**Capital budgeting**is the process of planning and controlling investments for long-term projects and programs.

**The costs that are considered in capital budgeting analysis include:**

**Avoidable cost**– cost that may be eliminated by ceasing an activity or by improving efficiency.**Common cost**– cost that is shared by all options and is not clearly allocable to any one of them.**Weighted-average cost of capital**– is the weighted average of the interest cost of debt (net of tax) and the implicit cost of equity capital to be invested in long-term assets. It represents a required minimum return of a new investment to prevent dilution of owners’ interest.**Deferrable or Postponable cost**– cost that may be shifted to the future with little or not effect on current operation.**Fixed cost**– cost that does not vary with the level of activity within the relevant range.**Imputed cost**– cost that does not entail a specified peso outlay formally recognized by the accounting system, but its nevertheless relevant to establishing the economic reality analyzed in the decision-making process.**Incremental cost**– is the difference in cost resulting from selecting one option instead of another.**Opportunity cost**– is the benefit forgone by not selecting the best**alternative**use of scarce resources.**Relevant cost**– future differential cost that vary with the action.**Sunk cost**– cost that cannot be avoided because expenditure or an irrevocable decision to incur the cost has been made.**Taxes**– tax consequences of an investment.

**Net investment**is the net outlay, or gross cash requirement, minus cash recovered from the trade or sale of existing assets, with any necessary adjustments for applicable

**tax**consequences.

**Net cash flow**is the economic benefit or cost, period by period, resulting from the

**investment**.

**Economic life**is the time period over which the benefits of the

**investment**proposal are expected to be attained, as distinguished from the physical or technical life of the asset involved.

**Depreciable life**is the period used for accounting and

**tax**purposes over which cost is to be systematically and rationally allocated. It is based upon permissible or standard guidelines and may have no particular relevance to economic life.

**Techniques that may be applied in evaluating capital investment proposals:**

**Discounted cash flow approaches:**

**Discounted or Internal rate of return.**This is an

**interest rate**computed such that the net present value (

**NPV**) of the

**investment**is zero. Hence the present value of the expected

**cash**outflows equals the present value of the expected

**cash**inflows.

**Investment = Annual cash inflow x Present value factor**

**Net Present Value**– this is the difference between the present value of the estimated

**net cash inflows**and the

**present value**of the

**net cash outflows.**

**Excess Present Value or Profitability Index**– this is the ratio of the present value of the future net

**cash**inflows to the present value of the initial

**investment**.

**PV Index**= Present value of Cash Inflows

**/**Present value of

**Cash Outflows**

**Nondiscounted Cash Flow Approaches**

**Payback Period**– this is the number of years required to complete the return of the original

**investment**. It is computed as follows:

**Payback period**= Investment

**/**Annual

**cash**inflows

**Accounting Rate of Return (ARR)**– this is the increase in accounting net income divided by the required

**investment**. This is computed as follows:

**ARR**= Average

**cash**inflow – Depreciation

Investment

Under the time-adjusted rate of return capital budgeting technique, it is assumed that

**cash**flows are reinvested at the**rate earned by the investment.**
The net present value capital budgeting technique can be used when

**cash**flows from period to period are**uniform**and**uneven.****Time-adjusted rate of return**is a capital budgeting techniques that assumed that

**cash**flows are reinvested at the rate actually earned by the

**investment**.

The net present value and internal rate of return methods of capital budgeting are superior to the payback method in that they:

**consider the time value of money.**
The payback method measure:

**how quickly investment pesos may be recovered.**
The capital budgeting method that divides a project’s annual incremental net income by the initial

**investment**is the :**Simple (or accounting) rate of return method.**
The relevance of a particular cost to a decision is determined by:

**potential effect on the decision.**
The term that refers to costs incurred in the past that are not relevant to a future decision is

**sunk cost.**
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