MS Mastery

Financial Management Concepts and Techniques for Planning, Control & Decision Making

CAPITAL BUDGETING - the process of identifying, evaluating, planning, and financing

capital investment projects of an organization.

CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS

1. Capital investment decisions usually require large commitments of resources.
2. Most capital investment decisions involve long-term commitments.
3. Capital investment decisions are more difficult to reverse than short-term decisions.
4. Capital investment decisions involve so much risk and uncertainty.

CAPITAL INVESTMENT FACTORS

1. Net investment 2. Net Returns 3. Cost of Capital

* NET INVESTMENT = costs or cash outflows less cash inflows or savings incidental to
the acquisition of the investment projects.

Costs or cash outflows:

1. The initial cash outlay covering all expenditures on the project up to the time
when it is ready for use or operation:
Ex. Purchase price of the asset
Incidental project-related costs such as freight, insurance taxes, handling,
installation, test-runs, etc.
2. Working capital requirements to operate the project at the desired level
3. Market value of an existing, currently idle asset, which will be transferred to or
utilized in the operation of the proposed capital investment project.

Savings or cash inflows:

1. Trade-in value of old asset (in case of replacement)
2. Proceeds from sale of old asset to be disposed due to the acquisition of the new
project (less applicable tax, in case there is gain on sale, or add tax savings, in
case there is loss on sale).
3. Avoidable cost of immediate repairs on old asset to be replaced, net of tax.

*NET RETURNS
1. Accounting net income
2. Net cash inflows

*COST OF CAPITAL
Cost of Capital - the cost of using funds; it is also called hurdle rate, required rate of
return, cut-off rate
- the weighted average rate of return the company must pay to its long-
term creditors and shareholders for the use of their funds.

Computation of COST OF CAPITAL

Source Capital Cost of Capital

Creditors Long-term debt After-tax rate of interest i (1
- TxR)
Stockholders:
Preferred Preferred Stock Preferred dividends per
share
.
Current market price or
Net issuance price
Common Common Stock CAPM or DGM

1. CAPITAL ASSET PRICING MODEL (CAPM)

R = RF + β (RM - RF)
where: R = rate of return
RF = risk-free rate determined by government securities
β = beta coefficient of an individual stock which is the correlation
between the volatility (price variation) of the stock market and
the volatility of the price of the individual stock.
Example: If the price of an individual stock rises 10% and the stock market
15%, the beta is 1.5.
RM = market return
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Financial Management Concepts and Techniques for Planning, Control & Decision Making

(RM - RF) = market risk premium or the amount above risk-free

rate required to induce average investors to enter
the market.

2. THE DIVIDEND GROWTH MODEL

a. Cost of Retained Earnings D1 + G
P0

where: P0 = current price

D1 = next dividend
G = growth rate in dividends per share (it is assumed that the
dividend payout ration, retention rate, and therefore the
EPS growth rate are constant)

b. Cost of New Common Stock = D1

P0 (1 - Flotation Costs) +G

Flotation Cost = the cost of issuing new securities

COMMONLY USED METHODS OF EVALUATING CAPITAL INVESTMENT PROJECTS

1. Methods that do not consider the time value of money
a. Payback
b. Bail-out
c. Accounting rate of return
2. Methods that consider the time value of money (discounted cash flow methods)
a. Net present value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return

METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY

PAYBACK PERIOD = Net cost of initial investment = the length of time required
Annual net cash inflows by the project to return the
initial cost of investment
Advantages:
1. Payback is simple to compute and easy to understand. There is need to
compute or consider any interest rate. One just has to answer the question:
“How soon will the investment cost be recovered?”
2. Payback gives information about liquidity of the project.
3. It is a good surrogate for risk. A quick 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 the cash flows that may occur after the payback period.

BAIL-OUT PERIOD - cash recoveries include not only the operating net cash inflows
but also the estimated salvage value or proceeds from sale at the
end of each year of the life of the project.

ACCOUNTING RATE OF RETURN - also called book value rate of return, financial
statement method, average return on investment and unadjusted
rate of return.

