SQ The Rorrew School of Cccovni!nmen » Mamagernerdt Udrrsorg Ferreas MAS-10: 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 + ASto COMMITMENT usually funds invested are tied up for a long period of time + Asto FLEXIBILITY usualy more aifficult to reverse than short-term decisions. + AS to RISK usually involves so much risks & uncertainties due to operational and economic changes over an extended pericd of time CAPITAL BUDGETING - 15 the process by which management identifies, evaluates, and makes decision on capital investment projects of an organization. An over-simplified capital budgeting process involves the following steps. Step 1 Step 2. Step 3: (C taentitcation ) > (__ Evaluation Decision Nature of Capital Investments Replacement (Equipment) Improvement (Products) > Expansion (Facihties) Addition (Technology) Reduction (Costs) ~ OF CONSIDERATION yc Costs of Capital Capital budgeting, after the selection | Non-discounted meihods Discounted methods of the capital investment project, Payback period "Net present value typically extends up to the financing, Bail-out payback Profitability index implementation and monitoring of | Accounting rate of return Internal rate of return the project Payback reciprocal Present value payback CAPITAL INVESTMENT FACTORS 1) NET INVESTMENTS (for decision-making purposes) + Costs less savings incidental to the acquisition of the capital investment projects + Cash outfiows less cash inflows incidental to the acquisition of the capital investment projects, Costs (Cash outflows) 1, Purchase price of the asset, net of related cash discount 2. Incidental project-related expenses such as freigitt, insurance, handling, installation, test-runs, etc CONDISER ALSO THE FOLLOWING, #f any + Additional working capital needed to support the operation of the project at the desired level t 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 2 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. depreciation expense) Page 1 of 8 pagesRSQ - The Remrew School of Uecovn taney MAS-10 CAPITAL BUDGETING 3) COSTS of CAPITAL + The ‘costs of capital’ used in cap ial uusigeting 's the Weighted Average Costs of Capital (WACC) These are specific costs ctu. nng-term funcs, obtained from the different sources: borrowed (debt) and invested (equity) In computing the cost of RE, flotation cost should be ignored as RE 1s not sold nor issued. + Alternatively, the cos! of equity capital may be coiputed based on Capital Asset Pricing Model (CAPM). NOTE: refer to MAS ~ 10 section on page 3 of the MAS Module 4 for detailed discussions en CAPM and the Dividend Growth Model + Other terms used to denote the weightes average cost of capital (WAC): 1% Minimum required rave ot rete: Minimum acceptable rate of re Cut-off rate Target rate Desired rate of return Standard rate Hurdle rate verve CAPITAL BUDGETING TECHNIQUES + Non-discounted metho:c - de not consider 1. Payback perioa metiios 2. Bail-out payback metho 3. Accounting rate of rots n method 4. Paybock reciprocal metnod value of money of money = Discounted methods - consider the time val 1. Net present value method 2. Profitability index method 3. Internal rate of return metho! 4. Present value payback metivoo NON-DISCOUNTED TECHNIQUES | Payback Period = Advantages: 1. Payback is simple to compute ana easy to understand. 2. Payback gives information about the /iquidity of the proyect. 3. This a good surrogote for nsk. A quirk cr short payback period indicates a less risky proyect Disadvantages: 1. Payback does not consider ‘ie tme value of money. All cash received during the payback period 1s assumed to be of equal valuc of analyzing the project. 2. It gives more emphasis oF liqu aty rather than on profitabilty of the project. In other words, more emphasis i$ given cn :ctur® of snvestment rather than the return on investment 3. It does not consider the salvage vaive of the project 4. It ignores cash flows that may occur after the payback period Ball-out Payback Period a modit'e:i payback period method wherein cash recoveries include not only the net cash inflows from operations but also the estimated salvage vvalue realizable at the end of each year of the project life Page 2 ot 8 pages >) SeKeSlh- the Rerrew School of Oecowetoney MAS-10 CAPITAL BUDGETING | Accounting Rate of Return (ARR) = Average annual net income. Investment® * may be based on original or average investment lovantages: 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 aver ti 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 ARK > Book rate of return > Approximate rate of return method > Unadjusted rate of return > Financial statement rate of return method > Simple rate of return at coc ifows Payback Reciprocal Payback reciprocal is a reasonable estimate of the discounted cash flow rate of return (a.k.a. IRR) provided that the following conditions are met 1. The payback period is at most haif of the economic life of the project. 