MAS 2 – 1304

FINANCIAL MANAGEMENT

Tactical planning – is the domain of middle managers (i.e., department heads, unit managers) that deals
with policies, standards, systems, procedures, and techniques concerning the short-term profitability
and liquidity of the business enterprise.

Strategic planning – happens at top-level management (i.e., Board of Directors, Chief Executive Officer,
Vice-Presidents) who exercise the power to define the direction, develop competitive advantage,
identify market niche and long-term focus of the business.

CAPITAL BUDGETING – Deals with analyzing the profitability and/or liquidity of a given project
proposal. It is premised on the following:
 Funds are available
 Business opportunities (i.e., project proposals) abound waiting to be tapped
 Business opportunities are subject to quantitative evaluation.

Several projects the need capital budgeting analyses includes replacement or expansion,
improvements or retention, and others such as research and development, exploration, new
projects and other similar strategic decisions.

Major concerns of capital budgeting:

 Net cost of investment
 Net returns
 Cost of capital
 Project Evaluation Techniques

Net cost of investment – refers to the net cash outflows, after tax considerations, which are normally
paid by investors in relation to the investing transaction. It includes opportunity cost such as possible
savings and tax effects on possible gain, loss or savings on related transactions.

NET COST OF INVESTMENT

CASH OUTFLOWS CASH INFLOWS
Net purchase price of the Direct Proceeds from sale or trade-in Direct cost
new asset (net of discount, cost allowance from disposal of old
whether taken or not.) asset.
Additional or incidental costs Direct Tax savings from loss on sale Indirect/future
paid or incurred to prepare cost of old asset cost
(i.e., ready) the asset for
use.
Increase in working capital Direct Savings from avoided repairs Indirect cost/
base. cost and maintenance, if the old opportunity
asset is replaced. cost
Additional tax paid or Indirect/
incurred in case of gain from future
sale or disposal of old asset cost
Additional tax paid from Indirect/
savings on avoided cost of future
repairs, if the old asset is cost
replaced.

The net cost of investment is the difference of the outflows and the inflows.

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Example 1.
NET COST OF INVESTMENT Co. plans to acquire a new equipment costing P 1,200,000 to replace the
equipment that is now being used. The terms of the acquisition are 3/30, n/90. Freight charges on the
new equipment are estimated at P23,000 and it will cost P14,000 to install. Special attachment to be
used with this unit will be needed and will cost P36,000. If the new equipments acquired, operation will
be expanded and this will require additional working capital of P250,000. The old equipment had an
amortized cost of P300,000 and will be sold for P180,000. If the new equipment is not purchased, the
old equipment must be overhauled at a cost of P90,000. This cost is deductible for tax purposes in the
year incurred. Tax rate is 35%. Compute the net investment in the new equipment for decision-making
purposes. 1,206,500

Net Returns

1. Net Cash Inflows (or net income)

2. Accounting net income
Indirect Method Direct Method
Cash flows from operations before taxe P x P x
Less: Depreciation expense x
Income before income tax x
Less: Income tax x x
NET INCOME x
Add back: Depreciation expense x __
NET CASH INFLOWS P x P x ..

Example 2.
NET CASH INFLOW Co. is planning to add a new product line to its present business. The new product
will require a new equipment costing P2,400,000 with a five-year life, no salvage value. The follwing
estimates are made available:
Annual sales P 12,000,000
Materials 4,400,000
Labor 2,200,000
Factory overhead (excluding depreciation on new equipment 1,300,000
Selling and administrative expenses 2,100,000
Income Tax rate 40%

Compute the net income and the net cash inflows. Net Income = 912,000; Net cash inflow = 1,392,000

COST OF CAPITAL

COST OF CAPITAL – is the cost of using funds; it is also called hurdle rate, required rate of return, cut-
off rate, opportunity cost of capital.
- The weighted average rate of return the company must pay to its long-term creditors and
shareholders for the use of their funds.

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 SOURCE CAPITAL COST OF CAPITAL
After-tax rate of interest i (1-
Creditors Long-term debt
tax rate)
Stockholders:

_Preferred dividends per share_

Preferred Preferred stock Current market price or Net
issuance price

Common Common stock CAPM or DDM

CAPITAL ASSET PRICING MODEL (CAPM)

R = RF + β(RM +RF)

where: R = rate of return

RF = risk free rate determined by government securities
Β = beta coefficient of an individual stock which is the correlation between the
volatility (price variation) of the stock market and the volatility of the price of
the individual stock.
RM = market return
(RM +RF) = market risk premium or the amount above risk-free rate required to induce
average investors to enter the market

THE DIVIDEND DISCOUNT MODEL ( of Dividend Growth Model)

a. Cost of Retained Earnings = D1

G
P0

where: P0 = current price

D1 = next dividend
G = growth rate in dividends per share (it is assumed that the dividend payout
ratio, retention rate, and therefore EPS growth rate are constant)

b. Cost of New Common Stock = D1

G
P0 (1 – flotation cost)

Flotation cost = the cost of issuing new securities

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Exercises
1.Abnoy corporation has sold P100 million of P1,000 par value, 10% coupon bonds. The bonds were
sold at a premium and the corporation received P1,200 per bond. If the corporate tax rate is 30%,
what is the after tax cost of these bonds for the first year?

