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CAPITAL INVESTMENT DECISIONS CAPITAL BUDGETING the process of deciding whether or not to commit resources to projects whose cost

t and benefits are spread over several time periods. CHARACTERISTICS OF A CAPITAL INVESTMENT DECISIONS 1. Substantial amount of funds are required in capital projects. 2. Because of the length of time spanned, the element of uncertainty becomes more critical. 3. The effect of managerial errors will be difficult to reverse. 4. Plans must be made well into an uncertain future 5. Success or failure of the company may depend upon a single or relatively few investment decisions. TYPES OF CAPITAL INVESTMENT A. INDEPENDENT CAPITAL INVESTMENT PROJECTS - These are projects which are evaluated individually and reviewed against predetermined corporate standards of accessibility resulting in an accept or reject decisions Examples: investment in long term assets (PPE); new product development; undertaking a large scale advertising campaign; introduction of a computer; corporate acquisitions (purchase of shares) B. MUTUALLY EXCLUSIVE CAPITAL INVESTMENT PROJECTS - These are projects which require the company to choose from among specific alternatives. The project to be acceptable must pass the criteria of acceptability set by the company and be better than the other alternatives. Examples: replacement against renovation of equipment or facilities; rent or lease against ownership of facilities; ELEMENTS OF CAPITAL BUDGETING 1. NET COST OF INVESTMENT - The initial cash outlay that is required to obtain future returns Computation: Initial Outlay Add: Additional Cash Outflows Additional or incidental costs paid or incurred to prepare the assets for use Increase in working capital Additional tax paid or incurred in case of gain from sale or disposal of old asset Additional tax paid from savings on avoided cost of repairs, if the old asset is replaced TOTAL Less: Additional Cash Inflow Proceeds from sale or trade-in allowance from disposal of old asset Tax savings from loss on sale of old assets Savings from avoided repairs and maintenance, if the old asset is replaced Decrease in working Capital Net cost of Investment xx

xx xx xx xx xx xx

xx xx xx xx

xx xx 1

Sample Problem: The MST Company plans to acquire a new equipment costing P1,164,000.00 to replace the old equipment that is now being used. Freight charges on the new equipment are estimated at P23,000.00 and it will cost P14,000 to install. Special attachments to be used with this unit will be needed and will cost P36,000.00. if the new equipment is acquired, operations will be expanded and this will require additional working capital of P250,000.00. the old equipment hand an amortized cost of P300,000.00 and will be sold for P180,000.00. If the new equipment is not purchased, the old equipment must be overhauled at a cost of P90,000.00. This cost is deductible for tax purposes in the year incurred. Tax rate is 35%. (P1, 206,500.00) 2. NET RETURNS -are the inflows of cash expected from a project reduced by the cash cost that can be directly attributed to the project. a. Net cash Inflow b. Accounting net income Computation: Annual Incremental Revenue from the project Less: Variable cost Contribution Margin Less: Fixed Cost Annual Cash Inflow before taxes Less: Incremental Depreciation Income before taxes Less: Income Tax Accounting Net Income Add back: Incremental Depreciation Annual Net Cash Inflow xx (xx) xx (xx) xx (xx) xx (xx) xx xx xx

Note: the depreciation expense is relevant in computing the net income but it is irrelevant in determining the net cash inflows. What is relevant in net cash inflows is the tax savings from depreciation expense Sample Problem: The MST Corporation is planning to add a new product line to its present business. The new product will require a new equipment costing P2,400,000.00 with a five year life, no salvage value. The following estimates are made available: Annual Sales P12,000,000.00 Selling and Admin expenses P2,100,000.00 Materials 4,400,000.00 Income tax rate 40% Labor 2,200,000.00 factory Overhead (excluding depreciation) 1,300,000.00 Compute the net income and net cash inflow (P912,000;P1,392,000) 3. COST OF CAPITAL -the cost of using money or fund from investors Investors Long-term Creditors Preference shareholders Common shareholders Computations: A. Individual Cost 2 Expected Returns Interest Dividends Dividends and Growths

a. Cost of Debt = Interest Rate (1-tax rate) b. Cost of PS = Dividend per share Market Value per share,PS c. Cost of CS = Dividend per share + Market Value per share, CS B. Weighted Average Cost of Capital: Source (a) Debt Preference shares Common shares Total Proportion (b) xx% xx% xx%

Dividend growth rate

Cost (c) xx xx xx

Weighted Cost (b*c) xx xx Xx

Sample problem: The following information on MST Corps capital structure is available from the latest FS: Sources Amount Proportion 6% Bank Loan P300,000.00 30% 5% Preferred Stocks 100,000.00 10% Common Stock 600,000.00 60% Additional data: Current Market price per share: PS P62.50 CS P40.00 Dividend per share PS P5 CS P2 Dividend growth rate 4% Tax rate 32% Compute the weighted average cost of capital (7.42%) 4. PROJECT EVALUATION TECHNIQUES a. TRADITIIONAL APPROACH do not consider time value of money 1. Payback Period measures the length of time required to recover the amount of initial investment Payback Period = Net Investment Annual cash returns

