MAS 07 CAPITAL BUDGETING

CAPITAL BUDGETING
CAPITAL BUDGETING – The process of identifying, evaluating, planning and financing capital investment
projects of an organization.

CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS

1. Capital investments decisions usually require 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.
4. Capital investments decisions involve so much risk and uncertainty.

CAPITAL INVESTMENT FACTORS

1. Net investments
2. Net Returns
3. Cost of Capital

 NET INVESTMENT – cost or cash outflows less cash inflows or savings up to the incidental to the
acquisition of the investment projects.

Costs or Cash Outflows:

1. The initial cash outlay covering all expenditures on the project up to the time when it is ready
for use or operation:
Ex. Purchase price of the asset
Incidental project-related costs such as freight, insurance taxes, handling, installation,
test-runs, etc.
2. Working capital requirement to operate the project at the desired level
3. Market value of an existing, currently idle asset, which will transferred to or utilized in the
operators of the proposed capital investment project.

Savings or Cash Inflows:

1. Trade-in value of old asset (in case of replacement).
2. Proceeds from sale of old asset to be disposed due to the acquisition of the new project (less
applicable tax, in case there is gain on sale, or add tax savings, in case there is loss on sale).
3. Avoidable of immediate repairs on old asset to be replaced, net of tax.

 NET RETURNS
a. Accounting net income
b. Net cash inflows

 COST OF CAPITAL
– The cost of using funds; it is also called hurdle rate, required rate of return, cut-off rate,
opportunity cost of capital.
- The weighted average rate of return the company must pay to its long-term creditors and
shareholders for the use of their funds.

Computation of COST OF CAPITAL:

Source Capital Cost of Capital
Creditors Long-term debt After-tax rate of interest (1 –
TxR)
Stockholders:
Preferred Preferred stock Preferred dividends per share
Current market price or Net
Issuance price
Common Common stock CAPM or DDM

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1. CAPITAL ASSET PRICING MODEL (CAPM)

R = RF + B(RM – RF)

Where : R = rate of return

RF = risk-free rate determined by government securities.
B = beta coefficient of an individual stock which is the correlation between the
volatility (price variation) of the stock market and the volatility of the price
of the individual stock.
Example: If the price of an individual stock rise 10% and the stock
market 15%, the beta is 1.5
RM = market return
(RM-RF) = market risk premium or the amount above risk-free rate required to
induce average investors to enter the market.

2. THE DIVIDENT DISCOUNT MODEL (OR DIVIDEND GROWTH MODEL)

D1 + G
a. Cost of Retained Earnings
P0
Where: P0 = current price
D1 = next dividend
G = growth rate in dividends per share (it is assumed the dividend pay-out ratio,
retention rate, and therefore the EPS growth rate are constant)

b. Cost of New Common Stocks = . D1 +G

P0 (1-Flotation Cost)

Floatation Cost = the cost of issuing new securities.

COMMONLY USED METHODS OF EVALUATING CAPITAL INVESTMENT PROJECTS:

1. Methods that do not consider the time value of money
a. Payback
b. Ball-out
c. Accounting rate of return
2. Methods that consider the time value of money (discounted cash flow methods)
a. Net present value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return

METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY

Net cost of initial investment The length of time required by the project
PAYBACK PERIOD = =
Annual net cash inflows to return the initial cost of investment

Advantages:
1. Payback is simple to compute and easy to understand. There is no need to compute or consider
any interest rate. One just has to answer the question: “How soon will be investment cost be
recovered”?
2. Payback gives information about liquidity of the project.
3. It is a good surrogate for risk. A quick 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 in analyzing the project.
2. It give us more emphasis on liquidity rather than on profitability of the project. In other words,
more emphasis is given on return of investment rather than the return on investment.
3. It does not consider the salvage value of the project.
4. It ignores the cash flows that may occur after the payback period.

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BAIL-OUT PERIOD – cash recoveries include not only the operating net cash inflows but also the estimated
salvage value or proceeds from sale at the end of each year of the life of the project.

ACCOUNTING RATE OF RETURN – also called book value rate of return, financial statement method,
average return on investment and unadjusted rate of return.

Average annual net income

Accounting Rate of Return =
investment

Advantages:
1. The ARR computation closely parallels accounting concepts of income measurement and
investment return.
2. It facilitates re-evaluation of projects due to the ready availability of data from the accounting
records.
3. This method considers income over the entire life of the project.
4. It indicates the project’s profitability.

Disadvantages:
1. Like the payback and ball-out 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
effect of inflation is ignored.