2. The net cash inflows are uniform throughout the Ife of the project 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 interests by putting it in a savings account or placing it ina 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. - Present value of cash Outfio J at Present Value (NPV) = Present value of cash I 7 Cash infiows include cash infused by the capital investment project on a regular basis (¢.9., ‘annual cash inflow) and cash realizable at the end of the capital investment project. (€.9., 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 outfinw. 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 fresent value of cash outflows rofitability Index = | NPV Index The profitability index method 1s 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, Page 3 ot 8 pages £) ‘39 page ©RSQ The Rerew School of lccormtarers MAS-10 CAPITAL BUDGETING Internal Rate of Return (IRR) ~ 15 she rate of returi shat equates the present value of cash inflows to present value ct cesin outflows. It is also known as discounted cash flow rate of return, time-wdjusted rate of return or sophisticated rate of return Guidelines in determining IRR 1 Determine the present value factor (?'VF; ‘or the internet rate of return (IRR) with the use of the follovang formula PVE tor 18) 2. Using the present value annuity tati>, ‘un en tine ‘n’ (economic fe) the PVF obtained in No. 1 The corresponding rate is the IRR_If {he exact rate 1s not found on the PVF table, ‘interpolation’ process may be necessary Advantages 1. Emphasizes cash flows 2. Recognizes the time vaive of mwuney 3. Computes true return of prec: Disadvantages 1. Assumes thal IRR is the 1o-vestmerc rate 2. When project includes negative 2arnine’ during its life, different rates of return may result. EXERCISES; CAPITAL BUDGETING 1. NET INVESTMENTS FOR DECISION-MAKING Mobile Company plans to replace a unt of equipment with a new one: ‘A)_ The old unit was acquired three yrars acc” «ne oks unn’s Carrying value ss now at P 60,000 while st can be sold for P 70,000. Tur cate +s 25% 8) The new unit can be acquired a a int ance of P 300,000. A 2% cash discount is available if the equipment is paid for withia 30 Joy. from acquisition date, Shipping, installation and testing charges to be paid sre estimated at P 18,000 €) Other assets with: a Book velue of P £2,000 that are to be retired as a result of the acquisition of the new machine can be salvaged and Sold for P 10,000. 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 news equipment has been estimated at P 50,000, The new equipment has a useful ite of 5 years with a salvage valve of P 2,000 at the end of 5 years REQUIRED: ‘What is the initial cost of nat « estments 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, 20,000 shares outstanding) 409,000 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, hew 28) Determine the weight2d average cost of capital puciv 1s the earnings per share (EPS)? Page 4 of 8 pagesRGU the Revrew School of Occowectaney MAS-10 CACITAIL BUDGETING SOLUTION GUIDE to fem 2 Operating income $00,060 ~ interests (8%) (48,000) epg Income available to common shares. Income before tax P 452,000 “Number of outstanding shares tax (30%) (135,500) Income after tax P 318,250 preferred dividends (5%) _ (10,0100) come available to common shares P 306,400* SOURCES "WEIGHT 306,400" 10,000 shares 30.64 dongs Preferred stock Common stock & Retained Earnings - es Weighted Average Cost of Capital (WACC) |_ 3. NET RETURNS (INCREASE IN REVERIIES) Fighter Cinema plans to install coffee vending machines costing P 200,000. Annual sales of coffee are ~stimated to be 10,000 cups to be sold for P 15 per cup. Vanable costs are estimated at P 6 per cup, while incremental fixed cash costs, excluding deprecation, 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 1s 20% REQUIRED: Determine the following A) The increase in annual net income 8) The annual cash inflows that will be generated by the prosect. 