Availability of funds
3. Decision Criteria
Step 6. Implementing and Reviewing Projects:
 The implementation stage involves developing formal procedures
for authorizing the expenditures of funds for capital projects,
 The review stage involves analyzing projects that have been
adopted in order to determine if they should be continued,
modified or terminated.
 The final aspect of capital budgeting process is the post audit
which involves:
 Comparing actual results with those predicted by the project’s
sponsors. And
 Explaining why any differences occurred
Capital investment decisions are highly significant due to
number of reasons, some of them are:
(a) Investment Linked with Objectives:
 An enterprise with an objective of survival and growth, incurs
capital expenditure every year and takes investment decisions
e.g., investment in fixed assets and inventory.
(b) Long Term Commitments:
 A capital project, like hydroelectric project is expected to bring
benefits in future years. Such projects require the commitment
of funds for future years, and draw the future direction by
determining its product, markets, production facilities and
technology.
(c) No-Going Back:
 It is difficult to reverse a capital project decision.
Techniques used in Capital Investment Decisions:
 For taking capital investment decisions, following

techniques are used to evaluate and select
the alternative methods:
1. Payback Period:
 This technique determines as to how long it will take (in years) to payback
invested capital.
 This period can be determined using the following formula:
 P = CI/R
 where, P = Pay-back period in year
 C I= Original capital investment
 R = Annual return expected i.e., total annual earnings after deducting taxes.
2. Present Worth Method:
 This method is more accurate and reasonable and is used to evaluate
the present value of new equipment. For the purpose of
comparison, future costs are translated into today’s money.
 A ‘present-worth peso’ is today’s value of money invested (at certain
interest rate) after given number of years from today.
 Formula:
 F = P (1 + i)n
 where, F = Worth of money in future
 P = Present amount of money
 i = Interest rate
 n = Number of years.
 Illustration:
We have ₱5000 to invest and we want to know what will be its worth in ten
years at 10 percent interest,
3. Rate of Return Method
 In this method, average annual net income (after tax and
depreciation deductions) is expressed as percentage of capital
investment.
 The formula used for this purpose is:
 Percentage rate of return = Earning per year/Net investment x 100}>
 Discounted Rate of Return:
 In this case, following formula is used:
 C = R / (1+r)n
 where, C = Investment cost
 R = Expected earning in nth year
 r = Rate of return.
 Let’s say you want to invest in a machine amounting to ₱50,000 with
estimated useful life of 5 years and estimated earnings of ₱13,000 per year.
What is your discounted rate of return?

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AE24

Analysis of Capital Investment Decisions

November 16, 2020

 Capital Investment Decision

 Capital Investment Decision includes:

Step 3- Estimating Cash Flows

Purchase Price of New Asset

Required: Compute the net initial investment in this project.

Annual Incremental Revenue from the

Step 5. Selecting Project

 For taking capital investment decisions, following

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