THE

CPA
BOARD EXAMS
OUTLINES
by John Mahatma G. Agripa, CPA

MANAGERIAL ACCOUNTING

CAPITAL
BUDGETING
Based on lectures and materials
by Rodel Roque, CPA (CPAR)

DEFINITIONS

Capital budgeting is the evaluation, planning and financing of

capital investment initiatives those requiring large outflows of
resources and long-term commitments, and are usually risky and
difficult to reverse
Three important factors are in consideration in making capital
budgeting decisions cost of capital, net investment and net
returns

CAPITAL INVESTMENT FACTORS:

COST OF CAPITAL

Also referred to as the hurdle rate, required rate of return and cutoff rate, this is used by entities as a benchmark measure in
determining whether a particular capital investment initiative is
feasible, compared against a desired rate of return
However, cost of capital is only appropriate for capital investment
projects evaluated to be of average risk
There are separate formulas for computing the cost of capital for
different kinds of financing debt, and preference and ordinary
shares. If more than one source is present, the cost of capital is
expressed as a weighted average
Cost of capital (k) for long-term debt is computed as follows:
Yield to maturity rate
MULTIPLY: (1 tax rate)
Cost of capital, long-term debt (kd)

xx%
xx
xx

For preferred stock, the formula is as follows:

Preference dividend per share
DIVIDE: Current market price per share
Cost of capital, preferred stock (kp)

xx
xx
xx

Depending on data given, cost of capital for ordinary shares can be

computed with either the Gordon Growth Model or the Capital
Asset Pricing Model as follows. Floatation costs below refer to
those incurred in the issuance of new shares
Dividend next year
DIVIDE: Current market price (1 floatation costs)
ADD: Growth rate
Cost of capital, ordinary shares (kc)

xx%
xx
xx
xx%
xx

Risk-free rate
ADD: Beta (market return rate risk-free rate)
Cost of capital, ordinary shares (kc, CAPM)

xx%
xx
xx

As mentioned, if more than one source of capital is present, the

cost of capital is expressed in weighted average. The carrying
values of the debt and shares have to be restated to their current
fair values. Total capital refers to the total debt and
preference/ordinary shares
Cost of capital, capital #1
MULTIPLY: Proportion of capital #1 to total capital
Weighted average cost of capital, capital #1

xx%
xx
xx

The weighted average cost of capital of the respective sources of

capital has to be added for the total weighted average
To decrease overall cost of capital, entities usually rely more on
long-term debt than equity since it is cheaper. This is referred to as
trading on the equity

CAPITAL INVESTMENT FACTORS:

NET INVESTMENT

This is the monetary cost of the capital investment project as used

for decision-making purposes, composed of all acquisition-related
and relevant outflows less any cash inflows. The net investment
figure is used in different capital investment evaluation techniques

 Net investment can be computed as follows:

ADD ALL: Initial cash outlay
Incidental expenses to put asset to use
Working capital requirement
Tax from gains on disposal
Tax from any avoided costs/savings
Fair value of any asset to be used in project
CASH OUTFLOWS

xx
xx
xx
xx
xx
xx

ADD ALL: Trade-in value of old asset

Proceeds from disposal, net of tax from gains
Tax from losses on disposal
Avoided costs/savings, net of tax above
Reduction in working capital investments
DEDUCT: CASH INFLOWS
Net investment

xx
xx
xx
xx
xx

xx

xx
xx

If the capital investment project involves purchase of a long-term

asset, the amount to be placed above shall follow rules of
recording PPE, such as removing purchase discounts from the
price whether the discount was taken or not

CAPITAL INVESTMENT FACTORS:

NET RETURNS

The net returns of an investment project can either be expressed as

net cash inflows (cash basis) or net income (accrual basis), both of
which can be computed as follows:
Annual cash inflows, after-tax, before depreciation
ADD: Tax savings from depreciation
Net cash inflow
DEDUCT: Depreciation expense
Net income

xx
xx
xx
xx
xx

Before depreciation mean that depreciation expense must not be

deducted from the annual cash inflows
The figures used are incremental (the effects from the capital
investment only) not the total annual cash flow from the entire
operation