METHODS THAT CONSIDER THE TIME VALUE OF MONEY (Discounted Cash Flow Methods)
NET PRESENT VALUE
Present value of cash inflows
- Present value of cash outflows
Net Present Value

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as the reinvestment rate
4. Easy to apply.

Disadvantages:
1. It requires predetermination of the cost 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.

PROFITABILITY INDEX:

Total present value of cash inflows

Profitability Index =
Total present value of cash outflows

DISCOUNTED CASH FLOW RATE OF RETURN – the rate of return which equates the present value (PV) of
cash inflows to PV of cash outflows.

1. Determine the present value factor (PVF) for the discounted cash flow rate of return (DCFRR) with
the use of the following formula:
Net cost of investment
PVF for DCFRR =
Net cash inflows

2. Using Table 2 (present value annuity table), find on line n (economic life) the PVF obtained in Step
1. The corresponding rate is the DCFRR.

Advantages:
1. Emphasis cash flows

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2. Recognizes the time value of money

3. Computes true return of project.

Disadvantages:
1. Assunes that the IRR is the re-investment rate.
2. When project includes negative earnings during their economic life, different rates of return
may result.

PAYBACK RECIPROCAL – a reasonable estimate of the discounted cash flows rate of return, provided that
the following conditions are met:
1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.

Net cash inflows

PAYBACK RECIPROCAL =
Investment

Or

1 .
PAYBACK RECIPROCAL =
Payback period

EXERCISES

COST OF CAPITAL:
1. A corporation has a 6%, 1,000 par value bonds outstanding with 10 years to maturity. The bond is
currently selling for P980. The corporation pays the corporate tax rate of 30%. It wishes to know what
the after-tax cost of a new bond issue is likely to be. The yield to maturity (YTM) on the new issue will
be the same as the yield to maturity on the old issue because the risk and maturity date will be similar.

REQUIRED:
1. Compute the approximate yield to maturity on the old issue and use this as the yield for the
new issue. What is the after-tax cost of debt?
2. Compute the new after tax cost of debt if the bond is issued at P1,200 per bond.
3. Compute the current yield if the bond is issued at P1,200 per bond.

2. The Victoria Corporation issued an 8%, 25-year bond 5 years ago. At the time of issue, it sold for its
par (face) value of P1,000. Comparable bonds sell for P870 today. The bond pays interest semi-
annually.

REQUIRED: Compute the approximate yield to maturity. If the tax rate is 30%, what is the after-tax
cost of debt?

Interest+discount amount or – premium amort

YTM = (proceeds x60%)+(maturity value x 40%)

Int first year

Current yield = Net price

Victoria Corporation’s common stock is currently trading at P50 a share. The stock is expected to pay
a dividend of P4 a share at the end of the year, and the dividend is expected to grow at a constant
rate of 5% a year. What is its cost of common equity?

3. Use the basic equation for the capital asset pricing model (CAPM) to work on each of the following:
a. Find the required rate of return for an asset with a beta of 1.20 when the risk-free rate and
market return are 7% and 12%, respectively.
b. Find the required rate of return for an asset with a beta of 0.80 when the risk-free rate of return
6%, and the market risk premium is 4%.

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c. Find the beta for an asset with a required return of 7.4% when the risk-free rate and market
return are 6% and 8%, respectively.

4. The Naruto Company uses a target capital structure when calculating the cost of capital. The target
structure and the current component costs based on market conditions follow:
Component Mix Cost*
Debt 25% 8%
Preferred stock 10 12
Common equity 65 20

*The costs of debt and preferred stock are already adjusted for taxes and/or flotation costs. The
cost of equity is unadjusted.

The firm expects to earn P20 million next year and plans to invest P18 million in new capital projects.
It generally pays dividends equal to 60% of earnings. Flotation costs are 10% for common and
preferred stock.

a. What is the initial weighted average cost of capital (WACC)?

b. What is the retained earnings breakpoint? (Round to the nearest P0.1M)
c. What is the new WACC after the break?
d. Naruto can borrow up to P4 million at a net cost of 8% as shown. After that, the net cost of debt
rises to 12%. Where is the second break in the MCC, i.e., what is the debt breakpoint?
e. What is the new WACC after the increase in the cost of debt?

