MODULE 8 Capital Budgeting
MODULE 8 Capital Budgeting
MODULE 8 Capital Budgeting
CAPITAL BUDGETING
CAPITAL INVESTMENT – involves significant commitment of funds to receive a satisfactory return – increase in revenue or reduction
in costs over an extended period of time. Example: purchase of equipment for expansion, replacement of old equipment.
CAPITAL BUDGETING – is the process by which management identifies, evaluates, and makes decision on capital investment
projects of an organization. It is the process of planning expenditures for assets, the return on which are expected to continue beyond
one-year period.
Net Returns
● ACCRUAL BASIS: Accounting net income (after tax)
● CASH BASIS: Net cash inflows
✔ DIRECT METHOD (Cash inflows – Cash outflows)
✔ INDIRECT METHOD (Net income after tax + Noncash expenses)
Bicol Company plans to replace a unit of equipment that was acquired three (3) years ago and is now recorded at a book value of
P65,000. This equipment can be sold now for P75,000. Tax rate is 25%.
New equipment can be acquired from Baguio Company at a list price of P200,000. Baguio will grant a 2% cash discount if the
equipment is paid for within 30 days from acquisition date. Shipping, installation and testing charges to be paid are estimated at
P14,000.
Other assets with a book value of P12,000 that are to be retired as a result of the acquisition of the new machine can be salvaged and
sold for P10,000.
Additional working capital of P18,000 will be needed to support operations planned with the new equipment.
The annual cash flow after income tax from the operation of the new equipment has been estimated at P50,000. The equipment is
expected to have a useful life of 5 years with a salvage value of P4,000 at the end of 5 years.
Required: What is the initial cost of investments for decision-making purposes? 145,000
CASH OUTFLOWS:
Tax – Gain on sale of old equipment (75k-65k) x 25% 2,500
Purchase price, net (P200,000 x 98%) 196,000
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Shipping, installation…. 14,000
Additional WC 18,000 230,500
CASH INFLOWS:
Proceeds from sale of old equipment 75,000
Proceeds from sale of other assets 10,000
Tax savings – loss on sale of O.A. (10k-12k) x 25% 500 85,500
The management of Star Cinema plans to install coffee vending machines costing P200,000 in its movie house. Annual sales
of coffee are estimated at 10,000 cups at a price of P15 per cup. Variable costs are estimated at P6 per cup, while incremental fixed
cash costs, excluding depreciation, at P20,000 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 is 30%.
a)
Incremental CM (P15 – P6) x 10,000 P 90,000
Incremental fixed cash costs (20,000)
Incremental depreciation (P200,000/5) (40,000)
Incremental NIBT P 30,000
Incremental tax (30%) (9,000)
Incremental NIAT P 21,000
b)
Incremental CM (P15 – P6) x 10,000 P 90,000
Incremental fixed cash costs (20,000)
Incremental tax (30%) (9,000)
Incremental net cash flows P 61,000
Moon Corporation is planning to buy cleaning equipment that can reduce service cost and other cash expenses by an average
of P70,000 per year. The new cleaning equipment will cost P100,000 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 32%.
Required: Determine the net cash inflows that will be generated by the project. 54,000
OR;
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CAPITAL BUDGETING TECHNIQUES IN EVALUATING PROJECTS
● Non-discounted methods – methods that do not consider the time value of money
a. Payback period method c. Bail-out payback method
b. Payback reciprocal method d. Accounting rate of return method
PV P100,000
75,131.48
FV to PV = FV x PVF
= 100,000 x 0.7513 = 75,130
CASH FLOWS
I. NON-DISCOUNTED METHODS
= Payback Period Method =
Payback period = Net initial cost of investment / Annual net after-tax cash inflows
Advantages:
1. Payback is simple to compute and easy to understand.
2. Payback gives information about the liquidity of the project.
3. It is a good surrogate for risk. A quick or short payback period indicates a less risky project.
Disadvantages:
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1. Payback does not consider the time value of money.
2. It gives more emphasis on liquidity rather than on profitability of the project.
3. It does not consider the salvage value of the project.
4. It ignores cash flows that may occur after the payback period (short-sighted)
= Payback Reciprocal =
OR; 1/PBP
= 1/4
= 25%
Advantages:
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.
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.
