Basic Capital Budgeting

7/27/2019 Basic Capital Budgeting

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THE BASICS OF CAPITALBUDGETING

Should we

build this

plant?


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What is Capital Budgeting?

Is a summary of planned investments in long

term assets.

Is the whole process of analyzing projects and

deciding which ones to include in the Capital

BudgetingThe process of planning expenditures on assets

whose cash flows are expected beyond one year.

OVERVIEW OF CAPITAL BUDGETING


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1.) The results of Capital Budgeting decisions

continue for many years, the firm loses some of

its flexibility.

2.) Timing is also important- Capital assets must

be available when they are needed.

3.) Can improve both the timing and the quality of

asset acquisitions.

IMPORTANCE OF CAPITAL BUDGETING


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Strategic Business Plan

- A long run plan that outlines in broad terms

the firms basic strategy for the next five to ten years.

-This involves the creation of strategies that are

aimed in maximizing the entitys future position

taking into consideration the various elements and

factors that may pervade the companys internal andexternal environment.

- It involves TOWS (threats, opportunities,

weakness and strength).

WHAT IS STRATEGIC BUSINESS PLAN?


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1.) Replacement: needed to continue current operations One category consists of expenditures to replace worn out or damaged equipment required in the production ofprofitable products.

2.) Replacement: cost reduction- This category includesexpenditures to replace serviceable but obsoleteequipment and thereby to lower costs.

3.) Expansion of existing products or markets These areexpenditures to increase out-put of existing products or toexpand retail outlets or distribution facilities in marketsnow being served.

4.) Expansion into new products or markets Theseinvestments relate to new products or geographic areas,and they involve strategic decisions that could change thefundamental nature of the business.

PROJECT CLASSIFICATION


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5.) Safety and / or environmental projects

Expenditures necessary to comply with

government orders, labor agreements, or

insurance policy terms fall into this category.

6.) Other projects This catch all includes items

such as office buildings, parking lots, and

executive aircraft.

7.) Mergers One firm buys another one. Buying a

whole firm is different from buying an asset such

as a machine or investing in a new airplanes, but

the same principles are involved.

PROJECT CLASSIFICATION


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1. Finding Investment Opportunities

2. Collect Relevant Information about

Opportunities

3. Select Discount Rate

4. Financial Analysis of Cash Flows

5. Decision

6. Project Implementation

7. Project Evaluation and Appraisal

STEPS TO CAPITAL BUDGETING


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1.) Independent projects if the cash flows of

one are unaffected by the acceptance of the

other.

2.) Mutually exclusive projects if the cash

flows of one can be adversely impacted by the

acceptance of the other.

WHAT IS THE DIFFERENCE BET WEEN

INDEPENDENT AND MUTUALLY EXCLUSIVE

PROJECTS?


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1.) Normal cash flow stream Cost (negative CF)

followed by a series of positive cash inflows. One

change of signs.

2.) Non normal cash flow stream Two or more

changes of signs. Most common: Cost (negative

CF), then string of positive CFs, then cost to closeproject. Nuclear power plant, strip mine, etc.

WHAT IS THE DIFFERENCE BET WEEN

NORMAL AND NON NORMAL CASH FLOW

STREAMS?


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1. Cash Inflows

Periodic cash inflows from operations, net of taxes

Investment tax credit

Proceeds from sale of old asset being replaced, net

of taxes

Avoidable costs, net of taxes

Return of some working capital invested in theproject

Cash inflow from salvage of the new long term

asset at the end of its useful life. This will be net of

tax consequence

CATEGORIES OF PROJECT CASH FLOWS


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2. Cash Outflows

Acquisition cost of purchasing and installing

assets

Additional working capital

Other cash flows such as severance payments,

relocation costs, restoration costs and similar

costs.

