THE BASICS OF CAPITAL BUDGETING

Should we build this plant?

OVERVIEW OF CAPITAL BUDGETING

What is Capital Budgeting? Is a summary of planned investments in long term assets. Is the whole process of analyzing projects and deciding which ones to include in the Capital Budgeting The process of planning expenditures on assets whose cash flows are expected beyond one year.

IMPORTANCE OF CAPITAL BUDGETING

1.) The results of Capital Budgeting decisions continue for many years, the firm loses some of its flexibility.

2.) Timing is also important- Capital assets must be available when they are needed. 3.) Can improve both the timing and the quality of asset acquisitions.

WHAT IS STRATEGIC BUSINESS PLAN?

Strategic Business Plan - A long run plan that outlines in broad terms the firms basic strategy for the next five to ten years.

-This involves the creation of strategies that are aimed in maximizing the entitys future position taking into consideration the various elements and factors that may pervade the companys internal and external environment.
- It involves TOWS weakness and strength). (threats, opportunities,

PROJECT CLASSIFICATION
1.) Replacement: needed to continue current operations One category consists of expenditures to replace worn out or damaged equipment required in the production of profitable products. 2.) Replacement: cost reduction- This category includes expenditures to replace serviceable but obsolete equipment and thereby to lower costs. 3.) Expansion of existing products or markets These are expenditures to increase out-put of existing products or to expand retail outlets or distribution facilities in markets now being served. 4.) Expansion into new products or markets These investments relate to new products or geographic areas, and they involve strategic decisions that could change the fundamental nature of the business.

PROJECT CLASSIFICATION
5.) Safety and / or environmental projects Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms fall into this category. 6.) Other projects This catch all includes items such as office buildings, parking lots, and executive aircraft. 7.) Mergers One firm buys another one. Buying a whole firm is different from buying an asset such as a machine or investing in a new airplanes, but the same principles are involved.

STEPS TO CAPITAL BUDGETING

1. Finding Investment Opportunities 2. Collect Relevant Information Opportunities 3. Select Discount Rate 4. Financial Analysis of Cash Flows 5. Decision 6. Project Implementation 7. Project Evaluation and Appraisal

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WHAT IS THE DIFFERENCE BET WEEN INDEPENDENT AND MUTUALLY EXCLUSIVE PROJECTS? 1.) Independent projects if the cash flows of one are unaffected by the acceptance of the other.

2.) Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other.

WHAT IS THE DIFFERENCE BET WEEN NORMAL AND NON NORMAL CASH FLOW STREAMS? 1.) Normal cash flow stream Cost (negative CF) followed by a series of positive cash inflows. One change of signs.

2.) Non normal cash flow stream Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

CATEGORIES OF PROJECT CASH FLOWS

1. Cash Inflows
Periodic cash inflows from operations, net of taxes Investment tax credit Proceeds from sale of old asset being replaced, net of taxes Avoidable costs, net of taxes Return of some working capital invested in the project Cash inflow from salvage of the new long term asset at the end of its useful life. This will be net of tax consequence

CATEGORIES OF PROJECT CASH FLOWS 2. Cash Outflows

Acquisition cost of purchasing and installing assets Additional working capital Other cash flows such as severance payments, relocation costs, restoration costs and similar costs.

NET INITIAL INVESTMENT OR PROJECT COST

Initial cash outlay Add: Additional cash outlay related to the asset Additional working capital Total Less: Cash inflow arising from sale of old asset being replaced Avoidable costs Net investment Pxxx Pxxx xxx

xxx Pxxx

Pxxx xxx xxx Pxxx

NET INITIAL INVESTMENT OR PROJECT COST

A new sorter can be purchased for P96,000. The dealer will grant a trade in allowance of P16,000 on the old machine. If a new machine is not purchased, Maingat Company will spend P10,000 to repair the old machine. Gains and losses on trade in transactions are not subject in income taxes. The cost to repair the old machine can be deducted in computing income taxes. Income taxes are estimated at 40% of the income subject to tax. Additional working capital required is P50,000.

