MAS 5: CAPITAL BUDGETING

CAPITAL INVESTMENT – involves significant commitment of funds to receive a satisfactory return over an extended period of time.

Example: purchase of equipment for expansion, replacement of old equipment

CHARACTERISTICS OF CAPITAL INVESTMENTS

 As to COST usually entails large amount of resources, relative to business size
 As to COMMITMENT usually funds invested are tied up for a long period of time
 As to FLEXIBILITY usually more difficult to reverse than short-term decisions
 As to RISK usually involves so much risks & uncertainties due to operation and economic
changes over an extended period of time

CAPITAL BUDGETING – the process by which management identifies, evaluates, and makes decision on capital investments projects of
an organization. An over-simplified capital budgeting process involves the following steps:

PRINCIPLES OF CAPITAL BUDGETING (Long-Term Decision Making):

1. Use cash flows, not accounting income. In the end, we care about how much cash we will be getting, not on how much is our
profit (which exists only on paper).

2. The timing of cash flows is important because of the time value of money

3. Cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when analyzing all capital budgeting
projects. Firm value is based on cash flows we get to keep, not on how much we send to the government.

4. Ignore irrelevant costs (sunk costs and future unavoidable costs)

5. Include opportunity costs and any qualitative factors.

6. The relevant cash flows are the incremental cash flows. That is, the addition/reduction of the cash flows if the project is
undertaken.

7. Depreciation is not a cash flow in and of itself but depreciation affects taxes; therefore, depreciation has an indirect effect on
the cash flow through the tax and should therefore still be accounted.

8. The discount rate “r” that should be used is the discount rate that reflects the project’s riskiness. Other names used for the
discount rate are “opportunity cost of capital”, “required rate of return”, and “interest rate”.

STEPS IN CAPITAL BUDGETING

Step 1: Identification
Nature of Capital Investments
a. Replacement (Equipment)
b. Improvement (Products)
c. Expansion (Facilities)
d. Addition (Technology)
e. Reduction (Costs)
Step 2: Evaluation
Discounted methods
a. Net present value
b. Profitability index
c. Internal rate of return
d. Present value payback/Discounted payback
Non-discounted methods
a. Payback period
b. Bail-out payback
c. Accounting rate of return
d. Payback reciprocal
Step 3: Decision

CAPITAL INVESTMENT FACTORS

1) NET INVESTMENTS (for decision-making purposes)

 Costs less savings incidental to the acquisition of the capital investments projects
 Cash outflows less cash inflows incidental to the acquisition of the capital investment projects

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 Costs (Cash outflows)
1. Purchase price of the asset, net of related cash discount
2. Incidental project-related expenses such as freight, insurance, handling, installation, test-runs, etc.

CONSIDER 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 (Cash inflows)

Proceeds from sale of the old asset disposed, net of related tax
CONSIDER ALSO THE FOLLOWING, if any:
 Trade-in value of old asset
 Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax

2) NET RETURNS
 ACCRUAL basis: Accounting net income (after tax)

 CASH basis: Net cash inflows

 DIRECT method

Net cash inflows = Cash inflows – Cash outflows

 INDIRECT method

Net cash inflows = Net income (after tax) + noncash expenses (e.g., deprecation expenses)

3) COSTS of CAPITAL
 The costs of capital used in capital budgeting is the Weighted Average Costs of Capital (WACC). 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*

Preferered 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

Expected cash dividend per share

Costs of CS and RE = + Dividend growth rate
Market price per common share
 The dividend growth rate is assumed to be constant over time
 In computing cost of CS & PS, the market price should be net of flotation ocsts (e.g., underwriting fees)
 In computing the cost of RE, flotation cost should be ignored as RE is not sold nor issued
 Alternative, the cost of equity capital may be computed based on Capital Asset Pricing Model (CAPM)

 Other terms used to denote the weighted average cost of capital (WACC):

 Minimum required rate of return

 Minimum acceptable rate of return
 Cut-off rate
 Target rate
 Desired rate of return
 Standard rate
 Hurdle rate

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

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 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 liquidity 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 in analyzing the project
2. It gives 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 cash flows that may occur after the payback period.