Accounting Rate of Return = Average annual net income

Investment

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Financial Management Concepts and Techniques for Planning, Control & Decision Making

Advantages:
1. The ARR computation closely parallels accounting concepts of income
measurement and investment return.
2. It facilitates re-evaluation of projects due to the ready availability of data from
the accounting records.
3. This method considers income over the entire life of the project.
4. It indicates the project’s profitability.

Disadvantages:
1. Like the payback and bail-out 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.

METHODS THAT CONSIDER THE TIME VALUE OF MONEY (Discounted Cash Flow
Methods)
NET PRESENT VALUE
Present value of cash inflows
- Present value of cash outflows
Net Present Value
Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as the reinvestment rate
4. Easy to apply.

Disadvantages:
1. It requires predetermination of the cost 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.

PROFITABILITY INDEX
Total present value of cash inflows
Profitability Index = Total present value of cash outflows

DISCOUNTED CASH FLOW RATE OF RETURN - the rate of return which equates the
present value (PV) of cash inflows to PV of cash outflows.

1. Determine the present value factor (PVF) for the discounted cash flow rate of
return (DCFRR) with the use of the following formula:

PVF for DCFRR = Net Cost of investment

Net cash inflows

2. Using Table 2 (present value annuity table), fine on line n (economic life) the PVF
obtained in Step 1. The corresponding rate is the DCFRR.

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes true return of project

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

PAYBACK RECIPROCAL - a reasonable estimate of the discounted cash flows rate of

return, provided that the following conditions are met:
1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.

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MS Mastery
Financial Management Concepts and Techniques for Planning, Control & Decision Making

Net cash inflows

Payback Reciprocal = Investment

or

1
Payback Reciprocal =
Payback period

EXERCISES:
COST OF CAPITAL
1. Aves Corporation has P 1,000 par value bond outstanding with 5 years to maturity.
The bond carries an annual interest payment of P 90 and is currently selling for P
1,100 per bond. The corporation pays the corporate tax rate of 30%. It wishes to
know that the after-tax cost of a new bond issue is likely to be. The yield to maturity
(YTM) on the new issue will be the same as the yield to maturity on the old issue
because the risk and maturity date will be similar

REQUIRED:
a. Compute the approximate yield to maturity on the old issue and use this as
the yield for the new issue. What is the after-tax cost of debt?
b. Compute the new after-tax cost of debt if the bond is issued at P 970 per
bond.
c. Compute the current yield if the bond is issued at P 970 per bond.

2. Havana Corporation is about to issue preferred stock that pays an annual dividend of
10%. It has a price of P 125 and a par value of P 100. The issue of these preferred
shares will cost the company P 5 in flotation cost. The corporate tax rate is 30%.

REQUIRED:
What is the required rate of return (yield) on the preferred stocks?

3. The preferred stock of C Corporation pays an annual dividend of P 5.60. It has a

required rate of return of 8%.

REQUIRED:
Compute the price of the preferred stock.

4. Full Hours Productions paid a dividend of P 2.40 per share on its common stock last
year. Over the next 12 months, the dividend is expected to grow at P 5%, which is
the constant growth rate (g) for the firm. The common stock currently sells for P 84
per share.

REQUIRED:
Compute the required rate of the return on the common stock.

5. D Corporation currently pays a P 2.10 annual cash dividend. It plans to maintain the
dividend at this level as no future growth is anticipated in the foreseeable future.

REQUIRED:
If the required rate of return is 12%, what is the price of the common stock?

6. Bella Corporation just paid a dividend of P 7.20 per share on its stock. The dividends
are expected to grow at a constant rate of 6% per year, indefinitely.

REQUIRED:
a. If investors require a 12% return on Bella stocks, what is the current price?
b. What will the price be in three years?

