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52 visualizzazioni17 pagineManagement Accounting - Capital Budgeting

Jul 13, 2018

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Management Accounting - Capital Budgeting

© All Rights Reserved

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11 mi piace11 non mi piace

Management Accounting - Capital Budgeting

© All Rights Reserved

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Case 1

Kendra Enterprises plans to add a new machine to increase

production capacity. The machine cost P180,000 plus P20,000

for installation and transportation costs and requires P40,000

additional working capital.

Installation and transportation costs ₱ 20,000

Additional net working capital ₱ 40,000

Net Investment ₱ 240,000

Installation and transportation ₱ 20,000

Depreciable basis ₱ 200,000

Add: Installation and transportation costs

Add: Additional net working capital

Less: Proceeds from sale of old asset

Add/Less: Tax effects on disposal of old asset

And/or the purchase of new one

Net Investment

NET OPERATING CAS

The management of Maingat Company plans to replace a sorting The Visayan Division o

machine that was acquired several years ago at a cost of P60,000. considering a new prod

The machine has been depreciated to its residual value of P10,000. materials costs by an e

The new method is als

A new sorter can be purchased for P96,000. The dealer will grant a of labor and overhead

trade-in allowance of P16,000 on the old machine. If a new machine is the estimated depreci

not purchased, Maingat Company will spend P10,000 to repair the old over a period of ten ye

machine. Gains and losses on trade-in transactions are not subject to of income before incom

income taxes. The cost to repair the old machine can be deducted in (or savings) expected f

computing income taxes. Income taxes are estimated at 40% of the

income subject to tax. Additional working capital required is P50,000. Solution:

Annual savings in direc

Required: Compute the net initial investment in this project. Annual savings in direc

Total savings before de

Solution: Less:

Purchase price of new sorter ₱ 96,000 Savings after depreciat

Add: Additional working capital ₱ 50,000 Less:

Total ₱ 146,000 Net increase in income

Less: Trade-in allowance on old sorter ₱ 16,000 Add:

Avoidable repairs cost on old sorter Net cash returns (savin

(net of increase in income taxes) ₱ 6,000 ₱ 22,000

Net Investment ₱ 124,000

NET OPERATING CASH FLOWS OR RETURNS

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 method amounting to P64,000 and

the estimated depreciation at P60,000 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 ₱ 52,000

Annual savings in direct labor and overhead costs ₱ 64,000

Total savings before depreciation ₱ 116,000

Depreciation ₱ 60,000

Savings after depreciation ₱ 56,000

Incremental income taxes (30%) ₱ 16,800

Net increase in income ₱ 39,200

Depreciation ₱ 60,000

Net cash returns (savings) ₱ 99,200

CONCEPT OF NET INVESTMENT COSTS CAPITAL BUDGETING

INVESTMENT PROPO

A company is considering to replace Machine A with Machine B. Assume that Great Com

Machine B will cost P150,000 and will result in annual savings of P40,000 which will be depreciate

before tax because of expected increase in operating efficiency. Machine B The machine will gener

has an estimated useful life of 10 years and salvage value of P10,000. Great will not incur add

Machine A has a book value of P16,000 and a disposal value of P20,000 now. tax rate is 35%.

Straight line depreciation is used and the company has an average income tax

rate of 35%. Required:

1

Required: Determine the Net Investment 2

3

Solution: 4

Net Investment: 5

Cost of Machine B ₱ 150,000

Adjustment: Solution:

Proceeds from disposal of Machine A ₱ (20,000) 1

Tax on gain ₱ 1,400

Net investment cost ₱ 131,400

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 Rate

if the problem is silent: 𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)

4 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜�=

𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)

5

CAPITAL BUDGETING TECHNIQUES IN EVALUATING CAPITAL

INVESTMENT PROPOSALS

which will be depreciated on a straightline basis over a ten-year period.

The machine will generate additional cash revenues of P12,000 a year.

Great will not incur additional costs except for depreciation. The income

tax rate is 35%.

Required:

Determine the net income after tax

Determine the accounting rate of return (ARR)

Determine the after tax annual cash flow

Determine the payback period and the payback reciprocal

Determine the payback bailout period.

Solution:

Incremental Cash revenues per year ₱ 12,000

Less: Annual depreciation ₱ 6,000

Taxable Income ₱ 6,000

Income tax ₱ 2,100

Net Income after tax ₱ 3,900

𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)

𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)

Income tax ₱ 2,100

Annual Cash Flow after tax ₱ 9,900

𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)

𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡)

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑅𝑒𝑐𝑖𝑝𝑟𝑜𝑐𝑎𝑙=(𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)/(𝑁𝑒𝑡

𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡)

16.5%

5.1

In some cases cash inflows are not equal throughout the life of investments.

