Capital Budgeting – the process of identifying, evaluating, planning, and financing capital investment projects of an

organization.

Characteristics (DULL)
Difficult to reverse – more difficult to reverse than short-term decisions.
Uncertainty – involve so much risk and uncertainty.
Large Fund – usually require large commitments of resources.
Long term – involve long-term commitments.

Step 1 Step 2 Step 3

Identification Evaluation Decision Making
Capital Investment Decisions: Factors of Consideration:
Replacement (Equipment) Net Investments
Improvement (Products) Net Returns
Expansion (Facilities) Cost of Capital
Addition (Technology) *Non-discounted methods
Reduction (Costs) *Discounted methods

Net Investment - Cash Outflows less Cash Inflows

Outflow Inflow
Tax payment on Gain Resale value of equipment*
Other Incidental Cost Avoidable cost (net of tax)
Working Capital Tax savings on Loss
Acquisition Cost Salvage Value

* Salvage Value, Market Value, Scrap Value – G/L taxable

*Trade in Value – G/L not taxable

Net Returns
1. Annual Cash Flows After Tax (ACFAT) and Net Income After Tax (NIAT)
a. Increase Revenue b. Cost Savings
Change in Sales xx Cash cost old xx
Change in Cash Cost (xx) Cash cost new (xx)
Change in CFBT xx Cash Savings xx
Change in Noncash Cost (Dep’n) + or - xx Change in Noncash Cost (Dep’n) xx
Change in NIBT xx Change in NIBT xx
Tax (xx) Tax xx
Change in NIAT xx Change in NIAT xx
Change in Noncash Cost (Dep’n) xx Change in Noncash Cost xx
ACFAT xx ACFAT xx

2. Terminal CFAT
Cost to remove (net of tax)
Working Capital Recovery*
Tax Payment on Gain or Tax Savings on Loss**
Salvage Value of New Equipment
 *Beware of Negative Working Capital
**Salvage Value – if considered or ignored on depreciation.
Old Asset not fully depreciated – check its salvage value.

Cost of Capital – cost of using funds

1. Debt
a. Yield to Maturity or Before Tax Cost of Debt
Interest + [( Par – Price) / Remaining Term]
60% Price + 40% Par
b. After Tax Cost of Debt
YTM x ( 1 – tax)
c. Current Yield
Interest / Current Price
d. Current Yield After Tax
CY x ( 1 – tax)

2. Preferred
Dividends / (Price – Flotation Cost)

3. Common
a. Growth Model
CE = [D1 / (P0 – Flotation Cost)] + g

b. Capital Asset Pricing Model

CE = Rfr + B (Market Price – Rfr)

4. Retained Earnings
(D1 / P0) + g

5. Weighted Average Cost of Capital

WACC = (Cost x Capital Mix)
*Capital Mix = Source of Capital / Total Capital

Or
Cost of Debt x Capital Mix xx
Cost of Preferred x Capital Mix xx
Cost of Common x Capital Mix xx
WACC xx

Evaluation Techniques
I. Non-discounted Techniques
- No discounting
- Ignores time value of money
1. Payback period
- Length of time to recover net investment
 Advantage Disadvantage
a. Liquidity Ignores:
b. Uses cash flows a. Time value of money
c. Easy to apply b. Profitability
c. Salvage value
d. Cash flow after tax payback

Even CFAT = Net investment

ACFAT

2. Accounting rate of return

Advantage Disadvantage
a. Considers profitability a. Ignores time value and cash flows
b. Easy to apply b. Averaging may be illogical
c. Accrual basis

ARR orig = Average NIAT

Orig. Net Investment

ARR ave. = Average NIAT

Ave. Investment
[(Net Inv + SV) / 2]

3. Payback bailout period

- Length of time to recover net investment considering a bail (using salvage value).
Advantage: Same with Payback except it considers salvage value.
Disadvantage: Same with payback excludes salvage value.

