COURSE MAS 5: STRATEGIC BUSINESS ANALYSIS

DEVELOPER AND Principal Authors:

THEIR BACKGROUND Derick S. Figueroa, CPA, CTT, MBA.
Email address: drsfigueroa@tsu.edu.ph

Olivette P. Flores, CPA

Email address: opflores@tsu.edu.ph

Editor:
Henry D. Rufino, CPA, MBA
Chairperson, Accountancy and Accounting Technology Department
Email address:hdrufino@tsu.edu.ph

COURSE The objective of this course is to advance the learning of the students in financial management in relation to business
DESCRIPTION planning and management accounting. The course will start with the budgeting process: both operational and
financial budgeting. Long-term or capital budgeting will then be tackled afterwards. It will cover next the management
accounting and advisory practice environment. Updates and recent trends in Management Accounting and Advisory
shall be integrated in this course. Business planning will be reviewed among areas of various business aspects such
as Marketing, Economic Aspect, Organization and Management, Production and Operations Management, Legal
and Environmental and Financial Accounting and Management Aspect. The final requirement of this course is a
business plan or a feasibility study or a consultancy service recommendation proposal .
COURSE OUTLINE 1. The Operational and Financial Budgeting Process
2. Capital Budgeting Techniques, The Capital Structure and The Weighted Average Cost of Capital (WACC)
Concept
3. The Management Accounting and Consultancy
4. Updates and Recent Trends in Management Accounting and Advisory/Consultancy
5. Business Aspects and their Relationship

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CHAPTER # 2

TITLE CAPITAL BUDGETING TECHNIQUES, THE CAPITAL STRUCTURE AND THE WEIGHTED AVERAGE COST OF CAPITAL
(WACC) CONCEPT
RATIONALE Capital expenditures relates to acquisition of long term assets and investments. Since a company’s resources are limited,
choosing the best asset to purchase is a challenge. The funds to be spent on a certain asset shall meet the required or desired
return by the business for it to be justified, otherwise, it is not a worthy investment. Capital budgeting techniques will help the
management choose the correct asset to spend the money with.

In financial management and management accounting point of view, business resources generally comes from two broad
financing: the internal financing and the external financing. Internal financing means that sources of funds are from investors or
owners by issuance of shares of stocks or by using retained fund or assets through retained earnings. While, external financing,
on the other hand relates to borrowing of funds through a financial loan or issuance of debt securities. This chapter focuses on
choosing the ideal capital structure, taking into consideration the required return from these two sources of capital. The weighted
average cost of capital is the basis of the average return needed to answer the desired rate return of the capital providers.
INSTRUCTION TO THE This module is designed to be comprehensive yet concise enough to include all relevant principles, rules and concepts. Further
USERS readings as to items that are critical in understanding the whole course shall be included here for student’s strong knowledge
foundation.

For complete discussion of the topic on hand, it will be beneficial to watch the following discussion videos provided by iCPA, an
organization focused on helping Accountancy Students in the Philippines. The discussion is in Tag-lish. This will be better for
easy understanding on your part.

Basic Concepts https://www.youtube.com/watch?v=Vlt7W7BA534

Elements of Capital Budgeting https://www.youtube.com/watch?v=n_KxNHoMnh4

Techniques in Capital Budgeting Part 1 (Non-discounted) https://www.youtube.com/watch?v=2zEOkt2OyW8

Techniques in Capital Budgeting Part 2 (Discounted) https://www.youtube.com/watch?v=qKGRCnAwsmM

Investment Decisions and Capital Rationing https://www.youtube.com/watch?v=nvX0M9WRZsA

Also, to review the concepts of Capital Structure and Weighted Average Cost of Capital as part of the course MAS 3: Financial
Management, you may also view the following video discussions provided by iCPA:

Basic Concepts https://www.youtube.com/watch?v=u_H1algvI0Y

Advanced Concepts https://www.youtube.com/watch?v=gKfTRJWAChM

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PRE-TEST
LEARNING At the end of this chapter, students are expected to explain and demonstrate mastery of the:
OBJECTIVES 1. The capital budgeting techniques used in investing and prioritizing capital assets.
2. The importance of capital structure in decision making regarding financing.
3. The concept of weighted average cost of capital and how to compute for it.
CONTENT In preparing the budgeted cash flow in financial budgeting, plan of acquisition of fixed assets and investments may be
PREPARATORY incorporated under investment activities. Also, financing activities, will include plans of the management for borrowings through
ACTIVITIES bank loans and issuance of debt securities. It is therefore imperative that completion of the financial budgeting process will be
done only after complete understanding of the concepts of capital budgeting techniques, capital structure and weighted average
costs of capital.