In such cases the computation of payback period will be different from what

has been presented. Assume the following cash inflow patterns:

Cash flows:

Year 1 ₱ 20,000

Year 2 ₱ 40,000

Year 3 ₱ 20,000

Year 4 ₱ 10,000

Net cash inflows

Year Initial Each year Cumulative

Investment Unrecovered cost

0 ₱ (60,000) 0 ₱ (60,000)

1 ₱ 20,000 ₱ (40,000)

2 ₱ 40,000 ₱ -

3 ₱ 20,000 ₱ 20,000

4 ₱ 10,000 ₱ 30,000

The payback period is exactly two years. But in some cases, the payback

period may not happen at an exact number of years.

payback will be presented as follows:

Year Initial Each year Cumulative

Investment Unrecovered cost

0 ₱ (62,000) 0 ₱ (62,000)

1 ₱ 20,000 ₱ (42,000)

2 ₱ 40,000 ₱ (2,000)

3 ₱ 20,000 ₱ 18,000

4 ₱ 10,000 ₱ 28,000

Notice that on the second year, the initial investment was almost

recovered and only a small portion of the next year's cash inflow

is needed to fully recover the initial investment. Thus, the exact

payback can be computed using the following formula:

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜�=2 𝑦𝑒𝑎𝑟𝑠+ 2,000/20,000

Average CF ₱ 22,500

Divided by Net Investment cost ₱ 62,000

Payback Reciprocal 36.29%

6 Payback bailout period:

1 ₱ 40,000

2 ₱ 35,000

3 ₱ 30,000

4 ₱ 25,000

5 ₱ 20,000

6 ₱ 15,000

7 ₱ 10,000

8 ₱ 5,000

9 ₱ 2,000

10 ₱ -

Year Net Annual Cumulative Scrap Value Total value

cash flow net cash inflow recovered

0

1 ₱ 9,900 ₱ 9,900 ₱ 40,000 ₱ 49,900

2 ₱ 9,900 ₱ 19,800 ₱ 35,000 ₱ 54,800

3 ₱ 9,900 ₱ 29,700 ₱ 30,000 ₱ 59,700

4 ₱ 9,900 ₱ 39,600 ₱ 25,000 ₱ 64,600

5 ₱ 9,900 ₱ 49,500 ₱ 20,000 ₱ 69,500

6 ₱ 9,900 ₱ 59,400 ₱ 15,000 ₱ 74,400

7 ₱ 9,900 ₱ 69,300 ₱ 10,000 ₱ 79,300

8 ₱ 9,900 ₱ 79,200 ₱ 5,000 ₱ 84,200

9 ₱ 9,900 ₱ 89,100 ₱ 2,000 ₱ 91,100

10 ₱ 9,900 ₱ 99,000 ₱ - ₱ 99,000

Note that at year 3, initial investment is almost recovered. However, an exact Payback bail-out

could be computed similar to uneven returns as follows:

3.47 years Add

3.74 years

divided by

Total amount

recoverable

₱ (62,000)

₱ (12,100)

₱ (7,200)

₱ (2,300)

₱ 2,600

₱ 7,500

₱ 12,400

₱ 17,300

₱ 22,200

₱ 29,100

₱ 37,000

(Total value recovered on the year of recovery - Total value recovered prior to recovery)

THOSE THAT DO CONSIDER TIME VALUE OF MONEY

PROJECT 1 PROJECT 2

Cost of Capital 10% 10%

Amount of invesment ₱ 1,000 ₱ 1,000

Yearly Net Cash Inflows

Year 1 ₱ 500 ₱ 100

Year 2 ₱ 400 ₱ 300

Year 3 ₱ 300 ₱ 400

Year 4 ₱ 100 ₱ 600

₱ 1,300 ₱ 1,400

cash flows cash flows

PROJECT 1

0 1.00

1 ₱ 500 0.91 ₱ 454.55

2 ₱ 400 0.83 ₱ 330.58

3 ₱ 300 0.75 ₱ 225.39

4 ₱ 100 0.68 ₱ 68.30

₱ 1,300 ₱ 1,078.82

PROJECT 2 0 1.00

1 ₱ 100 0.91 ₱ 90.91

2 ₱ 300 0.83 ₱ 247.93

3 ₱ 400 0.75 ₱ 300.53

4 ₱ 600 0.68 ₱ 409.81

₱ 1,400 ₱ 1,049.18

DISCOUNTED CASH FLOW METHODS

NET PRESENT VALUE

Assume that a certain project will cost P6,075 and will earn cash inflows,

after tax, of P2,000 for four years with a minimum desired rate of return of 10%

Determine whether the project is acceptable or not by using the net present valu

(NPV) method.

