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