DEVELOPMENTAL ACTIVITIES
CAPITAL BUDGETING
- Is the process by which management identifies, evaluates, and makes decision on capital investment projects of an organization. It is the process of
planning expenditures for assets, the return on which are expected to continue beyond one-year period.

Capital Investment involves significant commitment of funds to receive a satisfactory return (either increase in revenue or reduction in costs) over an extended
period of time.

CAPITAL INVESTMENT FACTORS:

Net Investments (for decision-making purposes)

 Costs less savings incidental to the acquisition of the capital investment projects
 Cash outflows less cash inflows incidental to the acquisition of the capital investment projects

Costs or cash outflows

1. Purchase price of the asset, net of related cash discount
2. Incidental project-related expenses such as freight, insurance, handling, installation, test-runs, etc.
CONSIDER ALSO THE FOLLOWING, If any:
 Additional working capital needed to support the operation of the project at the desired level.
 Market value of existing idle assets to be used in the operation of the proposed capital project.
 Training cost, net of related tax

Savings or Cash inflows

Proceeds from sale of old asset disposed, net of related tax
CONSIDER ALSO THE FOLLOWING, If any:
 Trade-in value of old asset
 Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax

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Illustrative Problem #1: Bag-You Company plans to replace a unit of equipment that was acquired three (3) years ago and is now recorded at a net book value
of P 65, 000. This equipment can be sold now for P 75, 000. Tax rate is 25%.

New equipment can be acquired from Bee-Cool Company at a list price of P 200,000. Bee-Cool will grant a 2% cash discount if the equipment is paid for within
30 days from acquisition date. Shipping, installation and testing charges to be paid are estimated at P 14, 000.

Other assets with a book value of P 12, 000 that are to be retired as a result of the acquisition of the new machine can be salvaged and sold for P 10, 000.
Additional working capital of P 18, 000 will be needed to support operations planned with the new equipment.

How much is the initial cost of net investments for decision-making purposes?

Suggested Answer
Cash Outflows Cash Inflow
Purchase Price, net of discount 196,000 Proceeds from sale of equipment 75,000
Shipping, Installation and Testing 14,000 Tax effect on gain (10, 000 * 25%) (2,500)
Additional Working Capital 18,000 Proceeds from sale of other assets 10,000
Total cash outflows 228,000 Tax savings due to loss (2, 000* 25%) 500
Total cash inflows 83,000
Net Investment (228, 000 - 83, 000) 145,000

Illustrative Problem #2: The management of Star-Luck Cinema plans to install coffee vending machines costing P 200, 000 in its movie house. Annual sales of
coffee are estimated at 10, 000 cups at a price of P 15 per cup. Variable costs estimated at P 6 per cup, while incremental fixed cash costs, excluding
depreciation, at P 20, 000 per year. The machines are expected to have a service life of 5 years, with no salvage value. Depreciation will be computed on a
straight-line basis. The company’s income tax rate is 30%.

REQUIRED: Assuming that the vending machines are installed, determine:

a. The increase in annual net income.
b. The annual cash inflows that will be generated by the project.

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 Suggested Answers
A. B.
Sales (P15*10, 000 cups) 150,000 Increase in annual income 21,000
Variable Costs (P6*10, 000) 60,000 Add back depreciation* 40,000
Fixed Costs excluding Depreciation 20,000 Annual net cash inflow 61,000
Depreciation (P200, 000/ 5 years) 40,000
*depreciation is a non-cash expense but produces tax
Net income before tax 30,000
shield for the company
Income Tax expense (30%) 9,000
Income after tax (increase in annual income) 21,000

CAPITAL BUDGETING TECHNIQUES IN EVALUATING PROJECTS

A. Non-discounted methods – methods that do not consider the time value of money
1. Payback period method
2. Bail-out payback method
3. Accounting rate of return method
4. Payback reciprocal method

B. Discounted method – methods that consider the time value of money

1. Net present value method
2. Profitability index method
3. Internal rate of return method
4. Present value payback method

NON-DISCOUNTED TECHNIQUES: METHODS THAT IGNORE TIME VALUE OF MONEY

PAYBACK PERIOD- It uses the net after tax cash flows provided every year of the investment as if it was a recovery of the net initial costs of investment. The
smaller the number of years or time computed, it would be better. It means that the amount invested in the project is recovered faster.

