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LECTURE NOTES IN CAPITAL BUDGETING . CAPITAL BUDGETING - the process of identifying, evaluating, planning, and financing capital investment projects of an organization. CHARACTERISTICS OF CAPITAL INVESTMENT DECISIONS 1. Capital investment decisions usually require large commitment of resources (e.g. fixed or non-current assets) 2. Most capital investment decisions involve long-term commitments. (since once locked in, resources are committed) 3. Capital investment decisions are more difficult to reverse than short-term decisions. 4. Capital investment decisions involve so much risk and uncertainty. (involves the future) CAPITAL INVESTMENT FACTORS 1. Net Investment - cost or cash outflows less cash inflows or savings incidental to the acquisition of investment projects Cost or cash outflows: ¢ The initial cash outlay covering all expenditures on the project up to the time when it is ready for use or operation: Ex: Purchase price of asset Incidental project-related costs such as freight, insurance taxes, handling, installation, test-runs, etc. * Working Capital Requirement to operate the project at a desired level (increase/decrease in current assets) © Market value of an existing, currently idle asset, which will be transferred to or utilized in the operations of the proposed capital investment project. Savi e : e Trade-in value of old asset (in case of replacement) * Proceeds from sale of old asset to be disposed due to the acquisition of the new project (less applicable tax, in case there is gain on sale, or add tax savings, in case there is loss on sale). e Avoidable cost of immediate repairs on old asset to be replaced, net of tax. Net Returns - Accounting net income - Net cash inflows COMMONLY USED METHODS IN EVALUATING CAPITAL INVESTMENT PROJECTS 1. Methods that do not consider the time value of money a. Payback b. Bail-out c. Accounting rate of return 2. Methods that consider the time value of money (discounted cashflow methods) a. Net present value b. Present value index c. Present value payback d. Discounted cash flow rate of return (internal rate of return) METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY PAYBACK PERIOD = Net cost of initial investment = The length of time required by Annual net cash inflows the project to return the initial cost of investment Advantages: 1. Payback is simple to compute and easy to understand. There is no need to compute or consider any interest tate. One just has to answer the question: “How soon will the investment cost be recovered?” 2. Payback gives information about liquidity of the project. 3. Itis a good surrogate for risk. A quick payback period indicates less risky project. Disadvantages 1. Payback does not consider the time value of money. All cash received during the payback period is assumed to be of equal value in analyzing the project. 6) CamScanner 2. It gives more emphasis on liquidity rather than on the profitability of the project. In other words, more * emphasis is given on return of investment rather than the return on investment. 3. Itdoes not consider the salvage value of the project. 4. Itignores the cash flows that may occur after the payback period. BAILOUT PERIOD - cash recoveries include not only the operating net cash inflows but also the estimated salvage value or proceeds from sale at the end of each year of the life of the project. ACCOUNTING RATE OF RETURN - also called book value rate of return, financial method, average return on investment and unadjusted rate of return. Accountingrate of = Average annual net income return Investment Advantages: 1. The ARR computation closely parallels accounting concepts of income measurement and investment return. 2. It facilitates re-evaluation of projects due to the ready availability of data from accounting records 3. This method considers income over the entire life of the project. 4. Itindicates the project's profitability. Disadvantages: 1. Like the payback and bail-out methods, the ARR method does not consider the time value of money. 2. With the computation of income and book value based on the historical cost of accounting data, the effect of inflation is ignored. METHODS THAT CONSIDER THE TIME VALUE OF MONEY (Discounted Cash flow Methods) NET PRESENT VALUE Present value of cash inflows - Present value of cash outflows Net Present Value Advantages: 1. Emphasizes cash flows 2. Recognizes the time value of money 3. Assumes discount rate as the reinvestment rate 4. Easy to apply Disadvantages: 1. Itrequires predetermination of the cost of capital or the discount rate to be used 2. The net present values of different competing projects may not be comparable because of differences in magnitudes or sizes of the projects PROFITABILITY INDEX - tae Total Present Value of cash inflows Profitability Index = Total Present Value of cash outflows DISCOUNTED CASH FLOW RATE OF RETURN - the rate of return which equates the present value (PV) of cash inflows to PV of cash outflows. STEPS: 4. Determine the present value factor (PVF) for the discounted cash flow rate of return (DCFRR) with the use of the following formula: ofi PVF for DCFRR Es Net cost of investment Net cash inflows 2. Using the table 2 (present value annuity table), find on line n (economic life) the PVF obtained in step 1. The corresponding rate is the DCFRR. Advantages: 1. Emphasizes cash flows 2. Recognizes the time value of money 3. Computes the return of project 6) CamScanner Name: Score: Section: CAPITAL BUDGETING EXERCISES Fill in the blanks. Please put your answers on the space provided. 