CAPITAL INVESTMENT EVALUATION:

UNDISCOUNTED TECHNIQUES

The capital investment factors figures are to be used in all the

capital investment evaluation techniques, which either use the
time value of money principle or not
The payback period gives information about a projects liquidity
when will the initial investment be recovered (thus prioritizing
return of investment, than return on investment) computed as
follows:
Cost of investment
DIVIDE: Net annual cash inflows
Payback period (in years)

xx
xx
xx

This formula is only used when the inflows are uniform over the
years, otherwise the running balance of cash to date is used. The
computed payback period will be compared against the period set
by company policy to determine feasibility. If none exists, a rule of
thumb exists that a project is feasible if the payback period is not
more than of the assets life
Payback bailout period, on the other hand, considers salvage value
and pinpoints when it is best to dispose of the asset as to not incur
any loss
The cumulative cash inflow as of the year is added with the salvage
value (for that year) and compared against the remaining balance
of the initial investment. When it reaches the balance, the bailout
year is reached. The fraction of the year is determined as follows:
Remaining balance at the year of bailout
DEDUCT: Residual value

xx
xx
xx
DIVIDE: Annual net cash inflow in the year of bailout xx
Fraction of year
xx

Remember that only the salvage value for the year is relevant.
Previous salvage values are ignored

 Accounting rate of return, also called unadjusted rate of return or

return on investment, is the only technique that uses net income.
ARR is compared against the cost of capital or any other desired
rate of return to judge feasibility. The rate is computed as follows:
Net income, after tax
DIVIDE: Cost of investment
Accounting rate of return

xx
xx
xx%

The cost of investment figure is usually the initial balance, not the
average, since it would result in a higher rate of return

CAPITAL INVESTMENT EVALUATION:

DISCOUNTED TECHNIQUES

Among the more popular evaluation techniques, net present value

determines all cash inflows and outflows at year zero by
discounting future inflows and outflows. The rate to be used in
discounting shall be a desired rate of return, which may not always
be the cost of capital
Present value of all cash inflows
DEDUCT: Cost of investment, future outflows at PV
Net present value

xx
xx
xx

Cash inflows for NPV purposes are composed of the following.

Each is discounted using present value of 1 or present value of
ordinary annuity/annuity due depending on their inflow pattern
and when the inflows occur
Inflows from operations, after tax (PVOA)
ADD: Salvage value, gross of tax (PV of 1)
ADD: Working capital released (PV of 1)
Present value of all cash inflows

xx
xx
xx
xx

In usual cases and if silent, since salvage value is involved in

computing depreciation, tax is not deducted from it in computing
inflows. If salvage value is ignored, salvage value shall be net of
tax. This is because when the asset is sold, the entity would record

a gain equal to the salvage value

A positive NPV indicates a feasible project, but this is not the
reason. The project is feasible because its inflows exceed the
outflows, not because the NPV is positive
Profitability/Desirability index is useful when comparing
alternative capital investment proposals with different costs of
investment, computed as follows:
Present value of all cash inflows
DIVIDE: Cost of investment
Profitability/desirability index

xx
xx
xx

Projects with indices more than one are desirable, but the one with
the highest profitability index must be chosen
The internal rate of return is considered the breakeven rate where
the present value of cash inflows match that of outflows, resulting
to a zero NPV. This is also called as time-adjusted/discounted
cash flow rate of return
The first step is to determine the present value factor that
corresponds to the IRR, which is computed using the same formula
as payback period. Since determining the exact IRR is such a
complex process, only the range within which the present value
factor is found is determined. The range is determined using trialand-error with the present value formulas. Remember that as the
rate increases, the present value factor decreases. You must
obtain figures (positive, negative) as close as possible to the total
cash outflows to get the range
Another means to approximate the IRR is the payback reciprocal (1
payback period), used only when the cash inflows are uniform
and the assets life is at least twice its payback period