II. Discounted Techniques

- With discounting
- Considers time value of money

1. Net Present Value

- Wealth added by the project at year 0.
Advantage Disadvantage
a. Considers time value a. Uses estimated discounted rate
b. Considers all cash flows b. Not comparable for varying size
c. Uses a realistic discount rate investments
*Assumptions:
a. CF are received at the end
b. Reinvestment rate – discount rate

PVCFAT (annual CFAT and Terminal CFAT) xx

Net Investment (xx)
NPV > 0 xx

2. Profitability Index
- Peso earned per peso invested
- Makes or converts NPV in comparable terms
PI = PV of CFAT
Net Investment

3. Internal Rate of Return

- Percentage of earnings or income based on cash basis
- Considers time value of money
- Also known as “time adjusted rate of return”
Advantage
a. Considers time value
b. Uses all cash flows
 c. Reveals true rate of return
Disadvantage
a. Complex to apply
b. Re-investment rate is not realistic – assumes IRR is the re-investment rate
c. Negative cash flows

IRR = Net Investment

Net cash inflows

4. Payback reciprocal
- Good estimate of IRR
- Conditions: a. CFAT should be nearly equal ; b. useful life = at least twice the payback period.

PR = 1 / payback period
Or
PR = ACFAT / Net Investment

5. Discounted payback period

- Length of time to recover net investment
- Considers time value
Advantage: same with payback except that it considers time value
Disadvantage: same with payback excludes time value

IRR = Discount ; NPV = 0 ; PI = 1

IRR > Discount ; NPV > 0 ; PI > 1
IRR < Discount ; NPV < 0 ; PI < 1

Cost of Capital
1. Josh Inc.’s currently outstanding 8% coupon bonds have yield to maturity of 10%. Josh believes it could issue
new bonds at par that would provide a similar yield to maturity. If the income tax rate is 30%, what is Josh
Inc.’s after-tax cost of debt?

2. A corporation has an 8%, P1,000 par value bond outstanding with 20 years to maturity. The bond is currently
selling for P1,200. The corporation pays the corporate tax rate of 30%. It wishes to know what the after-tax
cost of new bond issue is likely to be. The yield to maturity (YTM) on the new issue will be the same as the
yield to maturity on the old issue because the risk and maturity date will be similar.
Required:
a. Compute the approximate yield to maturity on the old issue and use this as the yield for the new
issue. What is the after-tax cost of debt?
b. Compute the new after-tax cost of debt if the bond is issued at P960 per bond.
c. Compute the current yield if the bond is issued at P960 per bond.

3. Winner corporation plans to issue some P90 par preferred stock with an 8% dividend. A similar stock is
selling on the market for P100. Winner must pay flotation costs of 2% of the issue price. The income tax rate
is 30%. What is the cost of preferred stock?

4. The P100 par value preferred stock of C corporation pays an annual dividend of 6%. It has a required rate of
return of 10%. Compute the price of the preferred stock.

5. Wagi corparation’s common stock is currently trading at P100 per share. The stock is expected to pay a
dividend of P4 per share at the end of the year, and the dividend is expected to grow at a constant rate of
6% a year. What is its cost of common equity?

6. F corporation just paid a dividend of P5.00 per share on its stock. The dividends are expected to grow at a
constant rate of 6% per year, indefinitely. If investors require a 10% return on F corporation stocks, what is
the current price?

7. Bagongpanahon corporation has a beta of 0.9. the yield on 3-month Treasury bill is 3% and the yield on a 10-
year T-bond is 7%. The market return is 12%. What is the estimated cost of common equity using CAPM?

8. Use the basic equation for the capital asset pricing model (CAPM) to work on each of the following:
 a. Find the required rate of return for an asset with a beta of 1.20 when the risk-free rate and market
return are 7% and 12%, respectively.
b. Find the required rate of return for an asset with a beta of 0.80 when the risk-free rate of return is
6%, and the market risk premium is 4%.
c. Find the beta for an asset with a required return of 7.4% when the risk-free rate and market return
are 6% and 8%, respectively.

9. A firm’s new financing will be in proportion to the market value of its current financing shown below:
Carrying Amount
Long-term debt P7,000,000
Preferred stock (100,000 shares) 1,000,000
Common stock (200,000 shares) 7,000,000

The firm’s bonds are currently selling at 80% of par, generating a current market yield of 9%, and the
corporation has a 40% tax rate. The preferred stock is selling at its par value and pays a 6% dividend. The
common stock has a current market value of P40 and is expected to pay a P1.20 per share this year.
Dividend growth is expected to be 10% per year, and flotation costs are negligible.

What is the firm’s weighted average cost of capital?

Net investment
1. The management of Leonor Company plans to replace a machine that was acquired several years ago at a
cost of P500,000. It has been depreciated to its salvage value of P50,000, and can be sold now for P40,000. A
new sorter can be purchased to replace the old one for P800,000. If a new machine is not purchased, Leonor
company will spend P150,000 to repair the old machine. The cost to repair the old machine can be deducted
in the first year to compute income tax. Moreover, the acquisition of the new machine will require
additional investment in working capital of P30,000. Income tax is estimated at 30% of the income subject to
tax.
Required:
a. Compute the net investment in the new machine for decision making purposes.
b. Use all the information given in the problem, except that instead of selling the old machine, the
same is traded in for P60,000. What will be the cost of the new machine for decision making
purposes.