NET INVESTMENT AND RETURNS

5. The management of Leonor Company plans to replace a sorting machine that was acquired several
years ago at a cost P500,000. The machine has been depreciated to its salvage value of P10,0000. A
new sorter can be purchased for P600,000. The dealer will grant a trade-in allowance of P60,000 on
the old machine. If a new machine is not purchased, Leonor Company will spend P200,000 to repair
the old machine. The cost to repair the old machine can be deducted in the first year to compute
income tax. Income tax is estimated at 30% of the income subject to tax.

REQUIRED:
1. Compute the net investment in the new machine for decision making purposes.
2. Assume that instead of trading in the old machine, the same is sold for P50,000. Assume also
that the acquisition of the new machine will require additional investment in working capital
of P40,000. What will be the cost of the new machine for decision making purposes?

6. Linda Summer, owner of Summer Company, was approached by a local dealer in air conditioning units.
The dealer proposed replacing Summer’s old cooling system with a modern, more efficient system.
The cost of the new system was quoted at P1,000,000, but it would save P200,000 per year in energy
costs. The estimated life of the new system is 10 years, with no salvage value expected. Excited over
the possibility of saving P20,000 per year and having a more reliable unit, Ms. Summer requested an
analysis of the project’s economic viability. All capital projects are required to earn at least the firm’s
cost of capital, which is 10 percent. Income tax rate is 30% of taxable income.

REQUIRED: Determine the annual net cash inflows and net returns (net income) for the proposed
project.

7. The management of Builders, Inc., an architectural design firm, is considering an investment with the
following cash flows:

Year Investment Cash Inflow

1 P20,000 P2,000
2 10,000 4,000
3 5,000
4 7,000

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5 8,000
6 8,000
7 6,000
8 4,000
9 3,000
10 2,000

REQUIRED:
1. Determine the payback period of the investment.
2. Would the payback period be affected if the cash inflow in the last year were several times as
large?

8. A company purchased a new machine on January 1 of this year for P45,000, with an estimated useful
life of 5 years and a salvage value of P5,000. The machine will be depreciated using the straight-line
method. The machine is expected to produce cash flow from operations, net of income taxes, of
P18,000 a year in each of the next five years. The new machine’s salvage value is P10,000 in years 1
and 2, and P7,500 in years 3 and 4.

REQUIRED: Compute the bailout period for this new machine.

9. Discount Company purchased a new machine for P80,000 to expand capacity. Sales are expected to
increase by 30%. Aside from the depreciation on the new machine (straight-line over five years with
no salvage value), additional fixed costs of P4,000 will be incurred. The income statement for the past
year is:

Sales P300,000
Variable expenses (180,000)
Fixed expenses (100,000)
Income before tax P 20,000
Tax (6,000)
Net income P 14,000

REQUIRED:
1. What is the expected annual after tax cash inflow from the new machine?
2. Compute the payback period.
3. Find the net present value (NPV) using a hurdle rate of 12%.

10. Mina Corporation contemplating the purchase of equipment to exploit a mineral deposit on land to
which the corporation has mineral rights. An engineering and cost analysis has been made, and it is
expected that the following cash flows would be associated with opening and operating a mine in the
area.

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Cost of equipment and timbers P275,000

Working capital required 100,000
Annual net cash receipts 120,000*
Cost to construct new roads in three years 40,000
Salvage value of equipment in four years 65,000

 Receipts from sales of ore, less out of pocket costs for salaries, utilities, insurance, and so forth.

The mineral deposit would be exhausted after four years of mining. At that point, the working capital
would be released for investment elsewhere. The company’s required rate of return is 20%

REQUIRED: Determine the net present value of the proposed mining project. Should the project be
accepted? Explain.
11. Risa Company manufactures copier equipment and has the opportunity to replace one of its existing
machines with a new model. The existing machine has a net book value of P120,000 and a market
value of P60,000. It has estimated remaining life of four years, at which time it will have no salvage
value. The company uses straight line depreciation of P30,000 per year on the machine, and its annual
cash operating cost is P280,000.

The new model costs P500,000 and has a four year estimated life with no salvage value. Its annual
cash operating cost is estimated at P160,000. The firm will use straight line depreciation. The tax rate
is 40% and the cost of capital is 12%. The purchase of the new, more efficient machine will enable the
company to reduce its investment in inventory by P80,000.

REQUIRED:
1. Determine the investment required to purchase the new machine.
2. Determine the net present value of the investment.
3. Suppose that the new machine has a 10% salvage value. The company will consider the
salvage value in determining annual depreciation. Determine the net present value of the
investment.
4. Suppose that the new machine has a 10% salvage value. The company will ignore the salvage
value in determining annual depreciation. The applicable tax rate is 40%. Determine the net
present value of the investment.

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