CAPITAL BUDGETING
(Learning Objectives 6-8)
Group Members:
Guillermo, Mica Moreen
Hernandez, Sophia Ivane
Rodil, Lyza Kate
Torzar, Princess Kristine Faye
A. Simple Rate of Return
ABC Company is looking at adding a stitcher that will add P40,000 to the revenues of the
company per year. The incremental (additional) cash operating expenses of this piece of
equipment would be P5,000 per year, and the equipment has a cost of P100,000 with a 5 year life
and no salvage value.
Annual incremental revenue
P40,000
Annual incremental operating expenses
P5,000
Annual depreciation (P100,000/5 years)
20,000
Annual incremental expenses
25,000
Annual incremental net operating income (loss)
P15,000
Simple rate of return = Annual incremental net operating income/Initial investment cost
= P15,000/P100,000
= 15%
B. The Mathematics of Interest
Assume Briatrix borrowed from Dianne and promised to pay 5% interest. How much will be
P100,000 be worth in one year?
𝐹𝑛 = 𝑃(1 + 𝑟)𝑛
𝐹𝑛 = 100,000(1 + 0.05)1
𝑭𝒏 = 𝑷𝟏𝟎𝟓, 𝟎𝟎𝟎
C. Compound Interest
If you have P100 and it earns 5% interest each year, how much money will you have at the end of
the second year?
𝐹𝑛 = 𝑃(1 + 𝑟)𝑛
𝐹𝑛 = 100(1 + 0.05)2
𝑭𝒏 = 𝑷𝟏𝟏𝟎. 𝟎𝟓
D. Present Value (discounting)
P7,000 for 3 years from now at 7% is worth how much today?
𝐹𝑛
𝑃=
(1 + 𝑟)𝑛
𝑃7,000
(1 + 0.07)3
𝑷 = 𝑷𝟓, 𝟕𝟏𝟒. 𝟎𝟗
Let’s verify that if we put P3,558.45 in the bank today at 7% interest that would grow to P7,000
at the end of 10 years.
Year 1
Year 2
Year 3
Beginning balance
P 5,714.09
6,114.08
6,542.07
Interest at 7%
399.99
426.99
457.94
Ending balance
P 6,114.08
6,542.07
7,000
𝑃=
E. Present Value of a Series of Cash Flows
Lancelot Company purchased a house on which a P10,000 payment will be due each year for the
next 3 years. What is the present value of this series of cash payments when the discount rate is
10%?
Present value of an annuity of 1 for 3 years: 2.4869
P10,000 x 2.4869 = P24,869
F. After-tax cost
1. A company incurs a tax-deductible cash expense of P5,000 and its tax rate is 30%. What is the
after-tax cost of this expense?
After-tax cost = (1 - Tax Rate) x Tax-deductible cash expense
= (1 - 0.30) x P5,000
= 0.70 x P5,000
After-tax cost = P3,500
2. A company receives a taxable cash receipt of P10,000 and its tax rate is 25%. What is the aftertax cost (net cash outflow) of this receipt?
After-tax cost (net cash outflow) = (1 - Tax Rate) x Taxable cash receipt
= (1 - 0.25) x P10,000
= 0.75 x P10,000
After-tax cost (net cash outflow) = P7,500
G. Depreciation Tax Shield
A company has purchased the asset amounting to P500,000 and depreciation is on straight-line
basis for 5 years i.e. depreciation per year is P100,000. The profit of the organization is P700,000.
Calculate the depreciation tax shield and the net operating profit. The applicable tax rate is 20%.
Depreciation Tax Shield = Depreciation x Applicable Tax Rate
= P100,000 x 20%
Depreciation Tax Shield = P20,000
H. Net Present Value Analysis including Income Taxes
Press Publishing Company hires students from the local university to collate pages on
various printing jobs. This collating is all done by hand, at a cost of $60,000 per year. A collating
machine has just come onto the market that could be used in place of the student help. The machine
would cost $140,000 and have a 10-year useful life. It would require an operator at an annual cost
of $18,000 and have annual maintenance costs of $7,000. New roller pads would be needed on the
machine in five years at a total cost of $20,000. The salvage value of the machine in 14 years would
be $40,000.
For tax purposes, the company computes depreciation deductions assuming zero salvage
value and uses straight-line depreciation. The collating machine would be depreciated over 10
years. Management requires a 10% after-tax return on all equipment purchases. The company tax
rate is 30%.
$ 60,000
Annual cost of student help in collating
Annual cost of new collating machine
Operator
18,000
Maintenance
7,000
(25,000)
$ 35,000
Net Annual Cost Saving
Items & Computation
Cost of new collating
machine
Annual Net Cost
Savings
Annual depreciation
deduction
Cost of new roller pads
Salvage value of new
machine
Net Present Value
Years
Amount
Now
$ (140,000)
1-10
35,000
1-10
14,000
Tax Effect
After-tax
Cash Flow
10% Factor
Present
Value
$ 140,000
1.000
$ (140,000)
1 – 0.30
24,500
6.1446
150,542.70
0.30
4,200
6.1446
25,807.32
-
5
(20,000)
1 – 0.30
14,000
0.6209
(8,692.60)
14
40,000
1 – 0.30
28,000
0.2633
7,372.40
$ 35,029.82