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DISCOUNTED CASH FLOW METHODS

1. 2. 3. 4. 5.

Net present value Profitability index Net present value index Present value payback Time adjusted rate of return

Capital Budgeting
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Principle of Time Value of Money

1. Present value (Discounting) 2. Future value (Compounding)

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Principle of Time Value of Money

1. Present Value Factor of 1 2. Present Value Factor of Annuity of 1 3. Present Value Factor of Annuity Due

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Annuity is any continuing payment with a fixed total amount

Ordinary annuity a series of equal payment made at the end of each period Annuity due payment is made immediately or at the beginning of the period.
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Example:
Assume that a project can generate net annual cash inflows of Php 500,000 over the next 3 years and cost of capital of 10%. Find the PV of the annual net cash flows.
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Example:
Assume that a project can generate net annual cash inflows of Php 500,000 during the 1st year, 650,000 2nd year, 600,000 3rd year. Find the PV of the annual net cash flows.
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NET PRESENT VALUE METHOD

PV of cash inflows Less: PV of cash outflows PV of Cash inflows Less: PV of Cost of investment PV of cash inflows Less: Cost of investment Capital Budgeting
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Example:
1. A project that will cost Php 400,000 is expected to generate cash inflows of Php 150,000 annually for 5 years. Cost of capital is 20%. Will this project be accepted?

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ANSWER:
YEAR 1 2 3 INFLOWS 150,000 150,000 150,000 PVF .83333 .69444 .57870 PV OF CASH 125,000 104,167 86,805

4 5
TOTAL PV LESS: COST NPV

150,000 150,000

.48225 .401878

72,338 60,282
448,592 400,000 48,592

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Example:
1. A project that will cost Php 300,000 is expected to generate cash inflows, as follows: Year 1 Php 150,000 Year 2 270,000 Year 3 120,000

Cost of capital is 20%

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ANSWER:
YEAR 1 2 3 TOTAL PV LESS: COST NPV INFLOWS 150,000 270,000 120,000 PVF .83333 .69444 .57870 PV OF CASH 125,000 187,499 69,444 381,943 300,000 81,943

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Example with Salvage value:

1. A project that will cost Php 400,000 is expected to generate cash inflows of Php 150,000 annually for 5 years. Salvage value is Php 20,000 after 5 years. Cost of capital is 20%. Will this project be accepted?

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ANSWER:
YEAR 1 INFLOWS 150,000 PVF .83333 PV OF CASH 125,000

2
3 4 5 Salvage Value TOTAL PV

150,000
150,000 150,000 150,000 20,000

.69444
.57870 .48225 .401878 .401878

104,167
86,805 72,338 60,282 8,218 456,810

LESS: COST
NPV

400,000
56,810

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Example with Salvage value & WC:

1. A project that will cost Php 400,000 is expected to generate cash inflows of Php 150,000 annually for 5 years. Salvage value is Php 20,000 after 5 years, working capital of Php 20,000. Cost of capital is 20%. Will this project be accepted?

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ANSWER:
YEAR INFLOWS PVF PV OF CASH

1
2 3 4 5 Salvage Value Working capita TOTAL PV LESS: COST (with WC) NPV

150,000
150,000 150,000 150,000 150,000 20,000 20,000

.83333
.69444 .57870 .48225 .401878 .410878 .410878

125,000
104,167 86,805 72,338 60,282 8,218 8,218 465,028 420,000 45,028

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Net Present Value Method

1. Considers time value of money 2. Considers cash flow over the entire life of the project 3. Use of discount rate should be carefully computed.

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Profitability Index
Present value index Desirability index Total present value index

This is the ratio of the present value of cash inflows to the present value of the cash outflows.

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Profitability Index
Total Present value of Cash inflows Total Present value of Cash outflows

In evaluating projects using profitability index, an index of 1.0 may be used as threshold point.

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EXAMPLE:
Management has considered the following projects.
PROJECT 1 Cost of investment 20,000 PROJECT 2 40,000

Annual net cash inflows Economic life

Cost of capital

8,000 5 years
10%

16,000 5 years
10%

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ANSWERS: .
PROJECT 1 PV of cash inflows (3.791) Cost of investment Net present value Profitability index 30,328 20,000 10,328 1.52 PROJECT 2 60,656 20,000 20,656 1.52

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Net Present Value Index

Net present value Present value of cash outflows
A positive net present value index indicates that the project is acceptable.

