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CHAPTER 12:
Cost of Capital and Capital Budgeting
☛What is Capital Budgeting? ☛What are the types of Capital Investment
CAPITAL BUDGETING involves long term Projects?
commitments with an expectation of increased 1. REPLACEMENT 2.IMPROVEMENT 3. EXPANSION
future returns. Thus, considers time value of
money and evaluating the profitability of certain ☛What are the factors of Capital Budgeting?
project proposal before accepting it. -Net Cost of Investment
-Net Returns
-Cost of Capital
LEVEL OF DEGREE OF ROLES
-Project Evaluation Techniques
PLANNING MANAGEMENT
Strategic Top-Level -Development of
vision and mission ☛What composes Net Cost of Investment?
statements -Costs or cash outflows less cash inflows or
-Formulation of
savings incidental to the acquisition of the
standards, policies
investment projects.
and reporting
systems
-Design of ☛Components of Costs or Cash Outflows:
organizational
1. Net Purchase Price (net of discount,
structure
taken or not taken)
-Formulation of
long-term 2. Incidental costs to prepare the new asset
strategies for use
Tactical Middle-level -Deals with 3. Increase in working capital requirement
policies, standards to operate the project at the desired level
and techniques 4. Additional tax paid on gain from disposal
regarding short
of the old asset
term profitability
5. Additional tax paid for the avoided costs
and liquidity
Operational Lower-level *Concerns with of repairs
daily operations. 6. Market value of an existing, currently idle
asset, which will be transferred to or utilized in the
☛Why are capital investment decisions more risky, operations of the proposed capital investment
uncertain and difficult to reverse than short term project
decisions?
Decline in Profits can be quickly recovered ☛Components of Savings or Cash Inflow?
once the managers see their errors but then when a 1.Proceeds from the disposal of the old
company invested in a certain project but it fails, asset
then the company will encounter difficulties to 2. Tax saving on loss from sale of the old
regain their costs which will now result into write asset
offs or losses. 3. Savings from avoided costs of repairs.
4. Decrease in Working Capital
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
73 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014
Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
Any form of reproduction of this copy is strictly prohibited!!!
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
74 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014
Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
Any form of reproduction of this copy is strictly prohibited!!!
SOLUTION:
Sales (70,000 x P1,750,000 Capital Asset
25) Pricing Model:
Risk free rate +
LESS Variable Costs ( 1,050,000) beta (Market rate
(70,000 x 15) less Risk-free
CONTRIBUTION MARGIN 700,000 rate)
LESS Incremental Fixed (150,000)
Cost Retained Dividends Expected
PROFIT BEFORE TAX 550,000 Earnings Dividends per
Tax (550,000 X (220,000) share/ Market
40%) price per share
PROFIT AFTER TAX 330,000 + Growth Rate
ADD Depreciation 55,000
Expense (275,000/5) [NOTE:] The lower the cost of capital, the
NET RETURNS P385,000 better. Thus, for a proposed investment to be
acceptable, it must have a rate of return on
investment greater than its cost of capital.
☛What is Cost of Capital?
-It is the cost incurred of using funds from
☛How can a company reduce its Weighted
investors.
Average Cost of Capital?
-Since debt has the lowest cost of capital,
☛What are the different sources of funds and their
an entity may reduce its cost of capital by increasing
corresponding costs of capital?
the proportional mix of the long term debt over the
SOURCES COST FORMULA
other resources. This process is called “trading on
Long Term Interest Effective Interest equity"
Liabilities Rate (1-tax)
[NOTE:] The owners of ordinary shares are also
Or
Interest rate, net the owners of retained earnings.
of tax/Market
value net of {QUICK CHECK} ???
flotation cost
SAMPLE PROBLEM #3: A firm’s new financing will be
Preference Dividends Dividends per in proportion to the market value of its current
Shareholders’ share/Market financing shown below:
Equity price per share-
flotation costs Carrying Amount
Ordinary Dividends Dividend Growth Long term debt P7, 000, 000
Shares’ Equity and Model:
Preferred stock (100,000 shares) 1, 000, 000
growth Expected
Dividends per Common stock (200,000 shares) 7,000, 000
share/Market
price per share The firm’s bonds are currently selling at 80% of par,
net of flotation generating a current market yield of 9%, and the
costs + Growth corporation has a 40% tax rate. The preferred stock
Rate is selling at its par value and pays a 6 dividend. The
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
75 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014
Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
Any form of reproduction of this copy is strictly prohibited!!!
common stock has a current market value of P40 and is expected to pay a P1.2 per share
this year. Dividend growth rate is expected to be 10% per year, and floatation costs is 2%.
