Capital Budgeting the process of identifying, evaluating, planning, and financing capital

investment projects of an organization.

Characteristics (DULL)
Difficult to reverse more difficult to reverse than short-term decisions.
Uncertainty involve so much risk and uncertainty.
Large Fund usually require large commitments of resources.
Long term involve long-term commitments.
Step 1
Step 3

Step 2

Identification

Evaluation

Capital Investment Decisions:

Replacement (Equipment)
Improvement (Products)
Expansion (Facilities)
Addition (Technology)
Reduction (Costs)

Decision

Factors of Consideration:
Net Investments
Net Returns
Cost of Capital
*Non-discounted methods
*Discounted methods

Net Investment - Cash Outflows less Cash Inflows

Outflow
Tax payment on Gain
Other Incidental Cost
Working Capital
Acquisition Cost

Inflow
Resale value of equipment*
Avoidable cost (net of tax)
Tax savings on Loss
Salvage Value

* Salvage Value, Market Value, Scrap Value G/L taxable

*Trade in Value G/L not taxable
Net Returns
1.
Annual Cash Flows After Tax (ACFAT) and Net
a.
Increase Revenue
Change in Sales
xx
xx
Change in Cash Cost
(xx)
(xx)
Change in CFBT
xx
xx
Change in Noncash Cost (Depn)
+ or - xx
xx
Change in NIBT
xx
xx
Tax
(xx)
xx
Change in NIAT
xx
xx
Change in Noncash Cost (Depn)
xx
xx
ACFAT
xx
2.

Terminal CFAT

Income After Tax (NIAT)

b. Cost Savings
Cash cost old
Cash cost new
Cash Savings
Change in Noncash Cost (Depn)
Change in NIBT
Tax
Change in NIAT
Change in Noncash Cost
ACFAT

xx

Cost to remove (net of tax)

Working Capital Recovery*
Tax Payment on Gain or Tax Savings on Loss**
Salvage Value of New Equipment
*Beware of Negative Working Capital
**Salvage Value if considered or ignored on depreciation.
Old Asset not fully depreciated check its salvage value.
Cost of Capital cost of using funds
1. Debt
a. Yield to Maturity or Before Tax Cost of Debt
Interest + [( Par Price) / Remaining Term]
60% Price + 40% Par
b. After Tax Cost of Debt
YTM x ( 1 tax)
c. Current Yield
Interest / Current Price
d. Current Yield After Tax
CY x ( 1 tax)
2. Preferred
Dividends / (Price Flotation Cost)
3. Common
a. Growth Model
CE = [D1 / (P0 Flotation Cost)] + g
b. Capital Asset Pricing Model
CE = Rfr + B (Market Price Rfr)
4. Retained Earnings
(D1 / P0) + g
5. Weighted Average Cost of Capital
WACC = (Cost x Capital Mix)
*Capital Mix = Source of Capital / Total Capital
Or
Cost of Debt x Capital Mix
Cost of Preferred x Capital Mix
Cost of Common x Capital Mix
WACC

xx
xx
xx
xx

Evaluation Techniques
I.
Non-discounted Techniques
- No discounting
- Ignores time value of money
1. Payback period
- Length of time to recover net investment
Advantage
a. Liquidity
b. Uses cash flows
c. Easy to apply

Disadvantage
Ignores:
a. Time value of money
b. Profitability
c. Salvage value
d. Cash flow after tax payback

Even CFAT = Net investment

ACFAT
2. Accounting rate of return
Advantage
a. Considers profitability
b. Easy to apply
c. Accrual basis
Disadvantage

a. Ignores time value and cash

flows
b. Averaging may be illogical

ARR orig = Average NIAT

Orig. Net Investment
ARR ave. = Average NIAT
Ave. Investment
[(Net Inv + SV) / 2]
3. Payback bailout period
- Length of time to recover net investment considering a bail (using salvage
value).
Advantage: Same with Payback except it considers salvage value.
Disadvantage: Same with payback excludes salvage value.
II.