7. H Corporation’s common stock has a beta of 1.2. The risk-free rate is 7.5% and the
market rate is 12%. Determine the
a. market risk premium c. required return
b. risk premium d. cost of the common stock equity

8. Use the basic equation for the capital asset pricing model (CAPM) to work on each of
the following:

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MS Mastery
Financial Management Concepts and Techniques for Planning, Control & Decision Making

a. Find the required rate of return for an asset with a beta of 0.90 when the
risk-free rate and market return are 8% and 12%, respectively.
b. Find the required rate of return for an asset with a beta of 1.25 when the
risk-free rate of return is 5%, and the market risk premium is 3%.
c. Find the beta for an asset with a required return of 15% when the risk-free
rate and market return are 10% and 12.50%, respectively.

9. The I corporation finds it necessary to determine its marginal cost of capital. I’s
current capital structure calls for calls for 45% debt, 15% preferred stock, and 40%
common equity. Initially, common equity will be in the form of retained earnings (K-
e), and then new common stock (Kn). The costs of the various sources of financing
are as follows: debt, 6.2%, preferred stock, 9.4%, retained earnings, 12%, and new
common stock, 13.4%.

a. What is the initial weighted average of capital? (Include debt, preferred stock,
and common equity in the form of retained earnings.)
b. If the firm has P 20 million in retained earnings, at what size of capital
structure will the firm run out of retained earnings?
c. What will the marginal cost of capital be immediately after that point? (Equity
will remain at 40% of the capital structure but will be in the form of new
common stock <Kn>.)
d. The 6.2% cost of debt referred to above applies only to the first P 36 million
of debt. After that, the cost of debt will be 7.8%. At what size of capital
structure will there be a change in the cost of debt?
e. What will the marginal cost of capital be immediately after that point?
(Consider the facts if both Parts c and d.)

RETURNS

1. NET INVESTMENT. Lupe Company is planning to purchase new equipment costing

P 500,000. Freight and installation costs are P 50,000. The new equipment will be
purchased to replace an old unit that was acquired several years ago at a cost of P
300,000, for which an accumulated depreciation of P 270,000 has been recorded.

The old unit will be sold for P 20,000. Other assets that are to be retired as a result
of the acquisition of the new machine can be salvaged and sold for P 100,000. The
gain on the retirement of these other assets is P 6,000, which will increase income
taxes by P 1,800.

If the new equipment is not purchased, extensive repairs on the old equipment will
have to be made at an estimated cost of P 30,000. This repairs expense can be
avoided by purchasing the equipment.

Additional gross working capital of P 50,000 will be needed to support operations

planned with the new equipment.

REQUIRED:
Compute the amount of investment for decision-making purposes.

2. RETURNS. The management of Lobo Trade School plans to install popcorn vending
machines in its school. Annual sales of popcorn are estimated at 3,000 units at a
price of P 8 per unit. Variable costs are estimated at P 3 per unit, while incremental
fixed costs, excluding depreciation, are at P 2,000 per year.

Lobo will acquire three vending machines at P 10,000 each, including installation
costs of P 1,000 per machine. 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 30%.

REQUIRED:
a. Determine the increase in annual net income of Lobo if the pop corn vending
machines were installed.
b. Determine the annual net cash inflows that will be generated by the project.

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MS Mastery
Financial Management Concepts and Techniques for Planning, Control & Decision Making

3. RETURNS. LRT is planning to buy trains cleaning equipment that can reduce trains
wash service cost and other cash expenses by an average of P 180,000 per year.
The new cleaning equipment will cost P 300,000 and will be depreciated for 5 years
on a straight-line basis. No salvage value is expected at the end of the equipment’s
life. Income tax is estimated at 30% of income before tax.

REQUIRED:
Determine the annual net returns (net income) and net cash inflows for the
proposed investment.

4. ALTERNATIVE PRODUCTION PROCESS. Manekin Statuary uses a labor-intensive

manufacturing process. Existing equipment has a book value of P 20,000, a five-
year remaining life, and a P 12,000 market value. Annual depreciation is P 4,000
and cash operating costs is P 64,000. The proposed process requires machinery
costing P 100000 with a useful life of five years and no salvage value. The new
machinery, which will replace the old one, requires P 40,000 in annual cash costs.
Straight-line depreciation will be used for tax purposes for the new machine. The tax
rate is 30% and the cost of capital is 12%.

