Sheet1EXERCISE ON CAPITAL BUDGETING

1. NET INVESTMENT FOR DECISION-MAKINGCash Outlay:Purchase Price of new equipment200,000.00Less: Cash Discount (2% of 200K)4,000.00196,000.00Shipping, installation and testing costs14,000.00Addtl Working Capital18,000.00Total Cash Outlay228,000.00Cash Inflow:Proceeds from sale of old equipment75,000.00Less: Tax to be paid from gain on sale (outflow)(75,000-65,000)*25%2,500.0072,500.00*There is a gain on sale of equipment. Thus, tax has to be paid.Proceeds from sale of other assets10,000.00Add: Tax savings (tax benefit)*Because there is a loss on sale of assets, no tax has to be paid. Thus, there is a tax savings on sale of assets.(10,000-12,000)*25%500.0010,500.0083,000.00NET INVESTMENT145,000.00

2. WEIGHTED AVERAGE COSTS OF CAPITAL (WACC)A. EARNINGS PER SHARE (EPS)EPS=Net Income Available for Common StockholdersCommon shares Outstanding=Net Income - Required Return for Preferred StockholdersCommon shares Outstanding=500,000 - (200,000 * 5%)10,000 shares=500,000 - 10,00010,000 sharesEPS=49.00per share

B. WEIGHTED AVERAGE COST OF CAPITAL (WACC)ABAxBSourcesAmountWeightCostsWACCBonds (Debt)600,000.000.306%2%Preferred Stock (PS)200,000.000.1010%1%Common stock and retained earnings1,200,000.000.609%5%Total2,000,000.008%WACC

Cost Debt=Interest rate * (1 - Tax rate)=8% * (1 - 30%)=6%Cost of PS=Dividend Requirement/No. of PSPS Market Price per share=(5% * 200,000) / (200,000/100 par)50=5.0050.00=10%Cost of CS and RE=Dividend per share+Growth rateMP per share=2.00+4%40.00=5%+4%=9%

3. NET RETURNS (INCREASE IN REVENUE)A. INCREASE IN ANNUAL NET INCOMESales150,000.00Variable Costs60,000.00Fixed Costs20,000.00Depreciation40,000.00120,000.00Earnings Before Income Tax (EBIT)30,000.00Less: Income Tax9,000.00Net Income21,000.00

B. ANNUAL CASH INFLOWSNet Income21,000.00Add: Depreciation40,000.00Cash Inflows61,000.00

4. PAYBACK PERIOD AND ACCOUNTING RATE OF RETURNA. PAYBACK PERIODSolve for the Cash Savings after tax

Pre-Tax Cash Savings40,000.00Less: DepreciationCost of Equipment90,000.00Less: Salvage Value10,000.00Depreciable Cost80,000.00Divided by: Useful Life of asset810,000.00Earnings before Income Tax (EBIT)30,000.00Less: Income Tax (40% of 30,000)12,000.00Net Income18,000.00Add: Depreciation10,000.00After-tax Cash Savings (Cash Flow)28,000.00Payback Period=Cost of InvestmentAnnual Cash Inflow=90,000.0028,000.00Payback Period=3.21

B. ACCOUNTING RATE OF RETURN ON ORIGINAL INVESTMENTARR=Net IncomeInvestment=18,000.0090,000.00ARR=20%

B. ACCOUNTING RATE OF RETURN ON AVERAGE INVESTMENTARR=Net IncomeAve. Investment=18,000.00(90000 + 0)/2ARR=40%

5. PAYBACK PERIOD AND ACCOUNTING RATE OF RETURNA. PAYBACK PERIOD IN MONTHSTotal Investment = P 90,000.00Cash FlowsYear 1Year 2Year 3

40,000.0035,000.0030,000.00

75,000.00Total Cash Flows after 2 yrs.

105,000.00Total Cash Flows after 3 yrs.* If total Cash Flows is 75,000 after two years and 105,000 after three years, thentotal Investment amounting to 90,000.00 can be recovered between the 2nd and3rd year (90,000 is between 75,000 and 105,000).Thus,Total Investment90,000.00Less: Total Cash Flows of two yrs.75,000.00Amount not yet recovered after 2 yrs.15,000.00Divided by: CF of 3rd yr.30,000.000.50

Payback Period = 2+ 0.5 =2.5 years orPayback Period = 30months

B. BOOK RATE OF RETURN

6. NET PRESENT VALUECash Inflows before Tax11,000.00Less: DepreciationCost of Equipment28,000.00Less: Salvage Value4,000.00Depreciable Cost24,000.00Divided by: Useful Life of asset46,000.00Earnings before Tax5,000.00Less: Tax (20%)1,000.00Earnings after Tax4,000.00Add: Depreciation6,000.00Cash Inflows after Tax10,000.00

Year 0PV FactorYear 1Year 2Year 3Year 4Total Investment(28,000.00)PV of Cash Inflows:Year 18,000.000.80010,000.00Year 26,400.000.64010,000.00Year 35,120.000.51210,000.00Year 44,100.000.41010,000.00Total PV of Cash Inflows23,620.00Net Present Value(4,380.00)

7. NPV, PROFITABILITY INDEX & INTERNAL RATE OF RETURNProject 1Project 2(Assume Net Cash Inflows of Project 2 decline 20,000.00 annually)A. NPVB. NPVCost of Investment(195,000.00)Cost of Investment(150,000.00)PV of Cash InflowsPV of Cash Inflows:Net Cash Inflows100,000.00Year 1100,000.00x0.90990,900.000PV Factor2.487248,700.00Year 280,000.00x0.82666,080.000Net Present Value53,700.00Year 360,000.00x0.75145,060.000202,040.000Net Present Value52,040.000C. Profitability IndexProfitability Index=PV of Cash InflowsD. Profitability IndexCost of InvestmentProfitability Index=PV of Cash Inflows=248,700.00Cost of Investment195,000.00=202,040.00Profitability Index=1.28150,000.00Profitability Index=1.35

8. DISCOUNTED & NON-DISCOUNTED CAPITAL BUDGETING TECHNIQUESA. PAYBACK PERIODPayback Period=Cost of InvestmentCash Inflows=400,000.00160,000.00Payback Period=2.50years

B. ARRAccounting Rate of Return=Net IncomeCost of Investment=Cash Inflows + DepreciationCost of Investment=240,000.00400,000.00ARR=60%

C. NET PRESENT VALUECost of Investment(400,000.00)PV of Cash Inflows:Annual Cash Inflow160,000.00PV Factor3.433549,280.003.4330809689Net Present Value149,280.00

D. PROFITABILITY INDEXProfitability Index=PV of Cash InflowsCost of Investment=549,280.00400,000.00Profitability Index=1.373

E. INTERNAL RATE OF RETURN (The rate where Cost of Investment is equal to PV of Cash Inflows)Let X = PV Factor400,000.00=160,000.00 XX=2.50If PV Factor = 2.500, thenInterpolationPV Factor28%2.5320.0320.049?2.50029%2.483IRR=28%+0.0321%0.049=28%+0.653%

IRR=28.653%

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