Illustration: Payback Period & Accounting Rate of Return (With Even Cash Flows)
Green Company considers the replacement of some old equipment. The cost of the new equipment is P90,000, with a useful
life estimate of 8 years and a salvage value of P10,000. The annual pre-tax cash savings from the use of the new equipment is
P40,000. The old equipment has zero market value and is fully depreciated. The company uses a cost of capital of 25%.
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2) PBR = 1/3.214
= 31.11%
= 36%
Illustration: Payback Period & Accounting Rate of Return (With Uneven Cash Flows)
Pole Company has an investment opportunity costing P90,000 that is expected to yield the following cash flows over the next
five years: (assume a cut-off rate of 30%)
Year 1: P40,000 Year 2: P35,000 Year 3: P30,000 Year 4: P20,000 Year 5: P10,000
Required:
1. Payback period in months 30 months
2. Book rate of return 20%
1) P90,000
(40,000) CF1
(35,000) CF2
P15,000 – Unrecovered investment, beg. Of yr 3
/ 30,000
0.5
= 9,000
(P90,000/2)
= 20%
Average NIAT:
YEAR ACF DEP EXP NIAT
It is a modified payback period method wherein cash recoveries include the estimated salvage value at the end of each year of
the project life.
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Illustration: Bail-out Payback Period
A project costing P180,000 will produce the following annual cash flows and salvage value:
P180,000
(50,000) CF1
(50,000) CF2
P 80,000
(35,000)
P 45,000
(50,000)
0.9 CF3
1. A project’s salvage value, realizable at the end of life of the project, is considered in the computation of the net investments for
decision-making purposes. F
2. The payback period emphasizes the profitability of a capital project while the accounting rate of return, on the other hand,
emphasizes the project’s liquidity. F
3. Annual cash inflows from the capital projects are measured in terms of
a. Income before depreciation and taxes c. Income before depreciation but after taxes
b. Income after depreciation and taxes d. Income after depreciation but before taxes
4. When computing for the accounting rate of return (ARR), which of the following is used?
a. Income before depreciation and taxes c. Income before depreciation but after taxes
b. Income after depreciation and taxes d. Income after depreciation but before taxes
5. Calculating the payback period for a capital project requires knowing which of the following?
a. Useful life of the project c. The project's NPV
b. The company's minimum required rate of return d. The project's annual cash flow
9. Payback period is the length of time it will take a company to recoup its outlay for an investment. T
10. Payback emphasizes the return of the investment and ignores the return on the investment. T
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12. Which of the following would not involve a capital-budgeting analysis?
a. The acquisition of new equipment.
b. The addition of a new product line.
c. The adoption of a new cost driver for overhead application.
d. The construction of a new distribution facility.
e. Whether a pro football team should trade for and sign a star quarterback to a long-term contract.
13. A major difference between an investment in working capital and one in depreciable assets is that
a. An investment in working capital is never returned, while most depreciable assets have some residual value.
b. An investment in working capital is returned in full at the end of the project’s life, while an investment in depreciable assets
has no residual value.
c. An investment in working capital is not tax-deductible when made, not taxable when returned, while an investment in
depreciable assets does allow tax deductions.
d. Because an investment in working capital is usually returned in full at the end of the project’s life, it is ignored in computing
the amount of the investment required for the project.
14. The cash inflow from the return on an investment in working capital is
a. Adjusted for taxes due.
b. Discounted to present value.
c. Ignored if any depreciable assets also involved in the project have no expected residual value.
d. Not real.
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 because of interests a peso could earn by putting it in a savings account or placing it in an investment that earns income. 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.
COSTS OF CAPITAL
The ‘costs of capital’ used in capital budgeting is the Weighted Average Costs of Capital (WACC). These are specific costs of using
long-term funds, obtained from the different sources: borrowed (debt) and invested (equity) capital.
SOURCES COSTS
Debt Interest rate (after tax)
Preferred Stock (PS) Dividend yield
Common Stock (CS) Dividend yield plus growth rate
Retained Earnings (RE) Dividend yield plus growth rate
⮚ 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 DPS / MPPCS) + Dividend growth rate
Where: DPS = Dividend per share, MPPCS = Market price per common share
⮚ 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 (e.g., underwriting fees).