Discounted Techniques
- With discounting
- Considers time value of money
1. Net Present Value
- Wealth added by the project at year 0.
Advantage
a. Considers time value
b. Considers all cash flows
c. Uses a realistic discount rate
Disadvantage
*Assumptions:
a. CF are received at the end
b. Reinvestment rate discount rate
PVCFAT (annual CFAT and Terminal CFAT)
Net Investment
NPV > 0

a. Uses estimated discounted

rate
b. Not comparable for varying
size investments

xx
(xx)
xx

2. Profitability Index
- Peso earned per peso invested
- Makes or converts NPV in comparable terms
PI = PV of CFAT
Net Investment
3. Internal Rate of Return
- Percentage of earnings or income based on cash basis
- Considers time value of money
- Also known as time adjusted rate of return
Advantage
a. Considers time value
b. Uses all cash flows
c. Reveals true rate of return
Disadvantage

a. Complex to apply
b. Re-investment rate is not realistic assumes IRR is the re-investment rate
c. Negative cash flows

IRR = Net Investment

Net cash inflows
4. Payback reciprocal
- Good estimate of IRR
- Conditions: a. CFAT should be nearly equal ; b. useful life = at least twice the
payback period.
PR = 1 / payback period
Or
PR = ACFAT / Net Investment
5. Discounted payback period
- Length of time to recover net investment
- Considers time value
Advantage: same with payback except that it considers time value
Disadvantage: same with payback excludes time value
IRR = Discount ; NPV = 0 ; PI = 1
IRR > Discount ; NPV > 0 ; PI > 1
IRR < Discount ; NPV < 0 ; PI < 1
Cost of Capital
1.
Josh Inc.s currently outstanding 8% coupon bonds have yield to maturity of 10%.
Josh believes it could issue new bonds at par that would provide a similar yield to
maturity. If the income tax rate is 30%, what is Josh Inc.s after-tax cost of debt?
2.

A corporation has an 8%, P1,000 par value bond outstanding with 20 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 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 P960 per bond.
c. Compute the current yield if the bond is issued at P960 per bond.

3.

Winner corporation plans to issue some P90 par preferred stock with an 8%
dividend. A similar stock is selling on the market for P100. Winner must pay flotation
costs of 2% of the issue price. The income tax rate is 30%. What is the cost of preferred
stock?

4.

The P100 par value preferred stock of C corporation pays an annual dividend of 6%.
It has a required rate of return of 10%. Compute the price of the preferred stock.

5.

Wagi corparations common stock is currently trading at P100 per share. The stock
is expected to pay a dividend of P4 per share at the end of the year, and the dividend
is expected to grow at a constant rate of 6% a year. What is its cost of common equity?

6.

F corporation just paid a dividend of P5.00 per share on its stock. The dividends are
expected to grow at a constant rate of 6% per year, indefinitely. If investors require a
10% return on F corporation stocks, what is the current price?

7.

Bagongpanahon corporation has a beta of 0.9. the yield on 3-month Treasury bill is
3% and the yield on a 10-year T-bond is 7%. The market return is 12%. What is the
estimated cost of common equity using CAPM?

8.

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 riskfree 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 riskfree 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.

9.

A firms 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 firms 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 flotation costs are negligible.
What is the firms weighted average cost of capital?

Net investment
1.
The management of Leonor Company plans to replace a machine that was acquired
several years ago at a cost of P500,000. It has been depreciated to its salvage value of
P50,000, and can be sold now for P40,000. A new sorter can be purchased to replace
the old one for P800,000. If a new machine is not purchased, Leonor company will
spend P150,000 to repair the old machine. The cost to repair the old machine can be
deducted in the first year to compute income tax. Moreover, the acquisition of the new
machine will require additional investment in working capital of P30,000. Income tax is
estimated at 30% of the income subject to tax.
Required:
a. Compute the net investment in the new machine for decision making purposes.
b. Use all the information given in the problem, except that instead of selling the
old machine, the same is traded in for P60,000. What will be the cost of the new
machine for decision making purposes.
Net returns
1.
Rowena Inc. is considering an investment of P500,000 in a new machine that will be
used to produce a new product. The machine is expected to have a useful life of 5
years, with no salvage value at the end of its life. A selling price of P30 per unit is
decided upon for the new product; unit variable cost is P20, and fixed operating costs,
including depreciation are estimated at P220,000 per year. The sales division believes
that a sales estimate of P30,000 units per year is realistic. Income tax is estimated at
30% of income before tax. Determine the annual net cash inflows and net returns (net
income) for the proposed investment projects.
2.

