Resa - De Review School of Gecowmtomeg, © Momegemont Services \ MS-10: CAPITAL BUDGETING involves significant commit extended period of time. Example: purchase of equipment for expansion, replacement of old equipment CHARACTERISTICS OF CAPITAL INVESTMENTS + As to COST usually involves large expenditure of resources, relative to business size 1 ASIC COMMITMENT usually funds invested are tied up for a long period of time 1 ASI FLEXIBILITY usually more difficult to reverse than short-term decisions + AS to RISK usually involves so much risks and uncertainties due to operational and economic changes over an extended period of time CAPITAL INVESTMENT - tment of funds to receive a satisfactory return over an CAPITAL BUDGETING ~ is the process by which management identifies, evaluates, and makes decision on Capital investment projects of an organization’ Typical capital budgeting process Wolves the following 3 steps: Identification) ————» (Evaluation > © Decision Making Capital Investment Decisions: =_FACTORS OF CONSIDERATION [-> Replacement (Equipment) [> Improvement (Products) a [-> Expansion (Facilities) "Net Investments Net Returns Costs of Capital I> Addition (Technology) Ls Reduction (Costs) Hon-discounted methe Discounted methods Payback period ‘Net present value Bail-out payback Profitability index Accauating rate of return 2I rate of retur Payback reciprocal Present value payback CAPITAL INVESTMENT FACTORS 1) Met Investments (for decision-making purposes) + Costs less savings incidental to the acquisition of the capital investment projects + Cash outflows tess cash inflows incidental to the acquisition of the capital investment projects Costs or cash outflows 1. Purchase price of the asset, #et-of related-cash-discount 2. Incidental project-related expenses such as freight; insurance; handling; installation; testsrunsyete, CCONDISER ALSO THE FOLLOWING, if any: + Additional. working capital needed to support the operation of the project at the desired level + Market-value-of existing idle-assets to be used in the operation of the proposed capital project * ‘Training:cost,-net.of related tax Savings or Cash inflows Proceeds from: sale of-old-asset-disposed, net-of-related tax CONSIDER ALSO THE FOLLOWING, if any: + Trade-in value of old asset «Avoidable costof immediate: ifs On the old'asset-to'be:replaced,-net-of related tax 2) Net Returns » net ACCRUAL BASIS: Accounting net Income (after tax) + CASH BASIS: Net cash inflows @_ DIRECT METHOD ‘ Ned cash Inflows = Cash Inflows ~ Cash outflows INDIRECT METHOD [er cash infiows = Het income (oRer tox) + noncash expanses (egy aopracauon ewe) ]3) Costs of Capital y +The ‘costs:oF capital used-in-capital-budgeting: is th CHAE). These are specific costs of using long-term funds, obtained from the different sources: borrowed (debt) and invested (equity) capital. Sources costs Debt ‘After-tax interest rate* Preferred Stock (PS) _Dividend yield** ‘Common Stock (CS) __Dividend yield plus growth rate Retained Earnings (RE) _Dividend yield** plus growth rate * The after-tax cost of debt is computed based on: interest yield rate (1 ~ tax rate) ** Dividend yield = dividend per share + price per share 1d RE = Expected cash dividend per share th rate cet price per common share —_* Dividend grow Cost of CS and RI > The dividend growth-rate: imed;to be consta mye * In computing cost of CS°& PS;-the market price should be= - (eg, underwriting fees). > In computing the cost of RE, any flotation cost should be ignored : > Alternatively;:thé: cost: of equity:capital-may-be-computed: based-on-Capital-Asset: Pricing Mode! (CAPM): > Refer to page 4 of MSQ ~ 10 for detailed discussions on CAPM and the Dividend Growth Model. ‘Other terms used to denote the weighted average cost of capital (WACC): > Minimum required rate of retura Minimum acceptable rate of return Cut-off rate Target rate Desired rate of return Standard rate Hurdle rate veevvey CAPITAL BUDGETING TECHNIQUES + Non-discounted methods - do not consider the time value of money 1. Payback period method 2. Bail-out payback method 3. Accounting rate of return method 4. Payback reciprocal method * Discounted methods - consider the time value of money 1. Net present value method 2. Profitability index method 3. Internal rate of return method 4. Present value payback method NON-DISCOUNTED TECHNIQUES Net initial cost of investment. Payback Period = —“Annual net after-tax cash inflows Advantages; 1. Payback Is simple to compute and easy to understand. 