NET COST OF INVESTMENT

Net cost of investment

The World Trade Center Company plans to acquire a new equipment costing P1,200,000 to replace
the equipment that is now being used. The terms of the acquisition are 3/30, n/90. Freight charges
on the new equipment are estimated atP23,000 and it will cost P14,000 to install. Special attachment
to be used with this unit will be needed and will cost P36,000. If the new equipment is acquired,
operations will be expanded and this will require additional working capital of P250,000. The old
equipment had an amortized cost of P300,000 and will be sold for P180,000. If the new equipment is
not purchased, the old equipment must be overhauled at a cost of P90,000. This cost is deductible
for tax purposes in the year incurred. Tax rate is 35%.

Compute the net investment in the new equipment for decision-making purposes.

NET RETURNS
Net cash inflows
The Paniqui Corporation 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 following
estimates are made available:

Annual Sales 12,000,000

Selling and administrative expenses 2,100,000
Materials 4,400,000
Income tax rate 40%
Labor 2,200,000
Factory overhead (excluding depreciation on
new equipment) 1,300,000

Compute the net income and the net cash inflows.

COST OF CAPITAL
Weighted average cost of capital. Basic Computations
Asian Company discloses the following data in evaluating capital expenditures proposals. Earnings,
capital structures, and current market prices of the company’s securities are:

EARNINGS CAPITAL STRUCTURE

Earnings before interest and tax (EBIT) 2,800,000 Mortgage bonds, 10%,10 years 2,000,000

Less: Interest expense on bonds 200,000 Preference shares, 12%, P100 par value 3,000,000

Income before income tax (IBIT) 2,600,000 Ordinary share, no par, 800,000 shares

Less: Income tax (40%) 1,040,000 oustanding 2,500,000

Net income 1,560,000 Share premium 1,500,000

Less: Preference shares dividends 360,000 Retained earnings 1,000,000

Earnings available to ordinary
shareholders 1,200,000 Total 10,000,000

Less: Ordinary share dividend 500,000

Increase in retained earnings 700,000

MARKET PRICES OTHER INFORMATION

Preference Share 96 Floatation costs (underwriting costs) 5%

Ordinary Share 10 Dividedn per ordinary share 1.50

Bonds 102 Expected growth rate 7%

Compute weighted average cost of capital.

Weighted average cost of capital. The optimal capital mix.

EFEM Corporation reported the following pre-tax cost of securities and optimal capital mix:

Cost of security Optimal capital mix

Bonds payable, 10% 6% 50%
Preference equity 10% 30%
Ordinary share 14% 10%
Retained Earnings 13% 10%

CH5: Capital Budgeting - kaeb

The company has available P4 million retained earnings for capital investments. The company’s tax
rate is 40%.

Required:
1. The weighted average cost of capital under the present condition.
2. The weighted average cost of capital if the Company finances a P20-million project.
3. The weighted average cost of capital if the Company finances a P30-million project.

The Gordon Growth Model. Cost of ordinary equity financing

Alpha Company has 10,000 outstanding shares with a market value of P25 each. It paid a P1 per share
dividend last year. Dividends are expected to grow at a constant rate of 10% and flotation costs are
5% of the selling price. The company is studying the best financing alternative for a P100 million
capital investments.

Required: Calculate the cost of ordinary equity, if:

1. New ordinary shares are issued.
2. Retained earnings were used to finance the investment proposals.

The CAPM Model: Cost of ordinary equity

B Company’s stock has a beta coefficient of 1.4 and its market rate is 12.5%, with a risk-free rate of
9%. The company’s floatation cost is 7%. What is the company’s cost of using ordinary equity in
financing capital investments?

PROJECT EVALUATION TECHNIQUES

Traditional models (do not consider)

Concept of Net Focus of
Model Returns Measurement Decision Criterion
the shorter, the
Payback Period net cash inflows liquidity better
the higher, the
Payback reciprocal net cash inflows liquidity better
the shorter, the
Payback Bailout net cash inflows liquidity better
Accounting rate of the higher, the
return net income profitability better

Discounted models (consider)

Concept of Net Focus of
Model Returns Measurement Decision Criterion
positive=reject
Net present value net cash inflows liquidity negative=accept
Internal rate of return net cash inflows liquidity the higher, the better
greater than 1.0=accept
Profitability index net cash inflows liquidity less than 1.0= reject
positive=reject
Net present value index net cash inflows liquidity negative=accept
Discounted payback method net cash inflows liquidity the shorter, the better

CH5: Capital Budgeting - kaeb

PAYBACK PERIOD
Even Cash Inflows Uneven Cash inflows
Payback period = Payback period is where:
Cost of investment / Net Cash Inflows Cash to date=Cost of investment

 EVEN CASH INFLOWS

A project requires an investment of P600,000 with 5 years useful life, no salvage value, and
uses straight line method of depreciation. Other data are:

Expected sales revenue 2,000,000

Out-of-pocket costs 1,600,000
Tax rate 40%
Additional working capital 500,000

Compute the payback period.

