CAPITAL BUDGETING CAPITAL BUDGETING CAPITAL INVESTMENT
CAPITAL INVESTMENT – involves si – involves significant commgnificant commitment of funds itment of funds to receive a sto receive a satisfactory retatisfactory return – increase in revurn – increase in revenue or reductionenue or reduction in costs over an extended period
in costs over an extended period of time. Example: purchase of equipment for expansion, replacement of old of time. Example: purchase of equipment for expansion, replacement of old equipment.equipment. GENERAL CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS
GENERAL CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS
AS TO COSTAS TO COST usually involves large expenditure of resources, relative to business sizeusually involves large expenditure of resources, relative to business size
AS TO COMMITMENTAS TO COMMITMENT usually funds invested are tied up for a long period of timeusually funds invested are tied up for a long period of time
AS TO FLEXIBILITYAS TO FLEXIBILITY usually more difficult to reverse than short-term decisionsusually more difficult to reverse than short-term decisions
AS TO RISKAS TO RISK usually involves so much risks and uncertainties due to operational usually involves so much risks and uncertainties due to operational and economic changes over anand economic changes over an extended period of time
extended period of time CAPITAL BUDGETING
CAPITAL BUDGETING – is – is the process by hich management identifies, evaluates, and makes decision on capital investmentthe process by hich management identifies, evaluates, and makes decision on capital investment pro!ects of an organization. "t is the
pro!ects of an organization. "t is the process of planning expenditures for assets, the return process of planning expenditures for assets, the return on hich are expected to on hich are expected to continue beyondcontinue beyond one-year period.
one-year period.
CAPITAL INVESTMENT FACTORS CAPITAL INVESTMENT FACTORS Net Investments (f!
Net Investments (f! "e#$s$n%m&'$n )*!)ses+"e#$s$n%m&'$n )*!)ses+
#osts less savings incidental to the acquisition of the capital investment pro!ects#osts less savings incidental to the acquisition of the capital investment pro!ects
#ash outflos less cash inflos incidental to the acquisition of the #ash outflos less cash inflos incidental to the acquisition of the capital investment pro!ectscapital investment pro!ects #osts or cash outflos
#osts or cash outflos $.
$. %urc%urchase phase price rice of thof the asse asset, net, net of et of relatrelated cased cash dish discountcount &.
&. "nci"ncidentadental pro!ect-rl pro!ect-relateelated expenses such as freighd expenses such as freight, insurant, insurance, handlice, handling, instalng, installatilation, test-ron, test-runs, etc.uns, etc. #'()"*E+ )' /E 0''1"(2, if
#'()"*E+ )' /E 0''1"(2, if any:any:
dditional orking c dditional orking capital needed to support apital needed to support the operation of the pthe operation of the pro!ect at the desiro!ect at the desired level.red level.
3arket value of existing idle assets to be used in the operation of the proposed capital pro!ect.3arket value of existing idle assets to be used in the operation of the proposed capital pro!ect.
raining cost, net of related taxraining cost, net of related tax )avings or cash inflos
)avings or cash inflos $.
$. %roc%roceeds feeds from srom sale of ale of old aold asset sset dispodisposed, sed, net onet of relaf related tted taxax #'()"*E+ )' /E 0''1"(2, if
#'()"*E+ )' /E 0''1"(2, if any:any:
rade-in value of old assetrade-in value of old asset
voidable cos voidable cost of immediatt of immediate repairs on the old ase repairs on the old asset to be replaceset to be replaced, net of related td, net of related taxax Net Ret*!ns
Net Ret*!ns
##+4 5 ##+4 5)"): )"): ccounting net ccounting net income 6after taxincome 6after tax77
#)/ 5)"): (et cash inflos#)/ 5)"): (et cash inflos
*"+E# 3E/'* 6#ash inflos – #ash outflos7*"+E# 3E/'* 6#ash inflos – #ash outflos7
"(*"+E# 3E/'* 6(et income after tax 8 (oncash expenses7"(*"+E# 3E/'* 6(et income after tax 8 (oncash expenses7
I,,*st!&t$n- Net Investments f! De#$s$n%M&'$n I,,*st!&t$n- Net Investments f! De#$s$n%M&'$n
5icol #ompany plans to replace a unit of equipment that as acquired three 697 years ago and is
5icol #ompany plans to replace a unit of equipment that as acquired three 697 years ago and is no recorded at a bookno recorded at a book value of %;,<<<. his equipment can be
value of %;,<<<. his equipment can be sold no for %=;,<<<. ax rate is &;>.sold no for %=;,<<<. ax rate is &;>.
