CAPITAL BUDGETING

Definitions of terms:

CAPITAL BUDGETING - also known as Capital Expenditure Planning, deals with the
allocation of capital among alternative investment opportunities.

Two types of investment decisions:

a. Selection decisions in terms of obtaining new facilities or expanding existing facilities.

b. Replacement decisions in terms of replacing existing facilities with new facilities.

PAYBACK PERIOD - is the length of time requires recovering the initial investment from the
incremental cash benefitss after tax. The conventional payback period does not consider the time
value of money while the discounted payback period gives due allowance for the time value of
money.

ACCOUNTING RATE OF RETURN - is defined as the average annual net income from the project
divided by the average (or initial) investment in the project. The net income is net of depreciation
and income taxes.

NET PRESENT VALUE - the present value of the future net cash inflow from the project minus
the initial investment. This is the presedsnt value of the net cash inflows (outflows) discounted at
a specified interest rate.

TIME - ADJUSTED RATE OF RETURN (Internal or Discounted Rate of Return) - This is the rate
of interest which would make the present value of the future cash flows from the project equal to
the initial investment.

PROFITABILITY INDEX - it is computed by dividing the present value of cash flows by the initial
investment. Profitability index is used in comparing the net present values of different projects to
make the comparison more meaningful.

OPPORTUNITY COST - it is the foregone benefits that could be derived from other possible
alternatives by choosing another alternative.

CONCEPT OF COST OF CAPITAL

COST OF CAPITAL - The firm's cost of capital is a weighted average of the costs of debt and
equity funds. Equity funds include both capital stock and retained earnings. Cost of capital is the
desired or target rate of return used in the net present value method of the discounted cah flow
computations. It is also the minimum acceptable rate used in choosing between projects
employing the time-adjusted rate of return method.
FOUR PRINCIPAL METHODS FOR EVALUATING INVESTMENTS

1. Accounting Rate of Return - Average Annual Net Income of Project (Net of Tax) divided by
Average ( or Initial ) Investment in the project

or ARR - Net cash inflow (net of Tax) - Depreciation divided by

Average ( or Initial ) Investment

2. Payback Period = Initial Investment divided by Annual Cash Flow

Payback Reciprocal = Annual Cash Flow divided by Initial Investment

3. Time - Adjusted Rate of Return = The rate of interest ( o discount ) that would make the
present value of the future cash flows from the project equal to the initial investment.

4. Net Present Value - is the present value of the future cash flows from the project minus the
initial investment. The firm's cost of capital is generally used to discount the future cash flows.

DETERMINING COST OF CAPITAL

1. COST OF DEBT = Interest Payment x (1 - Tax Rate) divided by

Market Value of debt ( e.g. Bonds )

2. COST OF PREFERRED STOCK = Preferred Dividends divided by

Market value of Preferred Stock

3. COST OF COMMON STOCK =

Dividends on Common Stock divided by + Expected Growth Rate in Dividends

Market value of Common Stock

4. COST OF RETAINED EARNINGS =

Cost of Common Satock x ( 1 - Marginal Tax Rate for Company Stockholders)

5. FIRM'S COST OF CAPITAL = The weighted average of 1 to 4, with the market values of
debt, preferred stock, common stock and retained earnings as weights.
EXAMPLE PROBLEM 1: (Cost of Capital Calculation)

The ABC Corporation made available the following data as requested:

Total interest payments on bonds payable P 60,000

Preferred stock dividends 20,000
Common stock dividends 24,000
Annual growth in common stock dividend 2%
Market values of :
Bonds payable P 400,000
Common stock 300,000
Preferred stock 200,000
Retained earnings 100,000
Company tax rate 30%
Stockholders' marginal tax rate 70%

REQUIRED : Calculate the firm's cost of capital

SOLUTION - EXAMPLE PROBLEM 1

1. Cost of debt = P60,000 x (1-30%) / P400,000 = 10.50%

2. Cost of Prederred Stock = P20,000 / P200,000 = 10.00%

3. Cost of Common Stock = P 24,000 / P300,000 + 2 % = 10.00%

4. Cost of retained earnings = 10% x ( 1 - 70% ) = 3.00%

5. Firm's Cost of Capital = 40% ( 10.5%) + 20% (10%) + 30% ( 10% ) + 10% (3%) = 9.5%

Weights Computation:

Weight of debt = P400,000 / )1,000,000 = 40%

Weight of Preferred Stock = P200,000 / P1,000,000 = 20%

Weight of Common Stock = P300,000 / P1,000,000 = 30%

Weight of Retained earnings = P100,000 / P1,000,000 = 10%

EXAMPLE PROBLEM 2:

The Hatton Company is planning to spend P60,000 for a machine which will be depreciated
on a straight-line basis over ten-year period. The machine will generate additional cash revenues
of P12,000 a year. Hatton will incur additional costs except for depreciation. The income tax rate
is 35%.