2. Payback gives information about the fiquidity of the project, 3, It is a good surrogate for risk. A quick or short payback period indicates a less risky project. Disadvantages: 1. Payback does not consider the time value of money. All cash received during the payback period is assumed to be of equal value of in analyzing the project, It gives more emphasis on liquidity rather than on profitability of the project, In other words, more emphasis js.aiven of 2 ornate solve. SU tei lave tpenl ral he 3. Te does nol consider the saliage vate of the project at 4. It Ignores cash flows that may occur after the payback period (short-sighted) Bailout Payback Period a modified payback period method wherein cash recoveries jacluc : i "_gstimated salvage value atthe end oteachyear of the project Mi| Accounting Rate of Return (ARR) ~Fverage annoarne Tevestinent™ ‘* may. be based on original or average investment. =] 1. The ARR closely parallels accounting concepts of income measurement and investment return. 2. It facilitates re-evaluation of projects due to ready availability of data from the accounting records, 3. This method considers income over the entire life of the project. 4. Itindicates and emphasizes the project's profitably. Disadvantages: 1. Like traditional payback methods, the ARR method does not consider the time value of money. 2. With the computation of income and book value based on the historical cost accounting data, the offect of inflation js. ignored > Book rate of return > Approximate rate of return method > Unadjusted rate of return > Financial statement rate of return method > Simple rate of return | Paybact Reciprocal = “neuer a Payback-reciprocalis @ reasonable .estimate-of: the discounted “cash: flow-rate’ of ‘return: (a:K.a“IRR) provided that the follow : the payback pariog. Lik 2 waPB pel 1. The 2. ‘the: throughout: the life-of the project, DISCOUNTED TECHNIQUES The dim: z is_an opportunity cost‘concept. A peso on hand today is worth more than a eso to be received tomorrow Because of interests a peso could earn by’putting it ina savings account Or placing it in an investment that earns income. The time value of money is usually measured by using a discount cate thet is implied to.he the interest foregone by receiving funds at a later time 2t Present Value (NPV) = * Cash inflows include cash infused by the capital investment project on a regular basis (e.g., annual cash inflow) and cash realizable at the end of the capital investment project, (e.9., salvage value, return of working capital réquirements) * The-net-investment--cost-required: at-the- inception -of -the-project-usually- represents: the present-value-of the cash outflows. Advantages: 1. Emphasizes cash flows 2. Recognizes the time value of money , 3. Assumes discount rate as reinvestment rate Disadvantages: 1. It requires determination of the costs of capital or the discount rate to be used, 2. The net present values of different competing projects may not be comparable because of differences in magnitudes or sizes of the projects. itty i i Ade @ common basis of ranking alternati \e profitability index method is designed to prov 5 oF ranking alteenodiocs ue ouke different amounts of investment. NOTE: Profitability Index method is also known a5 desirability index, present value index and benefit. cost ratio.ts the tate of return that equates the present value Oo” ce resent valire of cash wn a Internal Rate of Return (IRR) Guidelines in determining IRR 1. Determine the present value factor (PVF) for the intemal rate of return (IRR) with the use of the following formula: [eee Net cash inflows. 