Bail-out Payback Period – a modified payback period method wherein cash recoveries include not only the net cash inflows from
operations but also the estimated salvage value realizable at the end of each year of the project life.

Average Annual Net Income

Accounting Rate of Return (ARR) = Investment∗¿ ¿

*may be based on original or average investment

Advantages:

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. It indicates and emphasizes the project’s profitability.

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 effect of inflation is ignored.

Other terms used to denote the ARR:

 Book rate of return

 Unadjusted rate of return
 Simple rate of return
 Approximate rate of return method
 Financial statement rate of return method

DISCOUNTED TECHNIQUES

The time value of money is an opportunity cost concept. A peso on hand today is worth more than a peso to be received
tomorrow. A peso could earn interest by putting it in a savings account or placing it in a profitable investment. The time value of
money is usually measured by using a discount rate that is implied to be the interest foregone by receiving funds at a later time.

Net Present Value (NPV) = Present value of cash Inflows – Present Value of cash Outflows

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  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 projecgt (e.g., salvage value, return of working capital requirements)
 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.

Present value of cash inflows

Profitability Index =
Present value of cash outflows

NPV
NPV Index =
Investment

The profitability index method is designed to provide a common basis of ranking alternatives that require different amounts of
investment

NOTE: Profitability index method is also known as desirability index, present value index and benefit cost ratio

Internal Rate of Return (IRR) – is the rate of return that equates the present value of cash inflows to present value of cash
outflows. It is also known as discounted cash flow rate of return, time-adjusted rate of return or sophisticated rate of return

Guidelines in determining IRR

1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of the following formula:

Net investment cost

PVF for IRR =
Net cash inflows

2. Using the present value annuity table, find on line ‘n’ (economic life) the PVF obtained in No. 1. The corresponding rate is the
IRR. If the exact rate is not found on the PVF table, ‘interpolation’ process may be necessary.

Advantages:

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 earning during its life, different rates of return may result.

EXERCISES: CAPITAL BUDGETING

1. NET INVESTMENTS FOR DECISION-MAKING

Mobile Company plans to replace a unit of equipment with a new one:

A) The old unit was acquired three years ago: the old unit’s carrying value is now at P 60,000 while it can be sold for P 70,000.
Tax rate is 25%
B) The new unit can be acquired at a list price of P 300,000. 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 P 18,000
C) 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 sol for P 10,000.

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 D) Additional working capital of P 16,000 will be needed to support operations planned with the new equipment.
E) The annual cash flow from the operation of the new equipment has been estimated at P 50,000. The new equipment has a
useful life of 5 years with a salvage value of P 2,000 at the end of 5 years.

REQUIRED:

What is the initial cost of net investment s for decision-making purposes?

2. WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Legends 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

5% Preferred stock (P 100 par) 200,000
Common stock (no par, 10,000 shares outstanding) 400,000
Retained earnings 800,000
TOTAL P 2,000,000

Additional data:
1. Current market price per share:
 Preferred stock: P 100
 Common stock: P 40
2. Expected common dividend: P 2 per share
3. Dividend growth rate: 4%
4. Corporate tax rate: 30%

REQUIRED:

2A) Given an operating income of P 500,000, how much is the earnings per share (EPS)?
2B) Determine the weighted average cost of capital

3. NET RETURNS (INCREASE IN REVENUES)

Fighter Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee are estimated to
be 10,000 cups to be sold for P 15 per cup. Variable costs are estimated at P 6 per cup, while incremental fixed cash costs,
excluding depreciation, at P 20,000 per year. The machines are expected to have a service life of 5 years, with no salvage
value. Depreciation will be computed on a straight-line basis. The company’s income tax rate is 20%

REQUIRED: Determined the following:

a. The increase in annual net income.

b. The annual cash inflows that will be generated by the project

4. NET RETURNS (COST SAVINGS)

Marksman 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 30%.