REQUIRED:
a. What is the net investment on the new equipment?
b. What is the annual net cash inflow from the new equipment?

EVALUATION TECHNIQUES

1. PAYBACK AND ACCOUNTING RATE OF RETURN. Antigo Company is

contemplating the replacement of old equipment. The annual cost of operating the
old equipment is P 600,000, excluding depreciation, while the estimate fro the new
equipment is P 240,000. The cost of the new equipment is P 800,000 with a useful
life estimate of 5 years and no salvage value. Assume an income tax rate of 30%,
and a 20% cost of capital. The book value of the old machine is zero.

REQUIRED:
a. Payback period.
b. Accounting rate of return based on (a) original investment and (b) average
investment.

2. PAYBACK PERIOD COMPUTATION WITH UNEVEN CASH FLOWS. Footok

Cologne is considering the purchase of a special-purpose bottling machine for P
400,000. It is expected to have a useful life of five years with a zero terminal
disposal price. The plant manager estimates the following savings in cash-operating
costs, net of income tax:
Year Amount
1 P 176,000
2 160,000
3 112,000
4 80,000
5 64,000
Total P 592,000
Footok Cologne is using a required rate of return of 15% in its capital budgeting
decisions. It pays income tax at the rate of 30% of income before income tax.

REQUIRED:
Compute the payback period.

3. PAYBACK AND BAILOUT PAYBACK. Apple Company purchased a new machine on

January 1 of this year for P 180,000, with an estimated useful life of 5 years and a
salvage value of P 10,000. The machine will be depreciated using the straight-line
method. The machine is expected to produce cash flow from operations, net of
income taxes, of P 70,000 a year in each of the next five years. The new machine’s
salvage value is P20,000 in years 1 and 2, and P 15,000 in years 3 and 4.

REQUIRED:
Compute: (1) Payback period
(2) Bail-out period

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MS Mastery
Financial Management Concepts and Techniques for Planning, Control & Decision Making

4. NET PRESENT VALUE - UNIFORM CASH FLOWS. Kasalukuyan Company plans to

buy a new machine costing P 500,000. The new machine is expected to have a
salvage value of P 50,000 at the end of its economic life of 5 years. The annual
cash inflow before income tax from this machine has been estimated at P 200,000.
The tax rate is 30%. The company desires a minimum of 10% on invested capital.

REQUIRED:
Compute the net present value (NPV)

5. NET PRESENT VALUE WITH ENEVEN CASH FLOWS. Alexis Company is

evaluating a capital investment proposal that will require an initial cash investment
of P 600,000. The project will have a five-year life. The net after tax cash flows
form the project are expected to be P 200,000 in the first year, P 180,000 in the
second year, P 120,000 in the third year, P 100,000 in the fourth year, and P 60,000
in the fifth year. Salvage value of P 10,000 is expected to be received at the end of
the end of the life of the project. The straight-line method will be used to depreciate
the project. Income tax rate is 30%, and the company’s cost of capital is 10%.

REQUIRED:
What is the net present value?

6. PROFITABILITY INDEX. Alin Corporation gathered the following data on two

capital investment opportunities:
1 2
Cost of investment P 320,000 P 240,000
Discount rate 20% 20%
Net cash inflows P 128,000 per year for 5 years P 128,000 in the first year,
P96,000 in the next three
years and P 64,000 in the
fifth year

7. INTERNAL RATE OF RETURN. IRR 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 110,000 in each of the next 5 years
of its economic life. No salvage value is expected at the end of 5 years. The
company desires a minimum return of 10% on invested capital.

REQUIRED:
Internal rate of return.

8. DISCOUNTED CASH FLOW RATE OF RETURN WITH UNEVEN CASH FLOWS. A

new machine costing P 50,000 with three years useful life, no salvage value at the
end of three years, is expected to bring in the following cash inflows after tax:

First year P 30,000

Second year 20,000
Third year 10,000

REQUIRED:
Determine the time-adjusted rate of return.