2. Using the present value annuity table, find on line ‘n’ (economic life) the PVF obtained in No. 3. ‘The corresponding rate is the IRR. If the exact rate is not found on the PVF table, ‘interpolation’ process may be necessary. Aavantages: ‘1. Emphasizes cash flows, 2. Recognizes the time value of money 3. Computes true return of project Disadvantages: 1. Assumes that IRR Is the re-investment rate, 2. When project includes negative earnings during its if, different rates of return may result. EXERCISES: CAPITAL BUDGETING 1, NET INVESTMENTS FOR DECISION-MAKING Bag-You Company plans to replace a unit of equipment with a new one: a, * The old unit was acquired three years ago and is now recorded at a carrying value of P 65,000; xh $7 it-can be sold now at P 75,000, Tax rate is 25%. The new unit can be acquired at a list price of P200,000. A 2% cash discount is available if the equipment is paid for within 30 days from acquisition date. Shipping, installation and testing charges to be paid are estimated at 14,000. Other assets with a book value of P 12,000 that are to be retired as a result of the acquisition of the new machine can be salvaged and sold for P 10,000, . Additional working capital of P 23,000 will be needed to support operations planned with the new equipment. The annual cash flow from the operation of the new equipment has been estimated at P 50,000. Petwe, The equipment is expected to have a useful life of S years with a salvage value of P_4,000 at the end of 5 years. mg Gy feature Cash in Ciqnore) REQUIRED: ‘What is the initial cost of net investments for decision-making purposes? “P!5¢C00- 2. WEIGHTED AVERAGE COST OF CAPITAL (WACC) ‘Bee-Cool Company wants to determine the weighted average cost of capital that it can use to evaluate capital investment proposals. The company’s capital structure with corresponding market values follows: ‘8% Term Bonds P 600,000 #2, 5% Preferred stock (P 100 par) 200,000 10% ‘Common stock (no par, 10,000 shares outstanding) 400,000 2% Retained earnings 800,000 Yoy TOTAL tone 2,000,000 ~irp5 Additional data: 1) Current market price per share: > Preferred stock: P 50 » Common stock: 2) Expected common 3) Dividend growth rate: 4% 4) Corporate tax rate: 30% REQUIRED: rp eaiT 'A) Given an operating income of P 500,000, how much is the earnings per share? B) Determine the weighted average cost of capital, Ni Pls diene A) EPS? wrk Ave. C15 ‘outs Page 4 of 8 pagesSCUITION GUIDE to Item 2 Operating income 500,000 Pinterests (8%) Income before tax tax (30%) __ (135,600) Income after tax ~B316,400" 306,00" - preferred dividends (5%) (10,000) "°° = “10,000 shares > Regier: Income avaliable to common shares “P'306,400" esi 0 a ace 2% | FLEES): Soh lor | Sif CP values foo (2240) + Vo tot’ Weighted Average Cost of Capital 3. NET RETURNS (INCREASE IN REVENUES) Star-Luck Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee are estimated to be 10,000 cups at P15 per cup. Variable costs are estimated at P 6 per cup, while incremental fixed cash costs, excluding depreciation, at 20,000 per year. The machines are expected to have 2 service ife of 5 years, with no salvage value,” Depreciation will be computed on a straight-line basis. The company’s income tax rate is 30% REQUIRED: Determine te folowing ‘Ay ‘The icreawe in annual net micome. Pa/20- i. The annel cach Inflows that wil be generated by essrtekt Phzoo- 4. NET RETURNS (COST SAVINGS) ‘Moon-Use Corporation is planning to buy a high-tech machine that can reduce cash expenses by an average of P 70,000 per year. The new machine will cost P 100,000 and will be depreciated for 5 years on a straight-line basis. No salvage value is expected at the end of the machine’s life. Income tax rate is 20% of income, REQUIRED: ‘Determine the net cash inflows that will be generated by the project. “Plepco- 5, PAYBACK PERIOD & ARR (WITH EVEN CASH FLOWS) Green-ttiche Company considers the replacement of some old equipment. The cost of the new equipment is P 80,000, with a useful life estimate of 8 years and a salvage value of P 10,000. The annual pre-tax cash savings from the use of the new equipment isP 40,000.” The old equipment has zero market value and is fully depreciated. The company uses a cost of capital of 25%. Wresawore Sy en =e eonpicehen of PB pul REQUIRED: Assuming that the income tax rate is 40%, compute: “A) Payback period 2.2/y"S- 8) Accounting rate of return on original investment 2// _©) Accounting rate of return on average investment 2: 6. PAYBACK PERIOD & ARR (WITH UNEVEN CASH FLOWS) Pole-Land Company has an investment opportunity costing P 90,000 that is expected to yield the following.cash flovid over the next five years: (assume a hurdle rate of 30%) Ea fay fete eect Year 1 2 3 4 __10,000 135,000 ‘REQUIRED: 3 Fran payback period in months”Zomerths %B) Book rate of return GRR) 7. BAEL-OUT PAYBACK PERIOD ‘A project costing P 180,000 will produce the following annual cash flows and salvage value: Year Cashflows Salvage value 1 P 50,000 P 65,000 2 P 50,000 50,000 3 P 50,000 35,000. 4 P 50,000 20,000 REQUIRED: Pai-out payback period Page 5 of 8 pagesKeSQ - the Review School of Cecourdloncy MS-10 CAPITAL BUDGETING “ » 3 8. NET PRESENT VALUE (WITH UNIFORM CASH FLOWS) \ Bull-Can Company plans to buy a new machine costing P 28,000. The new machine is expected to have a salvage value of P 4,000 at the end of its economic life of 4 years. The annual cash inflows before income tax from this machine are estimated at P 11,000. The tax rate Is 20%. The company desires 3 minimum retum of 25% on invested capital, REQUIRED Determine the net present value. (Round-off factors to three decimal places) SOLUTION GUIDE to Jtem 8 Cash inflows before tax 00 Zee00-H,or— i 2 Gero Depreciation (Gee) —* dre, Earnings before tax ~ Tax (20%) Earnings after tax + Depreciati (Present) Year0 PV factor Yeart Year 2 Year 3 Year 4 28,060) ee te SEO ee a S/o SIZ {0,00D. 410 40 1900 ae) we 0. 9. NI oo crasuurry INDEX & IRR (EVEN vs. UNEVEN CASH FLOWS) Can-Yean Corporation gathered the following data on two capital investment opportunities: Pro} Cost of investment P'195,200 PF 150,000 Cost of capital 10% 10% Expected useful life 3 years 3 years Net cash inflows 100,000 100,000 * This amount is to dectine by P 20,000 annually thereafter. REQUIRED: Round-off factors to three decimal places in all cases. ‘il-in the blanks. Project 1 NPV: A) 23500 — P. Index: C) TZ 7¥ = £) What is project 1's internal rate of return? a. 23% Ff 25% b. 27% 4. 25% see ae F) What is project 2’s time-adjusted rate of return? > Jiecounted! Pak of? Paine Jephihtcbid Pack © a, Below 30% c. Between 31% and 32% Yi Between 30% and 31% d. Above 32% 10, PAYBACK RECIPROCAL Live-Biz Company is pianning to buy an equipment costing P 640,000 with an estimated life of 30 years and is expected to produce after-tax net cash iriflows of P 128,000 per year. . : REQUIRED: PP ph. GREE goog = Ss. tte. ‘Without using present value factors, estimate oe IRR. = 2 hog ty ee . ties out NOTE! Thelen de dhe mone Ceecunite ! geoo(x) = Te CADET eubebrine roca UEP Pe Po ‘it ke Mall-Asia Company is considering buying a new machine, requiring an immediate P 400,000 cash outlay. The new machine is expected to increase annual net after-tax cash receipts by P 160,000 in each of the next five years of its economic life. No salvage value is expected at the end of § years.. The company desires a minimum return of 14% on invested capital. REQUIRED: Round-off factors to three decimal places in all cases. ‘A). Payback period D) Profitability index B) ARR (based on original investment) E) Internal rate of return C) Net present value12, ReLATIONSHTPS - DISCOUNTED TECHNIQUES r | Answers to item 11 A) Payback period: 400,000 + 160,000 = 2.5 years B) Accounting rate of return (based on original investments): 80,000 + 400,000 = 20% ©) Net present value: 160,000 (3,433) ~ 400,000 = P 149,280 D) Profitability index: 549,280 + 400,000 = 1.37 times £). Internal rate of return: 28.65% (approximation through trial a ind error or interpolation) Fill in the blanks for each of the following independent cases. In all cases, the investment has 2 useful life of ten (10) years and no salvage value. Round off factors to three decimal places. Project Annual Cash Flow Investment Cost of Capital IRR, | nev 1 P 45,000 P 188,640 14% (2) deed 2 P 75,000 (3) Mah 12% Oe aos 3 P 300,000 6) / Bie P 115,000 P 450,000 12% (i) Ee [vo pit, [ke= C00 w+ aleays inv aopeeen nvestment opportunities. The company’s Cost of * @ |. CAPITAL RATIONING ~ RANKING PROJECTS ee is considering five different capital is(12%, Project Investment PV - Cash Flow: wey IRR (%) —P. Inde; ‘] SS eo op Ge T90D — tewdealy alt ve 2 “20,000 wasn "280 8B gD 3 2,000 374332543) 14 tie wf Gelacte 4 10,000 10,854 854 (D118 1.0 one 5 9,000 8,749 (251X101 0.9: REQUIRED: FI 'A) Rank the projects in descending order of preference according to NPV, JR and benefit/cost ratio, B) If only a budget of P.55,000 is available, which projects should bé chosen? SOLUTION GUIDE to Item 13 WRAP-UP EXERCISES (TRUE or FALSE; MULTIPLE-CHOICE) € 1. Aproject’s salvage value, realizable at the end of life of the project, is considered in the computation of the net investments for decision-making purposes. f 2. The payback period emphasizes the proftabilly of a capital project while the accounting rate of return, ‘on the other hand, emphasizes the project's liquidity. F 3. Annual cash inflows from the capital projects are measured in terms of ‘a. Income after depreciation and taxes b, Income before depreciation and taxes. Income before depreciation but after taxes i ‘d. Income after depreciation but before taxes. : 4, When computing for the accounting rate of return (ARR), which i ante tue! depreckton a0 tases ae es Jennings used ‘. Income before depreciation and taxes €. Income before depreciation but after taxes d. Income after depreciation but before taxes 5, What technique does not use cash flow for capital investment decisions? a. Payback ARR bo NPV ‘@. IRR Which of the following groups of capital budgeting technique: 6 Wi oi rate of return, payback and proftabilty Inde, noses te time value of money? BIRR, payback and Nev c._ IRR ARR and profitability index YF IRR, NPV and proftabity index7. Cost of capital is 3%; economic life in years = 4 years; simple PV factor for year 4 Is a. 0.915 0.455 0.888 4. 0,350 8. Discount rate is 11%; economic life in years = 3 years; PV annuity factor for 3 years is a. 0.731 # 24ag b. 1.713 ‘4. 3.102 9. As the discount rate increases, >a Present value factors increase “2 Present value factors decrease . Present value factors remain constant d. It is Impossible to tell what happens to the factors 10. What is the PV factor of any amount at year zero or zero percent? a. Zero b. 0.50 & 1.00 4. An amount that cannot be determined without more information 11. The present value of P 50,000 due in five years would be highest If discounted at a rate of a 0% “b. 10% #60 1.00 pig ©) 15% aod d. 20% 12. A capital project with a positive NPV also has a. A profitability index of one D. A positive profitability index ¢. A profitability index less than one SA profitability index greater than one 13. A capital project that has a positive NPV based on a discount rate of 12% also has an IRR of a. Zero b. 12% c. Less than 12% # Greater than 12% 14, Which of the following combinations is possible? Profitability Index NPY IRR a. Greater than1 Positive Equals cost of capital b. Greaterthan 1 Negative Less than cost of capital £ Less than 1 Negative Less than cost of capital ‘4. Less than 1 Positive Less than cost of capital 15. The net present value method assumes that the project's cash flows are reinvested at the a. Internal rate of return b, Simple rate of return Cost of capital ‘d. Payback period 16. The internal rate of return method assumes that the project’s cash flows are reinvested at the (2. Required rate of return (Zé Internal rate of return ‘c. Simple rate of return d. Payback period 17. Which one of these methods is a project ranking method rather than a project screening method? a, Net present value (2 Profitability index ‘c. Simple rate of return d. Sophisticated rate of return 18. If the IRR on an Investment is zero, ‘a. Its NPV is positive b. It is generally a wise investment Its cash flows decrease over Its life Xe ts annual cash flows equal Its required investment