REQUIRED:

1. Determine the net income after tax

2. Compute for Accounting Rate of Return (ARR)

3. Determine the after tax annual cash flow

4. Compute the payback period and and the payback reciprocal.

SOLUTION - EXAMPLE PROBLEM 2

1. Cash revenues per year P 12,000

Less : Annual depreciation (P60,000/10 years) 6,000
Taxable Income P 6,000
Income Tax ( 6,000 x 35% ) 2,100
Net Income After Tax P 3,900

2. Accounting rate of Return = P3,900 / P60,000 = 6.50%

3. Cash revenues per year P 12,000

Less : Income Tax 2,100
Annual cash flow After Tax P 9,900

4. Payback Period = P60,000 / P9,900 = 6.06 years

Payback Reciprocal = P9,900 / P60,000 = 16.50%

EXAMPLE PROBLEM 3:

Mayweather Company acquired an asset at a cost of P46,600. It had an estimated life of ten
years. Annual after tax cash benefits are estimated at P10,000 at the end of each year. The
following amounts appear in the interest table for the present value of an annuity of P1 at year-end
for ten years:

16% - 4.83 18% - 4.49 20% - 4.19

REQUIRED:

Determine the maximum interest rate (time-adjusted rate of return) that could be paid for the
capital employed over the life of this asset without loss, on this project.

SOLUTION - EXAMPLE PROBLEM 3

Step 1 - Determine the payback (Annuity) Factor = P46,600 / P10,000 = 4.66

Step 2 - Determine the Exact (true) Time-adjusted Rate of Return by interpolation since 4.66 is
between 16% and 18%. Pick the high factor at 16% as base.

Difference at 16% factor and true rate factor (4.83 - 4.66) = 0.17
Difference at 16% factor and at 18% factor (4.83 - 4.49) = 0.34

Exact Rate (True Rate) 16% + (17/34 x 2%). = 17%

EXAMPLE PROBLEM 4:

Cotley Company is considering to buy a new machine which cost P50,000. It will be a
labor saving investment which will reduce payroll by P13,500 per year. Its useful life is 8 years
and will have a zero salvage value. A minimum desired rate of return of 48% is used for capital
investment decisions. Information on present value factors is as follows:

Present value of P1 for 8 years at 18% 0.266

Present value of annuity of P1 for 8 periods 4.078

Should the machine be acquired?

SOLUTION - EXAMPLE PROBLEM 4

Present value of cash savings ( P13,500 x 4.078) P 55,053

Less Initial investment 50,000
Net present value - Positve P 5,053

Note: The present value of an annuity of P1 for 8 periods is used because the cash flows
(savings) per year are assumed to be uniform for 8 years.

DECISION RULE:

Accept the investment proposal if NPV is positive or zero and reject if NPV is negative.

If : NPV is more or equal to 0; ACCEPT

If : NPV is less than 0; REJECT

EXAMPLE PROBLEM 5:

The Cotto Company is considering the replacement of Machine A with Machine B that will
cost P160,000 and will result in annual savings of P40,000 before income taxes because of the
expected increase in operating efficiency. Machine B has an estimated useful life of 10 years
and salvage value of P10,000. Machine A has a book value of P16,000 ands a disposal value of
P20,000 now. Straight-line depreciation is used and the company has an average income tax
rate of 35%. The minimum desired rate of return on this investment is 20%. The present value
of an ordinary annuity of P1 in arrears for 10 periods at 20% is 4.192. The present value of P1 for
10 periods at 20% is 0.162.

REQUIRED:

1. Determine the Net Investment

2. Determine the annual cash flow net of income tax.

3. What is the present value of the investment?

SOLUTION - EXAMPLE PROBLEM 5

1. Net Investment:

Cost of Machine B P 160,000

Less: Disposal value of Machine A P 20,000
Tax on gain 35% X (P20,000-P16,000) 1,400 18,600
Net investment P 141,400

2. Annual Cash Flow net of Tax:

Annual cash savings from Machine B P 40,000 P 40,000

Less: Annual depreciation
(150,000-P10,000) / 10 years 14,000
Taxable Net Income P 26,000
Income tax x 35% 9,100
Annual Cash Flow Net of Income Tax P 30,900

3. Net Present Value:

Present value of annual cash savings

net of tax (P30,900 x 4.192) P 129,533
Less: Present value of salvage value of
 Machine B (P10,000 x 0.162) 1,620
Total Present Value P 127,913
Less: Net Investment 141,280
Net Present Value - Negative P (13,367)