II.

DISCOUNTED METHODS

• The time value of money is an opportunity cost concept.

o A peso on hand today is worth more than a peso to be received tomorrow because of interest a peso could earn by
putting it in a savings account or placing it in an investment that earns income.
o This does not consider inflation; all this means that an invested amount could be earning more
• The time value of money is usually measured by using a discount rate that is implied to be the interest foregone by receiving
funds later.
o This discount rate is the COST OF CAPITAL

COSTS OF CAPITAL

• The ‘costs of capital’ used in capital budgeting is the Weighted Average Costs of Capital (WACC).
o These are the specific costs of using long-term funds (interest and dividends), obtained from the different sources:
▪ Borrowed (debt) and
▪ Invested (equity) capital
• The average between the cost of debt and the cost of equity
o Cost of Debt = Interest Rate x (1 – Tax Rate)
o Cost of Equity = Dividend Yield = Dividend Per Share ÷ Price Per Share

SOURCES
Debt
Equity: Preferred Stock (PS)
Equity: Common Stock (CS)
Equity: Retained Earnings (RE)
COSTS
Interest rate (after tax)
Dividend yield
Dividend yield plus growth rate
Dividend yield plus growth rate

DIVIDEND YIELD = DIVIDEND PER SHARE / PRICE PER SHARE

➢ The after-tax cost of debt is computed based on: yield rate (1 – tax rate)

➢ Dividend yield = dividend per share ÷ price per share

Costs of CS and RE = (Expected Cash Dividend Per Share / Market Price Per Common Share) + Dividend growth rate

Common Shares:
Dividend Per Share – Last Year P5
Growth Rate 10%
Expected DPS (P5 x 1.1) P5.5
Market PPCS P102 – gross selling price of the shares
Flotation Cost P2

Cost of Common Equity = [P5.5 ÷ (P102 – 2)] + 10% = 15.5%

Cost of Retained Earnings = (P5.5 ÷ 102) +10% = 15.39%

➢ 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 costs or issue costs (e.g., underwriting fees).
o Cost of Retained Earnings are not net of flotation costs

➢ In computing the cost of RE, flotation costs should be ignored.

➢ Alternatively, 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 ☺ Desired rate of return
☺ Minimum acceptable rate of return ☺ Standard rate
☺ Cut-off rate ☺ Hurdle rate
☺ Target rate

If Return on Investment > Cost of Capital, then the entity is expecting a LOSS

If Return on Investment < Cost of Capital, then the excess of the ROI is the additional value of the entity
Illustration: Weighted Average Cost of Capital (WACC)

The Bow 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 (P100 par) 200,000
Common stock (no par, 10,000 shares outstanding) 400,000
Retained earnings 800,000
Total P 2,000,000

Additional data:
• Current market price per share:
o Preferred stock: P50
o Common stock: P40

• Expected common dividend: P2 per share

• Dividend growth rate: 4%
• Corporate tax rate: 30%

Required:

1. Given an operating income of P500,000, how much is the earnings per share?

EPS = Net Income Available to Ordinary Shares ÷ Outstanding Ordinary Shares

2. Determine the weighted average cost of capital.

NOTE: Capital Structure = Total assets – Current liabilities

Capital Asset Pricing Model – Illustrative Problems

• Describes the relationship between systematic risk and expected return for assets, particularly stocks
• Widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those
assets and costs of capital
• Main thing we are computing for is Expected Return for Assets
• This is another way on how to compute for the cost of equity

Formula: Cost of Equity = Risk Free Rate + Beta (Market Rate – Risk Free Rate) or K = Rf + B (Rm – Rf)
Market premium = (Market Rate – Risk Free Rate) or RPM = (Rm – Rf)
Risk premium = B (Rm – Rf)

Where: K = Cost of equity

Rf = Risk-free rate
B = Beta coefficient
Rm = Market rate

Risk-free rate of return

• Is the interest rate an investor can expect to earn on an investment that carries zero risk.
• In practice, the risk-free rate is commonly considered to be equal to the interest paid on a 3-month government Treasury bill,
generally the safest investment an investor can make

Market Rate
• Assumption is mas malaki sa Risk-Free Rate of Return
• Ito yung normally kinikita ng mga company para sa mga investment

Beta
• Measures a stock's relative volatility
o That is, it shows how much the price of a particular stock jumps up and down compared with how much the entire stock
market jumps up and down
o If a share price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise
by 15% if the market rose by 10% and fall by 15% if the market fell by 10%

NOTE: Risk Free Rate and Beta is constant

• When the other variables of the equation changes, these two remain constant

EXERCISES: WACC – CAPM

1. According to CAPM estimates, what is the cost of equity for a firm with beta of 1.5 when the risk-free interest rate is 6% and
the expected return on the market portfolio is 15%?

