Q1. HHH Corporation is happy with the cash conditions they have.

Their customers do
their payments through the bank and provide them the information. Direct deposit to the
firm’s bank account
Q2. This is a financial plan of the resources needed to carry out and meet financial goals.
Budget
Q3. This model balances that opportunity of holding cash against the transaction costs
associated with replenishing the cash account by selling off marketable securities or
borrowing. Baumol Model
Q4. Isabel Corp. P747,500
Q5. This factor affects the working capital policy of the firm because more current assets
such as accounts receivable and inventories are needed to support a higher level of sales.
The volume of sales
Q6. Investments in money-market instruments of an open-ended mutual fund Money
Market Mutual Fund
Q7. MMM Corporation pays their obligations slowly to keep cash available. Below are the
strategies they used except one Electronic depository transfer or payment by wire
Q8. This is related to a possibility that is not favourable when the real value of the
investment will decrease due to inflation Inflation Risk
Q9. It represents the value of the checks the firm has written but which are still being
processed and thus have not been deducted from the firm’s account by the bank
Disbursement Float
Q10. This is one of the factors affecting the firm’s working capital policy because working
capital requirements differ greatly among manufacturing, retailing and service
organizations. The Nature of Operations
Q11. It is the difference between the balance shown in a firm’s books and the balance on
the banks record. Float
Q12. Current assets that vary over the year due to seasonal or cyclical needs are called
Fluctuating or Seasonal Assets
Q13. In terms of checks, once it is received and a deposit is made, the deposited funds
are not available for use until the check clearing and credited to the corporate bank
account
Q14. It is the length of time funds are tied up in working capital or the length of time
between paying for working capital and collecting cash from the sale of inventory Cash
Conversion Cycle
Q15.Beatless Corp. 665,720
Q16. Examples of these are the portion of a firm’s current assets that remain unchanges
over the year, long-term investments and property, plant and equipment. Long-
term/Permanent Assets
Q17. This is developed by beginning with the current statement of financial position and
adjusting it for the data contained in other budgets. Budgeted Statement of Financial
Position
Q18. It arises from the delays in mailing, processing and clearing checks through the
banking system. Float
Q19. GJF Corporation is improving their cash funds through this strategy. Communication
to customers regarding this one should be done effectively as these are offered for early
or prompt payments. Incentives such as trade and cash discounts
Q20. ABC Corporation is challenged by the shortage of cash for the last 6 months. They
can improve their funds by doing this. If they receive checks from customers, they should
deposit to the bank right away. Prompt deposit
Q21. Kareton Company- Masugid Company..B P4.80…D P22,410…C P62,250…A
P22,950…A P1.60
Q22. The clearing period for checks in the banking system 3-6 days
Q23. Merchants Company…P210,000
Q24. MLM Corporation is very careful in buying marketable securities because of the
following reasons except one None of the given
Q25. These are issued at a discount from face value, often called risk-free security and
are short-term government securities with a maturity of one year or less. Treasury bills
Q26. This is the average length of time between the purchase of materials and labor or
merchandise and the payment of cash for them. Payables Deferral Period
Q27. This shows what products will be sold, in what quantities, at what prices, and is the
foundation on which all other short-term budgets are built. Sales Budget
Q28. Harry Corp. 9,000 units
Q29. It is defined as the difference between the balance shown in a firm’s books and the
balance on the banks record. Float
Q30. VVV Corporation keeps their cash balance on the right amount. They also have
marketable securities which they maintain due to the following reasons except one They
serve as lines of credit
Q31. It is the length of time in which the firm purchases or produce inventory, sell it and
receive cash. Operating Cycle
 CHAPTER 15
CALCULATING THE COST OF CAPITAL

INTRODUCTION

In Chapter 6, the investors’ required return given a particular risk profile is discussed. In this
chapter, the question from the firm’s point of view will be examined: How much must the firm pay
to finance its operations and expansions using debt and equity sources? Generally, firms use a
combination of debt and equity sources to fund their operations, projects, and any expansions
they may undertake. In Chapter 18, the factors that managers consider as they choose the optimal
capital structure mix will be explored. For now, we shall assume that management has chosen
the optimal mix for us and it is our task to implement it.

Investors face different kinds of risks associated with debt, preferred share and ordinary equity
so that their required rates of return for each debt or equity source differ as well as the firm uses
a combination of different financing sources, the investors’ average required rate of return must
be calculated. The weighted average is generally used since firms seldom use equal amounts of
debt and equity capital sources.

The weights are based on the proportionate debt and equity capital used. In other words, when
firms use multiple sources of capital, they need to calculate the appropriate interest rate for valuing
their firm’s cash flows or a weighted average of the capital component cost.

One important consideration about the component costs to be used in the firm’s computation of
the average required rate of return is that dividends paid to either ordinary equity or preferred
shareholders are not tax deductible while interest paid to debt holders is tax deductible. Thus,
paying a certain dividend rate to shareholders will already be the after-tax out-of-pocket interest
cost to the firm while the firm’s effective after-tax out-of-pocket interest cost on debt will be equal
paid multiplied by one minus the firm’s relevant tax rate.

SPECIFIC CAPITAL COMPONENT COSTS

The investor-supplied items — debt, preferred shares, and ordinary shares are called capital
components. For instance, XYZ Corporation can borrow money at 10% (net of tax); so its
component cost of debt is 10%. This cost is then combined to form a weighted average cost of
capital (WACC).

When calculating the WACC, our interest is with capital that must be provided by investors —
interest-bearing debt (long-term and short-term), preferred shares and ordinary equity (ordinary
shares and retained earnings). Accounts payable, and accruals which arise spontaneously from
operations are not included as part of investor-supplied capital because they do not come directly
from investors.

A. COST OF DEBT (Kd)

The cost of debt is the minimum rate of return required by suppliers of debt.

The before-tax cost of debt is the interest rate a firm must pay on its new debt. Firm’s can estimate
this rate by inquiring from their bankers what it will to borrow or by finding the yield to maturity on
their currently outstanding debt. However, the after-tax cost of debt should be used to calculate
the WACC. This is the interest rate on new debt less the tax savings that result because interest
is tax deductible.

After-tax cost of debt = Interest rate (1 — Tax rate)

In effect, the government pays part of the cost of debt because interest is tax deductible. If XYZ
Corporation can borrow at an interest rate of 12% and its marginal corporate tax rate is 35%, its
after-tax cost of debt will be 7.8%.

After-tax cost of debt = 12% (1 - 35%) = 7.8%

Computing the Cost of a New Bond Issue

The Computation requires three steps:

1. Determine the net proceeds from the sale of each bond.

Net proceeds of a bond sale = Market Price - Flotation Costs

2. Compute the before-tax cost of the bond.

If the flotation costs are required and the bond sells at par, the before tax cost of the bond is
simply its coupon rate which is the interest rate paid on the bond’s par value. It is important to
emphasize that the cost of debt is the interest rate on new debt not on already outstanding debt
because our primary concern with the cost of capital is its use in capital budgeting decision. For
instance, would a new machine earn a return greater than the cost of capital needed to acquire
the machine? The interest rate at which the firm has borrowed in the past is irrelevant when
answering this question because we need to know the cost of new capital. For these reasons, the
yield to maturity on outstanding debt (which reflects current market condition) ts a better measure
of the cost of debt than the coupon rate.

The before-tax cost of the debt issue is the rate of return that equates the present value of the
future interest payments and principal payment with the net proceeds from the sale of the bond
using the equation.

