CAPITAL BUDGETING 2019

 In deciding whether to accept a new project, we will focus on cash flows. Cash Flows represent the benefits generated from accepting a
capital-budgeting proposal.
 The first step in the decision making process is to identify the problem and assign responsibility.
 Strategic Planning is the process of deciding on an organization major programs and the approximate resource to be devoted to them.

CAPITAL BUDGETING
- The process of identifying, evaluating, planning, and financing capital investment projects of an organization.
- Describe the long-term planning for making and financing such cash outlay.
- The long-term planning for making and financing investments that affect financial results over more than just the next year.
- It is the process of making capital expenditure decisions
- 3 Phases:
1. Identifying potential investments
2. Choosing which investment to make (which include gathering data to aid the decision)
3. Follow-up monitoring, or “postaudit”, of the investments
- It is least likely to be used in evaluating the adoption of a new method of allocating non-traceable costs to product lines.
- A Capital Investment Decision is essentially a decision to exchange current cash outflows for the promise of receiving future cash inflows.
- The normal method of analyzing investments requires forecasts of cash flows expected from the project.

RISK & RETURN

- The higher the risk element in a period, the higher the discount rate is.
- Cost of capital is the cost the company must incur to obtain its capital resources.
- The following projects are listed in order of increasing risk
i. Replacement
ii. Expansion
iii. New Venture
- Projects associated with justifying investments in high-tech projects often include discount rates that are too high and time horizons that
are too short.
- In evaluating high-tech projects, both tangible and intangible benefits should be considered.

TYPES OF CAPITAL PROJECTS

- Independent Projects is a project that when accepted or rejected will not affect the cash flows of another project.

INVESTMENTS
- When disposing of an old asset and replacing it with new one, tax effect on gain on sale of the old asset increases the basis of the new
asset and loss on sale of the old asset reduces the basis of the new asset.
-

PAYBACK PERIOD
- Is the number of years needed to recover the initial cash outlay.
- It is the length of time over which the initial investment is recovered.
- This criterion measures how quickly the project will return its original investment; it deals with cash flows rather than accounting profits.
- It also ignores the time value of money and does not discount these cash flows back to the present.
- A capital budgeting technique that may potentially ignore part of a project’s relevant cash flows.
- In comparing two projects, it is often used to evaluate the relative riskiness of the projects.
- It does not routinely rely on the assumption that all cash flows occur at the end of the period.
- Payback method assumes that all cash inflows are reinvested to yield a return equal to zero.
o It measures how quickly investment dollar may be recovered.
o Criticized because it fails to consider investment profitability.
- The accept-reject criterion involves whether the project’s payback period is less than or equal to the firm’s maximum desired payback
period.
- All cash flows that occur after the payback period are ignored. This violate the principle that investors desire more in the way of benefits
rather than less – a principle that is difficult to deny.
Example: If a firm’s maximum desired payback period is three years and an investment proposal requires an initial cash outlay of
$100,000 and yields the following set of annual cash flows, what is its payback period?

After- Tax Cash Flow

Year 1 $ 2,000
Year 2 4,000
Year 3 3,000
Year 4 3,000
Year 5 1,000
In this case, after 3 years the firm will have recaptured $9,000 on an initial
Solution:
investment of $10,000, leaving $1,000 of the initial investment still to be recouped.
Cash Outlay
During the fourth year, a total of $3,000 will be returned from this investment.
Year 1 $ 2,000 $ 2,000
Assuming cash will flow into the firm at a constant rate over the year, it will take
Year 2 4,000 6,000
one third of the year (1,000/3,000) to recapture the remaining $ 1,000. Thus the
Year 3 3,000 9,000
payback period on this period is 3 & 1/3 years.
Year 4 1,000 10,000
CAPITAL BUDGETING 2019

