CHAPTER 5

CAPITAL BUDGETING DECISIONS

Average (or initial)

Investment

Capital Budgeting- also called Capital

Expenditure Planning, deals with the allocation
of capital among alternative investment
opportunities. There are typically two types of
investment decisions:
a.

Selection decisions in terms of obtaining new

facilities or expanding existing facilities.
b. Replacement decisions in terms of
replacing existing facilities with new
facilities.

3.

NPV = PV of Cash outflow PV of Cash inflow

4.

Time Adjusted Rate of Return (Internal

or Discounted Rate of Return) this is the rate of
interest which would make the present value of
the future cash flows from the project equal to
the initial investment.

5.

Profitability Index it is computed by

dividing the present value of cash flows by the
initial investment. Profitability index is used in
comparing the net present values of different
projects to make the comparison more
meaningful.

Opportunity Cost it is the foregone benefits

that could be derived from other possible
alternative by choosing another alternative.
FIVE PRINCIPAL METHODS FOR
EVALUATING INVESTMENTS
1. Payback Period is the length of time
requires recovering the initial investment from
the incremental cash benefits after tax. The
conventional payback period does not consider
the time value of money while the discounted
payback period gives due allowance for the
time value of money.

Net Present Value - the present value of the

future net cash inflow from the project minus the
initial investment. This is the present value of the
net cash inflows (outflows) discounted at a
specified interest rate.

Profitability Index = Total present value

of cash inflows
Total present
value of cash outflow
Or
If the cost of investment is the only
cash outflow:
Profitability Index = Total present value
of cash inflows
Cost of
Investment

Payback Period = Initial Investment

Annual Cash Flow
Payback Reciprocal = Annual Cash Flow
Initial
Investment

2.

Accounting Rate of Return is defined as

the average annual net income from the project
divided by the average (or initial) investment in
the project. The net income is net of
depreciation and income taxes.
Accounting Rate of Return = Average
Annual Net Income of Project (Net of
Tax)
Average (or initial) Investment
in the Project
Or ARR = Net
Cash Inflow (Net of Tax) Depreciation

Examples for Time Value of Money

1.

John Lloyd deposits P10,000 in an

account that pays 6 percent interest.
How much will he have in five years?

2.

Blueberry Company expects to receive

P1,100 one year from now. What is the
present value of this amount if the
discount rate is 10%?

3.

Rhiana have just celebrated her 19th

birthday. She received an indecent
proposal from an old man who will set up
a trust fund which will pay her P 150,000
when she turn 30. If the relevant
discount rate is 9 percent, how much is
this fund worth today?

EXAMPLES FOR CAPITAL BUDGETING

DECISIONS

REQUIRED :

3.
4.

Present value of P1 for 8 periods at

= _________
Present value of an annuity of P1 for 8
periods
= _________
18%

Should the machine be acquired?

PROBLEM 1
The Graven Company is planning to
spend P60,000 for a machine which will be
depreciated on a straight line basis over ten
year period. The machine will generate
additional cash revenues of P12,000 a year.
Graven will incur additional costs except for
depreciation. The income tax rate is 35 %

1.
2.

desired rate of return of 18% is used for capital

investment decisions. Information on present
value factors is as follows:

Determine the net income after tax

Compute for the Accounting Rate of Return
(ARR)
Determine the after tax annual cash flow.
Compute the payback period and the payback
reciprocal.

PROBLEM 4
Virginia Company invested in a four
year project. The companys expected rate of
return is 10%. Additional information on the
project is as follows:

Inflow from Operations

Value
Year
Income Taxes
of P1 at 10%
1
000
2
3

PROBLEM 2
Herman Company acquired an asset at
a cost of P46,600. It had an estimated life of
ten years. Annual after tax cash benefits are
estimated at P10,000 at the end of each year.
The following amounts appear in the interest
table for the present value of an annuity of P1
at year end for ten years.
16% - 4.83
4.19

18% - 4.49

20%

REQUIRED:
Determine the maximum interest rate (time
adjusted rate of return) that could be paid for
the capital employed over the life of this asset
without toss, on this project.
PROBLEM 3
NPV Company is considering to purchase a new
machine which cost P50, 000. It will be a labor
saving investment which will reduce payroll by
P13, 500 per year. Its useful life is 8 years and
it wilt have zero salvage value. A minimum

Cash
Present
Net

of

40,
.909
44, 000
.826
48, 000
.751
52, 000
.683

Assuming a positive Net Present Value of

P10,000, determine the amount of the original
investment.