NPd = I (PVIFAkd,n) + Pn (PVIFkd,n)

Net proceeds from the sale of bond, Pa~

Where:
NP = Net proceeds from the sale of bond, Pd-f
I = Annual Interest Payment in Pesos
Pn = Par or Principal repayment required in period n
kd = Before-tax cost of a new bond issue
n = length of the holding period of the bond in years
t = Time period in years

PVIFA = Present value interest factor of an annuity

B. COST OF PREFERRED SHARE (Kp)

Although preferred share is a part of a firm’s permanent financing mix but is not frequently issued.
Preferred share is a hybrid security that has characteristics of both debt and equity. Under
Philippine Financial Reporting Standard, when the preferred share is considered as debt, the
computational procedure in Section A will apply.

C. COST OF ORDINARY EQUITY SHARE

Ordinary equity share does not represent a contractual obligation to make specific payments thus
making it more difficult to measure its costs than the cost of bonds or preferred share.

Business firms raise equity capital-externally through the sale of new ordinary equity shares and
internally through retained earnings. Retained earnings represent the portion of accumulated
after-tax profits that the firm has not distributed to its shareholders and therefore is reinvested in
itself.

Cost of existing ordinary equity share is the same as the cost of retained’ earnings. No adjustment
is made for flotation costs in determining either the cost of existing ordinary equity share or the
cost of retained earnings.

The costs of new ordinary equity share and retained earnings are similar but not equal. The cost
of new ordinary equity share is higher than the cost of retained earnings because of the flotation
costs mvolved in selling new ordinary equity share which reduce the net proceeds to the firm.
Thus, firms will use the lower-cost retained earnings before they issue new ordinary equity share.
A. Cost of Equity

1. The CAPM Approach

The most widely used method for estimating the cost of ordinary equity is the Capital Asset Pricing
Model (CAPM).

Step 1: Estimate the risk-free rate (rRf). We generally use the 10year Treasury bond rate as the
measure of the risk-free rate, but some analysis use the short-term Treasury bill rate.

Step 2: Estimate the stock’s beta coefficient (bi) and use it as an index of the stock’s risk. The i
signifies the ith company’s beta. Beta coefficient, b is a metric that shows the extent to which a
given stock’s returns move up and down with the stock market. Beta thus measures systematic
market risk of the asset relative to average.

Step 3: Estimate the expected market risk premium. Recall that the market risk premium is the
difference between the return that investors require o on an average stock and the risk-free rate.

Step 4: Substitute the preceding values j in the CAPM equation to estimate the required rate of
return on the stock in question:

rs= rRF+ (RPm) bi

= rRF + (rm — rRF) bi

Thus, the CAPM estimate of r; is equal to the risk-free rate (rRF) plus a risk premium that is equal
to the risk premium on an average stock (rM — rRF), scaled up or down to reflect the particular
stock’s risk as measured by its beta coefficient (bi).

2. Bond Yield Plus Risk Premium Approach

In situation such as closely held companies where reliable inputs for the CAPM approach are not
available, analysts often use a somewhat subjective procedure to estimate the cost of equity.

The generalized risk premium or bond-yield-plus-risk premium required rate of return on

shareholder’s equity. The equation below shows that the required rate of return is equal to some
base rate (kd) plus a risk premium (rp). The base rate is often the rate on Treasury bonds or the
rate on the firm’s own bonds. The risk premium on a firm’s own stock over its own bonds is based
on a judgmental estimate but empirical studies suggest that it ranges between 3 to 5 percentage
points above the base rate. However, risk premiums are not stable over time, hence the estimated
value of ks is also judgmental.

3. Dividend Yield Plus Growth Rate Approach

Generally, both the price and the expected rate of return on an ordinary equity share, depend
ultimately on the share’s expected cash flows. For business firms that expect to remain in
business indefinitely the cash flows are the dividends.

The required rate of return on ordinary equity which for the marginal investor is also equal to the
expected rate of return.

4. Discounted Cash Flow (DCF) Approach

The method of estimating the cost of equity called the discounted cash flow or DCF method
considers not only the dividend yield (Dl/ Po), but also a capital gain (g) for a total expected return
of Ks and in equilibrium this expected return is also equal to the required rate of return.

It is not difficult to calculate the dividend yield but if stock prices fluctuate, the yield shall vary from
day to day which leads to fluctuations in the DCF cost of equity. Also it is not easy to determine
the proper growth rate. If part growth rates in earnings and dividend have been relatively stable,
and if investors expect a continuation of past events, 8 may be based on the firm’s historic growth
rate.

Illustrative Case 15-6. Determination of Cost of Equity Under the DCF Approach
Zeta stock sells for P23.06, its next expected dividend is P1.25, and analysts expect its growth
rate to be 8.3%. Thus, Zeta’s expected and required rates of return (hence, its cost of retained
earnings) are estimated to be 13.7%.

Solution: P1.25 / P23.06 + 8.3%

= 5.4% + 8.3% = 13.7%

Based on the DCF method, 13.7% is the minimum rate of return that should be earned on retained
earnings to justify plowing earnings back into the business rather than paying them out to
shareholders as dividends. In other words, since the investors are thought to have an opportunity
to earn 13.7% if earnings are paid out as dividends, the opportunity cost of equity from retained
earnings is 13.7%.

5. Earnings - Price Ratio Method

The earnings-price ratio method is a simplistic technique used to estimate the cost of ordinary
equity, which is based on the inverse of the firm’s price-earnings ratio. The earnings-price ratio is
easy to compute because it is based on readily available information, but there is little economic
logic to support the use of the earnings-price ratio to measure the cost of ordinary equity. For
example, this technique is unsuitable for a firm that is operating at a loss because it would
generate a negative cost of ordinary equity. The following equation shows that the earnings-price
ratio is found by dividing the current earnings per share (E) by the current market price of the
firm’s ordinary equity share (Po).

K =E/Po

where: | E = Current earnings per share Po = Current market price of ordinary equity share

Illustrative Case 15-7. Determination of Cost of Equity Using the Earnings Price Ratio

Prime Pipe Company had earnings per share for the past year of P6.50, and the firm’s ordinary
equity share is currently priced at P45.00. Using the earnings-price ratio method, the cost of
retained earnings would be 14.44%. This is found by substituting E = P6.50 and P, = P45.00.

Solution:

Ks = P6.50 | P45.00 =0.1444

B. Cost of New Ordinary Equity Shares

The Constant Growth Model for New Ordinary Equity Shares is generally used in measuring the
cost of new ordinary equity share. The equation is:

The cost of new ordinary equity (K,) is higher than the cost of retained earnings (K-) because of
the new issue must. be adjusted for flotation costs. These flotation costs include both underpricing
and an underwriting fee. Underpricing occurs when new ordinary equity share sells below the
current market price of outstanding ordinary equity share, in order to attract investors and to
compensate for the dilution of ownership that will take place. An underwriting fee covers the cost
marketing the new issue.

The Constant Growth Model assumes that dividends grow perpetually _at a constant annual rate,
g. Estimates of g are usually based on historical growth rates, if earnings and dividend growth
rates have been stable in the past, or on analysts forecasts.

C. Cost of Retained Earnings

Some have argued that retained earnings should be “cost-free” because they represent money
that is “left-over” after dividends are paid. While it is true that no direct costs are associated with
retained earnings, this capital still has a cost, an opportunity cost. The managers who work for
the shareholders can either pay out earnings in the form of dividend or retain earnings for
reinvestment in the business. When the decision is made, the manager should recognize that
there is an opportunity cost involved, that is, the shareholders could have received the earnings
as dividend and invested this money in other stocks, bonds, in real estate, etc. Therefore the firm
needs to earn at least as much as any earnings retained as the stockholder could earn an
alternative investment of comparative risk.
The cost of retained earnings is similar to the cost of existing ordinary equity share.

