CAPITAL BUDGETING

DEFINITIONS:
CAPITAL BUDGETING - also called Capital Expenditure Planning, deals with the allocation of capital
among alternative investment opportunities. There are typically two types of investment decisions:
a. Selection decisions in terms of obtaining new facilities or expanding existing facilities.
b. Replacement decisions in terms of replacing existing facilities with new facilities.

PAYBACK PERIOD – is the length of time requires recovering the initial investment from the incremental
cash benefits after tax. The conventional payback period does not consider the time value of money
while the discounted payback period gives due allowance for the time value money.]

ACCOUNTING RATE OF RETURN – is defined as the average annual net income from the project divided
by the average (or initial) investment in the project. The net income is net of depreciation and income
taxes.

NET PRESENT VALUE – the present value of the future net cash inflow from the project minus the initial
investment. This is the present value of the net cash inflows (outflows) discounted at a specified interest
rate.

TIME-ADJUSTED RATE OF RETURN (Internal or Discounted Rate of Return) – This is the rate of interest
which would make the present value of the future cash flows from the project equal to the initial
investment.-

PROFITABILITY INDEX – it is computed by dividing the present value of cash flows by the initial
investment. Profitability index is used in comparing the net present values of different projects to make
the comparison more meaningful.

OPPORTUNITY COST - it is the foregone benefits that could be derived from other possible alternative
by choosing another alternative.

CONCEPT OF COST OF CAPITAL

COST OF CAPITAL – The firm’s cost of capital is a weighted average of the costs of debt and equity funds.
Equity funds include both capital stock and retained earnings. Cost of the capital is the desired or target
rate of return used in the net present value method of discounted cash flow computations. It is also
minimum acceptable rate used in choosing between projects employing the time-adjustment rate of
return method.
FOUR PRINCIPAL METHODS FOE VALUATING INVESTMENTS

1. Accounting Rate of Return = Average Annual Net Income of Project (Net of Tax)
Average (or initial) Investment in the Project

Or ARR = Net Cash Inflow (Net of tax) – Depreciation

Average (or initial) Investment

2. Payback Period = Initial Investment

Annual Investment

Payback Reciprocal = Annual Cash Flow

Initial Investment

3. Time-adjusted Rate of Return – The rate of interest (or discounted) that would make the present
value of the future cash flow from the project equal to the initial investment.

4. Net Present Value – is the present value of the future cash flows from the project minus the initial
investment. The firm’s cost of capital is generally used to discount the future cash flows.

DETERMINING COST OF CAPITAL

1. COST OF DEBT = Interest Payments x (1 – Tax Rate)

Market Value of Debt (e.g Bonds)

2. COST OF PREFERRED STOCK = Preferred Dividends

Market Value of Preferred Stock
3. COST OF COMMON STOCK =

Dividends on Common Stock + Expected Growth Rate in Dividends

Market Value of Common Stock

4. COST OF RETAINED EARNING =

Cost of Common Stock x (1 – Marginal Tax Rate for Company Stockholders)

5. FIRM’S COST OF CAPITAL = The weighted average of 1 to 4, with the market values of debt preferred
stock, common stock and retained earnings as weights.
PROBLEM 1: (Cost Capital Calculation)
CCC Corporation made available the following data as requested:
Total Interest payments on bonds payable ₱ 60,000
Preferred stock dividends 20,000
Common stock dividends 24,000
Annual growth in common stock dividends 2%
Market values of:
Bonds payable ₱ 400,000
Common stock 300,000
Preferred stock 200,000
Retained Earnings 100,000
Company tax rate 30%
Stockholders’ marginal tax rate 70%

REQUIRED: Calculate the firm’s cost of capital.

PROBLEM 2

The Graven Company is planning to spend ₱60,000 for a machine which will be depreciated on
a straight-line basis over ten-year period. The machine will generate additional cash revenues
of ₱12,000 a year. Graven will incur additional costs except for depreciation. The income tax
rate is 35%.

REQUIRED:
1. Determine the net income after tax
2. Compute for the Accounting Rate of Return (ARR).
3. Determine the after tax annual cash flow.
4. Compute the payback period and the payback reciprocal.