⮚ 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
Common shares:
Dividend per share – last year P5
Growth rate 10%
Expected DPS (P5 x 1.1) P5.5
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MPPS P102
Flotation cost P2
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:
Additional data:
● Current market price per share:
o Preferred stock: P50
o Common stock: P40
Required:
1. Given an operating income of P500,000, how much is the earnings per share?
2. Determine the weighted average cost of capital.
EBIT P 500,000
Int exp (P600,000 x 8%) (48,000)
NIBT P 452,000
Tax (30%) (135,600)
NIAT P 316,400
Pref Div (P200,000 x 5%) (10,000)
NI available to OS P 306,400
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Capital Asset Pricing Model – Illustrative Problems
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%? 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?
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?
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:
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%?
Net present value = Present value of cash inflows – Present value of cash outflows
⮚ 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)
⮚ The net investment cost required at the inception of the project usually represents the present value of the cash outflows.
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.
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)
PVCF:
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ACF (P10,000 x 2.362) 23,620
SV (4,000 x 0.41)
Investment 28,000
NPV (4,380)
Profitability index = Present value of cash inflows / Present value of cash outflows
NPV index = NPV / Investment
The profitability index method is 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.
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:
Required:
1. Rank the projects in order of preference according to NPV, IRR and benefit/cost ratio.
NPV: 1,2,3,4,5
IRR: 4,1,2,3,5
PI: 2,1,3,4,5
1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of the following formula:
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.
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*
100,000 ? 1.952
PVCF 195,200 ACF x PVF
COI (195,200) Discount rate? (IRR)
NPV 0
PROJECT 2:
PVCF 150,000 - (100,000 x ? ) + (80,000 x ?) + (60,000 x ?)
COI (150,000)
NPV 0
@ 30%, PVCF:
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100,000 x 0.769 76,900
80,000 x 0.592 47,360
60,000 x 0.455 27,300 151,560
1,560 ÷
@ IRR, PVCF 150,000
1,920 = 0.8125
@ 31%, PVCF:
100,000 x 0.763 76,300
80,000 x 0.583 46,640
60,000 x 0.445 26,700 149,640
IRR = 30.8125%
100,000 x 0.764 76,400
80,000 x 0.584 46,720
60,000 x 0.447 26,820 149,940
PROJECT 2:
PVCF 202,040 - (100,000 x 0.909 ) + (80,000 x 0.826) + (60,000 x 0.751)
COI (150,000)
NPV 52,040
PROJECT 1:
PVCF (100,000 x 2.487) 248,700
COI 195,200
NPV 53,500
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
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PVPB period:
P250,000
(133,929)
(79,719)
(35,589)
763 / 31,776 = 0.024
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 1:
PVCF (45,000 x 5.621) 252,945
COI 188,640
NPV 64,305
COI/PVCF 188,640
÷ ACF 45,000
Required PVF 4.192
IRR:
@ 16%, PVF 5.159
@ 20%, PVF 4.193
@ 22%, PVF 3.923
@ 21%, PVF 4.054
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.
2.5
8) 160,000 X ???
PVCF 400,000 – ACF X PVF
COI 400,000
NPV 0
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DISCOUNT RATE???
Required PVF = 2.5
5)
PVCF:
ACF (P160,000 x 3.433) P 549,280
SV 0
Investment (400,000)
NPV P 149,280
6)
PI = PVCF ÷ Investment
= P549,280 ÷ P400,000
= 1.373
7)
P 400,000
PV-CF1 (P160,000 x 0.877) 140,320
PV-CF2 (P160,000 x 0.769) 123,040
PV-CF3 (P160,000 x 0.675) 108,000 P 28,640
PV-CF4 (P160,000 x 0.592) 94,720 0.30
PV-CF5 (P160,000 x 0.519) 83,040
1)
PBP = Investment / ACF
= P400,000 / P160,000
= 2.5 years
2)
PBR = ACF / Investment
= P160,000 / P400,000
= 40%
OR; = 1/PBP
= 1 ÷ 2.5
= 40%
3)
ARR – orig. = NIAT
Orig. inv.
= (P160,000 – P80,000)
P400,000
= 20%
4)
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ARR-ave. = NIAT
(P400,000/2)
= P80,000
P200,000
= 40%
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
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%
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%
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
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.
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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.
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