When Must External Equity Be Used?

Because of flotation costs, pesos raised by selling new stock must “work harder” than pesos
raised by retaining earnings. Moreover, because no flotation costs are involved, retained earnings
cost less than new shares. Therefore, firms should utilize retained earnings to the greatest extent
possible, However, if a firm has more good investment opportunities than can be financed with
retained earnings plus the debt and preferred share supported by those retained earnings, it may
need to issue new ordinary equity or ordinary share. The total amount of capital that can be raised
before new shares must be issued is defined as the retained earnings breakpoint, and it can be
calculated as follows:

Retained earning breakpoint =Addition to retained earnings for the year / Equity fraction

Problems to Consider With Estimates of Cost of Capital

There are a number of issues related to the cost of capital estimation that an analyst should be
aware of and choice of the applicable method would-require the use of the analyst’s considerable
judgment.

1. Privately Owned Firms

The discussion of the cost of equity generally focused on publicly owned firms and concentration
was made on the rate of return by public shareholders. What about the measurement of the cost
of equity for a firm whose shares are not traded? As a general rule, the same principles of cost of
capital estimation apply to both privately held and publicly owned firms, but the problem of
obtaining input data are somewhat different. Tax issues are also especially important in these
cases.

2. Measurement Problems

There are practical difficulties that are encountered in estimating the cost of equity. For example,
it is quite a formidable task to obtain good import for the CAPM, for g in the formula Ks = Dl/ Po
+ g, and the risk premium in the formula Ks = Bond Yield + Risk Premium. As a result, we can
never be sure of the accuracy of our estimated cost of capital.

3. Capital Structure Weights

In the previous illustrations we took as given the target capital structure. The establishment of the
target capital structure is a major task in itself.

4. Cost of Capital for Projects of Differing Risk

Different projects can differ in risk and, thus in their required rates of return. Also it is difficult to
measure a project’s risk hence to adjust the cost capital for capital budgeting projects with different
risks would also present some problems.

Although the list of problems appears formidable, the procedures presented in this section can be
used to obtain costs of capital estimates that are sufficiently accurate for practical purpose. Also,
the problems listed previously merely indicate the desirability of refinements. The refinements are
important But the problems noted do not necessarily invalidate the usefulness of the procedures
outlined in this chapter.

DETERMINATION OF WEIGHTED AVERAGE COST OF CAPITAL

Once the specific cost of capital of each long term financing source is Measured the firm’s
weighted average cost of capital (WACC), Kg, can be determined.

The target proportions of debt, preferred share, and ordinary equity along with the costs of those
components are used to calculate the firm’s weighted average cost of capital.

Assuming that all new ordinary equity is raised as retained earnings, as is true for most
companies, the WACC can be computed as follows:
WACC = (% of debt) (After-tax Cost of Debt) + (% of Preferred Share) (Cost of Preferred Share)
+ (% of Ordinary Equity) (Cost of Ordinary Equity)

Note that only debt has a tax adjustment factor (I — T). As discussed in this section, this is
because interest on debt is tax deductible but preferred dividends and returns on ordinary equity
share (dividends and capital gains) are not.

A WACC can be computed for either the firm’s existing financing or new financing. The cost of
capital acquired by the firm in earlier periods is not relevant for current decision making because
it represents a historical or sunk cost. Thus, only the WACC for new financing is generally
calculated.

WACC is computed by multiplying the specific cost of each type of capital by its proportion
(weight) in the firm’s capital structure and summing the weighted values.

There two major schemes in computing the weighted average cost of capital, namely:

A. Historical Weights
a) Book value weights
b) Market value weights

B. Target Weights

A. HISTORICAL WEIGHTS

Historical weights are based on the firm’s existing capital structure. Firms that believe their
existing capital structure is optimal should use historical weights. An optimal capital structure is
the combination of debt and equity that simultaneously maximizes the firm’s market value and
minimizes its weighted average cost of capital. There are two types of historical weights: (a) Book
value weights, and (b) Market value weights.

a) Book value weights measure the actual proportion of each type of permanent capital in the
firm’s structure based on accounting .values shown on the firm’s balance sheet. This basis
however may misstate the WACC because they ignore the changing market values of bonds and
equity over time, and may not provide a useful cost of capital for evaluating current strategies.

b) Market value weights measure the actual proportion of each type of permanent capital in the
firm’s structure at current market prices. This is considered more superior to book value weights
because they provide estimates of investors’ required rates of return. However, market value
weights are less stable than book value weights in computing cost of capital because market
prices change frequently.

B. TARGET WEIGHTS

Target weights are based on a firm’s desired capital structure. Firms using target weights
establish these proportions on the basis of optimal capital structure they wish to attain. Thus, the
firm raises additional funds so as to remain constantly on target with its optimal capital structure.
The preferable approach though is to use target weight based on market values rather than
historical weights. If these weights (market values) are used, the share price will be maximized
and the cost of capital simultaneously will be minimized.
 CHAPTER 16
BASICS OF CAPITAL BUDGETING

INTRODUCTION

The strategic asset allocation process is usually more involved than just deciding whether to buy
a particular fixed asset. Business establishments face broader issues like, whether they should
launch a new product or enter a new market.

Decisions such as those influence the nature of a firm’s operations and products for years to come
primarily because investments in fixed assets are ‘generally long. lived and not easily reversed
once they are made.

One fundamental decision a business must make concerns its product line of the business
enterprise.

Questions such as
1. What services will the firm offer or what will it sell?
2. What new products will it introduce?
3. In what markets will it compete?

will require answers that will involve commitment of its scarce and valuable capital to certain types
of assets.

As a result, all these strategic issues fall under the general heading of capital budgeting or
strategic asset allocation.

Capital budgeting question is probably the most important issue in corporate finance because the
fixed assets define the business of the firm. Of course, certain issues of concern such as how a
firm chooses to finance its operations (the question of capital structure) and how a firm manages
its short-term operating activities (the question of working capital) are also of utmost significance
that failure to address them appropriately could be disastrous to the firm.

Business firms possess a huge number of possible investments. Each possible investment is an
option available to the firm. Some options are valuable, others are not. The essence of successful
financial management is learning to identify and decide which potential business ventures are
worth undertaking.

Finally, capital budgeting is also essential because asset expansion typically involves substantial
expenditures and before a firm can spend a large amount of - money, it must have the funds
available and large amounts of money are not available automatically. Therefore, a firm
contemplating a major capital expenditure program should arrange its financing several years in
advance to be sure the funds required are available.

The end-product of this exercise is the firm’s strategic business plan which is a long-run plan
which outlines in broad terms.the firm’s basic strategy for the next 5 to 10 years.

CAPITAL BUDGETING PROCESS

The capital budgeting process is a system of interrelated steps for making longterm investment
decisions.

Step 1. GENERATING PROJECT PROPOSALS

A firm’s sustained growth and even its ability to remain competitive and to survive depends upon
a constant flow of ideas for new products, ways to making existing products better and ways to
produce output at a lower cost. A well-managed firm will therefore go to great lengths to develop
good capital project proposals. For example, the corporation’s “Research and Development
Department” is tasked to constantly search for new products and also for ways to improve existing
products. In addition, the company’s Executive Committee composed of the senior executives in
marketing, production, and finance sets long-term run targets spelled out in the corporation’s
strategic business plan for each division.

This plan provides a general guide to the operating executives responsible for meeting them as
well as the rewards that attract them if they perform well. If a company has capable and
imaginative executives and employees and if its incentive system is working properly, many ideas
for capital investment will be advanced. It is therefore imperative that procedures must be
established for evaluating the worth of such projects to the firm.

