Characteristics of Capital Investment Decisions

Investment- means any project for which the firm spends a certain amount and from
which it (the firm) expects something in return.
1. Capital investment decisions usually require relatively large commitments of
resources.
2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short-term
decisions.

The capital investment process

1. Identification of Potential Projects- Potential projects came from the proposals
submitted by the managers of the different divisions or departments of the company
that will be evaluated by top management.
2. Estimation of Costs and Benefits Managers submit their proposals accompanied by
the estimates of expected costs that the firm would incur for the project as well as the
expected revenues or cost savings that may be derived from the project.
3. Evaluated of Proposed Projects- Proposals are evaluated in the light of the
organizational goals and policies.
4. Development of the Capital Expenditure Budget - Consists of all capital investment
project proposals that have been approved for the budget period.
5. Reevaluation of Projects

Capital expenditure or investment projects can be generally classified as follows:

1. Replacement When an existing capital investment item becomes obsolete or suffers
irreparable damage.
2. Improvement Management may consider the improvement of a certain product or
process.
3. Expansion Involves enlargement of facilities, setting up additional business segment
and invasion of new markets.
Dependent or contingent proposals the acceptance of one proposal is dependent on the
acceptance of one or more potentials.
Mutually exclusive projects acceptance of one proposal will mean automatic rejection of
another proposal.

EVALUATIGN CAPITAL INVESTMENT PROJECTS

Capital investment factors

1. Net investment- net cost of investment is defined as the net outflow of cash, a
commitment of cash, or the sacrifice of an inflow of cash
Costs or cash outflows
a. Initial cash outlay
Purchase price of an asset
Incidental project-related costs
b. Working capital requirement
c. Market value of an existing, currently idle asset
Savings or Cash Inflow
a. Trade-in value of old asset
b. Proceeds from sale of old asset to be disposed
c. Avoidable cost of immediate repairs on old asset to be replaced
In case of replacement projects, the book value of the asset to be replaced is
not included in the computation of the net cost of investment because such
book value is a sunk cost thus, irrelevant.
For decision making purposes:
1. Includes all cash outlays necessary to carry out the project
2. Working Capital or net current asset committed to the project is included
3. Includes opportunity cost
4. Historical or sunk costs are excluded
5. The net proceeds or trade-in value of assets to be disposed are deducted
from the purchase price of the new asset to be acquired
6. Considers time value of money
In financial accounting
Must be in accordance with GAAP. Distinctions between capital and revenue
expenditures must be considered.
Working capital components have their own place in the balance sheet,
these are not capitalized as fixed asset. Opportunity costs are not recorded
in the books of accounts. Historical costs are taken up in financial accounting
records. These items are taken up separately in the Fin.Acc. records. Time
value of money is usually disregarded in the financial accounting records.

Illustrative example:
1. The management of NADULPIT FITNESS CENTER is planning to replace an
old slimming machine which was acquired 5 years ago at a cost of
P30,000. The old machine has been depreciated to its salvage value of
P4,000. Nadulpit has found a buyer who is willing to purchase the old
slimming machine for P6,000.

The new machine will cost P50,000. Incidental costs of installation,

freight and insurance will have to be incurred at a total cost of
P10,000.
Should the company decide to retain the old slimming machine
that must be upgraded and subjected to major repairs. The
estimated cost of this repairs expense amounts to P8,000. The
income tax rate is 35%.
Required: Compute the net cost of investment in the new machine
for decision making purposes.
Purchase price of the new machine
P50,000
Add incidental costs of installation, freight and insurance 10,000
Total cost/cash outflow
60,000
Less savings/cash inflows:
Proceeds from the sale of old machine
6,000
Less tax on the gain on sale
700 5,300
Proceeds on sale, net of tax
8,000
Avoidable cost of repairs on old machine
2,800
Less income tax
Avoidable cost of repairs,net of tax
5,20010,500
Net cost of investment
49,500
2. Assume that instead of selling the old machine for P6,000, Nadulpit will
sell it only for P3,000. How will this affect the computation?
Cash inflows/savings:
Proceeds from the sale of old machine

P3,000

Add tax savings due to loss on sale

Proceeds
Less book value

Loss on sale
X Tax rate

Proceeds from sale of old machine incl. tax savings due to loss on
sale

3. Assume that instead of selling the old machine, Nadulpit will just trade it
in with a new one. Assume that the dealer of the new machine will grant

a trade-in allowance of P5,000 for the old asset. How will this affect the
computation?

NET RETURNS

Accounting Net Income refers to the net income expected to be earned from project being
evaluated.
Net Cash Flow- It involves only the cash revenues, costs, and expenses

Example:

Pinky Company plans to buy a new machine to increase its plants productive capacity. The
new machines estimated installed cost is P50,000. It is expected to have no salvage value at
the end of its useful life of 5 years.
Based on Pinkys projections, the new machine can produce 100,000 units of product per
year. Because of the high demand for this product which the company sells at P5 each, it is
expected that all the units produced will be sold.
Relevant production, selling and administrative costs related to the product amount to P3
each, exclusive of depreciation. The company pays income tax at the rate of 35% of taxable
income.
Required:
1. Accounting net income from the new machine
2. The net cash inflows from the project

Sales(100,000 units x P5) P500,000

Less costs and expenses:
Production,selling and administrative costs including depreciation (100,000 x P3)
De

300,000