CHAPTER 20 CAPITAL BUDGETING DECISIONS 1. Questions 1. A capital investment involves a current commitment of funds with the expectation of generating a satisfactory return on these funds over a relatively extended period of time in the future, . Cost of capital is the weighted minimum desired average rate that a company must pay for lon; apital while discounted rate of return is the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project. The basic principles in capital budgeting are: 1, Capital investment models are focused on the future cash inflows and outflows - rather than on net income. 2. Investment proposals should be evaluated according to their differential effects on the company’s cash flows as a whole. 3. Financing costs associated with the project are excluded in the analysis of incremental cash flows in order to avoid the “double- counting” of the cost of money. 4. The concept of the time value of money recognizes that a peso of present return is worth more than a peso of future return, 5. Choose the investments that will maximize the total net present value of the projects subject to the capital availability constraint. 4, The major classifications as to purpose are: 1. Replacement projects = those involving replacements of worn-out assets to avoid disruption of normal operations, or to improve efficiency. 2. Product or process improvement = projects that aim to produce additional revenue or to realize cost savings. 3. Expansion = projects that enhance long-term returns due to increased profitable volume. 5. Greater amounts of capital may be used in projects whose combined returns will exceed any alternate combination of total investment. 20-1 Scanned with CamScannerChapter 20 Capital Budgeting Decisions 6. No. This implies that any equity funds are cost free and this is a dangerous position because it ignores the opportunity cost or altemative carnings that could be had from the fund, 7. Yes, if there are alternative earnings foregone by stockholders. Il, Matching Type veers -omo> sees moun Ill. Problems Problem 1 (Equipment Replacement Sensitivity Analysis) Requirement 1 Total Present Value A. New Situation: Recurring cash operating costs (P26,500 x 2.69) P 71,285 Cost of new equipment 44,000 Disposal value of old equipment now (5,000) Present value of net cash outflows ‘Bi0.285 B. Present Situation: Recurring cash operating costs (P45,000 x 2.69) 121,050 Disposal value of old equipment four years hence (1.342) (P2,600 x 0.516) Present value of net cash inflows P19,708 Difference in favor of replacement B_9.423 Requirement 2 P44,000 ~ P5,000 P18,500 2Lyears Payback period for the new equipment Requirement 3 Let X = annual cash savings Let O = net present value 20-2 Scanned with CamScannerCapital Budgeting Decisions Chapter 20 X (2.69) + P5,000 - P44,000 - P1,342 = O 2.69X = P40,342 X= P14.997 If the annual cash savings decrease from P18,850 to P14,997 or by P3,503, the point of indifference will be reached. Another altemative way to get the same answer would be to divide the net present value of P9,423 by 2.690. Problem 2 Annual cash expenses of the manual bookkeeping. machine system, P9,800 x. 12 P117,600 Annual cash expenses of computerized data processing $3,600 Annual cash savings before taxes B. 64,000 Year 1 Year 2 Year 3 Annual cash savings (a) P64,000 64,000 64,000 Depreciation 20,000 16.000 12.800 Inflow before tax 44,000 48,000. PS1,200, Income tax (50%) (b) 22,000. 24,000 25,600. Cash inflow after tax (a - b) ‘42,000 40,000 P38,400 After Tax Cash Inflows PY Factor Pv Year 1 42,000 x 0,909 P 38,178 Year 2 40,000 x 0.826 33,040 Year 3 38,400 x 0.750 28,800 Year3 Salvage 20,000 x 0.750 15,000 Year 3 Tax loss 15,600" x 0.750 700, P126,718 Investment (1) 100,000 Net present value (NPV) P26.718 ©The P15,600 tax benefit of the loss on the disposal of the computer at the end of year 3 is computed as follows: Estimated salvage value P 20,000 Estimated book val Historical cost 100,000 Accumulated depreciation 48,800 51,200 Estimated loss PG1200) 20-3 Scanned with CamScannerChapter 20° Capitat Bu Tax rate 50% Tax effect of estimated loss 45,600) Since the net present value is positive, the computer should be purchased replacing the manual bookkeeping system. Problem 3 Requirement 1 (a) Purchase price of new equipment (300,000) Disposal of existing equipment: Selling price P oO Book value 60,000 Loss on disposal P60,000 ‘Tax rate 04 Tax benefit of loss on disposal —24,000 Required investment (1) ‘P(276,000) (b) Increased cash flows resulting from change in contribution margin: Using new equipment [18,000 (P20 - P7)] * 234,000 Using existing equipment [11,000 (P20 - P9)) 21,000 Increased cash flows 113,000 Less: Taxes (0.40 x. P113,000) 45,200 Increased cash flows after taxes P 67,800 Depreciation tax shield: Depreciation on new equipment (P300,000 + 5) 60,000 Depreciation on existing equipment (P60,000 + 5) 2,000 Increased depreciation charge 48,000 Tax rate __0.40 Depreciation tax shield 19,200 Recurring annual cash flows 87,000 The new equipment is capable of producing 20,000 units, but ETC Products, can sell only 18,000 units annually. ‘The sales manager made several errors in his calculations of required investment and annual cash lows. The errors are as follows: Required investment: 204 Scanned with CamScannerIV. Capital Budgeting Decisions Chapter 20 = The cost of the market research study (P44,000) is a sunk cost because it ‘was incurred last year and will not change regardless of whether the investment is made or not. = The loss on the disposal of the existing equipment does not result in an actual cash cost as shown by the sales manager. The loss on disposal results in a reduction of taxes, which teduces the cost of the new ‘equipment Annual cash flows: = ‘The sales manager considered only the depreciation on the new equipment rather than just the additional depreciation which would result from the acquisition of the new equipment. = The sales manager also failed to consider that the depreciation is a roneash expenditure which provides a tax shield. = The sales manager's use of the discount rate (j., cost of capital) was incorrect. The discount rate should be used to reduce the value of future cash flows to their current equivalent at time period zero. Regutirement 2 Present value of future cash flows (P87,000 x 3.36) 292,320 Required investment (1) 276,000 Net present value B.16,320 Problem 4 Requirement 1: P(507,000) Requirement 2: P(466,200) Requirement 3: P(23,400) Multiple Choice Questions 1D 1. D 21.6 31.D 2 12.D 2B 32.C 3. B 13.D 23.C 33.€ 4B 14.€ 24.D 34.D 5A 15.€ 25. 35.D 6 C 16. D 26. 36.B 7D 17.D 27.D 37.B & B 18 B 28. B 38.B 20-5 Scanned with CamScannerChapter 20 Capital Budgeting Decisions 9B 19. A 29.D 39.D 10. A 20. A 30.A 40. B Scanned with CamScanner