COMPUTATION OF NET INITIAL INVESTMENT

Solution: Maingat Company
Purchase price of new sorter Add: Additional working capital Total Less: Trade in allowance on old sorter Avoidable repairs cost on old sorter Net Investment P 96,000 50,000 P146,000 P16,000

6,000

22,000 P124,000

ANNUAL CASH INFLOWS AND OUTFLOWS (NET CASH RETURNS)

Annual incremental revenue from the project Less: incremental cash operating costs Annual cash inflow before taxes Less: Taxes (Tax rate (Annual cash inflow before taxes Depreciation) Annual net cash inflow after taxes

ANNUAL CASH INFLOWS AND OUTFLOWS (NET CASH RETURNS)

Annual incremental revenue from the project Less: Incremental cash operating costs Annual cash inflow before taxes Less: Incremental depreciation Net income before taxes Less: Income after taxes Net income after taxes Add: Incremental depreciation Annual net cash inflow after taxes

ANNUAL CASH INFLOWS AND OUTFLOWS (NET CASH RETURNS)

Cash operating costs Less: Annual cash operating cost Cash savings before taxes Less: Incremental depreciation Increase in income before taxes Less: income taxes Increase in income after taxes Add: Incremental depreciation Net cash savings after taxes

TERMINAL CASH FLOWS 1. Tax Savings on Loss on sale of old machinery 2. Additional Tax on Gain on sale of old machinery 3. Recovery of Working Capital

METHODS TO EVALUATE CAPITAL PROJECTS

1.) Payback 2.) Discounted payback 3.) NPV (Net Present Value)

4.) IRR (Internal Rate of Return)

5.) MIRR (Modified Internal Rate of Return)

WHAT IS THE PAYBACK PERIOD? The number of years required to recover a projects cost, or How long does it take to get our money back ? Calculated by adding projects cash inflows to its cost until the cumulative cash flow for the project turns positive
Net Investment Annual Cash Returns

STRENGTHS AND WEAKNESSES OF PAYBACK

Strengths 1.) Provides an indication of a projects risk and liquidity. 2.) Easy to calculate and understand. Weaknesses 1.) Ignores the time value of money. 2.) Ignores CFs occurring after the payback period.

NET PRESENT VALUE (NPV)

Sum of the PVs of all cash inflows and outflows of a project :

RATIONALE FOR THE NPV METHOD

NPV = PV of inflows Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value.

COMPUTING FOR IRR METHOD

An investment of P50,000 will yield an average annual cash return of P7,500 a year for a period of 10 years.

1.) Investment = Annual Cash Returns (PV factor) 50,000 = 7,500x x = 50,000/7500 = 6.66667

COMPUTING FOR IRR METHOD

2.) 8% = 6.710 ? = 6.667 .043 .565 10% = 6.145 Exact discounted rate of return = 8% + .043 x 2% .565 = 8% + .15% = 8.15%

RATIONALE FOR THE IRR METHOD

If IRR > WACC, the projects rate of return is greater than its costs. There is some return left over to boost stockholders returns.

IRR ACCEPTANCE CRITERIA Accept> k, accept project. If IRR < k, reject project.

If projects are independent, accept both projects, as both IRR > k

COMPARING THE NPV AND IRR METHODS

If projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive If k > crossover point, the two methods lead to the same decision and there is no conflict. If k < crossover point, the two methods lead to different accept/reject decisions.

WHY USE MIRR VERSUS IRR?

MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs.

Managers like rate of return comparisons, and MIRR is better for this than IRR.

REINVESTMENT RATE ASSUMPTIONS

NPV method assumes CFs are reinvested at k, the opportunity cost of capital. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.

COMPARING THE PREFERENCE RATES

If an independent project is being evaluated, then the NPV and IRR criteria always lead to the same accept/reject decision. For mutually exclusive projects (choosing among acceptable alternative) especially those that differ in scale (project size) and / or timing a conflicts of ranking may arise. The IRR method may favor one alternative over another while the NPV method may indicate otherwise. If conflicts arise, the NPV method should be used. The NPV method assumes the cash flows will be reinvested at the firms cost of capital while the IRR method assumes reinvestment at the projects IRR. Because reinvestment at the cost of capital is generally a better (closer to reality) assumption, the NPV is superior to the IRR.

EXAMPLE: COMPUTE FOR THE INITIAL INVESTMENT

The management of Dawn Company plans to replace a sorting machine that was acquired several years ago at a cost of P850,000. The machine has been depreciated to its residual value of P90,000. A new sorter can be purchased for P2,940,000, 3/10, n/30. The dealer will grant a trade in allowance of P176,000 on the old machine. If the new machine is not purchased, Dawn will spend P745,000 to repair the old machine. Gains and losses on trade in transactions are not subject to income tax. The old to repair the old machine can be deducted in the first year for computing income tax. Income tax is estimated at 40% of the income subject to tax.