PAYBACK PERIOD = Net initial cost of investment

Annual net after-tax cash inflows

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Advantages:
(1) Payback is simple to compute and easy to understand (2) Gives information about the liquidity of the project. (3) It is good surrogate for risk. A quick or short
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 equal value of 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 cash flows that may occur after payback period (short-sighted)

BAIL-OUT PAYBACK PERIOD - a modified payback period method wherein cash recoveries include the estimated salvage value at the end of each year of
the project life.

ACCOUNTING RATE OF RETURN- also known as simple rate of return, book value rate of return, FS rate of return. It uses the accounting income instead of
the net cash flow as a basis of measuring return. It ignores the timing of inflow of cash. The higher the rate computed, the better. This measures the ability of
the project to produce accounting income.

ACCOUNTING RATE OF RETURN = Average annual net income

Investment (original or average)

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

Disadvantages:
1. Like traditional payback 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 cost accounting data, the effect of inflation is ignored.

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

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 PAYBACK RECIPROCAL = 1 Payback
period

DISCOUNTED TECHNIQUES: METHODS THAT CONSIDER THE TIME VALUE OF MONEY

NET PRESENT VALUE (NPV)- measures the difference between the net cash inflows and the newt cash outflows.

NET PRESENT VALUE (NPV) = Present value of cash Inflows – Present value of cash Outflows

 Cash inflows include cash infused by the capital investment project on a regular basis (e.g., annual cash inflows) and cash realizable at the end of
the capital investment project. (e.g., salvage value, return of working capital requirements)
 The net investment cost required at the inception of the project usually represents the present value of the cash outflows.

Advantages:
(1) Emphasis cash flows (2) Recognizes the time value of money and (3) Assumes discount rate as reinvestment rate.

Disadvantages:
(1) It requires determination of the costs 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.

THE PROFITABILITY INDEX METHOD is designed to provide a common basis of ranking alternatives that require different amounts of investment.
Profitability index method is also known as desirability index, present value and benefit cost ratio.

PROFITABILITY INDEX = Present value of cash inflows NPV INDEX = NPV___

Present value of cash outflows Investment

INTERNAL RATE OF RETURN - is the rate of return that equates the present value of cash inflows to present value of cash outflows. It is also known as
discounted cash flow rate of return, time-adjusted rate of return of sophisticated rate of return.

Guidelines in determining IRR:

1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of the following formula:

PVF for IRR = Net investment cost

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 Net cash inflows

2.Using the present value annuity table, find on line `n’ (economic life) the PVF obtained in No. 1. The corresponding rate is the IRR. If the exact rate is not
found on the PVF table, `interpolation’ process may be necessary.

Advantages:
(1) Emphasis cash flows (2) Recognizes the time value and (3) Computes true return of project

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

DISCOUNTED PAYBACK PERIOD- uses the same concept as the payback period but discounts the annual after tax cash inflows using the discount rate.

Illustrative Problem #3: FIG Company is considered the purchase of a machine, machines A and B are available for $80,000 each. Earnings after taxation are:

Year Machine A Machine B

1 24,000 8,000
2 32,000 24,000
3 40,000 32,000
4 24,000 48,000
5 16,000 32,000

Evaluate the two alternatives according to (a). Payback Method, (b). Accounting Rate of Return Method and (c). Net Present Value Method (discount rate-10%)

A. Payback Period
Suggested Solution
A B
Amount to be recovered 80,000 80,000
Cash recovered in Y1 24,000 8,000
Amount still to be recovered 56,000 72,000
Cash recovered in Y2 32,000 24,000
Amount still to be recovered 24,000 48,000
Cash recovered in Y3 40,000 32,000

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 Amount still to be recovered - 16,000
Cash recovered in Y4 24,000 48,000
- -
Payback period 2.6 years 3.33 years
2 years, 7 months 3 years, 4
and 6 days months
*Machine A is the better choice in Payback Period

