CAP BUD PPT

8/3/2019 CAP BUD PPT

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Define capital budgeting.

State the characteristics of capital investment decision.

Discuss the process of capital budgeting process.Compute initial investment, annual net cash

returns/savings of an investment proposal.

Apply the techniques in evaluating capital investment

projects such as payback period, accounting rate of return

and discounted cash flow analysis (net present value, IRR,profitability index).

Explain the process of ranking investment projects



What is Capital Budgeting?

The process of evaluating and selecting

long-term investments that are consistentwith the firms goal of maximizing

owners wealth.

The process of evaluating and selecting

long-term investments that are consistentwith the firms goal of maximizing

owners wealth.



Characteristics of Capital Investment

Decisions

1) Usually require relatively large commitments of

resources.2) Most capital investment decisions involve long-term

commitments.

3) Are more difficult to reverse than short-term decisions.

4) Influence the firms growth in the long run.

5) They affect the risk of the firm.

6) They are among the most difficult decisions to make.



The Capital Budgeting Process

1. Finding investment opportunities

2. Collect relevant info about opportunities3. Select discount rate

4. Financial Analysis of Cash Flows

5. Decision

6. Project Implementation

7. Project Evaluation and Appraisal



Elements of Capital Budgeting

1. The net amount of the investment.2. The operating cash flows or returns from the

investment.

3. The minimum acceptable rate of return on

the investment.



Initial Cash Outflows-Initial Cash Inflows

Initial Costs or Initial Cash Outflow:

1. The initial cash outlay covering all expenditures on the project up to the time

when it is ready for use or operation. Net purchase price

Incidental project related costs (freight, insurance, taxes, handling,

installation, test run, training cost)

2. Net working capital requirement

3. Market value of an existing, currently idle asset (if used)

Initial Savings or Initial Cash Inflow:

1. Trade in value of old asset in case of replacement

2. Proceeds from sale of an old asset to be disposed (less applicable tax in case

there is a GAIN on sale, or add tax savings in case there is a LOSS on sale)

3. Avoidable cost of immediate repairs on old asset to be replaced, net of tax

Net Initial Investment or Project Cost




Example:

The management of JRN Company is planning to replace an old

slimming machine which was acquired 5 years ago at a cost of P30,000.

the old machine has been depreciated to its salvage value of P4,000.

The company has found a buyer who is willing to purchase the oldslimming machine for P6,000.

The new machine will cost P50,000, incidental costs of installation,

freight and insurance will have to be incurred at a total cost of P10,000.

Should the company decide to retain the old slimming machine

(and forget about buying the new one) the same must be upgraded andsubjected to major repairs. The estimated cost of this repair expense

(which is tax deductible) amounts to P8,000. The income tax rate is

30%. How much is the net cost of investment in the new machine for

decision making purposes?




Initial costs or initial cash outflows:

Purchase price 50,000

Incidental costs 10,000

Total 60,000

Initial savings or cash inflows:

Proceeds from sale of old machine 6,000

Tax on the gain on sale

[(6,000-4,000)*30%] (600) 5,400

Avoidable cost of repairs 8,000

Tax on repairs expense (8,000*30%) (2,400) 5,600 11,000

Net Investment



Net Returns (Net Benefits or Net Savings or Annual After-tax Cash

Flows)

Annual incremental revenue from the project Pxx

Less: Incremental cash operating costs (xx)

Annual cash inflow before taxes Pxx

Less: Incremental depreciation (xx)

Net income before taxes Pxx

Less: Income taxes (xx)

Net income after taxes Pxx

Add: Incremental Depreciation xx

Annual net cash inflow after taxes Pxx




Flows)

Example:

JRN Co. currently has annual cash revenues of P3,500,000 and annual

operating costs of P2,800,000 (all cash items except depreciation of P400,000).

The company is considering the purchase of a new machine costing P1,800,000

that would increase cash revenues to P4,100,000 and operating costs (including

depreciation) to P3,100,000. The new machine would increase depreciation to

P600,000 per year. Revenue are expected to increase to P4,100,000 and

assuming a 30% income tax rate, JRN Co.¶s incremental after-tax cash flows from

the machine would be?




Flows)

Solution:

Incremental sales (4,100,000 - 3,500,000) P600,000

Incremental costs (3,100,000 - 2,800,000) (300,000)

Incremental IBIT P300,000

Incremental tax (30%) ( 90,000)

Incremental net income P210,000

Increase in depreciation (600,000 ± 400,000) 200,000

Incremental after-tax cash flows P410,000



The minimum required rate of return a

project must earn in order to cover thecost of raising funds being used by the

firm in financing of the proposal.

The minimum required rate of return a

project must earn in order to cover thecost of raising funds being used by the

firm in financing of the proposal.



Interest rate (1 ± corporate tax rate)

Dividends per shareMarket Value per share

Expected cash dividends per share + Dividend Growth Rate

Current price per share

Expected cash dividends per share + Dividend Growth Rate

Current price per share

Cost of Debt

Cost of Preference Shares

Cost of Ordinary

Shares

Cost of Retained

Earnings



Cost of Capital Problem

Narra Corporation¶s capital structure is as follows:

Bonds payable, 10 years, 10% P 1,000,000

10% Preferred stocks, P200 par value,

10,000 shares issued and outstanding 2,000,000

Common stocks, P50 per share,

30,000 shares issued and outstanding 1,500,000

Retained Earnings 500,000Total P 5,000,000

The company¶s earnings per common share (EPS) is P12. The common

shares¶ current market price is P60, while that of preferred shares is P250.