CATEGORIES OF PROJECT CASH FLOWS


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Initial cash outlay Pxxx

Add: Additional cash outlay

related to the asset Pxxx

Additional working capital xxx xxx

Total Pxxx

Less: Cash inflow arising from

sale of old assetbeing replaced Pxxx

Avoidable costs xxx xxx

Net investment Pxxx

NET INITIAL INVESTMENT OR PROJECT

COST


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A new sorter can be purchased for P96,000. The

dealer will grant a trade in allowance of P16,000

on the old machine. If a new machine is not

purchased, Maingat Company will spend P10,000to repair the old machine. Gains and losses on

trade in transactions are not subject in income

taxes. The cost to repair the old machine can be

deducted in computing income taxes. Income

taxes are estimated at 40% of the income subject

to tax. Additional working capital required is

P50,000.

NET INITIAL INVESTMENT OR PROJECT

COST


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Solution: Maingat Company

Purchase price of new sorter P 96,000

Add: Additional working capital 50,000

Total P146,000

Less: Trade in allowance on old

sorter P16,000

Avoidable repairs cost on

old sorter 6,000 22,000

Net Investment P124,000

COMPUTATION OF NET INITIAL

INVESTMENT


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Annual incremental revenue from the project

Less: incremental cash operating costs

Annual cash inflow before taxes

Less: Taxes

(Tax rate (Annual cash inflow before taxes

Depreciation)

Annual net cash inflow after taxes

ANNUAL CASH INFLOWS AND OUTFLOWS

(NET CASH RETURNS)


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Annual incremental revenue from the project

Less: Incremental cash operating costs

Annual cash inflow before taxes

Less: Incremental depreciation

Net income before taxes

Less: Income after taxes

Net income after taxes

Add: Incremental depreciation

Annual net cash inflow after taxes


(NET CASH RETURNS)


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Cash operating costs

Less: Annual cash operating cost

Cash savings before taxes

Less: Incremental depreciation

Increase in income before taxes

Less: income taxes

Increase in income after taxesAdd: Incremental depreciation

Net cash savings after taxes


(NET CASH RETURNS)


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1. Tax Savings on Loss on sale of old

machinery

2. Additional Tax on Gain on sale of oldmachinery

3. Recovery of Working Capital

TERMINAL CASH FLOWS


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1.) Payback

2.) Discounted payback

3.) NPV (Net Present Value)

4.) IRR (Internal Rate of Return)

5.) MIRR (Modified Internal Rate of Return)

METHODS TO EVALUATE CAPITAL

PROJECTS


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The number of years required to recover a

projects cost, or How long does it take to

get our money back?

Calculated by adding projects cash inflows

to its cost until the cumulative cash flow

for the project turns positive

Net Investment

Annual Cash Returns

WHAT IS THE PAYBACK PERIOD?


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Strengths

1.) Provides an indication of a projects risk

and liquidity.

2.) Easy to calculate and understand.

Weaknesses

1.) Ignores the time value of money.

2.) Ignores CFs occurring after the payback

period.

STRENGTHS AND WEAKNESSES OF

PAYBACK


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Sum of the PVs of all cash inflows and

outflows of a project :

NET PRESENT VALUE (NPV)


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NPV = PV of inflows Cost

= Net gain in wealth

If projects are independent, accept if the project

NPV > 0.

If projects are mutually exclusive, accept projects

with the highest positive NPV, those that add the

most value.

RATIONALE FOR THE NPV METHOD


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An investment of P50,000 will yield an average

annual cash return of P7,500 a year for a period

of 10 years.

1.) Investment = Annual Cash Returns (PV factor)

50,000 = 7,500x

x = 50,000/7500

= 6.66667

COMPUTING FOR IRR METHOD


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2.) 8% = 6.710

? = 6.667 .043 .565

10% = 6.145

Exact discounted rate of return = 8% + .043 x

2%

.565

= 8% + .15%

= 8.15%

COMPUTING FOR IRR METHOD


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If IRR > WACC, the projects rate of return is

greater than its costs. There is some return left

over to boost stockholders returns.