DISCOUNTED PAYBACK PERIOD

- A variation of payback period defined as the number of years required to recover the initial cash outlay from the discounted net cash flows.
- It uses discounted net cash flows rather than actual undiscounted net cash flows in calculating the payback period.
- The accept-reject criterion then becomes whether the project’s discounted payback period is less than or equal to the firm’s maximum
desired discounted payback period.
- The major problem comes in setting the firm’s maximum desired discounted payback period. This is an arbitrary decision that affects
which projects are accepted and which ones are rejected.
- POSITIVE FEATURES OF PAYBACK PERIOD METHOD:
 They deal with cash flows and therefore focus on the true timing of the project’s benefits and costs.
 They are easy to visualize, quickly understood, and easy to calculate.
 Often used as rough screening devices to eliminate projects whose returns do not materialize until later years.
- The disadvantages of both severely limit their value as discriminating capital-budgeting criteria.
Projects A B____
Initial cash outlay - $10,000 - $10,000
Annual net cash flows
Year 1 $ 6,000 $ 5,000
2 4,000 5,000
3 3,000 0
4 2,000 0
5 1,000 0
Solution:
Project A: Year Undiscounted Cash Flows PVIF17%,n Discounted Cash Flows Cumulative Discounted CF
0 - $10,000 1.0 - $10,000 - $10,000
1 6,000 0.855 5,130 - 4,870
2 4,000 0.731 2,924 - 1,946
3 3,000 0.624 1,872 - 74
4 2,000 0.534 1,068 994
5 1,000 0.456 456 1,450

Discounted Payback Period = 3 + (74/1,068) = 3.07 years

Note: 10,000 – (5,130 + 2,924 + 1,872) = 74
Project B: Same solution however it does not have a discounted payback period because it never fully recovers the project’s initial cash
outlay, and thus should be rejected.

NET PRESENT VALUE

- The net present value (NPV) of an investment proposal is equal to the present value of its annual after tax net cash flows less the
investment’s initial outlay.
𝐴𝐶𝐹𝑡
NPV = ∑𝑛𝑡=1 𝑡 – IO
(1+𝑘)
Where: ACFt = the annual after-tax cash flow in time period t (this can take on either positive or negative values)
k = the appropriate discount rate; that is, the required rate of return or cost of capital
IO = the initial cash outlay
n = the project’s expected life
- The project’s net present value gives a measurement of the net value of an investment proposal in terms of today’s dollars.
o Because all cash flows are discounted back to the present, comparing the difference between the present value of the annual cash
flows and the investment outlay is appropriate.
o The difference between the present value of the annual cash flows and the initial outlay determines the net value of accepting the
investment proposal in terms of today’s dollars.
o Whenever the project’s NPV is greater than or equal to zero, we will accept the project.
o Whenever there is a negative value associated with the acceptance of a project, we will reject the project.
o If the project’s new present value is zero, then it returns the required rate of return and should be accepted.
NPV ≥ 0.0: Accept NPV < 0.0: Reject
- The required rate of return or cost of capital is the rate of return necessary to justify raising funds to finance the project or, alternatively, the
rate of return necessary to maintain the firm’s current market price per share.
- The worth of the net present value calculations is a function of the accuracy of cash flows predictions. Before the NPV criterion can
reasonably be applied, incremental costs and benefits must be first estimated, including the initial outlay, the differential flows over the
project’s life, and the terminal cash flow.
- The NPV criterion is the capital-budgeting decision tool we will find most favorable.
o It deals with cash flows rather than accounting profits.
o It is sensitive to the true timing of the benefits resulting from the project. Moreover, recognizing that the time value of money
allows comparison of the benefits and cost in a logical manner.
o Because projects are accepted only if a positive net present value is associated with them, the acceptance of a project using this
criterion will increase the value of the firm, which is consistent with the goal of maximizing the shareholder’s wealth.
- The disadvantage of the NPV method stems from the need for detailed, long-term forecasts of the incremental cash flows accruing from the
project acceptance.
o Despite this drawback, the NPV is the theoretically correct criterion in that it measures the impact of a project’s acceptance on
the value of the firm’s equity.
CAPITAL BUDGETING 2019

Example: A firm is considering new machinery, for which the after-tax cash flows are:
After-tax Cash Flow After-Tax Cash Flow
Initial Outlay - $40,000 Inflow year 3 13,000
Inflow Year 1 15,000 Inflow year 4 12,000
Inflow year 2 14,000 Inflow year 5 11,000
If the firm has a 12% requires rate of return, how much is the present value of the after-tax cash flow and the present value of the new machinery?

Solution:
After-Tax Cash Flow PV Factor @ 12% Present Value
Inflow year 1 $ 15,000 0.893 $ 13,395
Inflow year 2 14,000 0.797 11,15 8
Inflow year 3 13,000 0.712 9,256
Inflow year 4 12,000 0.636 7,6 32
Inflow year 5 11,000 0.567 6,237
PV of Cash Flows $ 4 7,678
Initial outlay (40,000)
Net Present Value $ 7,678

The present value of the after-tax cash flow is $ 47,678 and the net present value of the new machinery is $ 7,678. Because this value is greater than
zero, the net present value criterion indicates that the project should be accepted.