SAMPLE PROBLEM #4: REIGNING IN LIFE Corporation desires its finance its capital expenditure in 2013. the
following data are assembled for consideration. Relevant data on company’s securities are as follows:
Shares Par Value Market Value Floatation Cost Optimal Capital Mix
8% Bonds Payable 400,000 P1,000 120 4% 60%
10% Preferred Shares 640,000 P100 125 5% 10%
Common Shares 3,000,000 P20 80 5% 30%
100%
Expected Common Dividend per share, P9
Expected Growth Rate, 6.5%
Tax Rate, 40%
The common equity market rate is 18%. the 90-day Philippine treasury bill is selling at a rate of 7% and the
company’s beta coefficient is 1.21.
Required: E. Cost of common Equity using the
A. Before tax cost of debt Capital Asset Pricing Model
Solution:
Solution:
80
7%+1.21(18%-7%)
(1,200-48)
=20.31%
=6.94%
B. After tax cost of debt
Solution: ☛What are the two classifications of Project
(80*.60) Evaluation Techniques?
(1,200-48)
=4.17% A. TRADITIONAL MODEL – doesn’t consider time
value of money
C. Cost of Preferred Equity
A1. Payback Period
Solution: A2. Payback Reciprocal
(100*.10) A3. Payback Bailout Period
(125-6.25) A4. Accounting Rate of Return
=8.42%
D. Cost of common Equity using the A1. PAYBACK PERIOD – determines when to recover
an investment.
Gordon Growth Model
9/(80-4) + 6.5%
=18.34%
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
76 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014
Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
Any form of reproduction of this copy is strictly prohibited!!!
Payback Period = 500,000/120,000 = 4.17 REQUIRED: Determine the payback bailout period?
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
77 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014
Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
Any form of reproduction of this copy is strictly prohibited!!!
certain investment. =NPV OF CASH INFLOWS – NPV [NOTES:] If the salvage value was considered in
OF CASH OUTFLOWS. computing the depreciation expense, in getting
the present value of the salvage value, ignore
SAMPLE PROBLEM #8: tax. Thus, PV=Salvage Value x PVF.
If the salvage value was not considered
The management of a DITO NA UNIVERSITY plans to
in computing depreciation expense, in getting its
install soda vending machines in its premises. Annual
present value, it would be net of tax. Thus, PV=
sales of soda are estimated at 70,000 cans at a price salvage value x (1-tax rate) x PVF.
of P25 per can. Variable costs is estimated at P15 per If the problem is silent as to whether
can while incremental fixed cost including the salvage value will be considered in
depreciation amounting to P150, 000 per year. The computing depreciation expense, the nature of
university will acquire five vending machines at the depreciation method used will be the basis
P50,000 each and will incur installation costs of whether to deduct the salvage value or not.
P5,000 per machine. The machines are expected to If the problem clearly states the
treatment of salvage value, it shall prevail
have a service life of 5 years, with 3,000 salvage
regardless of the nature of the depreciation
value each. The company uses straight line
method used.
Depreciation. Tax rate is 40%. The company’s cost of If the problem is silent whether to
capital is 10%. include the Present value of Additional Working
REQUIRED: Determine the net return of investment. Capital in the computation of Present Value of
SOLUTION: Net Cash inflows, ignore it.
Sales (70,000 x 25) P1,750,000 If there is a decrease in working capital
as a result of the investment, rule of thumb:
LESS Variable Costs ( 1,050,000) ignore it in the computation of NPV of Net Cash
(70,000 x 15) Inflows. Needless to say, an increase in working
CONTRIBUTION MARGIN 700,000 capital requirement shall form part of costs/ cash
LESS Incremental Fixed (150,000) outflows, hence, shall be considered for that
Cost matter.
PROFIT BEFORE TAX 550,000
Tax (550,000 X 40%) (220,000) B2. PROFITABILITY INDEX AND NPV INDEX – use to
PROFIT AFTER TAX 330,000 rank projects and determine which among those is
ADD Depreciation 52,000 the most favorable.
Expense (260,000/5)
Profitability Index = Present value of Cash
NET RETURNS P382,000
Inflows/Cost of Investment
NET PRESENT VALUE
NPV Index= Net Present Value/ Cost of
PRESENT VALUE OF (3.7908 x 1,447,971
ANNUAL NET 382,000) Investment
RETURNS
PRESENT VALUE (.6209 X 9,313.5 B3. INTERNAL RATE OF RETURN -breakeven rate of
15,000) return. The rate where PV of cash inflows equates
TOTAL PRESENT 1,457,284.5 cost of investment, NPV=0, Profitability index=1.
VALUE OF CASH
INFLOWS
PROCEDURES:
LESS: COST OF (55,000 x 5) (275,000)
INVESTMENT 1. Determine the PV factor of the investment.
NET PRESENT VALUE 1,182,284.5 PVF= Cost of investments/net cash inflows.
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
78 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014
Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
Any form of reproduction of this copy is strictly prohibited!!!
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
79 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014
Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
Any form of reproduction of this copy is strictly prohibited!!!
4. IRR
Solution:
PV factor of 22% is 2.864 while PV factor of 23% is
2.803. By trial and error, we can compute the IRR as
follows:
22% + (2.857-2.864)
2.864-2.803
=22.11%
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
80 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA