CAP BUD PPT
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Transcript of CAP BUD PPT
8/3/2019 CAP BUD PPT
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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
8/3/2019 CAP BUD PPT
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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.
8/3/2019 CAP BUD PPT
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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.
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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
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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.
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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
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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?
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Net Initial Investment or Project Cost
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
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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
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Net Returns (Net Benefits or Net Savings or Annual After-tax Cash
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?
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Net Returns (Net Benefits or Net Savings or Annual After-tax Cash
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
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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.
8/3/2019 CAP BUD PPT
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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
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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%
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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
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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
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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
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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
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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
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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
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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
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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.
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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
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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
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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
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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
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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.
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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