Capital Budgeting Decisions

Any decision that involves an outlay now in order to obtain a future return is a capital budgeting
decision. Typical capital budgeting decisions include:

1. Replacement decisions to continuous current operations

These consist of expenditures to replace worn-out or damaged equipment required in the

production of profitable products. The questions here are should the operation be continued and
if so, should the firm continue to use the same production processes? Should the equipment be
replaced now? If the answers are yes, the project will be approved without going through an
elaborate decision process.

2. Replacement to effect cost reduction

This category includes expenditures to replace still serviceable but obsolete equipment and
thereby to lower costs. These decisions are discretionary and may be deferred for later action
and a fairly detailed analysis is generally required.

3. Expansion into new products or markets

These investments relate to new products or geographic areas and they involve strategic
decisions that could change the fundamental nature of the business. Another example is should
a new plant warehouse or other facility be acquired to increase capacity and sales. A detailed
analysis is needed and decision is generally made at the top level of. . management. .

4. Expansion of existing products or markets

These are expenditures to increase output of existing products to expand distribution/retail outlets
in markets being currently served. Again, a more detailed analysis is required because expansion
decisions are more complex since they require an explicit forecast of growth in demand. Also,
decision is generally made at a higher level within the firm.

5. Equipment selection decisions

These investments relate to decisions at to which of several available machines should be

purchased or leased.

6. Safety and/or environmental projects

These are expenditures necessary to comply with government orders, labor agreements or
insurance policy terms. How these projects are handled depends on their size with some small
ones being treated much like the category/projects.

7. Mergers

In a merger, one firm buys another firm. Buying a whole firm is different from buying an asset
such as a machine or investing in a new equipment, but the same principles are involved. The
concepts of capital budgeting underlie merger analysis.

8. Other projects

This catch-all category includes items such as office buildings, parking lots, car plans, etc. How
they are handled varies among companies.

Categories of Capital Investment Decisions

Capital budgeting decisions fall into two broad categories:

A. Independent capital investment projects or Screening decisions

B. Mutually exclusive capital investment projects or Preference decisions

A. Independent capital investment projects or Screening decisions

These relate to whether a proposed project is acceptable — whether it passes a present hurdle.
These are projects which are evaluated individually and reviewed against predetermined
corporate standards of acceptability resulting in an “accept” or “reject” decision. For example, a
company may have a policy of accepting projects only if they promise a return of least 15% on
the investment. The required rate of return is the minimum rate of returns a project must yield to
be acceptable. Other examples are:

1. Investment in long-term assets such as property, plant and equipment.

2. New product development.
3. Undertaking a large scale advertising campaign.
4. Introduction of a computer.
5. Corporate acquisitions (such as purchase’ of shares m subsidiaries or affiliates).

B. Mutually exclusive capital investment projects or Preference decisions

These relate to selecting from among several acceptable alternatives. The project to be
acceptable most pass the criteria of acceptability set by the company and be better than the other
investment alternatives. To illustrate, a company may be. considering several different equipment
to replace an equipment on the assembly line. The choice of which machine to purchase is &
preference decision. Other examples are:

1. Replacement against renovation of equipment or facilities.

2. Rent or lease against ownership of facilities. 3. Manual bookkeeping system against
computerized system.
4. Preventive maintenance against periodic overhaul of machineries.
5. Purchase of machinery from an outside supplier against assembly of the machinery by the
company’s own staff.

Step 2. COLLECTING RELEVANT INFORMATION ABOUT OPPORTUNITIES

Capital budgeting is a dynamic process because the firm’s changing environment may affect the
desirability of current or proposed investment. Information is needed throughout the entire capital
budgeting process to ensure that the process is operating effectively. For instance, effective
record keeping is important in evaluating the accuracy of past estimates of revenue increases or
cost savings. Information such as a project’s expected costs and benefits forecasts of the
economic environment market research studies, actions of competitors and regulatory decisions
are used in the capital budgeting process.

Step 3. ESTIMATING CASH FLOWS

In a dynamic business environment characterized by uncertainty, projecting the cash flows of a

particular product is also difficult. For example, estimating the cash flows of a totally new product
over its useful life may be based on assumptions that represent little more than educated
guesses.

Deriving accurate estimates of cash flows is the most important and most difficult step in the entire
capital budgeting process. Estimating cash flows ts important because no step later in the process
can overcome inaccurate or unreliable information generated by this step.

Net cash flow is the difference between inflows and outflows of cash that result from a firm
undertaking a project.

Only incremental after-tax cash flows are relevant. Historical costs arising from past decisions are
sunk costs and therefore cannot affect future alternatives.

Cash flows of a project fall into three categories:

1. Net Initial Investment
2. Net Operating Cash F lows or Returns
3. Net Terminal Cash Flow

1. Net Initial Investment

Net investment is the net initial cash outlay needed to acquire a specific investment project. Most
capital projects require a significant initial outlay before they generate cash inflows. The net
investment ig calculated by subtracting any initial cash inflows that occur in placing an asset into
service from the amount of the initial cash outflows required by the project. The net investment is
assumed to occur Time Period Zero although the cash inflows and cash outflow, constituting the
net investment may occur at several points of time.

The general format for computing the net investment follows:

Purchase price of new asset

+ Installation and transportation costs
+ Additional net working capital
- Proceeds from sale of old asset
+/- Tax effects on disposal of old asset And/or the purchase of new one
Net investment

The initial cash outflows include the purchase price of the new asset, outlays for installation and
transportation, additional net working capital, and any other cost incurred to put the asset into
service. (Net working capital is the excess of additional current assets over increased current
liabilities required to support the project.) expansion projects normally require increases in net
working capital whereas replacement projects do not.

The initial cash inflows include the proceeds from the disposal of existing assets if the investment
proposal involves replacing an
existing asset with a new asset. The tax impact of selling a depreciable asset can produce an
increase or a decrease i in the firm’s income tax liability.

In certain cases, the net investment is the sacrifice of an inflow of cash, that is, the opportunity
cost that arises when a benefit is rejected. An example is when a company has in its possession
fixed assets no longer used in operation and are awaiting disposal through sale. If it should
happen that these assets can be put to good use on a proposed capital project rather than be
disposed of, then the estimated project cost or investment should include the net amount to be
realized from the sale of the assets.

2. Net Operating Cash Flows or Returns.

Net operating cash flows are the incremental changes in a firm’s cash flows that result from
investing in a project. Net operating cash flows may vary over the project’s life and the timing of
these varying flows may also vary during the year. However, operating cash flows ir generally
assumed to occur at the end of a given year.

Step 4. EVALUATING PROJECT PROPOSALS

After the cash flows are projected, the fourth step in ‘the capital budgeting process is evaluating
project proposals. Capital investments are evaluated under certainty or risk. Under certainty, the
exact values associated with the investment, such as the cash flows and the required rate of
return, are known in advance. In practice, few financial variables are known in advance with
absolute certainty. Under risk, variables required for evaluating investment proposals are not
certain and involve a margin of error. There are numerous techniques that may be used to
evaluate both individual and multiple projects under conditions of certainty and risk. Most of these
techniques employ time value of money concepts in order to account for a project’s cash flows
over time. The discounted (cost of capital) must be established if the discounted cash flow
approach is to be applied (Chapter 17). The various techniques for assessing the economic value
of investment projects are discussed in Chapter 17.