EXAMPLE: COMPUTE FOR THE NET RETURNS

The Horizons Corporation is planning to add a new product line to its present business. The new product will require a new equipment costing P12,000,000, having a five year useful life with no residual value. Tax rate is 30%. The following estimates are made available: Annual Sales P20M Annual costs & expenses; Materials P4.8M Labor 6.2M Factory overhead(excluding depreciation on new equipment) P2,540,000 Selling and Admin P1,700,000

EXAMPLE OF METHODS OF EVALUATION

Project A has a cost of P52,125, its expected net cash inflows are P12,000 per year for 8 years, and its cost of capital is 12 percent. Calculate the Projects 1. Payback period. 2. Discounted Payback period 3. NPV 4. Internal Rate of Return

SEATWORK: COMPUTE FOR THE INITIAL INVESTMENT

Sunshine Corporation is planning to purchase a new machine costing P2,800,000, with freight and installation costs amounting to P135,000. The old unit to be traded in will be given a trade in allowance of P260,000. Other assets that are to be retired as a result of the acquisition of the new machine can be residual and sold for P52,000. The loss on retirement of these other assets is P50,000 and will reduce taxes by P20,000. If the new machine is not purchased, extensive repairs on the old machine will have to be made at an estimated cost of P400,000. This cost can be avoided by purchasing the new machine. Additional gross working capital of P350,000 will be needed to support operations with the new machine.

SEATWORK: COMPUTE FOR THE INITIAL INVESTMENT

The Mabuhay Corporation plans to acquire a new equipment costing P1,340,000 to replace the equipment that is now being used. Freight charges on the new equipment are estimated at P75,000 and it will cost P90,000 to install. Special attachment to be used with this unit will be needed and will cost P64,000. If the new equipment is acquired, operations will be expanded and this will require additional working capital of P310,000. The old equipment had a net book value of P45,000 and will be sold for P25,000. If the new equipment is not purchased, the old equipment must be overhauled at a cost of P320,000. This is deductible for tax purposes in the year incurred. Tax rate is 30%

SEATWORK: COMPUTE FOR THE INITIAL INVESTMENT

The JT Company plans to open a new branch office wherein the company shall invest P2,500,000 in furnishings and equipment. Construction and other related outlays are estimated at P4,550,000. Sales from this new branch are estimated at P9,000,000 a year. One third of these sales will be in the form of accounts receivable at any given time. Cost of goods sold is estimated to be sixty percent of sales. The investment in merchandise inventory is approximately P400,000 at any time during the year. Cash of P120,000 will be needed to meet payments for operating expenses. Accounts payable and other current liabilities are expected to increase by 5% of sales.

SEATWORK: COMPUTE FOR THE INCREASE IN ANNUAL NET INCOME

Frelins Corporation is planning to replace its present printing equipment with a more efficient unit. The new equipment will cost P400,000 with five year useful life, no salvage value. The old unit was acquired three years ago for P500,000. The company uses the straight line method in appreciating its depreciable assets. The old unit is being depreciated at P62,500 per year. If the new equipment is acquired, the old one will be sold for P100,000. Otherwise, the company will just continue using for 5 years. Saving in cash operating costs are P100,000 and P220,000 for the new and old equipments, respectively. Income tax is at the rate of 32% of income before tax.

SEATWORK: COMPUTE FOR THE PAYBACK PERIOD, NPV, DISCOUNTED PAYBACK, IRR
The Liquid Corporation contemplates the replacement of an old machinery. The annual cost of operating the old machinery is P138,600, excluding depreciation, while the estimate for the new machinery is P91,300. The cost of the new machinery is P160,000, net of the trade in allowance, with an estimated useful life of 8 year, no residual value. The effective income tax rate of 40% and the cost of capital is 8%. The old machinery has an annual depreciation of P15,000 while the new machinery is estimated to have an annual depreciation of P20,000. The book value of the old machine is zero.

COMPUTE WHAT IS REQUIRED

The following data pertain to a five year project being considered by Alen C. Corporation: 1. A new equipment costing P1.8 million will be acquired on January 1, 200A. It will be depreciated using the straight line method over a five year period, with a salvage value of P200,000 at the end of 5 years. 2. The new equipment will replace an old one that has been fully depreciated to its salvage value of P220. Another company has offered to buy this old equipment for P250,000 on the replacement date.

COMPUTE WHAT IS REQUIRED

3. The project is expected to generate incremental sales of P50,000 units per year. The contribution margin per unit is P10. Incremental project fixed costs, excluding depreciation, is P130,000. 4. The project requires additional investment in working capital of P70,000. This amount is fully recoverable at the end of the fifth year. Alen C. Corporation is subject to an income tax rate of 32%. Its cost of capital (hurdle rate) is 10%.

REQUIRED:
1. Compute the net cost of investment in the new equipment. 2. The present value of expected incremental contribution margin.(net of tax) 3. The new equipment is expected to generate annual cash inflows, net of income taxes of? 4. The new equipments net present value?