 UNEVEN CASH INFLOWS

An investment of P400,000 can bring in the following annual cash income, net of tax:

1st year 40,000

2nd year 95,000
3rd year 85,000
4th year 160,000
5th year 86,000
6th year 70,000

Compute the payback period.

PAYBACK RECIPROCAL
Payback Reciprocal = 1/ Payback Period

PAYBACK BAILOUT PERIOD

An investment of P500,000 can bring in the following annual cash inflows and residual values:
Net Cash Inflows Residual values, end of year
1st year 130,000 230,000
2nd year 90,000 100,000
3rd year 85,000 40,000
4th year 160,000 20,000
5th year 75,000 10,000
6th year 70,000 5,000

Determine the payback bailout period.

ACCOUNTING RATE OF RETURN (ARR)

Original ARR = Profit / Original investment
Average ARR = Profit / Average investment
= Profit / [Original investment + Salvage Value)/2]

The Tarlac Company is considering the production of a new product line which will require an
investment of P3,000,000, with P200,000 residual value. The investment will have a useful life of
10 years during which annual cash inflows before income taxes of P1,400,000 are expected.

Required:
1. Annual net income
2. Accounting rate of return based on:
a. Original investment
b. Average investment

NET PRESENT VALUE

where:
= present value of cash
Present value of each inflows x PVCI PVCI inflows
Less: Present value of cash Less: = present value of cash
outflows (x) PVCO PVCO outflows
Net present value x NPV NPV = net present value

CH5: Capital Budgeting - kaeb

  EVEN NET CASH INFLOWS
An equipment costing P800,000 will produce annual net cash inflows of P250,000. At the end
of its useful life of 5 years, the equipment will have a P20,000 residual value. Additional
working capital of P200,000 is needed. The desired rate of return is 14%.

Determine the net present value.

 UNEVEN NET CASH INFLOWS

An equipment costing P680,000, with a residual value of P8,000 at its useful life of five years,
is expected to bring the following net of cash inflows:

1st year 350,000

2nd year 250,000
3rd year 150,000
4th year 100,000
5th year 50,000

Determine the net present value using a discount rate of 12%.

PROFITABILITY INDEX
Profitability Index = PVCI / COI

Millennium Corporation has P12 million available money for investment. It has already evaluated
several project proposals and now considers the following acceptable projects with following data:

Project COI PVCI NPV

A 5,000,000 5,500,000 500,000
B 6,000,000 6,900,000 900,000
C 4,000,000 4,850,000 850,000
D 3,000,000 3,470,000 470,000

Which project should the company invest?

THE INTERNAL RATE OF RETURN

Present value of cash inflows = Cost investment
Net present value = Zero
Profitability index = 1.00

 EVEN NET CASH INFLOWS

Twin Towers Company has the opportunity to buy a new equipment at P1 million. The machine
is estimated to have useful life of 4 years, no residual value and will yield an annual cash inflow
after tax of P375,000 during its economic life. The company’s rate of return is 14%.

Determine the time adjusted rate of return.

 UNEVEN NET CASH INFLOWS

An equipment costing P2,800,000 with P100,000 salvage value at the end of five years is
expected to bring in the following cash inflows, net of tax:

1st year 1,200,000

2nd year 950,000
3rd year 800,000
4th year 600,000
5th year 500,000

Determine the discounted cash flow rate of return.

IRR vs. Cost of Capital

High Clouds Corporation is analyzing two project capital investments with the following data:

Project 1 Project 2
Annual cash inflows P4 million P5 million
Life in years 5 5
Cost of capital 10% 10%
Internal rate of return 14% 8%

CH5: Capital Budgeting - kaeb

DISCOUNTED PAYBACK PERIOD
S&L Company is planning to invest P900,000 in a project which has an estimated life of 5 years, no
salvage value. The expected after tax cash benefits are P400,000 in the first year, P500,000 in the
second year, P250,000 in the third year, and P200,000 in the fourth year and fifth year. The
Company’s desired rate of return is 14%. What is the discounted payback period?

CH5: Capital Budgeting - kaeb