Step 5. SELECTING PROJECTS

The fifth step in the capital budgeting process is selecting projects. In theory, the firm should
invest in new projects up to the point where the rate of return from the fast project is equal to the
firm’s marginal cost of capital. In practice, many factors, quantitative as well as qualitative, should
be given consideration before the final decision is made as to the selection of a particular
investment. They will include among others, relationship of this opportunity to other aspects of
the company operations and long-term goals, the timing of the cash flows, the availability of funds
for investment purposes, the impact on the financial structure of the company, social impact of
the opportunity, and legal ramifications.

The final selection of projects depends on three major factors:

1. Project type
2. Availability of funds
3. Decision criteria

1. Capital expenditure decisions may be classified as independent and mutually exclusive. An

independent project is one having a distinct function. Acceptance or rejection of an independent
project does not necessarily preclude other projects from consideration. For example, a firm may
wish to construct a new building and to install a computer system. Both projects could be adopted
provided that each meets the firm’s investment criteria and sufficient funds are available.

A mutually exclusive project is an alternate way of performing the same function as other projects
under consideration. Acceptance of a mutually exclusive project eliminates the other alternatives
from further consideration. For example, a firm is considering building a new plant in one of four
possible locations. Selecting one location eliminates the need for the other three plant sites.

2. The availability of funds affects capital budgeting decisions. Unlimited funds allow a firm to
operate with no constraints on its capital expenditures. A firm with no capital constraints should
accept all projects that meet its selection criteria. Capital rationing occurs when a firm places an
upper limit on its capital expenditures. This limit on the size of the total capital budget is often self-
imposed. The dominant cause of a budget constraint is a debt limit imposed by internal
management. If there is an absolute limit on the amount of debt financing, expenditures will be
cut back under two conditions; internally generated funds are too small to make up the deficit, or
the firm is unwilling to undertake equity financing. Under capital rationing, a firm may not maximize
shareholder wealth because it may reject profitable projects (projects whose expected rate of
return exceeds the required rate of return). A firm that rations funds should allocate the funds in
a way that maximizes long-run return within the budget constraints.

3. Decision criteria are established to rank projects and to provide a cutoff point for capital
expenditures. Frequently there are more proposals for projects than the firm is able or willing to
finance. Ranking techniques are used to select the best subset of acceptable projects from a
larger set that cannot be fully funded. Projects are often ranked according to a prescribed hurdle
rate or minimum acceptable rate of return. Hurdle rates reflect the project’s riskiness; common
measures include the firm’s cost of capital (the required rate of return of investors who provide
funds to the firm), opportunity cost (the rate of return on the firm’s best alternative investment
available), or some risk-adjusted rate. The calculation of cost of capital is discussed thoroughly in
Chapter 15.

Capital budgeting techniques provide a useful quantitative basis for project selection. However,
other factors in addition to the economic appraisal of an - investment must be considered.
Qualitative. factors, such as personal preferences of decision makers, ethics, and social
responsibility, also serve ag inputs in the selection process.

Once the final projects are selected they must ‘be combined into a capital budget, which 1 is a
plan of ‘expenditures for fixed assets.

Step 6. IMPLEMENTING AND REVIEWING PROJECTS

The sixth and final step in the capital budgeting process is implementing and reviewing accepted
projects. The decision to accept or reject a proposed project must be communicated to its
originator and to others in the firm. Acceptable projects must then be implemented in a timely and
efficient manner. The implementation stage involves developing formal procedures for authorizing
the expenditures of funds for capital projects. The review stage involves analyzing projects that
have been adopted in order to determine if they should be continued, modified, or terminated.
The financial manager ‘works with managers in other departments to compile systematic records
on the uses of funds. The exercise of expenditure control helps to ensure that costs remain within.
the budgeted amounts. If cost overruns occur, corporate managers must decide upon the
appropriate action to take regarding the project. For example, managers may decide to abandon
a project if it no longef contributes to shareholder wealth.

After a project is completed, a post-audit is conducted in which comparisons are made between
earlier estimates and actual data. Review of past decisions may provide a basis for improving
management’s ability to evaluat? subsequent investment alternatives.

A final aspect of the capital budgeting process is the post-audit, which involves (1) comparing
actual results with those predicted by the project’s sponsors and (2) explaining why any
differences occurred. For example, many firms require that the operating divisions send a monthly
report for the first six months after a project goes into operation and a quarterly report thereafter,
until the projects results meet expectations. From then on, reports on the operation are reviewed
on a regular basis like those of other operations. The post-audit has two main purposes:

1. Improve forecasts

When decision makers are forced to compare their projections with actual outcomes, there is a
tendency for estimates to improve. Conscious or unconscious biases are observed and
eliminated; new forecasting methods are sought as the need for them becomes apparent; and
people simply tend to do everything better, including. forecasting, if they know that their actions
are being monitored.

2. Improve operations

Businesses are run by people, and people can perform at higher or lower levels of efficiency.
When a divisional team has made a forecast about an investment, the team members are, in a
sense, putting their reputations on the line. Accordingly, if costs are above and sales below
predicted levels, then executives in production, marketing, and other areas will strive to improve
operations and to bring results into line with forecasts. In a discussion related to this point, one
executive made this statement: “You academicians only worry about making good decisions. In
business, we also worry about making decisions good.”

The post-audit is not a simple process. First, we must recognize that each element of the cash
flow forecast is subject to uncertainty, so a percentage of all projects undertaken by any
reasonably aggressive firm will necessarily go awry. This fact must be considered when
appraising the performances of the Operating executives who sponsor projects. Second, projects
sometimes fail to meet expectations for reasons beyond the control of their sponsors and for
reasons that no one could be expected to anticipate. Third, it is often difficult to separate the
operating results of one investment from those of a larger system. Although some projects stand
alone and permit ready identification of costs and revenues, the cost savings that result from
assets like new computers may be very hard to measure. Fourth, it is often hard to hand out blame
or praise because the executives who were responsible for launching a given investment have
moved on by the time the results are known.

Because of these difficulties, some firms tend to play down the importance of the post-audit.
However, observations of both businesses and governmental units suggest that the best-run and
most successful organizations put a lot of emphasis on post-audits. Accordingly, we regard the
post-audit as an important element in a good capital budgeting system.

CAPITAL BUDGETING RISK

FORECASTING RISK

The key inputs into a DCF analysis are projected cash flows. If the projections are . Seriously in
error, then we have a classic “garbage in, garbage out system”. In such a Case, no matter how
carefully we arrange the numbers and manipulate them, the resulting answer can still be grossly
misleading. This is the danger in using a relatively sophisticated techniques like NPV, IRD, or
DPB. It is sometimes easy to get caught up in number crunching and forget the underlying
economic reality. For example, a basic principle of economics is that positive NPV investments
will be rare in highly competitive environment across. Therefore, proposals that appear to show
significant value in the face of stiff competition are particularly troublesome and the likely reaction
of the competition to any innovation must be closely examined.

Forecasting risk or estimation risk is the possibility that a bad decision will be made because of
errors in the projected cash flows. Because of forecasting risk, there is the danger that we will
conclude a project has a positive NPV when it really does not. How can that happen? It happens
if the analyst is overly optimistic about the future, and as a result, the projected cash flows do not
realistically reflect the possible future cash flows.

Risk should be considered in evaluating capital budgeting projects in both informal and formal
ways. These approaches cannot remove risk, but.they can provide 8 means of dealing with it in
a rational manner.

Informal approaches to risk adjusted are based on the decision maker’s subjective evaluation of
the project’s risk. The decision rules using informal techniques aré often internal to the decision
maker and they are simple and inexpensive. For instance, the decision maker may require a
shorter than normal payback for risky projects.
Formal methods in dealing with risk may also involve subjective judgment but they could provide
more objective and precise methods of accounting for risk.

