Cost of Capital and Capital Budgeting Analysis

UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014

Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
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CHAPTER 12:
Cost of Capital and Capital Budgeting
☛What is Capital Budgeting? ☛What are the types of Capital Investment
CAPITAL BUDGETING involves long term Projects?
commitments with an expectation of increased 1. REPLACEMENT 2.IMPROVEMENT 3. EXPANSION
future returns. Thus, considers time value of
money and evaluating the profitability of certain ☛What are the factors of Capital Budgeting?
project proposal before accepting it. -Net Cost of Investment
-Net Returns
-Cost of Capital
LEVEL OF DEGREE OF ROLES
-Project Evaluation Techniques
PLANNING MANAGEMENT
Strategic Top-Level -Development of
vision and mission ☛What composes Net Cost of Investment?
statements -Costs or cash outflows less cash inflows or
-Formulation of
savings incidental to the acquisition of the
standards, policies
investment projects.
and reporting
systems
-Design of ☛Components of Costs or Cash Outflows:
organizational
1. Net Purchase Price (net of discount,
structure
taken or not taken)
-Formulation of
long-term 2. Incidental costs to prepare the new asset
strategies for use
Tactical Middle-level -Deals with 3. Increase in working capital requirement
policies, standards to operate the project at the desired level
and techniques 4. Additional tax paid on gain from disposal
regarding short
of the old asset
term profitability
5. Additional tax paid for the avoided costs
and liquidity
Operational Lower-level *Concerns with of repairs
daily operations. 6. Market value of an existing, currently idle
asset, which will be transferred to or utilized in the
☛Why are capital investment decisions more risky, operations of the proposed capital investment
uncertain and difficult to reverse than short term project
decisions?
Decline in Profits can be quickly recovered ☛Components of Savings or Cash Inflow?
once the managers see their errors but then when a 1.Proceeds from the disposal of the old
company invested in a certain project but it fails, asset
then the company will encounter difficulties to 2. Tax saving on loss from sale of the old
regain their costs which will now result into write asset
offs or losses. 3. Savings from avoided costs of repairs.
4. Decrease in Working Capital
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
73 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
5. Trade in value of old assets (in case of repairs

replacement) Inc. in 25,000
working
capital
 {QUICK CHECK} ???
TOTAL P790,000 TOTAL 236,000
CASH CASH
SAMPLE PROBLEM #1: Nazhielle Company is
OUTFLOW INFLOW
planning to purchase a new equipment costing P700, NET COST OF INVESTMENT: 790,000-236,000 =
000 to replace its old unit with a cost of P500, 000 554,000
and an accumulated depreciation of P350,000 .
Additional Costs totaling P50, 000 will be incurred to ☛What are the two dimensions on concept of Net
bring the equipment to its use and location. The old Return?
unit will be sold for P180,000. Other assets with a *Yield-Preference Theory- denotes net
carrying amount of P50,000 are to be retired and income
can be sold for P30,000. *Liquidity-Preference Theory – denotes
cash inflows
The old equipment requires extensive
repairs with an estimated cost of P20,000 if the
SUGGESTED FORMULA:
company choose to continue its usage. Additional
Net Cash flows from operations before tax
gross working capital amounting to P25,000 will also
LESS: Depreciation Expense _______
be needed to support the operations of the new
Profit before income tax
equipment. Tax rate is 30%. Determine the net cost
LESS: Income tax _______
of investment.
PROFIT AFTER TAX
ADD: Depreciation Expense
SOLUTION:
Annual Cash Inflow
COSTS/CASH SAVINGS/CASH
OUTFLOWS INFLOWS
Purchase P700,000 Proceeds 180,000  {QUICK CHECK} ???
price of the from sale
new of old unit SAMPLE PROBLEM #2: The management of a DITO
equipment NA UNIVERSITY plans to install soda vending
machines in its premises. Annual sales of soda are
estimated at 70,000 cans at a price of P25 per can.
Incidental 50,000 Avoided 20,000
Variable costs is estimated at P15 per can while
costs cost of
repairs incremental fixed cost including depreciation
Additional 9,000 Tax 6,000 amounting to P150, 000 per year. The university will
tax paid savings acquire five vending machines at P50,000 each and
from gain from loss will incur installation costs of P5,000 per machine.
on sale of on sale of The machines are expected to have a service life of 5
old unit retired years, with no salvage value. Tax rate is 40%.
assets
Additional 6,000 Proceeds 30,000
Required: Determine the net return of investment.
tax paid on from sale
avoided of retired
cost of assets
SOLUTION:
Sales (70,000 x P1,750,000 Capital Asset
25) Pricing Model:
Risk free rate +
LESS Variable Costs ( 1,050,000) beta (Market rate
(70,000 x 15) less Risk-free
CONTRIBUTION MARGIN 700,000 rate)
LESS Incremental Fixed (150,000)
Cost Retained Dividends Expected
PROFIT BEFORE TAX 550,000 Earnings Dividends per
Tax (550,000 X (220,000) share/ Market
40%) price per share
PROFIT AFTER TAX 330,000 + Growth Rate
ADD Depreciation 55,000
Expense (275,000/5)  [NOTE:] The lower the cost of capital, the
NET RETURNS P385,000 better. Thus, for a proposed investment to be
acceptable, it must have a rate of return on
investment greater than its cost of capital.
☛What is Cost of Capital?
-It is the cost incurred of using funds from
☛How can a company reduce its Weighted
investors.
Average Cost of Capital?
-Since debt has the lowest cost of capital,
☛What are the different sources of funds and their
an entity may reduce its cost of capital by increasing
corresponding costs of capital?
the proportional mix of the long term debt over the
SOURCES COST FORMULA
other resources. This process is called “trading on
Long Term Interest Effective Interest equity"
Liabilities Rate (1-tax)
 [NOTE:] The owners of ordinary shares are also
Or
Interest rate, net the owners of retained earnings.
of tax/Market
value net of  {QUICK CHECK} ???
flotation cost
SAMPLE PROBLEM #3: A firm’s new financing will be
Preference Dividends Dividends per in proportion to the market value of its current
Shareholders’ share/Market financing shown below:
Equity price per share-
flotation costs Carrying Amount
Ordinary Dividends Dividend Growth Long term debt P7, 000, 000
Shares’ Equity and Model:
Preferred stock (100,000 shares) 1, 000, 000
growth Expected
Dividends per Common stock (200,000 shares) 7,000, 000
share/Market
price per share The firm’s bonds are currently selling at 80% of par,
net of flotation generating a current market yield of 9%, and the
costs + Growth corporation has a 40% tax rate. The preferred stock
Rate 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 P1.2 per share
this year. Dividend growth rate is expected to be 10% per year, and floatation costs is 2%.
SOURCES COST OF CAPITAL MARKET VALUES MIX % WACAC