PV of cash inflows 1 to 4 ₱ 2,000 3.1698654463

PV of cash outflows 0 ₱ (6,075) 1

Net Present Value

0 ₱ (6,075) ₱ (6,075)

1 ₱ 2,000 ₱ 1,800

2 ₱ 2,000 ₱ 1,800

3 ₱ 2,000 ₱ 1,800

Cumulative 4 ₱ 2,000 ₱ 1,800

Unrecovered cost

₱ (1,000)

₱ (545.45)

₱ (214.88)

₱ 10.52

₱ 78.82

₱ (1,000)

₱ (909.09)

₱ (661.16)

₱ (360.63)

₱ 49.18

INTERNAL RATE OF RETURN OR TIME ADJUSTED RATE OF RETURN

ll earn cash inflows, Using the same example, the PV factor is determined as follows:

sired rate of return of 10%

y using the net present value

P6,075 = P2,000 x PV Factor

₱ 6,339.73 IRR 12%

₱ (6,075.00)

₱ 264.73 Suppose the expected cash flow is P1,800 instead of P2,000.

Exact Rate 7% 8%

PV Factor 3.375 3.3872112565 3.31212684

IRR 7.16%

Looking in the PV factor table for the period Year 4, 3.375 is closest to 7%

which is 3.3872 and 8% which is 3.3121. The two interest rates where the

factor is between will be used as the guide in determining the IRR. So we

could say that the IRR is between 7% and 8%. However, to get an exact rate,

an interpolation of the two rates could be done as follows:

At 7% 3.3872 3.3872

PV factor 3.375

At 8% 3.3121

Difference 0.0751 0.0122

These computations become more complex if annnual cash inflows and outflows w

not uniform. Assume the following:

Cash inflows from operations for

Year 1 ₱ 20,000

Year 2 ₱ 40,000

Year 3 ₱ 60,000

At trial of 12%

Cash Present Value Total Present

Year Inflows Factor Values

1 ₱ 20,000 0.8928571429 ₱ 17,857.14

2 ₱ 40,000 0.7971938776 ₱ 31,887.76

3 ₱ 60,000 0.7117802478 ₱ 42,706.81

₱ 92,451.71

To interpolate:

Total Present Values

At 12% ₱ 92,451.71 ₱ 92,451.71

At true rate ₱ 90,000

At 14% ₱ 88,820.85

Difference ₱ 3,630.86 ₱ 2,451.71

13.34%

USTED RATE OF RETURN

mined as follows:

PROJECT 1

Cost of Capital 10%

Yearly Net Cash Inflows

Year 0 ₱ (1,000)

Year 1 ₱ 500

Year 2 ₱ 400

Year 3 ₱ 300

ad of P2,000. Year 4 ₱ 100

₱ 1,300

IRR 14.49%

r 4, 3.375 is closest to 7%

wo interest rates where the Table 1 If the cost of capital is equal to IRR

termining the IRR. So we

However, to get an exact rate, Year Loan Balance Cash flows

1 ₱ 1,000 ₱ 500

2 ₱ 644.89 ₱ 400

3 ₱ 338.33 ₱ 300

4 ₱ 87.34 ₱ 100

₱ 1,300

1 ₱ 1,000 ₱ 500

nnnual cash inflows and outflows were 2 ₱ 630.00 ₱ 400

3 ₱ 311.90 ₱ 300

4 ₱ 52.45 ₱ 100

₱ 1,300

₱ (90,000)

₱ 20,000 Table 3 If the cost of capital is greater than the IRR

₱ 40,000

₱ 60,000 Year Loan Balance Cash flows

1 ₱ 1,000 ₱ 500

At trial of 14% 2 ₱ 660.00 ₱ 400

Present Value Total Present 3 ₱ 365.60 ₱ 300

Factor Values 4 ₱ 124.10 ₱ 100

0.8771929825 ₱ 17,543.86 ₱ 1,300

0.7694675285 ₱ 30,778.70

0.6749715162 ₱ 40,498.29

₱ 88,820.85

PROJECT 2

10%

₱ (1,000)

₱ 100

₱ 300

₱ 400

₱ 600

₱ 1,400

11.79%

Payment applied to

Rate Interest Principal Loan Balance

14.49% ₱ 144.89 ₱ 355.11 ₱ 644.89

14.49% ₱ 93.44 ₱ 306.56 ₱ 338.33

14.49% ₱ 49.02 ₱ 250.98 ₱ 87.34

14.49% ₱ 12.66 ₱ 87.34 ₱ (0.00)

Payment applied to

Rate Interest Principal Loan Balance

13.00% ₱ 130.00 ₱ 370.00 ₱ 630.00

13.00% ₱ 81.90 ₱ 318.10 ₱ 311.90

13.00% ₱ 40.55 ₱ 259.45 ₱ 52.45

13.00% ₱ 6.82 ₱ 93.18 ₱ (40.73)

Payment applied to

Rate Interest Principal Loan Balance

16.00% ₱ 160.00 ₱ 340.00 ₱ 660.00

16.00% ₱ 105.60 ₱ 294.40 ₱ 365.60

16.00% ₱ 58.50 ₱ 241.50 ₱ 124.10

16.00% ₱ 19.86 ₱ 80.14 ₱ 43.95

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