Our goal in performing risk analysis is to assess the degree of forecasting risk and to identify the
most critical components of the success or failure of an investment.

Methods of Estimating and Measuring Risk

Among the formal methods of estimating and measuring risk.are:

1. Scenario Analysis
2. Sensitivity Analysis
3. Simulation Analysis
4. Beta Estimation

1. Scenario Analysis

The basic form of “what-if” analysis is called scenario analysis. This approach involves the
determination of what happens to NPV estimates when we ask what-if questions. For example,
what if unit sales realistically should be projected at level XXX units instead of XX units?

The analyst shall consider a number of possible scenarios. A starting point is with the worst-case
or pessimistic scenario. This will, show the lower bounds or minimum NPV of the project. Under
the pessimistic scenario, the least favorable value is assigned to each item or variable. This
means low values for variables such as units sold and price per unit while high values for costs.

The analyst can go ahead and determine the other extreme, the best case or optimistic scenario.
This puts an upper parameter on the NPV. Under the optimistic scenario, low values are assigned
for costs and high values for units sold and price per unit.

However, to use only the pessimistic and optimistic scenarios might be somewhat misleading.
There is a need to consider the cases that are reasonably or most likely to occur.

2. Sensitivity Analysis

One basic approach to evaluating cash flow and NPV estimates involves asking “what-if”
questions. Sensitivity analysis is the process of changing one or more variables to determine how
sensitive a project’s returns are to these changes. By asking “what-if” questions, the decision
maker is able to identify relevant variables affecting the final outcome. Once these variables are
identified, the decision maker can investigate the variables more carefully in order to improve
his/her ability to predict them.

The basic idea with a sensitivity analysis is to freeze all the variables except one and then see
how sensitive our estimate of NPV is to changes in that one variable. If the NPV estimate turns
out to be very sensitive to _ relatively small changes in the projected value of some component
of " project cash flow, then the forecasting risk associated with that variable is high.

Sensitivity analysis is useful for pointing out where forecasting errors will do the most damage but
does not tel] us what to do about possible errors.

What can be seen from the above analysis is that given the ranges, the estimated NPV of this
project is more sensitive to changes in projected unit sales than it is to changes in projected fixed
costs. In fact, even under the pessimistic scenario, the NPV is still positive. It could also be
observed that sensitivity analysis is useful in pinpointing which variables should be given more
attention. In the given case, NPV is especially sensitive to changes in a variable that is difficult to
forecast (such as unit sales), then the degree of forecasting risk is high. Probably, a good move
is to conduct further market research to avoid failure of the project.

Because sensitivity analysis is a form of scenario analysis, it suffers from the same limitations.
Sensitivity analysis is useful for pointing out where forecasting errors will do the most damage,
but it does not point out what to do with possible error.
3. Simulation Analysis

Simulation analysis is a combination of scenario and sensitivity analysis. With scenario analysis,
the analyst let all the different variables change but let them take on only a few values. With
sensitivity analysis, the analyst let only one variable change let it take on many values.

Simulation analysis let all the items vary at the same time. Since this could result to a very large
number of scenarios, computer assistance is almost certainly needed. Once values for all the
relevant components are determined, an NPY is computed and this sequence is repeated
probably several thousand times. The result is many NPV estimates that are summarized by
calculating the average value and some measure of how to spread out the different possibilities
are. From this distribution of returns, the decision maker is able to determine the expected value
of the return and the probability of achieving a specific return.

Thus simulation analysis helps improve the decision maker’s perception of the project’s risk.
Because simulation analysis is an extended form of scenario analysis, it suffers the same
drawbacks. Once the results are made available, no simple decision rule tells the decision maker
what to do. Furthermore, simulation assumes that the possible values were equally likely to occur.
It is probably more realistic to assume values near the “most likely scenario” than extreme values,
but coming up with the probabilities are difficult, to say the least. For reasons cited, the use of
simulation is somewhat limited in practice. However, recent advances in computer software and
hardware (and uses sophistication) lead us to believe that it is now becoming more common
particularly for large-scale projects.

4. Beta Estimation

This approach to risk measurement involves the concepts of Capital Asset Pricing Model (CAPM).
in the capital budgeting context, beta is a measure of the systematic risk of a project. Systematic
risk principle states that the reward of bearing risk depends only on that asset’s systematic risk.
The underlying rationale for this principle is straight-forward.

Because unsystematic risk can be eliminated at virtually no cost (by diversifying) there is no
reward for bearing it. Put another way, the market does not reward risks that are borne
unnecessarily. No matter how much total risk an asset has, only the systematic portion is relevant
in determining the expected return (and the risk premium) on that asset.

The specific amount of systematic risk present in a particular risky asset relative to that in average
risky asset is called the beta coefficient. By definition, an average asset has a beta of 1.0 relative
to itself. An asset with a beta of .50 has half as much systematic risk as an average asset, while
an asset with a beta of 2.0 has twice as much. Because assets with larger betas have greater
systematic risks, they will have greater expected returns. The project’s market risk is measured
by its effect on the firm's beta coefficient.

INFLATION AND CAPITAL BUDGETING

Does inflation affect a capital budgeting analysis? The answer is a qualified yes in that inflation
affects the number that are used in the analysis but does not affect the results of the analysis of
certain conditions are satisfied:
 CHAPTER 17
SCREENING AND SELECTING CAPITAL INVESTMENT PROPOSAL

INTRODUCTION

The fourth step in the capital budgeting process is evaluating or Screening project proposals.
Once the firm has calculated the cost of capital for a project eet estimated its cash flows, deciding
whether or not to invest in that project basicaly boils down to asking the question: “Is the project
worth its projected future value?”

No one can perfectly predict the future, so the techniques are by their very accompanied by
uncertainty. That said, the commonly used capital budgeting techniques include the following:

A. Discounted Cash Flow (time-adjusted) Approach

1. Net present value
2. Internal rate of return
3. Profitability index
4. Discounted payback period

B. Non-discounted Cash Flow (unadjusted) Approach

1. Payback period
2. Bailout payback period
3. Payback reciprocal
4. Accounting rate of return (book value rate of return)

CAPITAL BUDGETING TECHNIQUES

A. DISCOUNTED CASH FLOW (TIME-ADJUSTED) APPROACH

1. Net Present Value Method

Net present value (NPV) is the excess of the present values of a project’s cash inflows (net
operating cash flows plus net terminal cash) over the amount of the initial investment. The cash
flows are discounted at the firm’s cost of capital, which is used as the minimum acceptable rate
of return or the hurdle rate of return for investment projects of average risk.

The NVP model implicitly assumes that the project’s net operating cash inflows are reinvested at
a rate equal to the firm’s cost of capital (discount rate).

The advantages of using the NPV are that it considers the magnitude and timing of cash flows,
provides an objective criterion for decision making which maximizes shareholder wealth, and is
the most conceptually correct . capital budgeting approach.

At its heart, NPV model provides an absolute measure of a project’s worth because it measures
the total present value of peso return. It also works equally well for independent projects as it
does for choosing among mutually exclusive projects.

The disadvantages of using the NPV are that it is more difficult to compute than unsophisticated
methods and its meaning is difficult to interpret because the NPV does not provide a measure of
a project’s actual rate of return.

In independent projects, should be accepted if the NPV is zero or positive. In the latter case, the
mutually exclusive project with the highest NPV Should add the most wealth to the firm and so
management should accept it over any: competing projects.