PROFITABILITY INDEX (BENEFIT/COST RATIO)

- It is the ratio of the present value of the future cash flows to the initial outlay.
- Provides a relative measure of an investment proposal’s desirability- that is, the ratio of the present value of its future net benefits to its
initial cost.
𝐴𝐶𝐹𝑡
∑𝑛
𝑡=1
(1+𝑘)𝑡
PI =
𝐼𝑂
Where: ACFt = the annual after-tax cash flow in time period t (this can take on either positive or negative values)
k = the appropriate discount rate; that is, the required rate of return or cost of capital
IO = the initial cash outlay
n = the project’s expected life
- The decision criterion is to accept the project if the PI is greater or equal to 1.00 (PI ≥ 1.0: Accept), and to reject the project of the PI is less
than 1.00 (PI < 1.0: Reject)
- Same with NPV however, they will not necessarily rank acceptable projects in the same order.
- Because the NPV and PI criteria are the same, they have the same advantages over the other criteria examined.
- Major disadvantage of this criterion, similar to the NPV criterion, is that it requires detailed cash flow forecasts over the entire life of the
project.
Example: A firm with a 10% required rate of return is considering investing in a new machine with an expected life of 6 years. The after-
tax cash flows resulting from this investment are:
After-tax Cash Flow After-Tax Cash Flow
Initial Outlay - $ 50,000 Inflow year 4 12,000
Inflow Year 1 15,000 Inflow year 5 14,000
Inflow year 2 8,000 Inflow year 6 16,000
Inflow year 3 10,000

Solution:
After-Tax Cash Flow PV Factor @ 12% Present Value
Initial Outlay -$ 50,000 1.000 -$ 50,000
Inflow year 1 15,000 0.909 $ 13,63 5
Inflow year 2 8,000 0.826 6,608
Inflow year 3 10,000 0.751 7, 510
Inflow year 4 12,000 0.683 8, 196
Inflow year 5 14,000 0.621 8,694
Inflow year 6 16,000 0.564 9, 024
𝐴𝐶𝐹𝑡
∑𝑛
𝑡=1 (1+𝑘)𝑡
PI =
𝐼𝑂
= $13,615 + $6,608 + $7,510 + $8,196 + $8,694 + 9,024
$50,000
= $ 53,667 / $ 50,000
= 1.0733

Discounting the project’s future net cash flows back to the present yields a present value of $ 53,667; dividing this value by the initial
outlay of $50,000 gives a profitability index of 1.0733. This tells us that the present value of the future benefits accruing from project is
1.0733 times the level of the initial outlay.
CAPITAL BUDGETING 2019

INTERNAL RATE OF RETURN

- A capital budgeting technique that reflects the rate of return of a project earns. Mathematically, it is the discount rate that equates the
present value of the inflows with the present value of the outflows.
𝐴𝐶𝐹𝑡
IO = ∑𝑛𝑡=1
(1+𝐼𝑅𝑅)^𝑡
- It attempts to answer the question: What rate of return does this project earn?
- The IRR is analogous to the concept of the yield maturity for bonds. In other words, a project’s internal rate of return is simply the rate of
return that the project earns.
- The decision criterion is to accept the project if the IRR is greater than or equal to the required rate of return.
o We reject if its IRR is less than this required rate of return.
- If the IRR on a project is equal to the shareholder’s required rate of return, then the project should be accepted. This is because the firm is
earning the rate that its shareholders require.
o The acceptance of a project with an internal rate of return below the investors required rate of return will decrease the firm’s
stock price.
- If the NPV is positive, then the IRR must be greater than the required rate of return, k. thus all the discounted cash flow criteria are
consistent and will give similar accept-reject decisions.
- Because IRR is another discounted cash flow criterion, it exhibits the same general advantages and disadvantage as both the NPV and
profitability index,
o But as an additional disadvantage of being tedious to calculate if a financial calculator is not available.

