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MAS – LECTURE NOTES ARMIN GLENN ARANETA,CPA

CAPITAL BUDGETING

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.
2. Working capital requirement 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 operations 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 – the cost of using funds; it is also called hurdle rate, required rate of
return, cut-off rate, opportunity cost of capital.

- 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

Long-term debt = after-tax rate of interest (1 – tax rate)

Preferred stock = Preferred dividends per share

Current market price or Net issuance price

Common stock = CAPM OR DDM

1. CAPITAL ASSET PRICING MODEL (CAPM)

R= RF + ß (RM – RF)
Where: R = rate of return
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RF = risk-free rate determined by government securities

ß = 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.
RM = market return
(RM – RF) = market risk premium or the amount above risk free-rate required to
induce average investors to enter the market

2. THE DIVIDEND DISCOUNT MODEL ( DIVIDEND GROWTH MODEL)

A. Cost of Retained earnings = ( D1 ÷ P0 ) + G
Where: P0 = current price
D1 = next dividend
G = growth rate in dividends per share

B. Cost of New Common Stock = [D1 ÷ (P0 (1 – Floatation cost))] + G

Floatation 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
Annual net cash inflows
= the length of time required by the project to return the initial cost of
investment.
Advantages:
1. Payback is simple to compute and easy to understand. There is no 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.
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ACCOUNTING RATE OF RETURN = also called book value rate of return, financial
statement method, average return on investment and unadjusted rate of return.
ARR = Average annual net income
Investment
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 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

NET PRESENT VALUE

Present value of cash inflows less Present value of cash outflows
Advantages:
1. Emphasizes cash flows.
2. Recognizes the time value of money.
3. Easy to apply.
Disadvantages:
1. It requires predetermination of the cost of capital or the discount rate to be used.
2. The net present value 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
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 used of the following formula:

PVF of DCFRR = Net cost of investment

Net cash inflows

2. Using table 2. (present value annuity table), find 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 projects.

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.
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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.

= Net cash inflows = 1

Investment Payback period

Practice Problems:

COST OF CAPITAL

1. Minmin Corporation has sold P100 million of P1, 000 par value, 10% coupon bonds. The
bonds were sold at a premium and the corporation received P1, 200 per bond. If the
corporate tax rate is 30%, what is the after tax cost of these bonds for the first year?

2. Didaw Normal Corporation has a 6%, P1, 000 par value bond outstanding with 10 years
to maturity. The bond is currently selling for P1, 200. The corporation pays the corporate
tax rate of 30%. It wishes to know what 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 on the old
issue because the risk and maturity date will be similar.

Required:
1. 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?
2. Compute the new after tax cost of debt if the bond is issued at P980 per bond?
3. Compute the current yield if the bond is issued at P980 per bond.

3. Kuletz Corporation is selling P40 million of cumulative, non-participating preferred

stock. The issue will have a par value of P70 per share with a dividend rate of 8%. The
issue will be sold to investors for P80 per share, and issuance costs will be P%\5 per
share. The income tax rate is 30%. What is the cost of preferred stock to Kuletz
Corporation?

4. Mixed Nuts Corporation paid a dividend of P3.00 per share on its common stocks last
year. Over the next 12 months, the dividend is expected to grow at 6%, which is the
constant growth rate (g) for the firm. The common stock currently sells for P50 per share.
Compute the required rate of return on the common stock.

5. Use the basic equation for the CAPM to work on each of the following:
a. Find the required rate of return for an asset with a beta of 1.20 when the risk-free rate
and market return are 7% and 12%, respectively.
b. Find the required rate of return for an asset with a beta of 0.80 when the risk-free rate
of return is 6%, and the market risk premium is 4%.
c. Find the beta for an asset with a required return of 7.4% when the risk-free rate and
market return are 6% and 8%, respectively.
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6. Mabuhay’s new financing will be in proportion to the market value of its current
financing shown below:
Carrying Amount
Long-term debt P7, 000, 000
Preferred stock (100, 000 shares) 1, 000, 000
Common stock (200, 000 shares) 7, 000, 000

The firm’s bonds are currently selling at 80% of par, generating a current market yield of
9%, and the corporation has a 40% tax rate. The preferred stock is selling at its par value
and pays a 6% dividend. The common stock has a current market value of P40 and is
expected to pay a P1.20 per share this year. Dividend growth is expected to be 10% per
year, and floatation costs are negligible.

Required: What is the Mabuhay’s weighted average cost of capital?