The NPV of a project is computed as follows:

Present value of cash inflows computed based on minimum desired discount rate
....................Pxx
Less: Present value of investmentt...................xx
Net present value ............Pxx
2. Internal Rate of Return

IRR, also known as discounted rate of return and time-adjusted rate of return 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.

The IRR technique is, by far, the most popular rate-based capital budgeting technique. The main
reason for its popularity is that, if one is considering a project with normal cash flows that is
independent of other projects, the IRR statistic will give exactly the same accept/reject decision
as the NPV rule does.

The disadvantage of using IRR are that it can be tedious to compute especially with uneven net
cash inflows; assumes reinvestment of cash inflows at an often unrealistic rate and can produce
multiple IRRs with nonconventional cash flow patterns.

Steps in the Computation of the Internal Rate of Return (IRR)

A. Cash inflows are evenly received:

If the cash returns or inflows are evenly received during the life of the project, the computational
procedures are as follows:

1. Compute the Present Value Factor by dividing Net Investment by Annual Cash Returns.

2. Trace the PV factor in the Table for Present Value of P1 received annually using the life of the
project as point of reference.

3. The column that gives the closest amount to the PV factor is the “Discounted rate of return”.

4. To get the exact Discounted rate of return, interpolation is applied.

B. Cash inflows are not evenly received: The steps in computing for the discounted rate of return
are:

1. Compute the Average Annual Cash Returns by dividing the sum of the returns to be received
during the life of the project by the total economic life of the project.

2. Divided Net Investment by the Average Annual Cash Returns to get the Present Value Factor.

3. Refer to the Table for Present Value of P1 received annually to determine the rate that will give
the closest factor to the computed present value factor.

4.. Using the rate obtained in Step No. 3, refer to the Table for Present Value of P1. If the returns
are increasing, use a discount rate lower than the rate obtained in Step No. 3, if the returns are
decreasing, use a higher rate. Compute the present value of the annual cash

5. Add the present value of the annual returns and compare with the Net Investment.

6. If the result in Step No. 5 does not give equality of present value of returns and net investment,
try at another rate.

7. interpolate to get the exact discounted rate of return.

Decision Rule:

Once the IRR has been calculated, it will then be compared to the relevant cost of capital for the
project. The average rate of return to payback the project’s capital providers, gives the risk that
the project represents.

Accept Project if IRR > Cost of Capital

Reject Project if IRR < Cost of Capital

In capital investment decisions, companies seek to choose projects that are worth more than what
they pay for them, leaving room for economic profit. That is why all these capital budgeting rules
are “>” and “<” signs. Firms would only want to invest in projects when the rate it expects to get
(IRR) is larger than the required rate of return.

Relative Ranking of Projects: NPV vs. IRR

The relative ranking of projects, using the different DCF methods will be considered initially in
simple accept/reject situations. This will be. extended later to a detailed assessment of situations
where a choice has to be. made between two or more alternatives. In simple accept/reject
Situations, a firm is able to implement all projects showing a return at or above the firms cost of
capital. Both NPV and IRR would appear to be equally valid in the sense that they will both lead
to accept or reject the same projects. Using NPV, all projects with a positive net present value,
when discounted at the firm’s cost of capital, will be accepted. Using IRR, all projects which yield
an internal rate of return in excess of the firms cost of capital will be chosen. Although NPV and
IRR lead to the same conclusion regarding project acceptability, the ranking of a set of projects
obtained from IRR does not necessarily agree with that produced using NPV. Since, in the latter
case, the ranking may vary according to particular discount rate used. Arguments about the merits
of the relative ranking in simple accept/reject situation is thus concerned with the question of
value. It is argued that the IRR measures only the quality of the investment while NPV takes into
account both the quality and the scale. This is because the IRR provides a relative measure of
value (% IRR) while the NPV provides an absolute measure (P surplus). (The IRR would rank, for
example, a 100% return on an investment of Re. | considerably higher than a 20% return on an
investment of P10M, whereas the reverse would be true using NPV as long as the cost of capital
is below 20 %.)

While one project may have a higher rate of profit per unit of capital invested than another, if it
has fewer units of capital. invested in it, may make a smaller contribution to the wealth of the firm.
Thus, if the objective is to maximize the firm’s wealth, then ‘the ranking of project NPVs provides
the correct measure. If the objective is to maximize the rate of profitability per unit of capital
invested, then IRR would provide the correct ranking of projects, but this objective could be
achieved by rejecting all but the most highly profitable projects. This is clearly unrealistic and,
therefore, one would conclude that NPV ranking is correct and IRR unsatisfactory as a measure
of relative project value. When two investment proposals are mutually exclusive, both methods
will give contradictory results. When two mutually exclusive projects are not expected to have the
same life, NPV and IRR methods will give conflicting ranking.

3. Profitability Index

The profitability index (PI) (also known as benefit/cost ratio present value desirability index) is the
ratio of the total present value of future cash inflows divided by its net investment. The index
expresses the present value of cash benefits as to an amount per peso of investment in a project
and is used as a means of ranking projects in a descending order of desirability. This is computed
as follows:

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

The PV Index is a relative measure of a project’s profitability whereas - NPV is an absolute

measure of the total present value of peso return. The PV Index converts the NPV statistic into a
rate-based metric.

Decision Rule:

The higher the PV Index the more desirable the project. Projects with _index of 1 or greater than
one should be accepted; otherwise the project is rejected. A project where PV Index is equal-to
or greater than one will maintain or enhance the wealth of the owners as reflected in the share
price of the firm’s ordinary equity share.

The advantages of using the PV Index are that

1. It considers the magnitude and timing of cash flows;
2. it provides an objective criterion for decision making which maximizes shareholder wealth; and
3. It provides a relative measure of return per peso of net investment

The disadvantage of using the PV Index is that conflict may arise with the NPV when dealing with
mutually exclusive investment.
4. Discounted Payback Period (DPB)

Discounted payback period is a capital budgeting method that determines the length of time
required for an investments cash flows, discounted at the investments cost of capital, to cover its
cost.

it is a method that recognizes the time value of money in a payback context. The periodic cash
flows are discounted using an appropriate cost of capital rate. The payback period is computed
by summing the present values of the cash flows until a cumulative sum of zero is arrived at.

What benchmark should the firm use after getting the DPB? Management will set the DPB
maximum allowable payback exogenously and once again after arbitrarily.

An advantage in using the DPB is it complements the Payback (unadjusted) by providing

additional information to analyze capital budgeting decisions that is; it indicates the time
necessary to recoup investment plus interest.

One flow however of the DPB is that the decision statistics completely ignore any cash flows that
accrue after the project reaches its respective type of payback benchmark. Ignoring this important
information can have significant implications when managers choose between.two mutually
exclusive projects that have very similar paybacks but different cash flows after payback is
achieved.

B. NON-DISCOUNTED CASH FLOW (UNADJUSTED) APPROACH

1. Payback Period

Payback period is the length of time required for a project’s cumulative net cash inflows to equal
its net investment. It measures the time required for a project to break even.

Advantages of Payback Period Method

1. It is easy to compute and understand.

2. It is used to measure the degree of risk associated with a project.
3. Generally, the longer the payback period, the higher the risk.
4. It is-used to select projects which provide a quick return of invested funds.

Disadvantages of the Payback Period Method

1. It does not recognize the time value of money.

2. it ignores the impact of cash inflows after the payback period.
3. It does not distinguish between alternatives having different economic lives.
4. The conventional payback computation fails to consider salvage value, if any.
5. It does not measure profitability - only the relative liquidity of the investment.
6. There is no necessary relationship between a given payback and investor wealth maximization
so an investor would not know what an acceptable payback is.

