Part 2

PART 2: E1
CAPITAL
BUDGETING
PROCESS
CASH FLOWS IN CAPITAL
BUDGETING PROCESS
CAPITAL BUDGETING
Evaluating all of the different investing
opportunities available to the company
and determining which of them we should
invest in.
Expected future benefits > Initial and

ongoing costs at present.
2
6 Capital Budgeting
Process
Identify business Opportunities
Search for potential investment projects
Evaluation or info gathering
Selection
Financing
Implementation or Monitoring
3
CASH FLOWS IN
CAPITAL
BUDGETING
PROCESS
1. IDENTIFY WHICH CASH FLOWS ARE RELEVANT.
2. EXPECTED CASH FLOW IS USED.
3. CASH FLOWS RECORDED MUST BE THE AFTER-TAX CF.

key points in evaluating
cash flows
1. Income statement items that do not affect cash such as
amortization, gains, losses, depreciation (except of any
effects they may have on taxes) are ignored.
2. Sunk Costs are ignored
3. Investments in Working Capital are treated as outflows at
the time they incur, and inflow when released.
5
THREE RELEVANT
“PERIODS” DURING
PROJECT
1. Beginning of the Project (Initial Investment)

2. During the life of the project (CF @ Year n)
3. End of the Project’s Life (Terminal Value)
1. BEGINNING OF THE
PROJECT (OUTFLOW)
How much is the Net Initial Investment?
a. Purchase Price of New Asset +
b. Additional Costs +
c. Additional working capital +
d. Tax Savings on Loss (-) or Tax Cost on Gain (+)
Take Note: Tax Cost are relevant if the project involves replacing an
old asset (must compute for after tax cash received for old asset)
If SP > BV, tax cost on gain (outflow)
7
If SP < BV, tax savings on loss (inflow)
EXAMPLE #1
Nonchalant Company is planning to make a 200,000 investment for a new equipment,
replacing the old equipment worth 20,000 which can be sold for 15,000.
The new equipment will require an increase in Working Capital of 15,000 (which is
recoverable at the end of the Project’s life).
The new equipment has a 10-year life and will generate annual revenue of 80,000 and
expenses of 40,000. The average tax rate is 40%
1. What is the net cash investment?
New asset purchase 200,000

Working Capital 15,000
Proceeds from Sale (15,000)
Tax on Gain or Loss (2,000) 🡨 15,000 – 20,000 = (5,000) x 40%
8
Net cash investment 198,000
2. DURING THE LIFE
OF THE PROJECT
How much is the Cash Inflow After Tax on Year n?
a. Before tax cash flow (+)

b. Depreciation Tax Effect (+)
Take note: Depreciation is only relevant at the extent of its tax effect. 2 Approaches
Direct Approach Indirect Approach
9
EXAMPLE #2
OA Industries needs to add a small new plant to accommodate a special contract to supply
materials. The required initial cash outlays are:
LAND 500,000
BUILDING 2,000,000
EQUIPMENT 3,000,000
The company uses straight line depreciation over 10 years, but for tax purposes the
building is to be depreciated over 10 years and equipment for 5 years. The effective tax
rate is 40%.
Revenues from the special contract are estimated at 1.2M annually, and cash expenses are
estimated at 300,000. At the end of the fifth year, the assumed sale of the building and
equipment are 800,000 and 500,000 respectively.
How much is the net cash flow for period 3? 10

EXAMPLE #2
REVENUE 1,200,000
COSTS 300,000
EBIT 900,000
TAX (1-40%)
540,000
TAX SHIELD 80,000 🡨 2,000,000/10 x 40%
240,000 🡨 3,000,000/5 x
40%
EBIAT 860,000
11
3. END OF THE
PROJECT’S LIFE
How much is the Incremental After tax-Cash Flow at Disposal?
a. Cash received from disposal of equipment – net of tax

b. Recovery or Release of Working Capital – cash inflow, no tax effect.
c. Cash Inflow After Tax in the last year of operations
PROCEEDS = Selling Price – Cost x (1 - Tax rate) or (SP x tax rate) – SP
12
EXAMPLE #2
USL Company’s new product is expected to have annual sales of 100,000 units for the
next 5 years then to be discontinued. The new equipment will be purchased for 1.2M
and cost 300,000 to install. The equipment will be depreciated for 5 years on a
straight-line basis for financial reporting purposes, and only 3 years for tax reporting
purposes. At the end of the fifth year, it costs 100,000 to remove the equipment, which
can be sold for 300,000.
Additional Working Capital of 400,000 is required. The product will sell for 80 per
unit, with material costs of 65 per unit. Annual indirect cost will also increase by
500,000.
The effective tax rate is 40%.
What is the expected Cash flow at fifth year of operations? 13