(e equipment can be acquired from 5aguio #ompany at a list price of %&<<,<<<. 5aguio ill grant a &> cash discount if the (e equipment can be acquired from 5aguio #ompany at a list price of %&<<,<<<. 5aguio ill grant a &> cash discount if the equipment is paid for ithin
equipment is paid for ithin 9< days from acquisition date. )hipping, installation and testing charges to 9< days from acquisition date. )hipping, installation and testing charges to be paid are be paid are estimated atestimated at %$?,<<<.
%$?,<<<.
'ther assets ith a book value of %$&,<<< that are to be retired as a
'ther assets ith a book value of %$&,<<< that are to be retired as a result of the acquisition of the ne machine can beresult of the acquisition of the ne machine can be salvaged and sold for %$<,<<<.
salvaged and sold for %$<,<<<. dditional orking c
dditional orking capital of %$@,<<apital of %$@,<<< ill be needed to s< ill be needed to support operations planned itupport operations planned ith the ne equipment.h the ne equipment.
he annual cash flo after income tax from the operation of the ne equipment has been estimated at %;<,<<<. he he annual cash flo after income tax from the operation of the ne equipment has been estimated at %;<,<<<. he equipment is expected to have a useful life of ; years ith a salvage value of %?,<<< at the end of
equipment is expected to have a useful life of ; years ith a salvage value of %?,<<< at the end of ; years.; years.
I,,*st!&t$n- Net Ret*!ns (In#!e&se $n Reven*es+
he management of )tar #inema plans to install coffee vending machines costing %&<<,<<< in its movie house. nnual sales of coffee are estimated at $<,<<< cups at a price of %$; per cup. Bariable costs are estimated at % per cup, hile incremental fixed cash costs, excluding depreciation, at %&<,<<< per year. he machines are expected to have a service life of ; years, ith no salvage value. *epreciation ill be computed on a straight-line basis. he companyCs income tax rate is 9<>.
Re.*$!e"- ssuming that the vending machines are installed, determine:
a. he increase in annual net income b. he annual cash inflos that ill be generated by the pro!ect. I,,*st!&t$n- Net Ret*!ns (Cst S&v$ns+
3oon #orporation is planning to buy cleaning equipment that can reduce service cost and other cash expenses by an average of %=<,<<< per year. he ne cleaning equipment ill cost %$<<,<<< and ill be depreciated for ; years on a straight-line basis. (o salvage value is expected at the end of the equipmentCs life. "ncome tax is estimated at 9&>.
Re.*$!e"- *etermine the net cash inflos that ill be generated by the pro!ect. COSTS OF CAPITAL
The ‘costs of capital’ used in capital budgeng is the Weighted Average Costs of Capital (WACC). These are specic costs
of using long-ter funds! obtained fro the di"erent sources# borro$ed (debt) and invested (e%uit&) capital.
SOURCES COSTS
*ebt "nterest rate 6after tax7
%referred )tock 6%)7 *ividend yield
#ommon )tock 6#)7 *ividend yield plus groth rate +etained Earnings 6+E7 *ividend yield plus groth rate
he after-tax cost of debt is computed based on: yield rate 6$ – tax rate7 *ividend yield D dividend per share price per share
#osts of #) and +E D 6Expected #ash *%) F 3%%#)7 8 *ividend groth rate 1here: *%) D *ividend per share, 3%%#) D 3arket price per common share
he dividend groth rate is assumed to be constant over time.
"n computing cost of #) G %), the market price should be net of flotation costs 6e.g., underriting fees7. "n computing the cost of +E, flotation costs should be ignored.
lternatively, the cost of equity capital may be computed based on #apital sset %ricing 3odel 6#%37.