RATIONALE FOR THE IRR METHOD


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Accept> k, accept project.

If IRR < k, reject project.

If projects are independent, accept both

projects, as both IRR > k

IRR ACCEPTANCE CRITERIA


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If projects are independent, the two methods

always lead to the same accept/reject

decisions.

If projects are mutually exclusive

If k > crossover point, the two methods lead to

the same decision and there is no conflict.

If k < crossover point, the two methods lead todifferent accept/reject decisions.

COMPARING THE NPV AND IRR METHODS


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MIRR correctly assumes reinvestment at

opportunity cost = WACC. MIRR also avoids the

problem of multiple IRRs.

Managers like rate of return comparisons, and

MIRR is better for this than IRR.

WHY USE MIRR VERSUS IRR?


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NPV method assumes CFs are reinvested at k, the

opportunity cost of capital.

IRR method assumes CFs are reinvested at IRR.

Assuming CFs are reinvested at the opportunity

cost of capital is more realistic, so NPV method is

the best. NPV method should be used to choosebetween mutually exclusive projects.

Perhaps a hybrid of the IRR that assumes cost of

capital reinvestment is needed.

REINVESTMENT RATE ASSUMPTIONS


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If an independent project is being evaluated, then the NPV and

IRR criteria always lead to the same accept/reject decision.

For mutually exclusive projects (choosing among acceptable

alternative) especially those that differ in scale (project size)

and / or timing a conflicts of ranking may arise.The IRR method may favor one alternative over another while

the NPV method may indicate otherwise.

If conflicts arise, the NPV method should be used.

The NPV method assumes the cash flows will be reinvested atthe firms cost of capital while the IRR method assumes

reinvestment at the projects IRR. Because reinvestment at the

cost of capital is generally a better (closer to reality)

assumption, the NPV is superior to the IRR.

COMPARING THE PREFERENCE RATES


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The management of Dawn Company plans to replace a

sorting machine that was acquired several years ago

at a cost of P850,000. The machine has been

depreciated to its residual value of P90,000. A new

sorter can be purchased for P2,940,000, 3/10, n/30.

The dealer wil l grant a trade in allowance of P176,000

on the old machine. If the new machine is not

purchased, Dawn wil l spend P745,000 to repair the old

machine. Gains and losses on trade in transactionsare not subject to income tax. The old to repair the old

machine can be deducted in the first year for

computing income tax. Income tax is estimated at

40% of the income subject to tax.

EXAMPLE: COMPUTE FOR THE INITIAL

INVESTMENT


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The Horizons Corporation is planning to add a new

product line to its present business. The new productwill require a new equipment costing P12,000,000,

having a five year useful life with no residual value.

Tax rate is 30%. The following est imates are madeavailable:

Annual Sales P20M

Annual costs & expenses;

Materials P4.8MLabor 6.2M

Factory overhead(excluding depreciation on new

equipment) P2,540,000

Selling and Admin P1,700,000

EXAMPLE: COMPUTE FOR THE NET

RETURNS


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Project A has a cost of P52,125, its expected net cash

inflows are P12,000 per year for 8 years, and its cost

of capital is 12 percent. Calculate the Projects

1. Payback period.2. Discounted Payback period

3. NPV

4. Internal Rate of Return

EXAMPLE OF METHODS OF EVALUATION


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Sunshine Corporation is planning to purchase a new

machine costing P2,800,000, with freight andinstallation costs amounting to P135,000. The old

unit to be traded in will be given a trade in allowance

of P260,000. Other assets that are to be retired as aresult of the acquisition of the new machine can beresidual and sold for P52,000. The loss on retirement

of these other assets is P50,000 and will reduce

taxes by P20,000. If the new machine is not

purchased, extensive repairs on the old machine willhave to be made at an estimated cost of P400,000.