PROCEEDS FROM DISPOSAL 200,000
RECOVERY OF WORKING CAPITAL 400,000
TAX ON GAIN OR LOSS (80,000) <- Outflow since tax on gain
CASH INFLOW AFTER TAX 600,000
1,120,000
CIAT = Sale (Unit price – Unit Cost ) x Units

Cost (Hindi kasali tax shield on
depreciation since relevant hanggang
Gross year 3 lang siya for tax reporting
(1-tax) purposes)
CIAT
14
THANK YOU!
15
PART 2: E1
CAPITAL
INVESTMENT
ANALYSIS
METHODS
REQUIRED RATE OF RETURN
Cost of Capital (ka) = w1 k1 + w2 k2 + … + wn kn
where:
w = proportion that element comprises of the total capital
structure
k = cost of an element in the capital structure
1, 2, n = different types of financing
17
DIFFERENT TYPES
OF FINANCING
A. DEBT
B. PREFERRED STOCK
C. COMMON EQUITY
A. DEBT
After- Tax Cost of Debt = kd (1-t)
where:
kd = before-tax cost of debt
5 = firm’s marginal tax rate
B. PREFERRED STOCK
Cost of Preferred Stock (kp) = Dp / (Pp - F)
where:
kp = preferred stock dividend
Dp = current price per share
F = flotation cost per share 19
C. COMMON EQUITY
INTERNAL EQUITY
● Historical Rate of Return
● Dividend Growth Model
Cost of Internal Equity (ks) = (D1 / Po) + g

where: D1 = dividend per share at time 1
Po = market price per share at time 0
g = expected dividend growth rate
● Capital Asset Pricing Model (CAPM)

Cost of Internal Equity (ke) = Rf + B (km - Rf)
where: Rf = risk-free rate
B = stock’s beta estimate
20
km = estimate of the return on the market as a whole

External Equity
● Dividend Growth Model
Cost of Internal Equity (ke) = [D1 / (P0 - F - U)] + g
where:
D1 = dividend per share at time 1
Po = market price per share at time 0
g = expected dividend growth rate
U = underpricing losses per share
F = flotation cost per share
21
NET PRESENT VALUE
1. Determine net cash flows for each year
2. Identify the required rate of return
3. Determine the PV factor
● PV of Ordinary Annuity
● PV of Unequal Cash Flow
4. Determine the present value for the net cash
flows
5. Total the amounts in Step 4, then subtract the
initial investment amount
22
Internal Rate of Return
Present value of cash inflows = Initial investment,
therefore, NPV = 0
Payback and Discounted Payback

Payback Period
= Total Initial Investment / Expected Annual Net Cash
Flow
Payback Period
= Years Until Full Recovery + (Unrecovered Cost at the
Beginning of the Last Year / Cash Flow during the Last
Year)
23
THANK YOU!
24

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PART 2: E1

Expected future benefits > Initial and

2. EXPECTED CASH FLOW IS USED.

3. CASH FLOWS RECORDED MUST BE THE AFTER-TAX CF.

1. Beginning of the Project (Initial Investment)

1. What is the net cash investment?

New asset purchase 200,000

a. Before tax cash flow (+)

How much is the net cash flow for period 3? 10

a. Cash received from disposal of equipment – net of tax

PROCEEDS = Selling Price – Cost x (1 - Tax rate) or (SP x tax rate) – SP

The effective tax rate is 40%.

What is the expected Cash flow at fifth year of operations? 13

CIAT = Sale (Unit price – Unit Cost ) x Units

Cost of Capital (ka) = w1 k1 + w2 k2 + … + wn kn

Cost of Internal Equity (ks) = (D1 / Po) + g

● Capital Asset Pricing Model (CAPM)

km = estimate of the return on the market as a whole

● Dividend Growth Model

Cost of Internal Equity (ke) = [D1 / (P0 - F - U)] + g

Payback and Discounted Payback

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