'ther terms used to denote the eighted average cost of capital 61##7:
3inimum required rate of return *esired rate of return
3inimum acceptable rate of return )tandard rate
#ut-off rate /urdle rate
arget rate
I,,*st!&t$n- /e$0te" Ave!&e Cst f C&)$t&, (/ACC+
he 5o #ompany ants to determine the eighted average cost of capital that it can use to evaluate capital investment proposals. he companyCs capital structure ith corresponding market values follos:
@>erm5onds %<<,<<<
;> %referred )tock 6%$<< par7 &<<,<<< #ommon stock 6no par, $<,<<< shares outstanding7 ?<<,<<<
+etained earnings @<<,<<<
otal %&,<<<,<<<
dditional data:
#urrent market price per share:
o %referred stock: %;< o #ommon stock: %?<
Expected common dividend: %& per share *ividend groth rate: ?>
#orporate tax rate: 9<>
Re.*$!e"-$. 2iven an operating income of %;<<,<<<, ho much is the earnings per shareA &. *etermine the eighted average cost of capital.
C&)$t&, Asset P!$#$n M"e, 1 I,,*st!&t$ve P!2,ems F!m*,&-
H D +
f8 56+
m– +
f7
3arket premium D 6+
m– +
f7
+isk premium D 56+
m– +
f7
1here: H D #ost of equity
+
fD +isk-free rate5
D 5eta coefficient+
mD 3arket rateEXERCISES- /ACC % CAPM
$. ccording to #%3 estimates, hat is the cost of equity for a firm ith beta of $.; hen the risk-free interest rate is > and the expected return on the market portfolio is $;>A
&. he expected return on 2lobe 'il stock is [email protected];>. "f the market premium is @.&>, and the risk-free rate is .?>, hat is the beta of 2lobe 'il stockA
9. n investor as expecting an $@> return on his portfolio ith beta of $.&; before the market risk premium increased from @> to $<>. 5ased on this change, hat return ill no be expected on the portfolioA
?. he expected rate of return of stock of %hoslate #ompany, given a beta of $.&;, risk-free rate of =.;>, and a market risk premium of >, is:
;. 1hat is the risk-free rate given a beta of <.@, a market risk premium of >, and an expected return of I.@>A CAPITAL BUDGETING TECHNI3UES IN EVALUATING PRO4ECTS
Nn%"$s#*nte" met0"s – methods that do not consider the time value f money
a. %ayback period method c. 5ail-out payback method
b. %ayback reciprocal method d. ccounting rate of return method
D$s#*nte" met0"s – methods that consider the time value of money
a. (et present value method c. "nternal rate of return method
b. %rofitability index method d. %resent value payback method
I5 NON%DISCOUNTED METHODS
6 P&72&#' Pe!$" Met0" 6 P&72&#' )e!$" D (et initial cost of investment F nnual net after-tax cash inflos Advantages:
$. %ayback is simple to compute and easy to understand. &. %ayback gives information about the liquidity of the pro!ect.
9. "t is a good surrogate for risk. quick or short payback period indicates a less risky pro!ect. Disadvantages:
$. %ayback does not consider the time value of money.
&. "t gives more emphasis on liquidity rather than on profitability of the pro!ect. 9. "t does not consider the salvage value of the pro!ect.
?. "t ignores cash flos that may occur after the payback period 6short-sighted7 6 P&72&#' Re#$)!#&, 6 P&72&#' !e#$)!#&, 6 (et cash inflos F "nvestment
D $ F %ayback period
6 A##*nt$n R&te f Ret*!n Met0" 6 A##*nt$n !&te f !et*!n (ARR+ D verage annual net income F "nvestment J
Advantages:
$. he ++ closely parallels accounting concepts of income measurement and investment return. &. "t facilitates re-evaluation of pro!ects due to ready availability of data from the accounting records. Disadvantages:
$. ike traditional payback methods, the ++ method does not consider the time value of money.
