BA 115

Capital Budgeting

I. Capital investment and capital budgeting

Capital investment – acquisition of asset with an expected life ___________________. The relevant data for making
investment decisions are ____________________________. Since capital investments generally have multiperiod
cash flows, you have to consider the time value of money.

Capital budgeting – process of evaluating specific projects, estimating ____________ and ___________, and
selecting which projects to fund.

II. Time value of money

A peso today grows to larger sums through earning interest on the principal plus earning interest on interest.

A. Future value

Future value = __________________ + _________________

Formula for the future value:

Compute the future value of P100 in two years with interest compounded at the rate of 10% annually.

B. Present value

Formula for the present value:

How much must be invested today to have P121 after two years?

The process of reducing a future amount to a present value is called _____________________.

Present value factor/Discount factor in the above example is equal to ____________

Use of present value tables

Compute the present value of five annual receipts of P1,000 using a 10% discount rate.

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Capital Budgeting

III. Methods to evaluate cash flows

1. Present value or discounted cash-flow methods:

a.
b.
2.
3.

Example: Quartz is considering a device costing P100,000 to replace an obsolete production device.

1. The new device’s expected life is five years and can probably be sold at the end of Year 5 for P10,000.
2. The vendor recommends an updating in Year 3 at a cost of P20,000.
3. Capacity will increase by 1,000 units per year. Each unit sells for P55 and has P30 of variable costs.
4. Additional inventory of P3,000 is needed and will be released at the project’s end.
5. Operating costs will be reduced by P15,000 per year.
6. The old device can be sold for P8,000 now, which is the book value. But, it could be used for five more years
with no salvage or book value at that time.

Cash Flows: Today Year 1 Year 2 Year 3 Year 4 Year 5

New device
Salvage value of new device
Sale of old device
Added inventory
Added contribution margin
Operating cost savings
Updating costs

IV. Net present value method

Set the __________________________ .

Decision rule: If the net present value is _________________, approve the project.

Compute the net present value of Quartz’s capital investment cash flows.

Cash Flows: Today Year 1 Year 2 Year 3 Year 4 Year 5

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Project ranking: Even if a project has a positive net present value, too many good projects may exist given the
investment amount available. A ranking system such as the profitability index is needed.

Profitability index = _________________________________________

Compute the profitability index for Quartz.

V. Internal rate of return method

Compute the rate of return by setting the __________________________ equal to the present value of future net
____________________________.

Decision rule: Accept the project when the IRR is _________ the required rate of return.

Compute the IRR for Quartz’s capital investment.

Project ranking: List projects according to their rates of return from high to low.

The IRR method assumes that cash flows are reinvested at the project’s IRR but this is not always the case.

VI. Effects of taxes and depreciation

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Capital Budgeting

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