REQUIRED:
Determine the net cash inflows that will be generated by the project.

5. PAYBACK PERIOD & ARR (WITH EVEN CASH FLOWS)

Tank Company considers the replacement of some old equipment. The cost of the new equipment is P 90,000, with a
useful life estimate of 8 years and a salvage value of P 10,000. The annual pre-tax cash savings for the use of the new
equipment is P 40,000. The old equipment has zero market value and is fully depreciated. The company uses a cost of capital
of 25%.

REQUIRED: Assuming that the income tax rate is 40%, compute:

a. Payback period
b. Accounting rate of return on original investment
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 c. Accounting rate of return on average investment

6. PAYBACK PERIOD & ARR (WITH UNEVEN CASH FLOWS)

Assassin Company has an investment opportunity costing P 90,000 that is expected to yield the following cash flows
over the next five years: (assume a hurdle rate of 30%)

Year Amount
1 P 40,000
2 35,000
3 30,000
4 20,000
5 10,000
Total P 135,000

REQUIRED:

a. Payback in period in months

b. Book rate of return

7. BAIL-OUT PAYBACK PERIOD

A project costing P 180,000 will produce the following annual cash flows and salvage value:

Year Cash flows Salvage value

1 P 50,000 P 60,000
2 P 50,000 P 55,000
3 P 40,000 P 50,000
4 P 40,000 P 45,000

REQUIRED: Bail-out payback period

8. NET PRESENT VALUE (WITH UNIFORM CASH FLOWS)

Mage 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 a minimum return of 25% on invested capital.

REQUIRED: Determine the net present value.

9. NPV, PROFITABILITY INDEX & IRR (EVEN vs UNEVEN CASH FLOWS)

Support Corporation gathered the following data on two capital investment opportunities

Project 1 Project 2
Cost of investment P 195,200 P 150,000
Cost of capital 10% 10%
Expected useful life 3 years 3 years
Net cash inflows P 100,000 P 100,000**

* This amount is to decline by P 20,000 annually thereafter.

REQUIRED: Fill-in the blanks

Project 1 Project 2

NPV A) _____________________ B) _____________________

P. Index: C) _____________________ D) _____________________

E. What is project 1’s internal rate of return?

a. 23% c. 25%
b. 27 d. 29%

F. What is the project 2’s internal rate of return?

a. Below 30% c. Between 31% and 32%
b. Between 30% and 31% d. Above 32%

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10. CAPITAL BUDGETING TECHNIQUES
Bangbang 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 5 years. The company desires a minimum return of 14% on invested capital.

REQUIRED:
a. Payback period
b. ARR (based on original investment)
c. Net present value
d. Profitability index
e. Internal rate of return

11. RELATIONSHIPS - DISCOUNTED TECHNIQUES

Fill in the blanks for each of the following independent cases. In all cases, the investment has a 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 NPV

1 P 45,000 P 188,640 14% ________ _________
2 P 75,000 _________ 12% 18% _________
3 _________ P 300,000 16% P 81,440
4 _________ P 450,000 12% _________ P 115,000

12. CAPITAL RATIONING – RANKING PROJECTS

Maniac Corporation is considering five investment opportunities. The cost of capital is 12%

Project Investment PV – Cash Flow NPV IRR (%) P. Index

1 35,000 P 39,325 P 4,325 16 1.12
2 20,000 22,930 2,930 15 1.15
3 25,000 27,453 2,543 14 1.10
4 10,000 10,854 854 18 1.09
5 9,000 8,749 (251) 11 0.97

REQUIRED:

A) Rank the projects in descending order of preference according to NPV, IRR and profitability index.
B) If only a budget of P 55,000 is available, which projects should be chosen?