Debt 9%(1-40%) = 5.4% 5,600,000 38.36% 2.07%
Ordinary Shares 6/(10 x 98%) = 6.12 % 1,000,000 6.85% .4192%
Preference Shares 1.2/(40 x 98%) + 10% = 13.06 % 8,000,000 54.79% 7.16%
TOTAL 14,600,000 100% 9.65%
SAMPLE PROBLEM #4: REIGNING IN LIFE Corporation desires its finance its capital expenditure in 2013. the
following data are assembled for consideration. Relevant data on company’s securities are as follows:
Shares Par Value Market Value Floatation Cost Optimal Capital Mix
8% Bonds Payable 400,000 P1,000 120 4% 60%
10% Preferred Shares 640,000 P100 125 5% 10%
Common Shares 3,000,000 P20 80 5% 30%
100%
Expected Common Dividend per share, P9
Expected Growth Rate, 6.5%
Tax Rate, 40%
The common equity market rate is 18%. the 90-day Philippine treasury bill is selling at a rate of 7% and the
company’s beta coefficient is 1.21.
Required: E. Cost of common Equity using the
A. Before tax cost of debt Capital Asset Pricing Model
Solution:
Solution:
80
7%+1.21(18%-7%)
(1,200-48)
=20.31%
=6.94%
B. After tax cost of debt
Solution: ☛What are the two classifications of Project
(80*.60) Evaluation Techniques?
(1,200-48)
=4.17% A. TRADITIONAL MODEL – doesn’t consider time
value of money
C. Cost of Preferred Equity
A1. Payback Period
Solution: A2. Payback Reciprocal
(100*.10) A3. Payback Bailout Period
(125-6.25) A4. Accounting Rate of Return
=8.42%
D. Cost of common Equity using the A1. PAYBACK PERIOD – determines when to recover
an investment.
Gordon Growth Model
9/(80-4) + 6.5%
=18.34%
SAMPLE PROBLEM #5: COST OF INVESTMENT = 500,000

NET CASH INFLOWS RESIDUAL VALUE
COST OF INVESTMENT = 500,000 Yr. 1 120,000 10,000
ANNUAL NET CASH INFLOW= 120,000 Yr. 2 110,000 30,000
Yr. 3 185,000 15,000
Determine the Payback period? Yr. 4 190,000 5,000
Payback Period = 500,000/120,000 = 4.17 REQUIRED: Determine the payback bailout period?
SAMPLE PROBLEM #6:

NET CASH
COST OF INVESTMENT = 500,000 CASH TO
NET CASH INFLOWS INFLOWS DATE RV PB
Yr. 1 120,000 Yr. 1 120,000 120,000 10,000 1
Yr. 2 110,000 Yr. 2 110,000 230,000 30,000 1
Yr. 3 185,000 Yr. 3 185,000 415,000 15,000 1
Yr. 4 190,000 Yr. 4 190,000 500,000 5,000 0.42
3.42
SOLUTION:
Net Cash Inflow Cash to date PB  [NOTE]: Only 85,000 from year 4 will be needed
Yr. 1 120,000 120,000 1 for the complete recovery of the cost of
Yr. 2 110,000 230,000 1 investment. Residual value shall apply first in
Yr. 3 185,000 415,000 1 year 4, hence, 85,000-5,000=80,000 shall apply
to net cash inflows. Thus 80,000/190,000=.42 is
Yr.4 190,000 500,000 *.45
the additional time period in year 4 for the
3.45
company to recover fully its investment.
 [NOTE]: *.45, by the end of the 4th year, only
P85, 000 is what the entity needed to completely
A4. ACCOUNTING RATE OF RETURN- measures the
recovers its 500,000 investment. Thus,
85,000/190,000=.45, the length of time during profitability of an investment
the 4th year that the company recovered its *SIMPLE AVERAGE = Profit (after tax) /
investment. Original Investment
*WEIGHTED AVERAGE = Profit (after tax) /
A2. PAYBACK RECIPROCAL- percentage of annual [(Original Investment +residual value)/2]
net returns provided by an investment. NOTE: If the problem is silent on which method to
=1/PAYBACK PERIOD be used, use WEIGHTED AVERAGE METHOD
A3. PAYBACK BAILOUT PERIOD =this is applicable to B. DISCOUNTED MODEL

projects that are to be terminated anytime on which B1. Net Present Value
residual value is considered to determine the total B2. Profitability Index and NPV Index
cash value generated by the project. B3. Internal Rate of Return
B4. Discounted Payback Period.
SAMPLE PROBLEM #7: B1. NET PRESENT VALUE- determines the value now
COST OF INVESTMENT of the net cash inflows that would be generated by
certain investment. =NPV OF CASH INFLOWS – NPV  [NOTES:] If the salvage value was considered in
OF CASH OUTFLOWS. computing the depreciation expense, in getting
the present value of the salvage value, ignore
SAMPLE PROBLEM #8: tax. Thus, PV=Salvage Value x PVF.
If the salvage value was not considered
The management of a DITO NA UNIVERSITY plans to
in computing depreciation expense, in getting its
install soda vending machines in its premises. Annual
present value, it would be net of tax. Thus, PV=
sales of soda are estimated at 70,000 cans at a price salvage value x (1-tax rate) x PVF.
of P25 per can. Variable costs is estimated at P15 per If the problem is silent as to whether
can while incremental fixed cost including the salvage value will be considered in
depreciation amounting to P150, 000 per year. The computing depreciation expense, the nature of
university will acquire five vending machines at the depreciation method used will be the basis
P50,000 each and will incur installation costs of whether to deduct the salvage value or not.
P5,000 per machine. The machines are expected to If the problem clearly states the
treatment of salvage value, it shall prevail
have a service life of 5 years, with 3,000 salvage
regardless of the nature of the depreciation
value each. The company uses straight line
method used.
Depreciation. Tax rate is 40%. The company’s cost of If the problem is silent whether to
capital is 10%. include the Present value of Additional Working
REQUIRED: Determine the net return of investment. Capital in the computation of Present Value of
SOLUTION: Net Cash inflows, ignore it.
Sales (70,000 x 25) P1,750,000 If there is a decrease in working capital
as a result of the investment, rule of thumb:
LESS Variable Costs ( 1,050,000) ignore it in the computation of NPV of Net Cash
(70,000 x 15) Inflows. Needless to say, an increase in working
CONTRIBUTION MARGIN 700,000 capital requirement shall form part of costs/ cash
LESS Incremental Fixed (150,000) outflows, hence, shall be considered for that
Cost matter.
PROFIT BEFORE TAX 550,000
Tax (550,000 X 40%) (220,000) B2. PROFITABILITY INDEX AND NPV INDEX – use to
PROFIT AFTER TAX 330,000 rank projects and determine which among those is
ADD Depreciation 52,000 the most favorable.
Expense (260,000/5)
Profitability Index = Present value of Cash
NET RETURNS P382,000
Inflows/Cost of Investment
NET PRESENT VALUE
NPV Index= Net Present Value/ Cost of
PRESENT VALUE OF (3.7908 x 1,447,971
ANNUAL NET 382,000) Investment
RETURNS
PRESENT VALUE (.6209 X 9,313.5 B3. INTERNAL RATE OF RETURN -breakeven rate of
15,000) return. The rate where PV of cash inflows equates
TOTAL PRESENT 1,457,284.5 cost of investment, NPV=0, Profitability index=1.
VALUE OF CASH
INFLOWS
PROCEDURES:
LESS: COST OF (55,000 x 5) (275,000)
INVESTMENT 1. Determine the PV factor of the investment.
NET PRESENT VALUE 1,182,284.5 PVF= Cost of investments/net cash inflows.
2. Determine the rate appropriate to the derived PV