Linda summer, owner of Summer Company, was approached by a local dealer in air
conditioning units. The dealer proposed replacing Summers old cooling system with a
modern, more efficient system. The cost of the new system was quoted at P1,500,000,
but it would save P230,000 per year in energy costs. The estimated life of the new
system is 10 years, with no salvage value expected. Excited over the possibility of
saving P230,000 per year and having a more reliable unit, Ms. Summer requested an
analysis of the projects economic viability. All capital projects are required to earn at
least the firms cost of capital, which is 10%. Income tax rate is 30% of taxable income.
Determine the annual net cash inflows and net returns (net income) for the proposed
projects.

Non-discounted Techniques
1.
A piece of labor saving equipment has just come onto the market that Dikosan
Electronics could use to reduce costs in one of its plants. Relevant data relating to the
equipment follow:
Cost of the equipment
P800,000
Annual savings in cash operating costs
that will be provided by the equipment
200,000
Life of the equipment
10 years
The company pays 30% income tax rate.
Required:
a. Compute the payback period for the equipment. If the company requires a
payback period of 5 years or less, would the equipment be purchased?

b. Compute the accounting rate of return promised by the equipment based on (a)
original investment and (b) average investment. Would the equipment be
purchased if the companys required rate of return is 14%?
2.

A company purchased a new machine on January 1 of this year for P700,000, with
an estimated useful life f 5 years and a salvage value of P5,000. 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 P200,000 a year in each of the next 5
years. The new machines salvage value is P120,000 in years 1 and 2, and P8,000 in
years 3 and 4. Compute the bailout for this machine.

3.

Vhong corporation has determined that if a new equipment costing P120,000 is

purchased, the companys net income will increase by P10,000 per year. If the new
equipment will be depreciated using the straight-line method over a period of six years
to a zero salvage value. What is the payback period?

4.

Boogoy corporation is planning to invest P420,000 in a new machine which it will

depreciate on a straight-line basis over 10 years with zero salvage value. The new
machine is expected to generate cash flows from operations, net of income taxes, of
P50,000 per year in each of the first 6 years and P60,000 per year in each of the last 4
years of its life. What is the payback period?

Discounted Techniques
1.
Kelvin Corporation is considering the purchase of a new machine costing P450,000.
The machine will have an economic life of 5 years with no salvage value at the end of
its life. It will be depreciated using the straight-line method and is expected to produce
annual cash flows from operations, net of income taxes, of P150,000. Kelvin
Corporations cost of capital is 10%. It is subject to an income tax rate of 32%. What is
the Net Present Value of this capital investment project?
2.

Lily Healthcare Corp. is proposing to spend P109,296 on an 8 year project that has
estimated net cash flows of P22,000 for each of the 8 years.
Required:
a. Compute the Net Present Value, using a rate of return of 15%.
b. Determine the Internal Rate of Return by computing a present value factor for an
annuity of P1 and using the table of the present value of an annuity of P1.
c. Determine the internal rate of return, assuming that the project will have estimated
net cash inflows of P20,000 for each of the 8 years.

3.

Owl 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
P140,000 per year. What is the Payback Reciprocal?

4.

A new machine costing P80,000 with 3 years useful life, no salvage value at the end
of 3 years, is expected to bring in the following cash inflows after tax:
First year
Second year
Third year

P60,000
40,000
30,000

Required: if the companys cost of capital is 12%, what is the discounted payback
period?