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EXAMPLE:
Management has considered the following projects.
PROJECT 1 Cost of investment 20,000 PROJECT 2 40,000

Annual net cash inflows Economic life

Cost of capital

8,000 5 years
10%

16,000 5 years
10%

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ANSWERS: .
PROJECT 1 PROJECT 2

PV of cash inflows (3.791)

Cost of investment Net present value Profitability index NPV index

30,328
20,000 10,328 1.52 .52

60,656
20,000 20,656 1.52 .52

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Capital Rationing
The process of ranking prospect projects. The highest index has the highest priority.

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Example:
ABC Corporation availed of bank loans of Php 12 million to invest to various capital projects, as follows:
PROJECT A B C D COST 4,000,000 6,000,000 5,000,000 3,000,000 PV OF INFLOWS 4,850,000 7,200,000 5,500,000 3,470,000

Which among these projects should the Company invest?

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Drills (RS):
An equipment costing Php 800,000 will produce annual net cash inflows of Php 300,000. At the end of its useful life of 5 years, the equipment will have a residual value of Php 20,000. The desired rate of return is 18%. Calculate: 1. NPV 2. Profitability index 3. NPV index

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Present Value Payback

Cash flows to be used are converted to their present values.

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Example:
Let us consider the following data: Cost of investment Annual net cash inflows Cost of capital Payback period Present value payback
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Php 500,000 125,000 5% 4 years ???

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Discounted Cash flows

Time adjusted rate of return Internal rate of return (IRR) Discounted rate of return Discounted cash flow rate of return IRR > cost of capital, project should be accepted OBJECTIVE: NPV SHOULD EQUAL COST Capital Budgeting
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PV OF CASH INFLOWS = COST OF INVESTMENT

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Example (even cash flows):

1. FGU Management wants to buy a new equipment amounting to Php 1 million, with economic life of 4 years. Annual net cash inflows amounted to Php 375,000. The rate of return is 14%. How much is the internal rate of return?

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PV OF CASH INFLOWS = COST OF INVESTMENT PV factor (375,000) = 1,000,000 PV factor = 2.667 18% to 20%
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Drills (RS) (even cash flows):

Grop Corporation has the opportunity to buy a new machine at Php 520,000. This machine is expected to have a useful life of 4 years with no residual value and will yield an annual net cash inflow of Php 200,000. The companys rate of return is 10%

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Example (uneven cash flows):

Cost of investment Php 2,800,000

Salvage Value Year 1

Year 2 Year 3 Year 4 Year 5 Ave. cash inflows

100,000 1,200,000
950,000 800,000 600,000 500,000 830,000

Compute for IRR.

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Drills (RS) (uneven cash flows):

A new equipment costing Php 800,000 with five years useful life and Php 40,000 residual value at the end of five years. The following net cash inflows:
Year 1 Year 2 Year 3 Year 4 Year 5 350,000 300,000 250,000 150,000 80,000
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Drills (RS) (even cash flows):

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

18%-4.49

20%-4.19

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.

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Drills (RS) (even cash flows):

NPV Company is considering to buy 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 will have zero salvage value. A minimum desired rate of return of 18% is used for capital investment decisions. Information on present value factors is as follows: Present value of P1 for 8 periods at 18% Present value of an annuity of P1 for 8 periods Should the machine be acquired? .266 4.078

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Drills (RS) (uneven cash flows):

The Cap Company is considering the replacement of Machine A with Machine B that will cost P160,000 and will result in annual savings of P40,000 before income taxes because of the expected increase in operating efficiency. Machine B has an estimated useful life of 10 years and salvage of P10,000. Machine A has a book value of P16,000 and a disposal value of P20,000 now. Straight-line depreciation is used and the company has an average income tax rate of 35%. The minimum desired rate of return on this investment is 20% The present value of an ordinary annuity of P1 in arrears for 10 periods at 20% is 4.192. The present value of P1 for 10 periods at 20% is 0.162 REQUIRED: 1. Determine the Net Investment. 2. Determine the annual cash flow net of income tax. 3. What is the net present value of the investment.

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