9. PAYBACK RECIPROCAL. Owu Company is planning to buy equipment costing P

240,000 which has an estimated life of 30 years and is expected to produce after-tax
net cash inflows of P 48,000 per year.

REQUIRED:
Estimate the discounted cash flow rate of return without using present value
factors.

10. DISCOUNTED PAYBACK. A new machine costing P 40,000 wit three years useful
life, no salvage value at the end of three years, is expected to bring in the following
cash inflows after tax:

First year P 30,000

Second year 20,000
Third year 10,000
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MS Mastery
Financial Management Concepts and Techniques for Planning, Control & Decision Making

REQUIRED:
If the company’s cost of capital is 10%, what is the discounted
payback period?

11. Belle Co. wants to introduce a new product. The manager’s best estimates follow:
Selling price P 30,000
Variable costs 20,000
Sales volume 10,000

Bringing out the new project requires a P 50,000 increase in working capital, as well
as the purchase of new equipment costing P 250,000 and having a five-year useful
life with no salvage value. The new equipment has cash operating costs of P
100,000 per year and will be depreciated using the straight-line method. Belle pays
income tax at the rate of 40%. Its cost of capital is 12%.

REQUIRED:
Determine the NPV of this investment opportunity.

12. Risa Company manufactures copier equipment and can replace one of its existing
machines with a new model. The existing machine has a net book value of P
120,000 and a market value of P 60,000. It has an estimated remaining life of four
years; at which time it will have no salvage value. The company uses straight line
depreciation of P 30,000 per year on the machine, and its annual cash operating cost
is P 280,000.

The new model costs P 500,000 and has a four-year estimated life with no salvage
value. Its annual cash operating cost is estimated at P 160,000. The firm will use
straight line depreciation. The tax rate is 40% and the cost of capital is 12%. The
purchase of the new, more efficient machine will enable the company to reduce its
investment in inventory by P 80,000.

REQUIRED:
a. Determine the investment required to purchase the new machine.
b. Determine the net present value of the investment.
c. Suppose that the new machine has a 10% salvage value. The company will
consider the salvage value in determining annual depreciation. Determine the
net present value of the investment.
d. Suppose that the new machine has a 10% salvage value. The company will
ignore the salvage value in determining annual depreciation. The applicable
tax rate is 40%. Determine the net present value of the investment.

13. Albania Company expects to sell 100,000 units of its product annually for the next
four years at P 9 each, with variable cost of P 6 per unit, and annual cash fixed costs
of P 250,000. The product requires machinery costing P 320,000 with a four-year
life and no salvage value at the end of four years. The company will depreciate the
machine using the straight-line depreciation method. Additionally, working capital,
in the form of receivables and inventory, will increase by 150,000. This additional
working capital will be returned in full at the end of four years. The tax rate is 40%,
and the cost of capital is 12%.

REQUIRED:
a. Compute the expected net present value for this investment.
b. Compute the profitability index for this investment.

14. Mountain View Hospital has purchased new lab equipment for P 134,650. The
equipment is expected to last for three years and to provide cash inflows as follows:
Year 1 P 45,000
Year 2 60,000
Year 3 ?

REQUIRED:
Assuming that the equipment will yield exactly a 16% rate of return, what is
the expected cash inflows for year three?

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MS Mastery
Financial Management Concepts and Techniques for Planning, Control & Decision Making

15. Union Bay Plastics is investigating the purchase of a piece of automated equipment
that will save P 100,000 each year in direct labor and inventory carrying costs. This
equipment costs P 750,000 and is expected to have a ten-year useful life with no
salvage value. The company requires a minimum of 15% return on all equipment
purchases. Management anticipates that this equipment will provide intangible
benefits such as greater flexibility and higher quality output.

REQUIRED:
What peso value per year would the intangible benefits have to have to make
the equipment an acceptable investment?

Jasmin May Baniaga, CPA, CMA, MBA Page 9