14 - CAPITAL BUDGETING

CAPITAL BUDGETING – the process of identifying, evaluating, planning, and financing capital investment projects of an organization. It is a technique in strategic management that assesses the long-term need and direction of an organization.

Strategic plans have long-term effects, involve tremendous amount of investment and costs, and shape the major business plan of a firm. One of the strategic management techniques in fields of financial management is Capital Budgeting.

It deals with analyzing the PROFITABILITY and/or LIQUIDITY of a given project proposal.

Characteristics of Capital Budgeting:

1. Requires large commitments of resources.2. Involves long-term commitments.3. More difficult to reverse than short-term decisions4. Involves so much risk and uncertainty.

Types of Capital Investment Projects

1. Replacement2. Improvement3. Expansion

Independent Projects are projects that do not compete with one another so that the acceptance of one does not eliminate the others for further consideration

Mutually Exclusive Projects are those that compete with one another so that the approval or acceptance of one eliminates the others in the group for further consideration.

Main Issues in Capital Budgeting

I. The Net Cost of Investment – refers to the net cash outflows, after tax considerations that are normally paid by investors in relation to the investing transaction. It includes opportunity costs such as possible savings and tax effects on possible gains, loss or savings on related transactions.

Basic Formula:

Cash Outflows Cash InflowsO1) Net purchase price of the new asset

O2) Additional or incidental costs paid or incurred to prepare the asset for use

O3) Increase in working capital base

O4) Additional tax paid or incurred in case of gain from sale or disposal of old asset*

o-I2) Additional tax paid from savings on avoided cost of repairs, if the old asset is replaced**

I1) Proceeds from sale or trade-in allowance from disposal of asset

I2) Savings from avoided repairs and maintenance, if the old asset is replaced.

I3)Tax savings from loss on sale of old asset*

*The existence of the other cash flow eliminates the other. **Dependent on the Existence of I2; Can also be netted against I2.

Sample Problem:

Dear Jommy Inc. is considering replacing an old press that cost P800, 000 6 years ago with a new one that would cost P2, 250,000. Shipping and installation would cost an additional P 200,000. The old press has a book value of P150, 000 and would be sold currently for P50, 000. The cost of immediate repairs on the old press is P20, 000. The new press would require an increase in: inventories by P40, 000; Accounts Receivable by P160, 000; and accounts payable by P140, 000. Tax Rate is 35%. The Net Investment would be?

Cash Outflows Cash InflowsO1) 2,250,000

O2) 200,000

O3) 60,000

-

o-I2) 7,000

I1) 50,000

I2) 20,000

I3) 35,000

2,517,000 105,000

P 2,412,000 – Net InvestmentII. Net Returns – could either be Accounting Net Income or Net Cash Inflow(Net income plus

non-cash charges).

Basic Formula(Expansion): Basic Formula(Replacement):Cash flow from operations before tax P x Increase in annual RevenueLess: Depreciation Expense x Less: Increase in out-of-pocket Income before income tax x operating costsLess: Income tax x Increase in depreciation chargesNet Income x Incremental Income before income taxAdd: Depreciation Expense x Less: Incremental Income taxAnnual Cash Inflow x Incremental Net Income

Add: Incremental DepreciationIncremental Cash Returns

Sample Problem:

Deutsche Bank is considering on replacing their old machine with a book value of P 60, 000 and remaining life of 5 years with a new machine that would cost P 150, 000 with a useful life of 5 years. The old machine can generate annual revenue of P 100, 000 and the new machine with P 200, 000. The acquisition will increase out-of-pocket operating costs by P 20, 000. The tax rate is 35%. What is the Net Cash Inflow?

Increase in annual Revenue P 100, 000Less: Increase in out-of-pocket operating costs (20, 000) Increase in depreciation charges (18, 000)Incremental Income before income tax P 62, 000Less: Incremental Income tax (21, 700)Incremental Net Income 40,300Add: Incremental Depreciation 18, 000Incremental Cash Returns P 58,300

III. Cost of Capital – refers to cost of using money or funds from investors. Decision Making:Cost of Capital > Return on Investment = Reject ProjectCost of Capital < Return on Investment = Accept

Sample Problem:

Katrina Inc. wants to acquire a new machine. The machine has a net cost of investment of P 70, 000 and would provide net operating cash inflow of P 17, 500 with a useful life of seven years. The purchase would be financed by a bank loan with interest of 9%. Should Katrina Inc. purchase the project (ignore taxes)?