The income tax rate is 30%.

Sources of Funds Cost of Capital Proportion of Funds Weighted Cost

Bonds

Preferred stocks

Common stocks and

Retained Earnings

7%

8%

20%

1/5

2/5

2/5

1.40%

3.20%

8.00%

WACC 12.60%



Screening Capital Investment Proposals

Non-discounted

Cash Flow Approach

Payback Period

Accounting

Rate of Return

Bail-out Period

Payback

Reciprocal

Discounted Cash

Flow Approach

Net Present Value

Internal Rate of

Profitability Index

Net Present Value

Index

Discounted

Payback Period



Also known as PAYOFF and PAYOUT period,

measures the length of time required to recover

the amount of initial investment.

When the periodic cash flows are uniform:

Payback period = Investment required / Annual Cash Returns



Advantages

Easy to compute and understand.

Used to measure the degree of risk

associated with a project.

Generally, the longer the payback

period, the higher the risk. Used to select projects which

provide a quick return of investedfunds.

Disadvantages

Does not recognize the time value of

money.

Ignores the impact of cash inflows

after the payback period.

Does not distinguish betweenalternatives having differenteconomic lives.

The conventional payback

computation fails to consider salvage

value, if any.

It does not measure profitability-

only the relative liquidity of theinvestment.

Decision Rule:

If: PB period < Max. allowed PB period; Accept

If: PB period > Max. allowed PB period; Reject



Payback reciprocal is a reasonable estimate to thediscounted cash flow rate of return, provided thatthe following conditions are met:

The economic life of the project is at least twice the paybackperiod

The net cash inflows are constant (uniform) throughout the life of the project

Payback Reciprocal = 1/payback period

= annual cash inflows/net investment



Involves the computation of bail-out period wherein cashrecoveries 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.

AACF Salvage valueTotal Cash

FlowsBalance Year

40,000 100,000 140,000 110,000 1

30, 000 70,000 100,000 80,000 1

25,000 60,000 85,000(80,000-

60,000)/25,0000.8

20,000 0 2.8

Net Investment: P150,000



Also known as BOOK VALUE RATE of RETURN,

measures profitability from the conventional

accounting standpoint by relating the required

investment to the future annual net income.

± Based on initial investment

± Based on average investment

ARR = Average Annual Net Income/ Investment



Advantages

Easily understood by investors

acquainted with financial

statements.

Used as a rough preliminary

screening device of investmentproposals.

Disadvantages

Ignores the time value of money by

failing to discount the future cash

inflows and outflows.

Does not consider the timing

component of cash inflows. Different averaging techniques may

yield inaccurate answers.

Utilizes the concept of capital and

income primarily designed for the

purposes of financial statements

preparation and which may not be

relevant to the evaluation of theinvestment proposals.

Decision Rule:

If: ARR > Required rate of return; Accept

I

f: ARR < Required rate of return; Reject



Advantages:

1. More reliable because the time value of money is taken into account.

2. Income over the entire life of the project is considered.

3. More objective and relevant because it focuses on cash flow.

Disadvantages:

1. Not easily understood

2. More complex and difficult to apply.3. Requires detailed long term forecasts of incremental cash flow data.

4. Requires pre-determination of the cost of capital or the discount rate to

be used.



It is the excess of the PV of cash inflows generated

by the project over the amount of the initial

investment.

Decision rule:

If: NPV > 0; Accept

If: NPV < 0; Reject

NPV = PV of all cash inflows ± PV of all cash outflows

= PV of all cash inflows ± cost of investment



1. Present value of 1: used to compute for the PV of unequal annual cash

flows.

2. Present value of ordinary annuity: used to compute for the PV of equal

annual cash flows and the annual cash flows occur at the end of the year.

3. Present value of annuity due: used to compute for the PV of equal

annual cash flows and the annual cash flows occur at the beginning of the

year.

PV of 1 = (1 + i)-n

PVOA = 1- (1 + i)-n

i

PVOA = [ {1- (1 + i)-(n-1)}/i ] +1



Also known as PRESENT VALUE INDEX and BENEFIT-COST RATE DESIRABILITY INDEX. The index expressesthe PV of cash benefits as to an amount per peso of investment in a project and is used as a measure of ranking

projects in a descending order of desirability.

Decision rule:

If: PV Index > 1; Accept

If: PV Index < 1; Reject

PV Index =PV of Cash Inflows/PV of net Investment



Also known as NET PROFITABILITY INDEX Some

practitioners compute the desirability index using the net

present value instead of the total present value of cash

inflows.

Decision rule:

If: NPV Index > 0; Accept

If: NPV Index < 0; Reject

NPV Index = Net Present Value / Net Investment

= Net Present Value / PV of all Cash Outflows



It is a method that recognizes the time value of money in a

payback context.

Periodic cash flows are discounted using an appropriate cost of

capital rate.

The payback period is computed using the discounted cash flowvalues rather than the actual cash flows.



Is the rate which equates the present value of the future cash

inflows with the cost of the investment which produces them.

It is also the equivalent maximum rate of interest that could be

paid each year for the capital employed over the life of an

investment without loss on the project.

Decision Rul e:

if : IRR > Required rate of return; Accept

if: IRR < Required rate of return; Reject

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CAP BUD PPT