Professional Documents
Culture Documents
FINANCIAL MANAGEMENT
Tactical planning – is the domain of middle managers (i.e., department heads, unit managers) that deals
with policies, standards, systems, procedures, and techniques concerning the short-term profitability
and liquidity of the business enterprise.
Strategic planning – happens at top-level management (i.e., Board of Directors, Chief Executive Officer,
Vice-Presidents) who exercise the power to define the direction, develop competitive advantage,
identify market niche and long-term focus of the business.
CAPITAL BUDGETING – Deals with analyzing the profitability and/or liquidity of a given project
proposal. It is premised on the following:
Funds are available
Business opportunities (i.e., project proposals) abound waiting to be tapped
Business opportunities are subject to quantitative evaluation.
Several projects the need capital budgeting analyses includes replacement or expansion,
improvements or retention, and others such as research and development, exploration, new
projects and other similar strategic decisions.
Net cost of investment – refers to the net cash outflows, after tax considerations, which are normally
paid by investors in relation to the investing transaction. It includes opportunity cost such as possible
savings and tax effects on possible gain, loss or savings on related transactions.
The net cost of investment is the difference of the outflows and the inflows.
Net Returns
Example 2.
NET CASH INFLOW Co. is planning to add a new product line to its present business. The new product
will require a new equipment costing P2,400,000 with a five-year life, no salvage value. The follwing
estimates are made available:
Annual sales P 12,000,000
Materials 4,400,000
Labor 2,200,000
Factory overhead (excluding depreciation on new equipment 1,300,000
Selling and administrative expenses 2,100,000
Income Tax rate 40%
Compute the net income and the net cash inflows. Net Income = 912,000; Net cash inflow = 1,392,000
COST OF CAPITAL
COST OF CAPITAL – is 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.
R = RF + β(RM +RF)
2. Iya 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 P5 per share. The income tax rate is 30%. What is the
cost of preferred stock of Iya corporation?
3. The preferred stock of C Corporation pays an annual dividend of P4.8. it has a required rate of return
of 8%.
4. D 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.
5. F Corporation just paid a dividend of P4.00 per share on its stock. The dividends are expected to
grow at a constant rate of 7% per year, indefinitely.
Required: 1. If investors require a 12% return on F Corporation stocks, what is the current price?
2. What will the price be in two years?
6. Use the basic equation for the capital asset pricing model (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.
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 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 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.
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 accounting data, the
effect of inflation is ignored.
Advantages:
1. Emphasizes cash flows
2. recognized 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
DISCOUNTED CASH FLOW RATE OF RETURN – the rate of return that 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:
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 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.
Or
1
PAYBACK RECIPROCAL =
Payback period
Examples
1. BAILOUT METHOD
A Company 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 P20,000 in years 1 and 2, and P15,000 in years 3 and 4.
2. BAILOUT METHOD
Cost of Investment – P150,000
Cash inflows:
Year Net Operating Cash Inflows Salvage Value
1 P 40,000 P 100,000
2 30,000 70,000
3 25,000 60,000
4 20,000 50,000
5 20,000 30,000
6 20,000 10,000
Required: Compute the payback period and the accounting rate of return for this equipment.
For the coming period, the available fund for capital investment is P1,600,000 only. Both machine
have 4-year lives and no anticipated salvage value. The company uses straight line depreciation
and has a 30% income tax rate.
9. A new machine costing P40,000 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 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?
10. 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 value is expected at the end of 5 years. The
company desires a minimum return of 10% on invested capital.
11. A new machine costing P18,000 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 P10,000
Second year 8,000
Third year 5,000
12. Owu 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.