Net Operating cash inflow of P17, 500 Since the ROI of 10.7% is greater than cost of capital of 9%, Less: Depreciation 10, 000 Katrina can purchase the machine.Net Income 7, 500Divide by Net Investment 70, 000Return on Investment 10.7%

IV. Project Evaluation Techniques

What is Payback Period?

Refers to the length of time before an investment is recovered. The time period where the cumulative cash inflow is equal to the cost of investment. Otherwise known as the “BREAK EVEN TIME”

Payback Period = Cost of Investment / Net Cash Inflow

What is Payback Reciprocal?

Is equal to one over payback period. Represents the percentage of annual net cash returns provided by an investment.

Payback Period = 1/ Payback Period

NOTE: The higher the payback reciprocal, the better.

Explain Payback Bailout Period.

There are times where a project could be terminated anytime during its life such as projects funded by government money where the budget depends on congress approval and projects where their continuity depends on the approval of the funding agency. In this case, the residual value is considered in determining the total cash provided by the project. It is the basis of using the payback bailout period.

What is Accounting Rate of Return (ARR)?

Measures the profitability of a proposed project. Referred to as unadjusted rate of return, return on investment, return on assets, and simple

accounting rate of return. May be computed based Original or Average investment.

ARR (Original) = Net Income / Original Investment

ARR (Average) = Net Income / Average Investment

= Net Income / [(Original Investment + Salvage Value)/ 2]

NOTE: The Higher the ARR, the better.

Sample Problem 1:

Payback Period, Payback Reciprocal, and Accounting Rate of Return:

Salih Company is planning to buy a new machine costing P 500,000 with a useful life of five years, no salvage value. Other data were made available:

Expected Annual Sales Revenue P 600,000

Annual Out of Pocket Cost` 450,000

Income Tax Rate 40%

Depreciation Method: Straight Line

Required:

Determine the Payback Period, Payback Reciprocal, ARR (Original Investment), and ARR

(Average investment)

SOLUTION:

Sales P600,000

Out-of-pocket costs (450,000)

Depreciation expense (P500,000/5) (100,000)

IBIT 50,000

Tax (40%) (20,000)

Net income 30,000

Depreciation expense 100,000

Annual cash inflows P130,000

Payback period = P500,000 / P130,000 = 3.85 yrs.

Payback reciprocal = 1 / 3.85 = 25.97%

ARR (original) = P30,000/P500,000 = 6%

ARR (average) = [P 30,000 / (P 500,000/2)] = 12%

Sample Problem 2:

Payback Bailout Method

An equipment costing P 1,000,000 is expected to yield the following net cash inflows and salvage values:

Year Net Cash Inflow Residual Value, Net of Tax

01 300,000 200,000

02 400,000 100,000

03 200,000 50,000

04 150,000 20,000

Required: Determine the payback bailout period.

SOLUTION:

Year

Net Cash Cash to SalvageTotal Cash

Payback

Inflows Date Value Period

1 P300,000 P300,000 P200,000 P500,000 1

2 400,000 700,000 100,00 800,000 1

3 200,000 900,000 50,000 950,000 1

4 150,000 1,000,000 20,000 1,000,000 0.53 (100,000 - 20,000

150,000

Total 3.53 yrs.

Discuss the concept of Net Present Value

Net Present Value (NPV) determines the cash inflows and outflows at the same time period. Since cash inflows are to be received in the future while cash outflows are made at the start of the project, there is an apparent inconsistency in the timing of cash flows. The solution is to discount the future cash inflows to their present values before comparing to the cost of investment.

Present Value of Cash Inflows (PVCI) xxx

Less: Cost of Investment (COI) xxx

Net Present Value xxx

Give the formula in computing:

Profitability Index

NPV Index

Profitability index = PVCI / COI

NPV Index = NPV / COI

Sample Problem 3

NPV, Profitability Index, and NPV Index

An equipment costing P 800,000 will produce annual net cash inflows of P 300,000. At the end of its useful life of five years, the equipment will have a residual value of P 20,000. The desired rate of return is 18%.