B. Rate of return on Investment Method

Particular Machine A Machine B

Total Cash Flows 136,000 144,000

Average Annual Cash Flows 136,000 / 5 = 27,000 144,000 / 5 = 28,800

Annual Depreciation 80,000 / 5 = 16,000 80,000 / 5 = 16,000

Annual Net Savings 27,200 – 16,000 = 11,200 28,800 – 16,000 = 12,800

Average Investment 80,000 / 2 = 40,000 80,000 / 2 = 40,000

ROI = (Annual Net Savings / Average

(11,200 / 40,000) x 100 (12,800 / 40,000) x 100
Investments) x 100

Average Rate of Return = 28% = 32%

*Machine B is the better choice using Accounting Rate of Return

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C. Net Present Value Method
Year Discount Factor Machine A Machine B

(at 10%) Cash Flows ($) P.V ($) Cash Flows ($) P.V ($)

1 .909 24,000 21,816 8,000 7,272

2 .826 32,000 26,432 24,000 19,824

3 .751 40,000 30,040 32,000 24,032

4 .683 24,000 16,392 48,000 32,784

5 .621 16,000 9,936 32,000 19,872

136,000 104,616 144,000 103,784

Net Present Value = Present Value – Investment

Net Present Value of Machine A: $1,04,616 – $80,000 = $24,616
Net Present Value of Machine B: $1,03,784 – 80,000 = $23,784

Using the Net Present Value Method (NPV), Machine A will be the better choice as its Net Present Value is higher than that of Machine B.

Illustrative Problem #4: BAIL-OUT PAYBACK PERIOD

A project costing P 180, 000 will produce the following annual cash flows and salvage value:
Year Cash Flows Salvage Value
1 P 50, 000 P 65, 000
2 P 50, 000 P 50, 000
3 P 50, 000 P 35, 000
4 P 50, 000 P 20, 000

Compute for the bail-out payback period.

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 Suggested Answer
Cumulative Cash flow
At the end of Year Salvage Value Cumulative Payback
from operation
1 50,000 65,000 115,000
2 100,000 50,000 150,000
3 150,000 35,000 185,000

In bail-out payback period, the salvage value is an assured cash inflow, therefore, the cash flow from operation will be
used to compute for the fractional period of recovery.
2 years, 3 months
2 years + (15, 000 / 50, 000)= 2.3 years
and 18 days

Illustrative Problem #5: PAYBACK RECIPROCAL (Estimating IRR)

Live-Biz Company is planning to buy an equipment costing P 640, 000 that has an estimated life of 30 years and is expected to produce after-tax net cash
inflows of P 128, 000 per year. Without using present value factors, estimate the IRR

Suggested Answer
Payback Period= 640, 000 / 128, 000 5 years

Payback Reciprocal*= 1
20%
( 1 / Payback Period) 5

*Recall that payback reciprocal can be used to estimate the IRR as long as, the useful life of the asset is at least twice the payback period and the net cash
inflow are uniform in amount.

CAPITAL STRUCTURE

Refers to the particular combination of debt and equity used by a company to finance its overall operations and growth. Debt comes in the form of bond issues
or loans, while equity may come in the form of common stock, preferred stock, or retained earnings.

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Types of Capitalization Structures
Firms can either issue either more debt or equity to fund its operations. By issuing equity, firms give up some ownership in the company without the need to pay
back investors; by issuing debt, companies increase their leverage by needing to pay back investors. A company's debt-to-equity ratio is a measure of risk for
investors.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

- also referred as the minimum rate of return, cut-off rate, target rate, desired rate of return, standard rate, and hurdle rate. The weighted average cost of capital
(WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock,
preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.
SOURCES COSTS
Debt Interest rate (after tax)*
Preferred Stock (PS) Dividend yield**
Common Stock (CS) Dividend yield plus growth rate
Retained Earnings (RE) Dividend yield plus growth rate

*The after-tax cost of debt is computed by

After tax cost of debt = Debt Interest Rate X (1- Tax Rate)

**Dividend yield on the other hand is computed as:

Cost of CS and RE = expected cash dividend

market price per common share + dividend growth rate

 The dividend growth rate is applied to common shares and retained earnings but not to preferred shares and assumed to be constant over time.
 In computing cost of CS & PS, the market should be net of flotation costs (e.g., underwriting fees) but ignored in computing the cost of RE.
 Alternatively, the cost of equity capital may be computed based on Capital Asset Pricing Model (CAPM)