4 NET RETURNS (COST SAVINGS) Marksman Corporation 1s planning to buy 2 high-tech machine that can reduce cash expenses by an average of P 70,000 per year. The new machine wili cost P 100,000 and will be depreciated for 5 years on @ straight-line basis. No salvage value 's 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 (WITI1 EVEN CASH FLOWS) Tank Company considers the replacement of some oid 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 from 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 capstal of 25%: REQUIRED: Assuming that the income tax rats 15 40%, compute: ‘A) Payback period 8) Accounting rate of return on criyinal investment ©) Accounting rate of return on average investment 6 PAYBACK PERIOD & ARR (WITH UNEVEN CASH FLOWS) ‘Assassin Company has an invesiment opoortunity costing P 90,000 that 1s expected to yield the following cash flows over the next five years: (assume a hurdle rate of 30%) Year Amount © 40,000 35,000 30,900 20,000 10,000 P 135,000 REQUIRED: ‘A) Payback period in months 8) 800k rate of return 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 50,0¢0 60,000 2 P-50.000 55,000 3 > 49,000 50,000 4 p-40,000 45,000 REQUIRED: Bail-out payback period Page 5 of 8 pagesRSA the Rerrew School of Aeconestancy MAS-10 CAPITAL BUDGETING NET PRESENT VALUE (WITH UNIFORM ©4054 FLOWS) ‘Mage Company plans te buy a new machine costng F 28,000. The new machine is expected to have a salvage vaiue of 4,000 at the end of sts econeraic Me of 4 years. The annual cash inflows before income tax from this machine are estimated 27 1,000. The tax rate 15 20%. The company desires a minimum Feturn of 25% on invested capital REQUIRED: (Round-olf present val ‘Determine the net present value SOLUTION GUIDE to Item 8 Cash inflows pe/are tax - Depreciation Earnings before tax Fac (26%, ays efter tax » Depreciation Cash intiows after tax e factors to three decimal place: Year 0 Pvfactor Year Year 2 Year 3 Year 4 <_ 9 NPV, PROFITABILITY INDEX & IRR (EVEN vs UNEVEN CASH FLOWS) ‘Support Corporation gathered the following date on :410 Capital investment opportunities. Project 4 Project 2 Cost of mvestme 195,200 © P-150,000 Cost of capital 10% 10% Expected useful 3 years 3 years Net casts » 490,00 P 100,000 + This arcu ty nually thereafter REQUIRED: (Round: off present vatue fartors to F wee de Filln the blanks, feegerna NPV: A) P. Index: C) __ E) What is project 1's internal rete of return” a. 23% © 25% b. 27% a 975 F) What 1s project 2's internal rate of re\nin a Below 30% Between 31% and 32% b. Between 30% ani 31 Above 32% 10. CAPITAL BUDGETING TECHNIQUES Bangbang Company 1s consider yj “uv "g a new machine, requinng an immediate P 400,000 cash outlay. The new machine 1s expected 19 increas annvai net after-tax cash receipts by P 160,000 in each of the next five years of its economic life. No salvage valve 1s expected at the end of 5 years. The company desires a minimum return of 14% on invested capital REQUIRED: Round-off factors to three decina! places 1m all cases 'A). Payback period B) ARR (based on onginal inve= )_Net present vaiue D) Profitability index E) Internal rate of return ‘Answers and solutions; A). Payback period: £00,900 ~ 260,00 = 2.5 years 8) Accounting rate of return (based on original investments): 60,000 = 400,000 = 20% ©) Net present value: 160,000 (3.433) ~ £00,000 = » 149,280 1D) Profitabwity index. 549,280 = 400,009 ~ 1.37 tine £) Internat rate of return: 28.65% (approx mation through tral and error or interpolation) Page 6 of 8 ~ages iPSU Uhe Reson Schaol of Gecowndomren MAS-10 CAPITAL BUDGETING 3 PAYBACK PECIPROCAL Savage Company is planning te buy an equipment costing P 640,000 with an estimated Ife of 30 years 1nd 15 expected to produce after-tax net cash inflows of P 128,000 per year PEQUIRED Without using present value factors, what 1s (t » best estimate of the IRR? Answers and solutions Peyback period: 640,000 ~ 128,000 = 5 years Payback reciprocal: 1 = 5 years = 20% Besed on page 3, PAYBACK RECIPROCAL 1s @ reasonable estimate of the internal rate of return (IRR) provided that the following conditions are met & Payback penod 1s at most hatf of the economic Ife of the project [1.€., 5 years = (30 = 2)) 2 Net cash inflows are uniform throughout the life of the project. RELATIONSHIPS - DISCOUNTED TECHNIQUES Ful in the blanks for each of the following incizp.cncent cases. In all cases, the investment has 2 useful lite of ten (10) years and no salvage value. Round off factors to three decimal places. Project Annual Cash Flow Investment Cost of Capital TR Nev 1 P 45,000 P 188,640 14% a) yo 2 75,000 (3) 12% 18% ) 3 (S)_____ BP 300,000° (6) _ 16% P 81,440 | ees 450,000 12% (8) P:115,000 CAPITAL RATIONING ~ RANKING PROJECIS Maniac Corporation is considering five investment opportunities. The cost of capital is 12%. Project Investment Pv - Cac Fiow IRR (%) P_Index 1 35,000 p39325 P4325 16 112 2 20,000 22,970 2,930 15 115 3 25,000 27.433 2.543 14 1.10 4 10,000 10,858 854 18 1.09 5 9,000 8,749 Qs 0.97 REQUIRED: ‘A) Rank the projects in descending order of preference according to NPV, IRR and profitability index. 