2. Iya Corporation is selling P40 million of cumulative, non-participating preferred stock. The issue will
have a par value of P70 per share with a dividend rate of 8%. The issue will be sold to investors for
P80 per share, and issuance costs will be P5 per share. The income tax rate is 30%. What is the
cost of preferred stock of Iya corporation?

3. The preferred stock of C Corporation pays an annual dividend of P4.8. it has a required rate of return
of 8%.

Required: Compute the price of preferred stock.

4. D Corporation paid a dividend of P3.00 per share on its common stocks last year. Over the next 12
months, the dividend is expected to grow at 6%, which is the constant growth rate (g) for the firm.
The common stock currently sells for P50 per share.

Required: Compute the required rate of return on the common stock

5. F Corporation just paid a dividend of P4.00 per share on its stock. The dividends are expected to
grow at a constant rate of 7% per year, indefinitely.

Required: 1. If investors require a 12% return on F Corporation stocks, what is the current price?
2. What will the price be in two years?

6. Use the basic equation for the capital asset pricing model (CAPM) to work on each of the following:
a. Find the required rate of return for an asset with a beta of 1.20 when the risk-free rate and market
return are 7% and 12%, respectively.
b. Find the required rate of return for an asset with a beta of 0.80 when the risk-free rate of return is
6%, and the market risk premium is 4%
c. Find the beta for an asset with a required return of 7.4%, when the risk-free rate and market return
are 6% and 8%, respectively.

EVALUATING CAPITAL INVESTMENT PROJECTS

Commonly used methods of evaluating capital investment projects:
1. Methods that do not consider the time value of money
a. Payback
b. Bail-out
c. Accounting rate of return
2. Methods that consider the time value of money (discounted cash flow methods)
a. Net present value
b. Present value index
c. Present value payback
d. Discounted cash flow rate of return

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METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY

Net cost of initital investment the length of time required by the

PAYBACK
= = project to return the initial cost of
PERIOD Annual net cash inflows investment

Advantages:
1. Payback is simple to compute and easy to understand. There is no need to compute or
consider any interest rate. One just has to answer the question: “How soon will the
investment cost be recovered”?
2. Payback gives information about liquidity of the project.
3. It is good surrogate for risk. A quick payback period indicates a less risky project.

Disadvantages:
1. Payback does not consider the time value of money. All cash received during the payback
period is assumed to be of equal value in analyzing the project.
2. it gives more emphasis on liquidity rather than on profitability of the project. In other words,
more emphasis is given on return of investment rather than the return on investment.
3. It does not consider the salvage value of the project.
4. It ignores the cash flows that may occur after the payback period.

BAIL-OUT PERIOD – cash recoveries include not only the operating cash inflows but also the
estimated salvage value or proceeds from sale at the end of each year of the life of the
project.

ACCOUNTING RATE OF RETURN – also called book value rate of return, financial statement
method, average return on investment and unadjusted rate of return.

ACCOUNTING RATE OF Average annual net income

=
RETURN Investment

Advantages:
1. The ARR computation closely parallels accounting concepts of income measurement and
investment return.
2. It facilitates re-evaluation of projects due to the ready availability of data from the accounting
records.
3. This method considers income over the entire life of the project.
4. It indicates the project’s profitability.

Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not consider the time value of
money.
2. With the computation of income and book value based on the historical accounting data, the
effect of inflation is ignored.

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METHODS THAT CONSIDER THE TIME VALUE OF MONEY

NET PRESENT VALUE

Present value of cash inflows

-- Present value of cash outflows
Net Present value

Advantages:
1. Emphasizes cash flows
2. recognized the time value of money
3. assumes discount rate as the reinvestment rate
4. easy to apply

Disadvantages:
1. It requires predetermination of the cost of capital or the discount rate to be used.
2. The net present values of different competing projects may not be comparable because of
differences in magnitudes or sizes of the projects.

PROFITABILITY INDEX

Total present value of cash inflows

PROFITABILITY INDEX =
Total present value of cash outflows

DISCOUNTED CASH FLOW RATE OF RETURN – the rate of return that equates the present
value (PV) of cash inflows to PV of cash outflows.

1. Determine the present value factor (PVF) for the discounted cash flow rate of return (DCFRR)
with the use of the following formula:

Net cost of investment

PVF for DCFRR =
Nest cash inflows

2. Using Table 2 (present value annuity table), find on line n (economic life) the PVF obtained in
Step 1. The corresponding rate is the DCFRR.

Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes true return of project

Disadvantages:
1. Assumes that the IRR is the re-investment rate
2. When project includes negative earnings during their economic life, different rates of return
may result.