Computation of the Weighted Average Cost of Capital (WACC) Step by Step Procedure

1. Compute for the percentage of capital arising from debt and percentage of capital arising from equity accounts separately.
2. Compute for the cost of capital of the debt financing and the cost of capital of the equity financing separately.
3. Finally, the computed percentage in Step 1 is multiplied to the cost of the capital in Step 2, then added. Simply stated, it is:

Weighted Average Cost of Capital (WACC)= (Percentage of Debt X Cost of debt) + (Percentage of Equity X Cost of equity)

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For the complete formula, it can be expressed as:

WACC= (% of debt X cost of debt) + (% of PS X cost of PS) + (% of CS X cost of CS) + (% of RE X cost of RE)

Illustrative Problem: The COVIDUVY Company wants to determine the weighted average cost of capital that it can use to evaluate capital investment
proposals. The company’s capital structure with corresponding market values follows:
8% Term Bonds 600, 000
5% Preferred stock (P 100 par) 200, 000
Common stock (no par, 10, 000 shares outstanding) 400, 000
Retained earnings 800, 000
TOTAL P 2, 000, 000

 Current market price per share: Preferred stock: P120 Common stock: P45
 Expected common dividend: P 2 per share
 Dividend growth rate: 4%
 Corporate tax rate: 30%

a. Given an operating income of P 500, 000, how much is the earnings per share?
b. Determine the weighted average cost of capital.

Suggested Answer
A. B.
Operating Income 500,000 After tax cost of debt (8%*(1-30%)) 5.60%
Less: Interest Expense (600, 000* 8%) 48,000 Cost of PS (P5per share / P120 per share) 4.17%
Net Income before tax 452,000 Cost of CS and RE (P2per share/P45per share)+ 4% 8.44%
Income tax expense (30%) 135,600
Net income after tax 316,400 Capital Structure
Preference Dividends (200, 000*5%) 10,000 Debt (600, 00/ 2, 000, 000) 30%
Earnings available for common shareholders 306,400 PS (200, 000/2, 000, 000) 10%
Common shares outstanding 10,000 CS and RE (1, 200, 000/ 2, 000, 000) 60%
Earnings per share 30.64

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 Weighted Average Cost of Capital (WACC)
(5.60%*30%)+(4.17%*10%)+(8.44%*60%) = 7.16%

CLOSURE ACTIVITIES As a take-home exercise, students are advised to answer this problem:

Exercise Problem#1: DISCOUNTED & NON-DISCOUNTED CAPITAL BUDGETING TECHNIQUES

Metro-Magic Mall is considering buying a new machine, requiring an immediate P 400, 000 cash outlay. The new machine is
expected to increase annual net after-tax cash receipts by P 160, 000 in each of the next five years of its economic life. No
salvage at the end of 5 years. The company desires a minimum return of 14% on invested capital. Round-off factors to 3
decimal places in all cases. Determine the ff:
a. Payback period
b. ARR (based on original investment)
c. Net present value
d. Profitability index
e. Internal rate of return

Answer to this take home activity will be uploaded or provided before the next chapter of the course will be discussed.

SYNTHESIS/  In choosing or prioritizing the most advantageous investment, capital budgeting techniques can be used.
GENERALIZATION  Payback period, bailout period, Accounting Rate of return ignores time value of money element
 Net Present Value and Internal Rate of Return considers time value of money.
 The ideal capital structure shall be determined appropriately for purposes of financial management and leveraging.
 Every source of fund requires return which is referred to as “cost of capital”
EVALUATION The following questions shall now be answerable by the students:
1. What are the different techniques used in capital budgeting? Explain their advantages and disadvantages.
2. How would one company’s capital structure affects financing decisions?
3. How do you compute for the cost of capital under debt financing and equity financing?
ASSIGNMENT / Students should conduct research and answer the following questions:
AGREEMENT 1. Which is a better basis in prioritizing project, Net Present Value or Internal Rate of Return? Explain by citing concepts.
2. Advantages and disadvantages of debt financing and equity financing respectively.
SUGGESTED READINGS Investopedia.com/ Capital-Budgeting
Capital Budgeting, Roque, 2007e
Capital Budgeting, Financial Management, Balatbat- Cabrera 2016e
Operating and Financial Leverage, Balatbat-Cabrera, 2016e
Capital Budgeting, Management Advisory Services, Agamata 2016e

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