1, The management of Leonor Company plans to replace a sorting machine that was acquired several years ago at a cost of P50,000. The machine has been depreciated to its salvage value of P5,000, Anew sorter can be purchased for P60,000. The dealer will grant a trade-in allowance of P6,000 on the old machine. C If anew machine is not purchased, Leonor Company will spend P20,000 to repair the old machine. The cost to repair the old machine can be deducted in the first year to compute income tax. Income tax is estimated at 40% of the income subject to tax. Required: a. Compute the net investment in the new machine for decision-making purposes. b. Assume that instead of trading in the old machine, the same is sold for P6,000. Assume also that the acquisition of the new machine will require additional investment in working capital of P10,000. What will be the cost of the new machine for decision making purposes? 2. Dell Company plans to replace a unit of equipment acquired three (3) years ago and is now recorded at a net book value of P65,000. The equipment can be sold now for P75,000. The income tax rate is 30%. Micro Company can acquire new equipment at a list price of P200,000, The dealer will grant 2% cash discount if the equipment is paid for within 30 days of acquisition. Shipping charges to be paid by Dell are estimated at P11,750. The cost to install the equipment has been estimated at P2,250. Before the equipment can be used for operations, a testing run that will cost P3,500 is deemed necessary. Additional working capital of P30,000 will be needed to support operations planned with the new equipment. The equipmentis expected to have a useful life of 5 years with a salvage value of P4,000 at the end of Syears. The annual cash flow after income tax from the operation of the new equipment has been estimated at P50,000. Required: a. The amount of investment for decision-making purposes b. Suppose the old equipment can be sold now for P50,000, determine the net investment required. 3. Dulce, Inc. is considering an investment of P2million in a new product line. Depreciation of P200,000is to be deducted in each of the next ten years (salvage value is estimated at zero). A selling price of P40 per units is decided upon; unit variable cost is P18, and fixed operating costs, excluding depreciation are estimated at P400,000 per year. The sales division believes that a sales estimate of 50,000 units per year is realistic. Income taxis estimated at 30% of income before tax. Z Required: Determine the annual net cash inflows and net income for the proposed investment project. 4, Naga Company is considering the sale of a machine with a book value of P80,000 and 3 years remaining useful life, Straight-line depreciation of P25,000 annually is available. The machine has a current market value of P100,000. What is the cash flow from selling the machine if the tax rate is 40%? 5, Nabua company is considering replacing a machine with a book value of P200,000, a remaining useful life of 5years, and an annuat straight-line depreciation of P40,000. The existing machine has a current market value of P200,000. The replacement machine would cost P300,000 have a 5-year life, and save P100,000 per year in cash operating costs. The replacement machine would be depreciated using the straight-line method and the tax rate is 40%. What would be the annual net cash flow increase if the company replaces the machine? 6) CamScanner Ligao Company is analyzing a capital investment proposal for new machinery to produce a new product over the next 10 years. At the end of ten years, the machinery must be disposed of with a zero net book value but with a scrap salvage value of P20,000. It will require some P30,000 to remove the machinery. The applicable tax rate is 35%. The approximate “end-of-life” cash flow based on the foregoing information is: 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 P100,000, but it would save P20,000 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 P20,000 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 Percent. Income tax rate is 30% of taxable income. Required: Determine the annual net cash inflows and net income for the proposed investment project. 8. Tanjiro Corp. uses a labor-intensive manufacturing process. Existing equipment has a book value of P20,000, a five-year remaining life, and a P25,000 market value. Cash operating costs is P75,000. The proposed Process requires machinery costing P120,000 with a useful life of five years and no salvage value. The new machinery, which will replace the old one, requires P35,000in annual cash costs. The tax rate is 30% and the cost of capitalis 12%. Required: a. Whatis the net investment of the new equipment? b,. What is the annual net cash inflow from the new equipment? 9. Apiece of labor-saving equipment has just come onto the market that Pikachu Electronics could use to reduce costs in one of its plants. Relevant data relating to the equipment follow: Purchase cost of the equipment P432,000 Annual cost savings that will be P90,000 provided by the equipment Life of the equipment 12 years The company pays the 30% income tax rate. Required: a. Compute the payback period for the equipment. b. If the company requires a payback period of 4 years or less, would the equipment be purchased? 10. The management of Builders, Inc., an architectural design firm, is considering an investment with the following cash flows: Year Investment Cash Inflow P15,000 P1,000 P8,000 2,000 2,500 4,000 5,000 6,000 5,000 4,000 3,000 2,000 = wolo)N] ala} a} a ° Required: a. Determine the payback period of the investment. b. Would payback period be affected if the cash inflow in the last year were several time as large? 