Required: Calculate the Net Present Value, Profitability Index, and the Net Present Value Index in relation to the proposed investment in equipment.

SOLUTION:

PVCI:

Annual cash inflows (P300,000 x 3.127) P938,100

Salvage value (P20,000 x 0.437) 8,740 P946,840

Less: COI 800,000

Net present value P146,840

Profitability index = P946,840 / P800,000 =1.184

NPV index = P146,840 / P 800,000 =0.184

What is Internal Rate of Return (IRR)?

Is the Break Even Rate of Return It is where:

PVCI = COI

NPV = Zero

Profitability Index = 1

If IRR > Cost of Capital = Accept Project If IRR < Cost of Capital = Reject Project

Sample Problem 4

Internal rate of Return

Czarin Company has the opportunity to buy a new machine at P 520,000. This machine is expected to have a useful life of four years, no residual value and will yield annual net cash inflow after tax of P 200,000 during its economic life. The company’s rate of return is 10%.

Required: Determine the time adjusted rate of return

SOLUTION

PVF Annuity = P 520,000 / P 200,000 = 2.6

b. Using Table 2 (PVFA Table), the IRR is computed as follows:

2%

18% 2.690

0.090

0.102

2.600

?

0.012

20% 2.588

IRR = 18% + 0.090

x 2%

= 19.76% 0.102

EXERCISES

1. An investment of P 400,000, can bring in the following annual cash income, net of tax:

1st year P 70,000

2nd year 90,000

3rd year 85,000

4th year 160,000

5th year 75,000

6th year 70,000

Determine the Payback Period

2. An equipment costing P 600,000 with a residual value of P 30,000 at its useful life of five years, is expected to bring the following net cash inflows:

First Year P 350,000

Second Year 250,000

Third Year 150,000

Fourth Year 100,000

Fifth Year 50,000

The Company uses a 12% discount rate

Compute the Net Present value in relation to the proposed investment

3. Vuntez Company is considering the following investment alternatives:

NET CASH FLOW AFTER TAX

Project 1 Project 2 Project 3

Year 0 (5,000,000) (8,000,000) (1,400,000)

Year 1 2,400,000 5,500,000 200,000

Year 2 2,200,000 2,600,000 600,000

Year 3 1,800,000 700,000 1,000,000

Year 4 1,100,000 200,000 800,000

Salvage Value 200,000 200,000 80,000

The company uses a 14% discount rate and has P 13,500,000 available money for investment.

Required: Using the PROFITABILITY INDEX MODEL, determine which project should the company invest its money.

4. A new equipment costing P 800,000 with five years useful life and P 40,000 residual at the end of five years, is expected to bring the following cash inflows, after tax:

Year Net Cash Inflow

01 350,00002 300,00003 250,00004 150,00005 80,000

Determine the discounted rate of return

5. Mr. Danny invested P 203,000 for 1,400 shares of Benpres Company common stock. He received a cash dividend of P 20 per share in the next five years and sold the stock for 200,000 at the end of five years. The acceptable ROI for this type of investment is 10%.

Required: Compute for the Net Present Value and the internal rate of return of the investment.

Jomil purchased a special machine one year ago at a cost of P 200, 000. At that time, the machine was estimated to have a useful life of 8 years and zero disposal value. The annual cash operating expenses is approximately P 400, 000. A new machine that has just come on the market will do the same job but with an annual cash operating expenses of P 340, 000. This new machine costs P 385, 000 and has an estimated life of 7 years with no expected savage value. The old machine can be sold for P 120, 000. The company’s income tax rate is 40 %, and its cost of capital is 12%.

6. What is the net cost of investment?

7. What is the net cash return?

8. Compute the Net Present Value.

Cat Lover Company’s President, Katrina wants to expand the operations of the company. Its options for investment are Project Jommy, Project Leo, and Project Joey. The details for the project proposals are:

Project Investment Net Income

Jommy P 2, 000, 000 P 300, 000

Leo P 2, 200, 100 P 312, 000

Joey P 1, 900, 000 P 295, 000

Cat Lover’s Cost of Capital is 14%.

9. Assuming the projects are mutually exclusive which proposal should be approved?

10. Assuming the projects are independent with available capital for investment of P 4, 300, 000, which projects should be approved?