Decision Rule: If PB period < Maximum allowed PB period; ACCEPT If PB period > Maximum allowed PB period; REJECT Advantages - Easy to compute and understand - Used to measure the degree of risk associated with a project - Used to select project which provide a quick return of invested funds Disadvantages - Does not recognize time value of money 3

- Ignores the impact of cash inflows after the payback period - Does not measure profitability only the relative liquidity of investment 2. Payback Reciprocal the percentage of annual net cash returns provided by investments PB Reciprocal = 1/PB Period Decision Rule: the higher the PB reciprocal the better. 3. Accounting Rate of Return measures profitability from the conventional accounting standpoint by relating the required investment to the future annual net income. ARR = Net Income Average Investment

Decision Rule: If ARR > required cost of capital; ACCEPT < required cost of capital; REJECT b. DISCOUNTED MODELS consider the time value of money Advantages: - More reliable because the time value of money is taken into account - Income over the entire life of the project is considered - More objective and relevant because it focuses on cash flows Disadvantages - Not easily understood - More complex and difficult to apply - Requires detailed long term forecast of incremental cash flow data - Requires predetermination of the cost of capital or the discount rate to be used. TIME VALUE OF MONEY 1. Future Value 2. Present Value a. PV of a single amount (lump sum) or PV of 1 b. PV of equal receipts or PV of annuity of 1 Computations: PV of 1 = (1 + i) PV of Annuity of 1 = 1 (1 + i) I 1. NET PRESENT VALUE (NPV) Method Annual Cash Inflow xx x by: PV Factor xx Present Value of Cash Inflow xx Less: Net Investment xx Net Present Value xx Decision Rule: if NPV is positive or zero; ACCEPT 2. Internal Rate of Return (IRR) rates which equates the present value of the future cash inflows with the cost of investment which produces them. IRR = LR + (HR-LR) PVLR -PB 4

PVLR PVHR Decision rule: If IRR is higher than cost of capital = ACCEPT 3. Profitability Index the ratio of PV of future cash flows to the investments PI = PV of cash Inflow Investments Decision Rule: If PI greater than 1.0 = ACCEPT

Sample Problems: Problem 1 Bullmark Company is considering a new product that will sell for P11 per unit and ahs variable cost of P8 per unit and annual cash fixed cost of P90,000. Equipment required to produce the product costs P210,000 and is expected to last, and be depreciated on a straight line basis, for six years, with no expected salvage value. Bullmark estimates that sales of the new product will be 60,000 per year for six years. Bullmarks tax rate is 40% and its cost of capital is 14%. Required: a. Net cost of Investment (210,000.00) b. Net Cash Inflow (net returns) c. Payback Period d. Payback Reciprocal e. Accounting rate of return average f. NPV g. IRR h. Profitability Index a. P210,000 b. P68,000.00 Annual Incremental Revenue from the project Less: Variable cost Contribution Margin Less: Fixed Cost Annual Cash Inflow before taxes Less: Incremental Depreciation (210K/6) Income before taxes Less: Income Tax (40%) Accounting Net Income Add back: Incremental Depreciation Annual Net Cash Inflow c. 3.10 years Payback Period =

660,000.00 480,000.00 180,000.00 90,000.00 90,000.00 35,000.00 55,000.00 22,000.00 33,000.00 35,000.00 68,000.00

Net Investment Annual cash returns = 210,000.00 68,000.00 = 3. 10 years

d. 32.25% PB Reciprocal = 1/PB Period = 1/3.10 = 32.25% 5

e. 31% ARR = Net Income Average Investment = 33,000.00 (210,000/2) = 31%

f.

P54,452.00 - ACCEPT Annual Cash Inflow x by: PV Factor, PV of 1 at 6 years 14% Present Value of Cash Inflow Less: Net Investment Net Present Value 68,000.00 3.889 264,452.00 210,000.00 54,452.00

g. IRR IRR = LR + (HR-LR) PVLR -PB PVLR PVHR IRR = 22% + (24%-22%) 3.167 3.10 3.167 3. 020 = h. Pi PI = 264,452.00 210,000.00 = 1.26 Problem 2 BI inc. has the following investment opportunities.

Cost Cash Inflow by year Year 1 Year 2 Year 3 Year 4 Total Annual Income

70,000.00 35,000.00 10,000.00 45,000.00 20,000.00 110,000.00 10,000

Required: Compute for PB period, ARR and NPV using 16% discount rate Solutions: PB = 110,000/70,000 = 2.6 years Year 1 2 3 4 Total Investment NPV Cash Flow 35,000.00 10,000.00 45,000.00 20,000.00

ARR = 10,000/ (70,000/2) = 28.60% PV Factor .862 .743 .641 .552 Present Value 30,170.00 7,430.00 28,845.00 11,040.00 77,485.00 70,000.00 7,485.00 6