&. 1ith the computation of income and book value based on the historical cost accounting data, the effect of inflation is ignored. 'ther terms used to denote the ++:
5ook value rate of return pproximate rate of return method
4nad!usted rate of return 0inancial statement rate of return method
)imple rate of return verage return on investment
I,,*st!&t$n- P&72&#' Pe!$" 8 A##*nt$n R&te f Ret*!n (/$t0 Even C&s0 F,9s+
2reen #ompany considers the replacement of some old equipment. he cost of the ne equipment is %I<,<<<, ith a useful life estimate of @ years and a salvage value of %$<,<<<. he annual pre-tax cash savings from the use of the ne equipment is
%?<,<<<. he old equipment has zero market value and is fully depreciated. he company uses a cost of capital of &;>. Re.*$!e"- ssuming that the income tax rate is ?<>, compute:
$. %ayback period &. %ayback reciprocal
9. ccounting rate of return on original investment ?. ccounting rate of return on average investment
I,,*st!&t$n- P&72&#' Pe!$" 8 A##*nt$n R&te f Ret*!n (/$t0 Uneven C&s0 F,9s+
%ole #ompany has an investment opportunity costing %I<,<<< that is expected to yield the folloing cash flos over the next five years: 6assume a cut-off rate of 9<>7
Kear $: %?<,<<< Kear &: %9;,<<< Kear 9: %9<,<<< Kear ?: %&<,<<< Kear ;: %$<,<<<
Re.*$!e"-'.
%ayback period in months.
5ook rate of return6 B&$,%*t P&72&#' Pe!$" 6
"t is a modified payback period method herein cash recoveries include the estimated salvage value at the end of each year of the pro!ect life.
I,,*st!&t$n- B&$,%*t P&72&#' Pe!$"
pro!ect costing %$@<,<<< ill produce the folloing annual cash flos an salvage value:
Kear #ash 0los )alvage Balue
$ %;<,<<< %;,<<< & %;<,<<< %;<,<<< 9 %;<,<<< %9;,<<< ? %;<,<<< %&<,<<< Re.*$!e"- #ompute for the bail-out payback period.
II5 DISCOUNTED METHODS
he time value of money is an opportunity cost concept. peso on hand today is orth more than a peso to be received tomorro because of interests a peso could earn by putting it in a savings account or placing it in an investment that earns income. he time value of money is usually measured by using a discount rate that is implied to be the interest foregone by receiving funds at a later time.
6 Net P!esent V&,*e Met0" 6 Net )!esent v&,*e 6 %resent value of cash inflos – %resent value of cash outflos
#ash inflos include cash infused by the capital investment pro!ect on a regular basis 6e.g., annul cash inflo7 and cash
realizable at the end of the capital investment pro!ect. 6e.g., salvage value, return of orking capital requirements7
he net investment cost required at the inception of the pro!ect usually represents the present value of the cash outflos.
Advantages:
$. Emphasizes cash flos
&. +ecognizes the time value of money
9. ssumes discount rate as reinvestment rate Disadvantages:
$. "t requires determination of the costs of the discount rate to be used.
&. he net present values of the different competing pro!ects may not be comparable because of differences in magnitudes or sizes of the pro!ects.
I,,*st!&t$n- Net P!esent V&,*e (/$t0 Un$f!m C&s0 F,9s+
#an #ompany plans to buy a ne machine costing %&@,<<<. he ne machine is expected to have a salvage value of %?,<<< at the end its life of ? years. he annual cash inflos before income tax from this machine have been estimated at %$$,<<<. he tax rate is &<>. he company desires a minimum return of &;> on invested capital.
Re.*$!e"- *etermine the net present value. 6+ound-off factors to three decimal places7 6 P!f$t&2$,$t7 In"e: Met0" 6 P!f$t&2$,$t7 $n"e: 6 %resent value of cash inflos F %resent value of cash outflos NPV $n"e: 6 (%B F "nvestment
he profitability index method is designed to provide a common basis of ranking alternatives that require different amounts of investment.
Nte- %rofitability index method is also knon as desirability index, present value index and benefit-cost ratio. I,,*st!&t$n- C&)$t&, R&t$n$n 1 R&n'$n P!;e#ts
Lone #orp. is considering five different investment opportunities. he companyCs cost of capital is $&>. *ata on these opportunities under consideration are given belo:
%ro!ect "nvestment %B – #ash 0lo (%B "++ 6>7 %. "ndex
$ %9;,<<< %9I,9&; %?,9&; $ $.$&
& &<,<<< &&,I9< &,I9< $; $.$;
9 &;,<<< &=,?;9 &,;?9 $? $.$<
? $<,<<< $<,@;? @;? $@ $.<I
; I,<<< @,=?I 6&;$7 $$ <.I=
Re.*$!e"-$. +ank the pro!ects in descending order of preference according to (%B, "++ and benefitFcost ratio.
