Study Notes in Management Advisory Services

Topic: Capital Budgeting, Part 1

Capital Budgeting – planning the acquisition of capital investment projects/ expenditures

- Also involves decision making (whether to buy or not) the capital expenditures

Characteristics of Capital Investment Decisions:

a. Requires large amount of money or funds
b. Viewed as long-term commitment or for a long period of time
c. More difficult to reverse than short-term non-routine decisions
d. Involves so much risk and uncertainty

Things to consider in Capital Budgeting (CAPITAL INVESTMENT FACTORS)

1. Net Cost of Investment
2. Cost of Capital
3. Returns/ Income arising from the capital project

COST OF CAPITAL
 All sources of funds to be used in capital projects involves COST
 There are different sources of funds and also these sources have different amount of costs

Source of Capital Notation Salient Points Formula to compute

Long-term Debt kd This should be after tax because interest
expense is tax-deductible (reduces taxable Current Yield =
income).
After this computation, multiply the
Cost of debt can be the after-tax yield-to-
resulting amount to (1- tax rate) to get
maturity (YTM) or the after-tax current yield
kd
If YTM is available, then use this because
current yield is just the rate of return on
bonds FOR THE FIRST YEAR only YTM =

Notes:
Usually the maturity value is always P1,000 because
normally the face value of bonds is P1,000.

The weights used are 60:40 because the resulting

approximate YTM from this computation is very close
to the exact YTM.

Always pay attention to the interest payments of

bonds (i.e. semi-annual, quarterly).

After this computation, multiply the

resulting amount to (1- tax rate) to get
kd

Preference kp This should NOT be after-tax because dividends (cost)

Shares are not expense and therefore don’t affect income.

This is a form of hybrid financing because its form is kp =

stocks but the essence of its returns is just like bonds
(interest) because it’s fixed.
Dividend per share is calculated as par value
multiplied by dividend rate.
Net Price per Share – flotation costs (cost of
issuance) should be deducted
Ordinary Shares kc/ks/kn This should NOT be after-tax because dividends (cost) Using DGM:
are not expense and therefore don’t affect income.
kc =
Can be computed using the Dividend Growth Model
(DGM) or the Capital Asset Pricing Model (CAPM). Using CAPM:
DGM should be used when there is a given g (growth kc = RF + β(RM - RF)
rate) notes:
CAPM should be used when there is a given β (beta) – RF is risk-free rate or the rate of Treasury bills or
volatility of the company’s stock price in relation to the Treasury bonds.
different stocks in the stock market. RM is the market return or the return of other
investments with risk
RM-RF = market risk premium
β(RM-RF) = risk premium

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CAN A COMPANY USE RETAINED EARNINGS AS A SOURCE OF FUND FOR CAPITAL PROJECTS?
Answer: YES
Cost of Retained Earnings (ke)
 Firms can use retained earnings as a source of fund for capital projects by not paying dividends to shareholders.
Computation:

ke =

Take note: The cost of retained earnings is just the same as the cost of ordinary shares; however the denominator is
only PRICE (not net Price) because using retained earnings as a source of fund DOESN’T entail issuance or flotation
costs. With this, we can infer that if a company doesn’t have flotation cost, kc = ke.

Terms to remember:
Weighted Average Cost of Capital – cost of capital based on the weighted market values and corresponding costs of the
different sources of capital. If the market value of the sources of capital can’t be determined, the book value or carrying
values can be used.
Capital Structure – the mix of all the sources of capital of a company.
Optimal Capital Structure – the capital structure mix which minimizes the WACC or the mix with the lowest cost.

 In finance, the amount of retained earnings for the computation of capital structure is often added to the amount of
ordinary share because apparently, retained earnings are reserved to ordinary shareholders (assume that dividends to
preference are already paid).
 When Retained Earnings are used as a source of fund for capital projects, as if the ordinary shareholders are
REINVESTING their earnings to the company (for allowing to use it in the mean time for capital investments.)
 Rule of thumb – Utilize first ALL Retained Earnings before issuance of new ordinary shares because issuance of new
shares may cause dilution of ownership to the shareholders. Also, cost of ordinary shares issuance normally has higher
cost than the cost of retained earnings.

If kc and ke are available, what to use to compute WACC?

Answer: It depends.
If the amount of capital expenditure is at or within the Retained Earning Breakpoint, use ke; otherwise use kc.
Retained Earnings Breakpoint – the amount of capital expenditure wherein all retained earnings will be utilized without
the need for the issuance of new ordinary shares.

Exercises:
1. Mindset Company’s bonds have 4 years remaining to maturity. Interest is paid annually; the bonds have a P1,000, face value;
and the coupon interest rate is 9%. What is the estimated yield to maturity of the bonds at their current market price of P829?
2. What is the approximate yield to maturity for a BestSetEver Co.’s P1000 par value bond selling for P1120 that matures in 6
years and pays 12 percent interest annually?
3. GoldenSet Corporation is selling P25million of cumulative, non-participating preferred stock. The issue will have a par value of
P65 per share with a dividend rate of 6%. The issue will be sold to investors for P68 per share, and issuance costs will be P4
per share. The cost of preferred stock is ____.
4. Pinagpala Company is expected to pay an upcoming dividend of P3.29. The company's dividend is expected to grow at a
steady, constant rate of 5% well into the future. Pinagpala currently has 1,600,000 shares of common stock outstanding. If the
required rate of return for Pinagpala is 12%, what is the best estimate for the current price of its common stock?
5. Suppose that Blessed Co. recently purchased a share of stock for P45. The most recent dividend was P3, and dividends are
expected to grow at a perpetual rate of 5% indefinitely. What should be the required return on the stock?
6. The common stock of Set 1 has a beta of 1.20. The risk-free rate is 5 percent and the market risk premium is 6 percent.
Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. What is the company’s
cost of retained earnings?
7. An analyst has collected the following information regarding Set 2 Co.:
The company’s capital structure is 70 percent equity and 30 percent debt.
The yield to maturity on the company’s bonds is 9 percent.
The company’s year-end dividend is forecasted to be P0.80 a share.
The company expects that its dividend will grow at a constant rate of 9 percent a year.
The company’s stock price is P25.
The company’s tax rate is 40 percent.
The company anticipates that it will need to raise new common stock this year. Its investment bankers anticipate that the total
flotation cost will equal 10 percent of the amount issued. Assume the company accounts for flotation costs by adjusting the
cost of capital. Given this information, calculate the company’s WACC.
8. Set 3 Company has P1,500,000 of outstanding debt and P1,000,000 of outstanding common equity. Management plans to
maintain the same proportions of financing from each source if additional projects are undertaken. If the company expects to
have P60,000 of retained earnings available for reinvestment in new projects in the coming year, what peso amount of new
investments can be undertaken without issuing new equity?

Check figures:
1. 14.79% 2. 9.33% 3. 6.09% 4. P47 5. 12% 6. 12.2% 7. 10.41% 8. 150,000

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