COST OF CAPITAL
- Capital Components: Debt, Preferred Shares, Ordinary Shares
- COST OF DEBT (Kd)
o It is the minimum rate of return required by suppliers of debt.
o Before-Tax Cost of Debt is the interest rate a firm must pay on its new debt.
 This can be estimated by inquiring from their banker what it will to borrow or by finding the yield to maturity on their
currently outstanding debt.
o After-Tax Cost of Debt should be used to calculate the weighted average cost of capital (WACC). This is the interest on new
debt less the tax savings that result because interest is tax deductible.
After-Tax Cost of Debt = Interest rate (1 – Tax Rate)
o Computing the Cost of a New Bond Issue
1. Determine the net proceeds from the sale of each bond.
Net Proceeds of a Bond Sale = Market Price – Flotation Cost
2. Compute the before-tax cost of the bond.
 If the flotation costs are required and the bonds sells at par, the before-tax cost of the bond is simply the
coupon rate which is the interest rate paid on the bond’s par value.
 The cost of debt is the interest rate on new debt not on already outstanding debt. The yield to maturity on
outstanding debt is a better measure of the cost of debt than the coupon rate.
 The before-tax cost of the debt issue is the rate of return that equates the present value of the future interest
payments and principal payment with the net proceeds from the sale of the bond.
NPd = I (PVIFAkd,n) + Pn (PVIFkd,n)
Where: NPd = Net proceeds from the sale of the bond, P d – f
I = Annual interest payment in peso
Pn = Par or Principal repayment required in period n
Kd = before-tax cost of a new bond issue
n = length of the holding period of the bond in years
t = time period in years
PVIFA = Present value interest factor of an annuity
PVIF = Present value interest factor of a single amount
Pd – f = (market price – flotation cost)
 The before-tax cost of a new bond issue also means to maturity or yield to maturity.
3. Compute the after-tax cost of debt:\
kdt = kd (1 – T)
Where: kdt = after-tax cost of debt
kd = before-tax cost of debt
T = marginal tax rate

4.
- COST OF PREFERRED SHARE (Kp)
o Preferred share is a hybrid security that has characteristics of both debt and equity.
 Under PFRS, when the preferred share is considered as debt, the computational procedure is Section A will apply.
 If preferred shares have fixed dividend payments and no stated maturity dates, the component cost of new preferred
share is computed as follows:
Kp = Dp / NPp
Where: Dp = Annual dividend per share on preferred share
NPp = Net proceeds from the sale of preferred share (market price – flotation cost)

 The cost of existing preferred share is determined by substituting the current market price per share of preferred in the
denominator in the above equation that is, lieu of net proceeds from sale of preferred share.
CAPITAL BUDGETING 2019

- COST OF ORDINARY EQUITY SHARE

o Ordinary equity share does not represent a contractual obligation to make specific payments thus making it more difficult to
measure its costs than the costs of bonds or preferred share.
o Cost of existing ordinary equity share is the same as the cost of retained earnings. No adjustment is made for flotation costs in
determining either the cost of existing ordinary equity share or the cost of retained earnings.
o Costs of new ordinary equity share and retained earnings are similar but not equal. The cost of new ordinary equity share is
higher than the cost of retained earnings because of the flotation costs involved in selling new ordinary equity share which
reduce the net proceeds to the firm.
 Thus, firms will use the lower cost retained earnings before they issue new ordinary equity share.
o CAPITAL ASSET PRICING MODEL (CAPM) APPROACH
 Most widely used method for estimating cost of ordinary equity.
a) Estimate the risk-free rate (rRF).
 Generally use the 10-year Treasury bond rate, but some analysis use the short-term Treasury bill
rate.
b) Estimate the stock’s beta coefficient (bi) and use it as an index of the stock’s risk.
c) Estimate the expected market risk premium. This is the difference between the return that investors require on
an average stock and the risk-free rate.
d) Substitute the preceding values in the CAPM equation to estimate the required rate of return on the stock in
the question;
rs = rRF + (RPm)bi
= rRF + (rm - rRF) bi
 The CAPM estimate of rs is equal to the risk-free rate (rRF) plus a risk premium that is equal to the risk premium on an
average stock (rm - rRF), scaled up or down to reflect the particular stock’s risk as measured by its beta coefficient.
o BOND YIELD PLUS RISK PREMIUM APPROACH
 The equation shows that the required rate of return is equal to some base rate (kd) plus a risk premium (rp).
 The base rate is often the rate on Treasury bonds or the rate on the firm’s own bonds.
 The risk premium on a firm’s own stock over its own bonds is based on a judgmental estimate but empirical
studies that ranges between 3 to 5 percentage above the base rate.
o Risk premiums are not stable over time, hence the estimated value of kd is also judgmental