.
"f only a budget of %;;,<<< is available, hich pro!ects should be chosenA6 Inte!n&, R&te f Ret*!n Met0" 6
"++ is the rate of return that equates the present value of cash inflos to present value of cash outflos. "t is also knon as discounted cash flo rate of return, time-ad!usted rate of return or sophisticated rate of return.
Guidelines in determining IRR:
$. *etermine the present value factor 6%B07 for the internal rate of return 6"++7 ith the use of the folloing formula: PVF f! IRR D (et investment cost F (et cash inflos
&. 4sing the present value annuity table, find on line MnC 6economic life7 the %B0 obtained in (o. $. he corresponding rate is the "++. "f the exact rate is not found on the %B0 table, MinterpolationC process may be necessary.
Advantages:
$. Emphasizes cash flos
&. +ecognizes the time value of money 9. #omputes the true return of pro!ect Disadvantages:
$. ssumes that "++ is the re-investment rate.
&. 1hen pro!ect includes negative earnings during its life, different rates of return may result. I,,*st!&t$n- NPV< PI 8 IRR (Even vs5 Uneven C&s0 F,9s+
Kahoo #orp. gathered the folloing data on to capital investment opportunities:
%ro!ect $ %ro!ect &
#ost of investment %$I;,&<< %$;<,<<<
#ostofcapital $<> $<>
Expected useful life 9 years 9 years
(et cash inflos %$<<,<<< %$<<,<<<J J his amount is to decline by %&<,<<< annually thereafter.
Re.*$!e"- +ound-off factors to three decimal places in all cases. $. 0ill-in the blanks.
%ro!ect $ %ro!ect &
(%B %;9,;<< %;&,<?<
%rofitability index $.&= $.9;
&. 1hat is the pro!ect $Cs "++A
a. &9> b.&=> c.&;> d.&?>
9. 1hat is pro!ect &Cs time-ad!usted rate of returnA
a. 5elo 9<> b. 5eteen 9<> G 9$> c. 5eteen 9$> G 9&> d. bove 9&> P!esent V&,*e P&72&#' 1 I,,*st!&t$ve P!2,em
%roblema #o. is considering the purchase of ne machinery. he estimated cost of the machine is %&;<,<<<. he machine is not expected to have a residual value at the end of four years. he machine is expected to generate annual cash inflos for the next four years as follos:
Kear nnual #ash "nflo
$ %$;<,<<<
& $<<,<<<
9 ;<,<<<
? ;<,<<<
%roblema #o. requires a $&> return on this investment. he present values of $, end of each period, discounted at $&> follo:
Kear %resent Balue of
$ <.@I&@
& <.=I=$I
9 <.=$$=@
? <.9;;&
1hat is the present value paybackA
0ill in the blanks for each of the folloing independent cases. "n all cases, the investment has a useful life of $< years and no salvage value. +ound off factors to three decimal places.
%ro!ect nnual #ash 0lo "nvestment #ost of #apital "++ (%B
$ %?;,<<< %$@@,?< $?>
& %=;,<<< $&> $@>
9 %9<<,<<< $> %@$,??<
? %?;<,<<< $&> %$$;,<<<
I,,*st!&t$n- D$s#*nte" 8 Nn%D$s#*nte" Te#0n$.*es
3all #ompany is considering buying a ne machine, requiring an immediate %?<<,<<< cash outlay. he ne machine is expected to increase annual net after-tax cash receipts by %$<,<<< in each of the next five years of its economic life. (o salvage value is expected at the end of ; years. he company desires a minimum return of $?> on invested capital.
Re.*$!e"- +ound-off factors to three decimal places in all cases.
$. %ayback period ?. %rofitability index
&. ++ 6based on original investment7 ;. "nternal rate of return 9. (et present value
/RAP%UP EXERCISES (TRUE OR FALSE= MULTIPLE%CHOICE+
$. pro!ectCs salvage value, realizable at the end of life of the pro!ect, is considered in the computation of the net investments for decision-making purposes.
&. he payback period emphasizes the profitability of a capital pro!ect hile the accounting rate of return, on the other hand, emphasizes the pro!ectCs liquidity.
9. nnual cash inflos from the capital pro!ects are measured in terms of
a. "ncome before depreciation and taxes c. "ncome before depreciation but after taxes b. "ncome after depreciation and taxes d. "ncome after depreciation but before taxes ?. 1hen computing for the accounting rate of return 6++7, hich of the folloing is usedA
a. "ncome before depreciation and taxes c. "ncome before depreciation but after taxes b. "ncome after depreciation and taxes d. "ncome after depreciation but before taxes ;. he technique that does not use cash flo for capital investment decisions.
a.%ayback b.(%B c.++ d."++
. 1hich of the folloing groups of capital budgeting techniques uses the time value of moneyA a. 5ook rate of return, payback and profitability index c. "++, ++ and %"
b. "++, payback and (%B d. "++, (%B and %"
=. #ost of capital is 9>N economic life in years D ? yearsN simple %B factor for year ? is
a. <.I$; b. <.@@@ c. <.?;; d. <.9;<
@. *iscount rate is $$>N economic life in years D 9 yearsN %B annuity factor for 9 years is
a.<.=9$ b. $.=$9 c. &.??? d. 9.$<&
I. s the discount rate increases,
a. %resent value factors increase c. %resent value factors remain constant
b. %resent value factors decrease d. "t is impossible to tell hat happens to the factors $<. he %B0 of any amount at year zero or zero percent is alays equal to #
a. Lero b. <.;< c. $.<< d. cannot be determined
$$. he present value of %;<,<<< due in five years ould be highest if discounted at a rate of
a.<> b.$<> c.$;> d.&<>
$&. n investment ith a positive (%B also has
$9. company is considering the purchase of an investment that has a positive (%B based on a $&> discount rate of. 1hat is the "++A
a. Lero b. $&> c. 2reater than $&> d. ess than $&> $?. 1hich of the folloing combinations is possibleA
%rofitability index (%B "++
a. O$ %ositive D cost of capital
b. O$ (egative P cost of capital
c. P$ (egative P cost of capital
d. P$ %ositive P cost of capital
$;. he (%B method assumes that the pro!ectCs cash flos are reinvested at the
a. "nternal rate of return b. )imple rate of return c. #ost of capital d. %ayback period $. he internal rate of return method assumes that the pro!ectCs cash flos are reinvested at the
a. "nternal rate of return b. )imple rate of return c. +equired rate of return d. %ayback period $=. 1hich one of these methods is a pro!ect ranking method rather than pro!ect screening methodA
a. (%B method b. )imple rate of return c. %rofitability index d. )ophisticated rate of return $@. "f the "++ on an investment is zero,
a. "ts (%B is positive c. "t is generally a ise investment b. "ts annual cash flos equal its required investment d. "ts cash flos decrease over its life
SOLUTION: YAHOO CORP. – NO. 3 PVCF P150,000 (copied !o" COI# COI 150,000 NPV $0$ ACF % PVF & PV P 100,000 ' 0,000 ' )0,000 ' PVCF P150,000
U*i+ -!i/ +d e!!o! 302
P 100,000 % 0.)4 & P ),400 0,000 % 0.54 & 6,3)0 )0,000 % 0.655 & ,300 P151,5)0 312 P 100,000 % 0.)3 & P ),300 0,000 % 0.53 & 6),)60 )0,000 % 0.665 & ),00 P164,)60
T7e!eo!e, IRR i* 8e-9ee+ 302 +d 312.. U*i+ i+-e!po/-io+ 164,)60 3)0 150,000 1,40 151,5)0 3)0 1,40 & 0.15
IRR & 31 – 0.15 & 30.152 P!oo: 30.152 P 100,000 % 0.)65 & P ),650 0,000 % 0.566 & 6),5 )0,000 % 0.66) & ),0 P150,006
