EXERCISE ON CAPITAL BUDGETING

1. NET INVESTMENT FOR DECISION-MAKING

Cash Outlay:
Purchase Price of new equipment
Less: Cash Discount (2% of 200K)
Shipping, installation and testing costs
Addtl Working Capital
Total Cash Outlay

200,000.00
4,000.00

Cash Inflow:
Proceeds from sale of old equipment
75,000.00
Less: Tax to be paid from gain on sale (outflow)
(75,000-65,000)*25%
2,500.00
Proceeds from sale of other assets
10,000.00
Add: Tax savings (tax benefit)
(10,000-12,000)*25%
500.00
NET INVESTMENT

196,000.00
14,000.00
18,000.00
228,000.00

72,500.00 *There is a gain on sale

*Because there is a loss

10,500.00
83,000.00
145,000.00

2. WEIGHTED AVERAGE COSTS OF CAPITAL (WACC)

A. EARNINGS PER SHARE (EPS)
EPS

=
=
=
=

EPS

Net Income Available for Com

Common shares Out
Net Income - Required Return for Preferre
Common shares Out
500,000 - (200,000 * 5%)
10,000 shares
500,000 - 10,000
10,000 shares
49.00 per share

B. WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Sources
Bonds (Debt)
Preferred Stock (PS)
Common stock and retained earnings
Total

Amount
600,000.00
200,000.00
1,200,000.00

A
Weight
0.30
0.10
0.60

B
Costs
6%
10%
9%

2,000,000.00

Cost Debt

=
=
=

Interest rate * (1 - Tax ra

8% * (1 - 30%)
6%

Cost of PS

=
=
=
=

Cost of CS
and RE

=
=
=
=

3. NET RETURNS (INCREASE IN REVENUE)

A. INCREASE IN ANNUAL NET INCOME
Sales
Variable Costs
Fixed Costs
Depreciation
Earnings Before Income Tax (EBIT)
Less: Income Tax
Net Income
B. ANNUAL CASH INFLOWS
Net Income
Add: Depreciation
Cash Inflows

150,000.00
60,000.00
20,000.00
40,000.00

120,000.00
30,000.00
9,000.00
21,000.00

21,000.00
40,000.00
61,000.00

4. PAYBACK PERIOD AND ACCOUNTING RATE OF RETURN

A. PAYBACK PERIOD
Solve for the Cash Savings after tax
Pre-Tax Cash Savings
Less: Depreciation
Cost of Equipment
Less: Salvage Value
Depreciable Cost
Divided by: Useful Life of asset
Earnings before Income Tax (EBIT)

40,000.00
90,000.00
10,000.00
80,000.00
8

10,000.00
30,000.00

Dividend Req
PS Market
(5% * 200,000)
5.00
50.00
10%
Dividend per share
MP per share
2.00
40.00
5%
9%

Less: Income Tax (40% of 30,000)

Net Income
Add: Depreciation
After-tax Cash Savings (Cash Flow)

12,000.00
18,000.00
10,000.00
28,000.00

Payback Period

Cost of Investment
Annual Cash Inflow
90,000.00
28,000.00
3.21

=
=

Payback Period

B. ACCOUNTING RATE OF RETURN ON ORIGINAL INVESTMENT

ARR

=
=

ARR

Net Income
Investment
18,000.00
90,000.00
20%

B. ACCOUNTING RATE OF RETURN ON AVERAGE INVESTMENT

ARR

=
=

ARR

Net Income
Ave. Investment
18,000.00
(90000 + 0)/2
40%

5. PAYBACK PERIOD AND ACCOUNTING RATE OF RETURN

A. PAYBACK PERIOD IN MONTHS
Total Investment = P 90,000.00
Year 1
40,000.00

Cash Flows
Year 2
35,000.00

Year 3
30,000.00

75,000.00
Total Cash Flows after 2 yrs.

105,000.00
Total Cash Flows after 3 yrs.

* If total Cash Flows is 75,000 after two years and 105,000 after three years, then
total Investment amounting to 90,000.00 can be recovered between the 2nd and
3rd year (90,000 is between 75,000 and 105,000).
Thus,
Total Investment
Less: Total Cash Flows of two yrs.
Amount not yet recovered after 2 yrs.
Divided by: CF of 3rd yr.

90,000.00
75,000.00
15,000.00
30,000.00
0.50

Payback Period = 2+ 0.5

= 2.5 years or
Payback Period =
30 months
B. BOOK RATE OF RETURN

6. NET PRESENT VALUE

Cash Inflows before Tax
Less: Depreciation
Cost of Equipment
Less: Salvage Value
Depreciable Cost
Divided by: Useful Life of asset
Earnings before Tax
Less: Tax (20%)
Earnings after Tax
Add: Depreciation
Cash Inflows after Tax

Total Investment
PV of Cash Inflows:
Year 1
Year 2
Year 3
Year 4
Total PV of Cash Inflows
Net Present Value

11,000.00
28,000.00
4,000.00
24,000.00
4

Year 0
(28,000.00)

6,000.00
5,000.00
1,000.00
4,000.00
6,000.00
10,000.00
PV Factor

8,000.00
6,400.00
5,120.00
4,100.00
23,620.00
(4,380.00)

7. NPV, PROFITABILITY INDEX & INTERNAL RATE OF RETURN

0.800
0.640
0.512
0.410

Year 1

10,000.00

Project 1
A. NPV
Cost of Investment
PV of Cash Inflows

(195,000.00)
Net Cash Inflows
PV Factor

100,000.00
2.487

Net Present Value

248,700.00
53,700.00

C. Profitability Index
Profitability Index

=
=

Profitability Index

PV of Cash Inflows
Cost of Investment
248,700.00
195,000.00
1.28

8. DISCOUNTED & NON-DISCOUNTED CAPITAL BUDGETING TECHNIQUES

A. PAYBACK PERIOD
Payback Period

=
=

Payback Period

Accounting Rate of Return

Cost of Investment
Cash Inflows
400,000.00
160,000.00
2.50 years

B. ARR

=
=
ARR

C. NET PRESENT VALUE

Cost of Investment
PV of Cash Inflows:

Net Income
Cost of Investment
Cash Inflows + Depreciation
Cost of Investment
240,000.00
400,000.00
60%

(400,000.00)
Annual Cash Inflow
PV Factor

160,000.00
3.433

Net Present Value

549,280.00
149,280.00

D. PROFITABILITY INDEX
Profitability Index

PV of Cash Inflows

Profitability Index

=
=

Profitability Index

Cost of Investment
549,280.00
400,000.00
1.373

E. INTERNAL RATE OF RETURN (The rate where Cost of Investment is equal to PV of Cash Inflows)
Let X = PV Factor
400,000.00
=
160,000.00 X
X
=
2.50
If PV Factor = 2.500, then
Interpolation

PV Factor
28%
2.532
?
2.500
29%
2.483
IRR

=
=

IRR

0.032

28%

28%

28.653%

here is a gain on sale of equipment. Thus, tax has to be paid.

ecause there is a loss on sale of assets, no tax has to be paid. Thus, there is a tax savings on sale of assets.

me Available for Common Stockholders

Common shares Outstanding
ed Return for Preferred Stockholders
Common shares Outstanding

AxB
WACC
2%
1%
5%
8%

erest rate * (1 - Tax rate)

* (1 - 30%)

WACC

Dividend Requirement/No. of PS
PS Market Price per share
(5% * 200,000) / (200,000/100 par)
50

Dividend per share

MP per share

4%

4%

Growth rate

Year 2

Year 3

Year 4

10,000.00
10,000.00
10,000.00

Project 2 (Assume Net Cash Inflows of Project 2 decline 20,000.00 annually)

B. NPV
Cost of Investment
PV of Cash Inflows:
Year 1 100,000.00 x
0.909
90,900.000
Year 2
80,000.00 x
0.826
66,080.000
Year 3
60,000.00 x
0.751
45,060.000
Net Present Value
D. Profitability Index
Profitability Index =
=
Profitability Index =

3.43308097

PV of Cash Inflows
Cost of Investment
202,040.00
150,000.00
1.35

of Cash Inflows)

0,000.00 X

0.049

0.032
0.049
0.653%

1%

tax savings on sale of assets.

cline 20,000.00 annually)

(150,000.00)

202,040.000
52,040.000