6) CamScanner 15. The Witch Company is considering a new popper for one of its portable caramel popcorn stands. The analysis is narrowed to the “Pak” or the “Boom”. Information on the two devices is: PAK BOOM Purchase Price P90,000 P60,000 Annual cash inflows 34,000 24,000 Salvage value in five years 8,000 5,000 Useful Life Syears Syears Other devices will do the job equally as well. Witch uses a 16% cost of capital. Required: a. Which machine has the higher NPV? b. Using the profitability index, which machine is more attractive? c. If Witch has P120,000 to invest in popping machines, what should it do? 16. Memon’s Donut Corner is investigating the purchase of a new P18,600 donut-making machine. The new machine would permit the company to reduce the amount of part-time help needed, at a cost-savings of P3,800 per year. In addition, the new machine would allow the company to produce one new style of donut, resulting in the sale of 1,000 dozen more donuts each year. The company requires a contribution margin of P1.20 per dozen donuts sold. The new machine would have a six-year useful life. Required: a. What would be the toral annual cash inflows associated with the new machine for capital budgeting purposes? b. Find the internal rate of return promised by the new machine to the nearest whole percent. c. Inaddition to the data given previously, assume that the machine will have a P9,125 salvage value at the end of six years. Under these conditions, compute the internal rate of return to the nearest whole percent. 17. Anew machine costing P54,000 with three years useful life, no salvage value at the end of three years, is expected to bring in the following cash inflows after tax: First year P30,000 Second Year 24,000 Third Year 15,000 Required: Determine the time-adjusted rate of return. 18. Owu Company is planning to buy an equipment costing P300,000 which has an estimated life of 20 years and is expected to produce after-tax net cash inflows of P60,000 per year. Required: Estimate the discounted cash flow rate of return without using present value factors. 19. A new machine costing P50,000 with three years useful life, no salvage value at the end of three years, is expected to bring in the following cash inflows after tax: First year P40,000 Second Year 25,000 Third Year 10,000 Required: If the company’s cost of capital is 20%, what is the discounted payback period? 20. Risa Company manufactures copier equipment and has the opportunity to replace one of its existing machine with a new model. The existing machine has a net book value of P120,000 and a market value of P60,000. It has an estimated remaining life of four years; at which time it will have no salvage value. The company uses straight-line depreciation of P30,000 per year on the machine, and its annual cash operating cost is P280,000. The new model costs P500,000 and has a four-year estimated life with no salvage value. Its annual cash operating costs is estimated at P160,000. The firm will use straight line depreciation, The tax rate is 40% and the cost of capital is 12%. The purchase of the new, more efficient machine will enable the company to reduce its investment in inventory by 80,000. Required: a. Determine the investment required to purchase the new machine. b. Determine the net present value of the investment. 6) CamScanner 21. 22; 23. c. Suppose that the new machine has a 10% salvage value. The company will consider the salvage value in determining annual depreciation. Determine the net present value of the investment. Suppose that the new machine has a 10% salvage value. The company will ignore the salvage value in determining annual depreciation. The applicable tax rate is 40%. Determine the net present value of the investment. Mountain View Hospital has purchased a new lab equipment for P134,650. The equipment is expected to las for three years and to provide cash inflows as follows: d. Year 1 P45,000 Year 2 60,000 Year 3 Ke Required: Assuming that the equipment will yield exactly a 16% rate of return, what is the expected cash inflows for year three. Hugo Company is investigating the purchase of a piece of automated equipment that will save P400,000 each year in direct labor and inventory carrying costs. This equipment costs P2,500,000 and is expected to have a 15-year useful life with no salvage value. The company’s required rate of return is 20% on all equipment purchases. Management anticipates that this equipment will provide intangible benefits such as greater flexibility and higher-quality output that will result in additional future cash flows. Required: What peso value per year would these intangible benefits have to have to make the equipment an acceptable investment? Plunge-price Foods is considering replacing all of its old cash registers with new ones. The old registers are fully depreciated and have no disposal value. The new registers cost P749,700 (in total). Because the new registers are more efficient than the old-registers, Plunge-Price will have an annual incremental cash savings from using the new registers in the amount of P160,000 per year. The registers have a seven-year useful life and no terminal disposal value and are depreciated using the straight-line method. Plunge-price requires and 8% real rate of return. Required: a. Assume that the company’s tax rate is 30%. Calculate the NPV of the project assuming no inflation. b, Again, assuming that the company faces a 30% tax rate, calculate the NPV of the project under an inflation rate of 5.5% ¢. Based on your answers to requirements 1 and 2, should Plunge-Price buy the new cash registers? CamScanner 