NET INVESTMENT AND RETURNS

1. Amizu Company is planning to purchase a new equipment costing P500, 000. Freight and
installation costs is P10, 000. The new equipment will be purchased to replace an old unit
that was acquired several years ago at a cost of P200, 000, for which an accumulated
depreciation of P120, 000has been recorded.

The old unit will be sold for P60, 000. Other assets that are to be retired as a result of the
acquisition of the new machine can be salvaged and sold for P80, 0000. The gain on the
retirement of these other assets is P15, 0000, which will increase income taxes by P4,
500.

If the new equipment is not purchased, extensive repairs on the old equipment will have
to be made at an estimated cost of P30, 000. This repairs expense can be avoided by
purchasing the equipment.

Additional gross working capital of P20, 000 will be needed o support operations planned
with the new equipment.

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

2. The management of a review school plans to install popcorn vending machine in its
premises. Annual sales of popcorn are estimated at 20, 000 units at a price of P20 per
unit. Variable costs is estimated at P12 per unit, while incremental fixed costs, excluding
depreciation, at P80, 0000 per year.

The school will acquire four vending machines at P25, 000 each, including installation
costs of P2, 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:
1. Determine the increase in annual net income if the popcorn vending machines were
installed.
2. Determine the annual net cash inflows that will be generated by the project.
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EVALUATION TECHNIQUES

1. AB-R KING Company is considering the purchase of new production technology that
would require an initial investment of P500, 000 and have an expected life of 5 years. At
the end of its life, the equipment would have no salvage value. By installing the new
equipment, the firm’s annual labor and quality costs would decline by P200, 000. The tax
rate is 30%.

Required:
a. Compute the payback period for this investment.
b. Assume instead that the annual net cash inflows would vary according to the
following schedule:

Year Annual net cash inflows

1 P160, 000
2 150, 000
3 140, 000
4 120, 000
5 100, 000

Compute the payback period under the revised circumstances.

2. BorharPort Services creates and maintains shipping channels a various ports around the
world. The company is considering the purchase of a P140 million ocean-going dredge
that has a 5 year life and no salvage value. The company depreciates assets on a straight
line basis. The expected annual cash flow on a before tax basis for this equipment is P50
million. Borhar requires that an investment be recouped in less than 3 years and have an
accounting rate of return of at least 15 percent. The tax rate is 30%.

Required: Compute the payback period and accounting rate of return for this equipment.

3. Colossus Corporation purchased a new machine on January 1 of this year for P90, 000,
with an estimated useful life of 5 years and a salvage value of P10, 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 P36, 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 P15, 000 in
years 3 and 4.

Required: Compute the bailout period for this new machine.

4. Managers of MRR Electric are considering whether to increase capacity for one of their
products. Expanding capacity by 100, 000 units will require equipment costing P6, 000,
000 and having a five-year economic life with no salvage value. The new machinery will
increase annual cash fixed costs by P2.8 million. If they do increase capacity, they expect
annual sales to increase by 100, 000 units. The unit sells for P80. Unit variable costs are
P30. The company has a 10% cost of capital and an income tax rate of 30%.
Required: Compute the net present value (NPV) of the investment.

5. Ikot-ikot Corporation gathered the following data on two capital investment

opportunities:
HAND-FED MACHINE SEMI- AUTOMATIC MACHINE
Cost of investment P800, 000 P1, 400, 000
Discount rate 14% 14%
Net cash inflows P365, 000 P590, 000
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For the coming period, the available fund for capital investment projects is P1, 600, 000
only. Both machines have 4 year lives and no anticipated salvage value. The company
uses straight line depreciation and has a 30% income tax rate.

Required:
a. Which alternative has the higher NPV?
b. Using the profitability index method, which alternative is more attractive?

6. IRR Company is considering to buy a new machine, requiring an immediate P20, 000
cash outlay. The new machine is expected to increase annual net after tax cash receipts by
P8, 000 in each of the next 5 years of its economic life. No salvage is expected at the end
of 5 years. The company desires a minimum return of 10% on invested capital.

Required: Compute the internal rate of return (IRR).

7. Atiklaham Company is planning to buy an equipment costing P600, 000 which has an
estimated life of 20 years and is expected to produce after-tax net cash inflows of P120,
000 per year.

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

8. A new machine costing P40, 000 with three years useful life, no salvage value at the end
of three years, is expected to bring the following cash inflows after tax:

First year P30, 000

Second year 25, 000
Third year 10, 000

Required: If the company’s cost of capital is 20%, what is the discounted payback
period?

“Even the smallest person can change the course of the future.”
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