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 PAYBACK RECIPROCAL - a reasonable estimate of the discounted cash flows rate of return,
provided that the following conditions are met:
1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.

Net cash inflows

PAYBACK RECIPROCAL =
Investment

Or

1
PAYBACK RECIPROCAL =
Payback period

Examples

1. BAILOUT METHOD
A Company purchased a new machine on January 1 of this year for P90,000, with an
estimated useful life of 5 years and a salvage value of P10,000. The machine will be depreciated
using the straight-line method. The machine is expected to produce cash flow from operations, net
of income taxes, of P36,000 a year in each of the next five years. The new machine’s salvage
value P20,000 in years 1 and 2, and P15,000 in years 3 and 4.

Required: Compute the bailout period for this new machine.

The following data are made available to you:

2. BAILOUT METHOD
Cost of Investment – P150,000
Cash inflows:
Year Net Operating Cash Inflows Salvage Value
1 P 40,000 P 100,000
2 30,000 70,000
3 25,000 60,000
4 20,000 50,000
5 20,000 30,000
6 20,000 10,000

Required: Compute the bailout period for this investment.

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3. ACCOUNTING RATE OF RETURN METHOD
A company is planning to acquire a new machine that will cost P60,000. This machine is
expected to generate net income of P12,000 per year. No salvage value is expected to be
recovered at the end of its useful life of ten years.

Required: Compute the Accounting Rate of Return

4. ACCOUNTING RATE OF RETURN AND PAYBACK METHOD

Harbor Port Services creates and maintains shipping channels at various ports around the
world. The company is considering the purchase of a P140 million ocean-going dredge that has a
5-year life and no salvage value. The company depreciates assets on a straight-line basis. The
expected annual cash flow on a before-tax basis for this equipment is P50 million. Harbor requires
that an investment be recoup in less than 3 years and have an accounting rate of return of at least
15 percent. The tax rate is 30%.

Required: Compute the payback period and the accounting rate of return for this equipment.

5. NET PRESENT VALUE METHOD

Alberto Go Oil Mills, Inc. is contemplating the purchase of a new equipment that will cost
P350,000. It is expected to generate cash inflows, net of income taxes in the amount P120,000
per year during its economic life of 5 years. No salvage value is expected to be recovered at the
end of the 5th year. Alberto Go’s cost of capital is 20%.
The present value factor per year is as follows:
Year Present Value Factor
1 0.833
2 0.694
3 0.579
4 0.482
5 0.402

Required: Compute the net present value of the new equipment.

6. NET PRESENT VALUE METHOD

Managers of LSR Electric are considering whether to increase capacity for one of their
products. Expanding capacity by 100,000 units will require equipment costing P6,000,000 and
having a five-year economic life with no salvage value. The new machinery will increase annual
cash fixed costs by P2.80 million. If they do increase capacity, they expect annual sales to
increase by 100,000 units. The unit sells for P80. Unit variable costs are P30. The company has a
10% cost of capital and an income tax rate of 30%.

Required: Compute the net present value (NPV) of the investment.

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7. Meemon Company is evaluating a capital investment proposal that will require an initial cash
investment of P250,000. The project will have a three-year life. The net after tax cash flows from
the project are expected to be P130,000 in the first year, P90,000 in the second year, and
P70,000 in the third year. Salvage value of P 5000 is expected to be received at the end of the life
of the project. The straight line method will be used to depreciate the project. Income tax rate is
30%, and the company’s cost of capital is 12%.

Required: What is the net present value?

8. DI Corporation gathered the following data on two capital investment opportunities:

Hand-Fed Machine Semi-Automatic Machine
Cost of investment P800,000 P1,400,000
Discount rate 14% 14%
Net cash inflows P365,000 P590,000

For the coming period, the available fund for capital investment is P1,600,000 only. Both machine
have 4-year lives and no anticipated salvage value. The company uses straight line depreciation
and has a 30% income tax rate.

Required: 1. Which alternative has the higher net present value?

2. Using the profitability index method, which alternative is more attractive?

9. A new machine costing P40,000 with three years useful life, no salvage value at the end of three
years, is expected to bring in the following cash inflows after tax:
First year P30,000
Second year 25,000
Third year 10,000

Required: If the company’s cost of capital is 20%, what is the discounted payback period?

10. IRR Company is considering to buy a new machine requiring an immediate P20,000 cash outlay.
The new machine is expected to increase annual net after tax cash receipts by P8,000 in each of
the next 5 years of its economic life. No salvage value is expected at the end of 5 years. The
company desires a minimum return of 10% on invested capital.

Required: Internal rate of return.

11. A new machine costing P18,000 with three years useful life, no salvage value at the end of three
years, is expected to bring in the following cash inflows after tax:
First year P10,000
Second year 8,000
Third year 5,000

Required: Determined the time-adjusted rate of return.

12. Owu Company is planning to buy an equipment costing P600,000, which has an estimated life of
20 years and is expected to produce after-tax net cash inflows of P120,000 per year.

Required: Estimate the discounted cash flow rate of return without using present value factors.

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