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 WRAP-UP EXERCISES (MULTIPLE CHOICE)

1. Capital budgeting is the process

a. Used in make-or-buy decision making
b. Of eliminating unprofitable product line
c. Of making capital expenditure decisions
d. Of determining how much capital stock is issued

2. Which of the following is considered in computing the net investment for the decision to replace an old machine with a new
one?
I) Purchase price of the old machine
II) Purchase price of the new machine
III) Salvage value of the old machine
IV) Salvage value of the new machine

a. I and II
b. II and III
c. III and IV
d. IV and I

3. The corporate tax rate is important to which of the following costs of capital?
a. Cost of debts
b. Cost of retained earnings
c. Cost of common equity
d. Cost of preferred equity

4. The dividend growth rate is relevant to which of the following costs of capital?
a. Cost of debts and equity
b. Cost of common and preferred equity
c. Cost of common equity and retained earnings
d. Cost of debts, common equity and retained earnings

5. Annual cash inflows from the capital projects are measured in terms of
a. Income after depreciation and taxes
b. Income before depreciation and taxes
c. Income before depreciation but after taxes
d. Income after depreciation but before taxes

6. When computing for the accounting rate of return (ARR), which of the following is used?
a. Income after depreciation and taxes
b. Income before depreciation and taxes
c. Income before depreciation but after taxes
d. Income after depreciation but before taxes

7. What technique does NOT use cash flow for capital investment decisions?
a. Payback period
b. Net Present Value (NPV)
c. Accounting Rate of Return (ARR)
d. Internal Rate of Return (IRR)

8. Which of the following is a TRUE statement regarding non-discounted capital budgeting techniques?
a. Payback period (liquidity of project); ARR (liquidity of project)
b. Payback period (liquidity of project); ARR (profitability of project)
c. Payback period (profitability of project); ARR (liquidity of project)
d. Payback period (profitability of project); ARR (profitability of project)

9. Which of the following groups in capital budgeting techniques considers the time value of money?
a. Payback period, ARR, IRR and profitability index
b. ARR, NPV and profitability index
c. IRR, NPV and profitability index
d. ARR, IRR and payback period

10. Cost of capital is 6%, economic life in years = 4 years; what is the simple PV factor for year 4?
a. 0.839
b. 0.792
c. 0.244

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 d. 0.153

11. Discount rate is 12%; economic life in years = 3 years; what is the PV annuity factor for 3 years?
a. 0.712
b. 1.690
c. 2.402
d. 3.157

12. What is the PV factor of any amount at year zero or zero percent?
a. Zero
b. 0.50
c. 1.00
d. An amount that cannot be determined without more information

13. A capital project with a positive NPV also has:

a. A profitability index of one
b. A positive profitability index
c. A profitability index less than one
d. A profitability index greater than one

14. 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%
d. Greater than 12%

15. Which of the following combination is possible?

Profitability Index NPV IRR

a. Greater than 1 Positive Equals cost of capital

b. Greater than 1 Negative Less than cost of capital
c. Less than 1 Negative Less than cost of capital
d. Less than 1 Positive Less than cost of capital

16. 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
c. Cost of capital
d. Payback period

17. The internal rate of return method assumes that the project’s cash flows are reinvested at the
a. Required rate of return
b. Internal rate of return
c. Simple rate of return
d. Payback period

18. Mutually exclusive projects are those that:

a. If accepted, preclude the acceptance of competing projects
b. If accepted, can have a negative effect on the company’s profit
c. IF accepted, can also lead to the acceptance of a competing project
d. If accepted, can also lead to the acceptance of a competing project
e. Require all managers to consider and make a decision on the capital investment project

19. In choosing from among mutually exclusive investments, an entity shall normally select the one with the highest
a. Net present value
b. Profitability index
c. Book rate of return
d. Internal rate of return

20. Which capital budgeting method is a project-ranking method rather than a project-screening method?
a. Net present value
b. Profitability index
c. Simple rate of return
d. Sophisticated rate of return

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