Solution:
K = 6% + 1.5 (15% - 6%)
= 19.5%

2. The expected return on Globe Oil stock is 18.95%. If the market premium is 8.2%, and the risk-free rate is 6.4%, what is the
beta of Globe Oil stock?

Solution:
18.95% = 6.4% + B (8.2%)
12.55% = B (8.2%)
B = 1.53

3. An investor was expecting an 18% return on his portfolio with beta of 1.25 before the market risk premium increased from 8%
to 10%. Based on this change, what return will now be expected on the portfolio?

Solution:
18% = Rf +1.25 (8%)
18% = Rf + 10%
Rf = 8%

K = Rf + 1.25 (10%)
K = 8% + 12.5%
K = 20.5%
 4. The expected rate of return of stock of Phoslate Company, given a beta of 1.25, risk-free rate of 7.5%, and a market risk
premium of 6%, is:

Solution:
K = 7.5% + 1.25 (6%)
K = 7.5% + 7.5%
K = 15%

5. What is the risk-free rate given a beta of 0.8, a market risk premium of 6%, and an expected return of 9.8%?

Solution:
9.8% = Rf + 0.8 (6%)
9.8% = Rf +4.8%
Rf = 5%

= Net Present Value Method =

This will be the beginning of the lecture on the discounted techniques.

• Remember that for Discounted Method, convert future values to present value before comparing for the cost of investment

Net present value = Present value of cash inflows – Present value of cash outflows
NPV Index = NPV ÷ PV of Cash Outflows
NOTE that Cash Outflows = Cost of Investment

➢ Cash inflows include cash infused by the capital investment project on a regular basis (e.g., annul cash inflow) and cash
realizable at the end of the capital investment project. (e.g., salvage value, return of working capital requirements)
o Annual Cash Flow will use the discount rate from PVF of OA
o Salvage Value and Return of Working Capital must be converted to present value kasi future amounts ito (PVF of 1)
➢ The net investment cost required at the inception of the project usually represents the present value of the cash outflows.
➢ Used for project screening para sa mga mutually exclusive projects

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 the discount rate to be used.
2. The net present values of the different competing projects may not be comparable because of differences in magnitudes or sizes
of the projects.

Illustration: Net Present Value (With Uniform Cash Flows)

Can Company plans to buy a new machine costing P28,000. The new machine is expected to have a salvage value of P4,000 at the end
its life of 4 years. The annual cash inflows before income tax from this machine have been estimated at P11,000. The tax rate is 20%.
The company desires a minimum return of 25% on invested capital.

Required: Determine the net present value. (Round-off factors to three decimal places)

• Understanding the Given

o Minimum Return of 25% on invested capital is the WACC and will be used as the discount rate

If Net Present Value > 0 (Positive Amount): ACCEPTED

• If negative, that would mean that you have an investment of 28,000 but the amount that returns to you is 25,260. Nalugi ka ng
2,740

Profitability Index = Present value of cash inflows / Present value of cash outflows
= 25,260 / 28,000
Profitability Index = 0.90
 = Profitability Index Method =

Profitability index = Present value of cash inflows / Present value of cash outflows

NPV index = NPV ÷ Investment or (1 – Profitability Index)

• Is designed to provide a common basis of ranking alternatives that require different amounts of investment.
• Ratio of the Benefit to the Cost
• This method is used for project ranking
o When you have many options of projects, use this to assess which one you will chose / alin yung uunahin mo

If Profitability Index > 1: Accepted

• If below 1, it can be interpreted as mas mataas ang investment kaysa sa value of cash flow.
• The higher the PI, the better

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

Illustration: Capital Rationing – Ranking Projects

Zone Corp. is considering five different investment opportunities. The company’s cost of capital is 12%. Data on these opportunities under
consideration are given below:

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

1 P35,000 P39,325 P4,325 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:

1. Rank the projects in order of preference according to NPV, IRR and benefit/cost ratio.

NPV: Projects 1, 2, 3, 4, 5
IRR: Projects 4,1, 2, 3, 5
PI: Projects 2, 1, 3, 4, 5

2. If only a budget of P55,000 is available, which projects should be chosen? Choose Projects 2 and 1

In deciding which Projects to invest on when facing a constraint, assess the ranking of the Profitability Index. Highest are
Projects 2 and 1.
NPV of 2 + NPV of 1 = 7,255
No other two projects would get a higher combination than these two.

P 55,000
(20,000) – Project 2
(35,000) – Project 1
-0-

3. If only a budget of P45,000 is available, which projects should be chosen? Choose Projects 2 and 3

Even if 1 has a higher PI than 3, hindi na kakasya sa constraint yung investment. That is why, we go to the next highest.

P 45,000
(20,000) – Project 2
(25,000) – Project 3
-0-

Here, the priority is making use of the investments efficiently.

 = Internal Rate of Return Method =

• IRR is the rate of return that equates the present value of cash inflows to present value of cash outflows.
o Ang hinahanap dito ay yung Discount Rate
• It is also known as discounted cash flow rate of return, time-adjusted rate of return or sophisticated rate of return.
• Know the discount rate para ang maging PV of Cash Flow = Cost of Investment (mag break-even sila)
o PV of Cash Flow – Cost of Investment = 0

If IRR > Cost of Capital: Accepted

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:

PVF for IRR = Net investment cost / 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 the true return of project

Disadvantages:
1. Assumes that IRR is the re-investment rate.
2. When project includes negative earnings during its life, different rates of return may result.

Illustration: NPV, PI & IRR (Even vs. Uneven Cash Flows)

Yahoo Corp. gathered the following data on two capital investment opportunities:

Project 1 Project 2
Cost of investment P195,200 P150,000
Cost of capital 10% 10%
Expected useful life 3 years 3 years
Net cash inflows P100,000 P100,000*

* This amount is to decline by P20,000 annually thereafter.

Required: Round-off factors to three decimal places in all cases.

1. Fill in the blanks.
Project 1 Project 2
NPV 53,500 52,040
Profitability index 1.274 1.347
NPV Index 0.274 0.347

Net Present Value:

Project 1:
PVCF (100,000 x 2.487) 248,700
Cost of Investment 195,200
NPV 53,500

Project 2:
PVCF (100,000 x 0.909) + (80,000 x 0.826) + (60,000 x 0.751) 202,040
Cost of Investment 150,000
NPV 52,040
 Profitability Index:
Project 1:
PVCF 248,700
÷ Cost of Investment 195,200
PI 1.274

Project 2:
PVCF 202,040
÷ Cost of Investment 150,000
NPV 1.347

NPV Index: NPV ÷ Cost of Investment

Project 1 = 53,500 ÷ 195,200 = 0.274
Project 2 = 52,040 ÷ 150,000 = 0.347

NOTE that NPV Index shortcut is just (1 – Profitability Index)

2. What is Project 1’s IRR?

a. 23% b. 27% c. 25% d. 24%

PVCF 195,200 (100,000 x 1.952)

COI 195,200
NPV -0-

PVF at IRR = 1.952

Trial and Error Method
@ 23% = 2.011
@ 24% = 1.981
@ 25% = 1.952

Interpolation Method
Assume the following values:
PVF @ IRR 2.2 (220,000 ÷ 100,000)

Trial and Error

@ 15% = 2.283
@ 16% = 2.245
@ 17% = 2.210
@ 18% = 2.174

IRR = Between 17% and 18%

@ 17% = 2.210
@ IRR = 2.2
@ 18% = 2.174

2.210 – 2.2 = 0.01

2.210 – 2.174 = 0.036

0.01 ÷ 0.036 = 0.278 + 17% = 17.278%

PVF @ 17.278% = 2.2

3. What is project 2’s time-adjusted rate of return?

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

PVCF(100,000 x ?) + (80,000 x ?) + (60,000 x ?) 150,000

COI 150,000
NPV -0-

@ 30% = (100K x 0.769) + (80K x 0.5921) + (60K x 0.455) 151,560

@ IRR, PVCF 150,000
@ 31% = (100K x 0.763) + (80K x 0.583) + (60K x 0.445) 149,640

151,560 – 150,000 = 1,560

151,560 – 149,640 = 1,920
1,560 ÷ 1,920 = 0.8125 + 30% = 30.8125%
 = Present Value Payback =

• This has uneven cash flow

• Do not use PVF of OA, isa isa dapat so USE PVF of 1

Present Value Payback – Illustrative Problem

Problema Co. is considering the purchase of new machinery. The estimated cost of the machine is P250,000. The machine is not expected
to have a residual value at the end of four years. The machine is expected to generate annual cash inflows for the next four years as
follows:
Year Annual Cash Inflow
1 P 150,000
2 100,000
3 50,000
4 50,000

Problema Co. requires a 12% return on this investment. The present values of 1, end of each period, discounted at 12% follow:
Year Present Value Factor
1 0.89286
2 0.79719
3 0.71178
4 0.63552

What is the present value payback?

Illustration: Relationships – Discounted Techniques

Fill in the blanks for each of the following independent cases. In all cases, the investment has a useful life of 10 years and no
salvage value. Round off factors to three decimal places.

Project Annual Cash Flow Investment Cost of Capital IRR NPV

1 P45,000 P188,640 14%
2 P75,000 12% 18%
3 P300,000 16% P81,440
4 P450,000 12% 14% P115,000

Illustration: Discounted & Non-Discounted Techniques

Mall Company is considering buying a new machine, requiring an immediate P400,000 cash outlay. The new machine is expected to
increase annual net after-tax cash receipts by P160,000 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: Round-off factors to three decimal places in all cases.

1. Payback period 2.5 years 5. Net present value P149,280
2. Payback reciprocal 0.4 6. Profitability index 1.3732
3. ARR (based on original investment) 20% 7. Present Value Payback 3.3 years
4. ARR (based on average investment) 40% 8. Internal rate of return 28.65%

SOLUTIONS
3. ARR – Based on Original Investment
Net Income After Tax ÷ Original Investment
= (160,000 – 80,000*) ÷ 400,000 = 20%

*80,000 = Depreciation Expense

4. ARR – Based on Original Investment

Net Income After Tax ÷ Original Investment
= (160,000 – 80,000) ÷ 200,000 = 40%
5. Net Present Value
549,280 = 160,000 x 3.433
(400,000)
149,280

7. Present Value Payback

8. 400,000 ÷ 160,000 = 2.5

@28% = 2.532
@IRR = 2.5
@29% = 2.483

0.032 ÷ 0.049 = 0.65 + 28% = 28.65%

 EXERCISES (MULTIPLE-CHOICE)

1. The technique that does not use cash flow for capital investment decisions.
a. Payback b. NPV c. ARR d. IRR

2. Which of the following groups of capital budgeting techniques uses the time value of money?
a. Book rate of return, payback and profitability index c. IRR, ARR and PI
b. IRR, payback and NPV d. IRR, NPV and PI

3. Cost of capital is 3%; economic life in years = 4 years; simple PV factor for year 4 is
a. 0.915 b. 0.888 c. 0.455 d. 0.350

4. Discount rate is 11%; economic life in years = 3 years; PV annuity factor for 3 years is
a.0.731 b. 1.713 c. 2.444 d. 3.102

5. As the discount rate increases,

a. Present value factors increase c. Present value factors remain constant
b. Present value factors decrease d. It is impossible to tell what happens to the factors

6. The PVF of any amount at year zero or zero percent is always equal to
a. Zero b. 0.50 c. 1.00 d. cannot be determined

7. The present value of P50,000 due in five years would be highest if discounted at a rate of
a. 0% b. 10% c. 15% d. 20%

8. An investment with a positive NPV also has

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

9. A company is considering the purchase of an investment that has a positive NPV based on a 12% discount rate of. What is the
IRR?
a. Zero b. 12% c. Greater than 12% d. Less than 12%

10. Which of the following combinations is possible?

Profitability index NPV IRR
a. >1 Positive = cost of capital
b. >1 Negative < cost of capital
c. <1 Negative < cost of capital
d. <1 Positive < cost of capital

11. The NPV 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

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

13. Which one of these methods is a project ranking method rather than project screening method?
a. NPV method b. Simple rate of return c. Profitability index d. Sophisticated rate of return

14. If the IRR on an investment is zero,

a. Its NPV is positive c. It is generally a wise investment
b. Its annual cash flows equal its required investment d. Its cash flows decrease over its life

15. If a company’s required rate of return is 12 percent and in using the profitability index method, a project’s index is greater than
1.0, this indicates that the project’s rate of return is
a. equal to 12 percent. c. less than 12 percent.
b. greater than 12 percent. d. dependent on the size of the investment.

16. In choosing from among mutually exclusive investments the manager should normally select the one with the highest
a. Net present value c. Profitability index.
b. Internal rate return d. Book rate of return.