8) If only a budget of P 55,000 is availabie, which projects should be chosen? SOLUTION GUIDE Project NEV IRR, Index WRAP-UP EXERCISES (MULTIPLE-CHOICE) 1, Capital budgeting is the process, ’2. Used in make-or-buy decision making b. Of eliminating unprofitable product ine ¢. Of making capital expenditure decisions 4. Of determining how much capital stock 1s issued 2. Which of the following 1s considered in. carriputing the net investment for the decision to replace an old machine with a new one? 1) Purchase price of the oid mac: _iI1) Salvage value of the old machine 1) Purchase price of the new machine 1) Salvage value of the new machine a. Land I Mand 1v b. Mand il d. Wand 3. The corporate tax rate is important to which of the following costs of capital? 3. Cost of debts ©. Cost of common equity b. Cost of retained earnings 4. Cost of preferred eauity 4. The dividend growth rate is relevant ‘0 shicl of the following costs of capital? ’38. Cost of debts and equity b. Cost of common and preferrec ea\ ¢. Cost of common equity and retained n wrnings d. Cost of debts, common equity and retained earnings 5. Annual cash inflows from the capital projec's are measured in terms of ‘a. Income after depreciation and taxes b. Income before depreciation and taxes Income before depreciation but after taxes 4d. Income after depreciation but betore taxes Page 7 of 8 paves & ryReSQ. The Review School of lice snitaey MAS-10 CAPITAL BUDGETING 6 When computing for the accounting rate uf return (ARK), vihich of the following is used? a. Income after cepreciation ani tyxes —c._Income before depreciation but after taxes b._ Income before depreciation ana taxes. Income after depreciation but before taxes 7. What technique does NOT use cash flow for capital investment decisions? a. Payback period . Accounting Rate of Return (ARR) b. Net Present Value (NPV) 4 internal Rate of Return (IRR) 8. Which of the following 1s a TRUE statement regarding nen-discounted capital budgeting techniques? 2. Payback period (liquidity of project); ARP (lnquiclty of project) b. Payback period (Iiquidity of projzct), ARP. (crofitabrity of project) ¢ Payback period (profitabs ty of project’, ARR (liquidity of project) . Payback Denod (profitability of aroyert), ARP. (profitability of project) 9. Which of the following grouos of capiial budgeting techniques considers the time value of money? a. Payback period, ARK, IER wnt profitability index 1b. ARR, NPV and profitabiity inde» © IRR, NPV and profitabiity index 4. ARR, IRP and payback period 10. Cost of capital 1s 6%; economic life 1 sears = 4 years; what is the stmple PV factor for year 4? 2 0.839 < 0.288 b. 0.792 a. 0.152 11. Discount rate is 12%, economic life in years = 3 years, what 1s the PV annuity factor for 3 years? a 0.712 < 21802 b 1.690 a 3357 12. What 1s the PV factor of any amcunt at year zero oF zer9 percent? a. Zero b. 0.50 < 100 4. An amount that cannot he determined withcut more information 13. A capital project with a positive NPV also has a. A profitability index of one b. A positive profitabiity index © Aprofitability index less than one 4. Aprofitability index greater thai one 14. A capital project that has a pusitie NPV based un a descount rate of 12% also has an IRR of 2 Zero © Less than 12% b. 12% Greater than 12% 15. Which of the following combinaticas 13 possibie: Profitability Index NPV aR 2. Greaterthan 1 Posie Equals cast of capital b. Greater than 1 Negative I ess than cost of capital c Less than 1 Negative ess than cost of capital 4. Less than 1 Positive Less than cost of capital 16. The net present value method assumes chat the project’s cash flows are reinvested at the ‘a. Internal rate of return b. Simple rate of return Cost of capital 4d. Payback period 17, The internal rate of return metivoa asstimes that the project's cash flows are reinvested at the 2. Required rate of returs Internal rate of return Simple rate of return 4. Payback period 18, Mutually exclusive projects are those thet a. If accepted, preclude the acceptance of competing projects b. If accepted, can have a negative effect cn tne company’s profit ¢._ Ifaccepted, can also lead fo the accepianse of « competing project 4. Require all managers to consider one ‘ke deasion on the capital mvestment project 19. In choosing from among mutuar's excinsive vestments, an entity shall normally select the one with the highest ‘a. Net present value b. Profitability index ©. Book rate of return 4. Internal rate of return 20. Which capital budgeting method 1s 3 project-ranking inethod rather than a project-screening method? a. Net present value b. Profitability index . Simple rate of returr . Sophisticated rate of : Poge 8 of 2 pages