factor. Comprehensive Problem #1:
 [Note:]The higher the rate, the lower the PVF 1. JKM Company has the opportunity to market a
B4. DISCOUNTED PAYBACK PERIOD – it’s the same new product. The sales manager believes the
with payback period except that the cash inflows are company could sell 20,000 units per year at $10 per
discounted to its present value. unit for five years. The product requires machinery
☛When to accept or reject projects? that costs $200,000 and has a five year life and no
salvage value. Variable costs per unit are $4. The
Project Condition Accept Reject machinery has fixed operating costs requiring cash
Evaluation -Better disbursements of $30,000 annually. Straight line
Techniques depreciation will be used for both book and tax
1) Traditional purposes. The tax rate is 40% and the cut off rate is
Models 14%.
-do not consider Requirements:
the time value of
money. 1.Increase in annual net income and in annual cash
1.a)Payback Shorter  inflows expected from the investment.
Period Longer  Solution:
Lower  Sales (20,000*$10) 200,000
Variable costs (20,000*4) 80,000
1.b)Payback Higher 
Reciprocal Contribution Margin 120,000
Fixed operating costs 30,000
Shorter 
Cash inflow before taxes 90,000
1.c)Payback Bail Longer 
Depreciation (200,000/5) 40,000
out
Increase in taxable income 50,000
1.d) Accounting Lower 
Income tax at 40% 20,000
Rate of Return Higher 
Increase in annual income 30,000
2) Discounted
Add Back: Depreciation 40,000
Models
Increase in annual cash inflow 70,000
-consider the
time value of
2. NPV
money.
Solution:
2.a)NPV Positive 
Net cash inflow per year 70,000
Negative 
PV factor 3.433
2.b)NPV Index Positive 
PV of future cash inflows 240,310
Negative 
less investment 200,000
2.c)PI Index Greater  NPV 40,310
than 1
Less than  3. Payback Period
1 Solution:
2.d) IRR Lower  200,000/70,000=2.857 years
Higher 
4. IRR
Solution:
PV factor of 22% is 2.864 while PV factor of 23% is
2.803. By trial and error, we can compute the IRR as
follows:
22% + (2.857-2.864)
2.864-2.803
=22.11%
5. Accounting rate of return on the average

investment.
Solution:
30,000____ =30%
(200,00/2)
6. Suppose that the machinery has a salvage value of

$5,000 at the end of its useful life which is not
considered in computing the annual depreciation
expense. What is the NPV then?
Solution:
PV of net cash inflows 240,310
PV of SV net of tax:(5,000*.60*0.519) 1,557
Total PV 241,867
Cost of Investment 200,000
NPV 41,867
7. Suppose the project also involves an increase in

inventories and receivables totaling 40,000. What is
the NPV?
Solution:
PV of net cash inflows 240,310
PV of additional working capital
(40,000*0.519) 20,760
Total PV 261,070
Less Investment 240,000
NPV 21,070

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UNIVERSITY OF SAINT LOUIS-TUGUEGARAO

School of Business Administration and Accountancy, 2013-2014

5. Trade in value of old assets (in case of repairs

SOURCES COST OF CAPITAL MARKET VALUES MIX % WACAC

SAMPLE PROBLEM #5: COST OF INVESTMENT = 500,000

SAMPLE PROBLEM #6:

A3. PAYBACK BAILOUT PERIOD =this is applicable to B. DISCOUNTED MODEL

2. Determine the rate appropriate to the derived PV

5. Accounting rate of return on the average

6. Suppose that the machinery has a salvage value of

7. Suppose the project also involves an increase in

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