This cost can be avoided by purchasing the new

machine. Additional gross working capital of

P350,000 will be needed to support operations with

the new machine.

SEATWORK: COMPUTE FOR THE INITIAL

INVESTMENT


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The Mabuhay Corporation plans to acquire a newequipment costing P1,340,000 to replace theequipment that is now being used. Freightcharges on the new equipment are estimated at

P75,000 and it will cost P90,000 to install.Special attachment to be used with this unit willbe needed and will cost P64,000. If the newequipment is acquired, operations will beexpanded and this will require additional working

capital of P310,000. The old equipment had anet book value of P45,000 and will be sold forP25,000. If the new equipment is not purchased,the old equipment must be overhauled at a costof P320,000. This is deductible for tax purposes

in the year incurred. Tax rate is 30%


INVESTMENT


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INVESTMENT

The JT Company plans to open a new branch office

wherein the company shall invest P2,500,000 infurnishings and equipment. Construction and other

related outlays are estimated at P4,550,000. Sales

from this new branch are estimated at P9,000,000 ayear. One third of these sales will be in the form ofaccounts receivable at any given time. Cost of goods

sold is estimated to be sixty percent of sales. The

investment in merchandise inventory is

approximately P400,000 at any time during the year.Cash of P120,000 will be needed to meet payments

for operating expenses. Accounts payable and other

current liabil ities are expected to increase by 5% of

sales.


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SEATWORK: COMPUTE FOR THE

INCREASE IN ANNUAL NET INCOME

Frelins Corporation is p lanning to replace its present

printing equipment with a more efficient unit. The new

equipment will cost P400,000 with five year useful life,

no salvage value.

The old unit was acquired three years ago for P500,000.

The company uses the straight line method in

appreciating its depreciable assets. The old unit is being

depreciated at P62,500 per year. If the new equipment is

acquired, the old one will be sold for P100,000.

Otherwise, the company will just continue using for 5

years.

Saving in cash operating costs are P100,000 and

P220,000 for the new and old equipments, respectively.

Income tax is at the rate of 32% of income before tax.


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SEATWORK: COMPUTE FOR THE PAYBACK

PERIOD, NPV, DISCOUNTED PAYBACK, IRR

The Liquid Corporation contemplates the replacement

of an old machinery. The annual cost of operating

the old machinery is P138,600, excluding

depreciation, while the estimate for the newmachinery is P91,300. The cost of the new

machinery is P160,000, net of the trade in

allowance, with an estimated useful life of 8 year, no

residual value. The effective income tax rate of 40%

and the cost of capital is 8%. The old machinery has

an annual depreciation of P15,000 while the new

machinery is estimated to have an annual

depreciation of P20,000. The book value of the old

machine is zero.


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COMPUTE WHAT IS REQUIRED

The following data pertain to a five year project being

considered by Alen C. Corporation:

1. A new equipment costing P1.8 million will be

acquired on January 1, 200A. It will be depreciated

using the straight line method over a five yearperiod, with a salvage value of P200,000 at the

end of 5 years.

2. The new equipment will replace an old one that has

been fully depreciated to its salvage value of P220.Another company has offered to buy this old

equipment for P250,000 on the replacement date.


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COMPUTE WHAT IS REQUIRED

3. The project is expected to generate incremental

sales of P50,000 units per year. The contribution

margin per unit is P10. Incremental project fixed

costs, excluding depreciation, is P130,000.

4. The project requires additional investment inworking capital of P70,000. This amount is fully

recoverable at the end of the fif th year.

Alen C. Corporation is subject to an income tax rate of

32%. Its cost of capital (hurdle rate) is 10%.


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REQUIRED:

1. Compute the net cost of investment in the

new equipment.

2. The present value of expected incremental

contribution margin.(net of tax)3. The new equipment is expected to generate

annual cash inflows, net of income taxes of?

4. The new equipments net present value?

Documents

Basic Capital Budgeting