2. Bail-out Period

In conventional payback computations, investment salvage value is usually ignored. An approach

which incorporates the salvage value in payback computations is the “Bail-out period”. This is
reached when the cumulative cash earnings plus the salvage value at the end of a particular year
equals the original investment.

3. Payback Reciprocal

Payback Reciprocal measures the rate of recovery of investment during the payback period.

4. Accounting Rate of Return

Accounting rate of return (ARR) or simple rate of return is a measure of a project’s profitability.
from a conventional accounting standpoint by relating the required investment to the future annual
net income.
There are numerous ways to compute the ARR, but the most used way is to divide the project’s
average annual net income by its initial investment or average net investments. Average annual
net income is determined by summing the expected net incomes over the project’s life and dividing
by the total number of periods in the life of the project. Average net investment is assumed to be
one-half of the net investment.

Advantages of Using the ARR

1. It is easily understood by investors acquainted with financial statements.

2. It is used as a rough preliminary screening device of investment proposals.

Disadvantages of Using the ARR

1. It ignores the time value of money by failing to discount the future cash inflows and outflows.
2. It does not consider the timing component of cash inflows.
3. Different averaging techniques may yield inaccurate answers.
4. It utilizes the concepts of capital and income primarily designed for the purposes of financial
statements preparation and which may not be relevant to the evaluation of investment proposals.

CONCLUSION ON CAPITAL BUDGETING METHODS

In this chapter, we apply time value of money concepts to project valuation with the main goal of
finding projects that convey enough control power to the acquirer . thaf they are worth more than
they cost, even taking into account the cost of capital.

Of the capital budgeting techniques, NPV is the single best criterion because it provides a direct
measure of value the project adds to shareholder wealth, NPV works equally well with even as
well as uneven cash flows and with independent or mutually exclusive. projects. However,
additional capital budgeting techniques such as Internal Rate of Return, Payback Period, and
Discounted Payback Period may provide supplementary guidance whether to accept a project or
not. IRR for instance, measures profitability expressed as a percentage rate of return which is.
interesting to decision makers. It also contains information, concerning the project’s “safety
margin” and reinvestment rate assumption.

Payback and discounted payback provide indications of a project’s liquidity and risk. A long
payback means that investment pesos will be locked up for a long time, hence the project is
relatively illiquid. In addition, a long payback means that cash flows must be forecasted far out
into the future and that. probably makes the project riskier than one with a shorter payback.

In summary, the different measures provide different types of information. Since it is not too
difficult to calculate all of them, all should be considered when capital budgeting decisions are
being made. For most decisions, the greatest weight should be given to NPV but should also give
due consideration to the information provided by the other criteria.

SELECTION PROBLEMS

The three types of capital budgeting decisions are:

1. Accept — reject decisions
2. Mutually exclusive project decisions
3. Capital rationing decisions

1. ACCEPT — REJECT DECISION

This occurs when an individual project is accepted or rejected without regard to any other
investment alternatives.

Generally, as long as a firm has unlimited funds and only independent projects, all projects
meeting the minimum investment criteria should be accepted. Independent projects are those for
which the acceptance of one does not automatically eliminate the others from further
consideration. Using sophisticated capital budgeting techniques, such as NPV, PI, and IRR, to
evaluate single, independent projects with conventional cash flow patterns always leads to
identical accept-reject decisions and the maximization of shareholder wealth. The accept-reject
decision rules for capital budgeting techniques under certainty have already been stated, that is,
the decision maker knows in advance the future values of all information affecting the decision
have already been discussed.
2. MUTUALLY EXCLUSIVE PROJECTS DECISION

These are competing investment proposals that will perform the same function or task. The
acceptance of one or a combination of projects eliminates the Others from further consideration.

The ranking of mutually exclusive projects may conflict based on accept-reject decision rules.
Among the major reasons for conflicting rankings among mutually exclusive projects using
sophisticated or advanced capital budgeting techniques are:

1. Difference in expected economic lives of the projects;

2. Substantially difference in net investments (size) of the projects;
3. Difference in timings of cash flows; and
4. Difference in reinvestment rate assumptions in discounted cash flow techniques.

When conflicting ranking occurs, ‘the NPV is theoretically considered thie superior technique. The
reasons are:

1. NPV. method provides correct rankings of mutually exclusive investment projects, whereas
other DCF techniques sometimes do not.

2. NPV implicitly assumes that the operating cash flows generated by the project are reinvested
at the firm’s cost of capital which approximates the opportunity cost for reinvestment. The IRR
method assumes reinvestment at the IRR which may not be a realistic rate. Also, IRR uses
different reinvestment rates for each competing alternatives.

3. NPV does not suffer from the weakness of either the IRR or PV Index and leads to maximizing
shareholders’ wealth.

3. CAPITAL RATIONING DECISION

Optimal Capital Budget is the annual investment in long-term assets that maximizes the firm’s
value. For planning purposes, manager must forecast the total capital budget, because the
amount of capital raised affects the Weighted Average Cost of Capital (WACC) and thus
influences projects’ Net Present Values (NPVs).

It may be reasonable to assume that large, mature firms with good track records can obtain
financing for all its profitable projects. However, smaller firms, new firms and firms with dubious
track records may have difficulties raising capital even for projects that the firm concludes would
have highly positive NPVs. In such circumstances, the size of the capital may be constraint, a
situation called Capital rationing. Capital rationing is a situation where a constraint or budget
ceiling is placed on the total size of capital expenditures during a particular period.

Capital rationing can also be described as the selection of the investment proposals in a situation
of constraint on availability of capital funds, to maximize the wealth of the company by selecting
those projects which will maximize overall NPV (net present value) of the concern.

In capital rationing situation, a company may have to forego some of the projects whose IRR
(internal rate of return) is.above the overall cost of the firm _ due to ceiling on budget allocation
for the projects which are eligible for ' capital investment. Capital rationing refers to a situation
where a company . cannot undertake all positive NPV projects it has identified because of
shortage of capital. In terms of financing investment projects, the following - : important questions
to be answered:

1. What would be the requirement of funds for capital investment decisions in the forthcoming
planning period?
2. How much quantum of funds are available for capital investment?
3. How to assign the available funds to the acceptable proposals which require more funds than
are available?

The answers to the first and second questions are determined based on the capital investment
appraisal decisions made by the top management. The third question is answerable using specific
reference to the appraisal of investment decisions within the preview of capital rationing.
Under capital rationing, management has to determine not only the profitable investment
opportunities but also decides on the combination of profitable projects which generates the
highest NPV within the available funds by ranking them according to their relative profitability.

COMPARING PROJECTS WITH UNEQUAL LIVES

In previous examples, replacement decisions involved comparing two mutually exclusive projects:
retaining the old asset versus buying a new one. It is also assumed that the new equipment had
a life equal to the remaining life the old equipment. However, if we were deciding between two
mutually exclusive alternative with significantly different lives, an adjustment would be necessary.
This problem may be dealt with using any one of these procedures,

]. The replacement chain method and

2. The equivalent annual annuity method (EAA)

Replacement Chain (Common Life) Approach

This method compares project of unequal lines which assumes that each project can be repeated
as many times as necessary to reach a common life span. The Net Present Values (NPVs) over
this life span are then compared, and the project with the higher common life NPV is chosen.

Equivalent Annual Annuity (EAA) Approach

Another procedure, known as the equivalent annual annuity (EAA) method may also be used in
evaluating mutually exclusive projects with different lives.

Equivalent Annual Annuity (EAA) Method is a method which calculates the annual payments a
project would provide if it were an annuity. Generally, when comparing projects of unequal lives,
the one with the higher equivalent annual annuity should be chosen.