Net returns
1. Rowena Inc. is considering an investment of P500,000 in a new machine that will be used to produce a new
product. The machine is expected to have a useful life of 5 years, with no salvage value at the end of its life.
A selling price of P30 per unit is decided upon for the new product; unit variable cost is P20, and fixed
operating costs, including depreciation are estimated at P220,000 per year. The sales division believes that a
sales estimate of P30,000 units per year is realistic. Income tax is estimated at 30% of income before tax.
Determine the annual net cash inflows and net returns (net income) for the proposed investment projects.

2. Linda summer, owner of Summer Company, was approached by a local dealer in air conditioning units. The
dealer proposed replacing Summer’s old cooling system with a modern, more efficient system. The cost of
the new system was quoted at P1,500,000, but it would save P230,000 per year in energy costs. The
estimated life of the new system is 10 years, with no salvage value expected. Excited over the possibility of
saving P230,000 per year and having a more reliable unit, Ms. Summer requested an analysis of the project’s
economic viability. All capital projects are required to earn at least the firm’s cost of capital, which is 10%.
Income tax rate is 30% of taxable income.

Determine the annual net cash inflows and net returns (net income) for the proposed projects.

Non-discounted Techniques
1. A piece of labor saving equipment has just come onto the market that Dikosan Electronics could use to
reduce costs in one of its plants. Relevant data relating to the equipment follow:
Cost of the equipment P800,000
Annual savings in cash operating costs
that will be provided by the equipment 200,000
Life of the equipment 10 years
 The company pays 30% income tax rate.
Required:
a. Compute the payback period for the equipment. If the company requires a payback period of 5
years or less, would the equipment be purchased?
b. Compute the accounting rate of return promised by the equipment based on (a) original investment
and (b) average investment. Would the equipment be purchased if the company’s required rate of
return is 14%?

2. A company purchased a new machine on January 1 of this year for P700,000, with an estimated useful life f
5 years and a salvage value of P5,000. The machine will be depreciated using the straight-line method. The
machine is expected to produce cash flow from operations, net of income taxes, of P200,000 a year in each
of the next 5 years. The new machine’s salvage value is P120,000 in years 1 and 2, and P8,000 in years 3 and
4. Compute the bailout for this machine.

3. Vhong corporation has determined that if a new equipment costing P120,000 is purchased, the company’s
net income will increase by P10,000 per year. If the new equipment will be depreciated using the straight-
line method over a period of six years to a zero salvage value. What is the payback period?

4. Boogoy corporation is planning to invest P420,000 in a new machine which it will depreciate on a straight-
line basis over 10 years with zero salvage value. The new machine is expected to generate cash flows from
operations, net of income taxes, of P50,000 per year in each of the first 6 years and P60,000 per year in each
of the last 4 years of its life. What is the payback period?

Discounted Techniques
1. Kelvin Corporation is considering the purchase of a new machine costing P450,000. The machine will have
an economic life of 5 years with no salvage value at the end of its life. It will be depreciated using the
straight-line method and is expected to produce annual cash flows from operations, net of income taxes, of
P150,000. Kelvin Corporation’s cost of capital is 10%. It is subject to an income tax rate of 32%. What is the
Net Present Value of this capital investment project?

2. Lily Healthcare Corp. is proposing to spend P109,296 on an 8 year project that has estimated net cash flows
of P22,000 for each of the 8 years.
Required:
a. Compute the Net Present Value, using a rate of return of 15%.
b. Determine the Internal Rate of Return by computing a present value factor for an annuity of P1 and
using the table of the present value of an annuity of P1.
c. Determine the internal rate of return, assuming that the project will have estimated net cash inflows of
P20,000 for each of the 8 years.

3. Owl company is planning to buy an equipment costing P600,000 which has an estimated life of 20 years and
is expected to produce after-tax net cash inflows of P140,000 per year. What is the Payback Reciprocal?

4. A new machine costing P80,000 with 3 years useful life, no salvage value at the end of 3 years, is expected to
bring in the following cash inflows after tax:

First year P60,000

Second year 40,000
Third year 30,000

Required: if the company’s cost of capital is 12%, what is the discounted payback period?