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5. Selecting Projects
6. Implementation
7. Project Evaluation
Capital Budgeting Process
1. Finding Investment Opportunities.
where:
*Cash Outflows:
1. Initial Cash outlays covering all expenditures
2. Additional working capital requirement to operate at the desired level
**Cash Inflows:
1. Trade in value of old assets (in case of replacement)
2. Proceeds from sale of old assets to be disposed due to the acquisition
of new projects (less applicable tax)
3. Avoidable cost of immediate repairs on old assets to be replaced
(net of tax)
Capital Budgeting Process
Things to know in estimating cash flows:
1. Net Cash Investment or Net Investment
Illustration:
ABC Inc. provides hot, ready-to-eat meals to construction workers. The company
is considering the purchase of a new truck to replace an old truck now in use in
delivering meals to construction sites. The new truck would cost P2M. If the new
truck is purchased, the old truck will be sold as is to another company for
P400,000. This old truck was acquired for P1.2M and has a current book value of
P500,000. If the new truck is not purchased, the company will have to continue
using the old one, although extensive repairs would be needed that will cost
P250,000. This repairs cost will be expensed, for tax purposes, in the year
incurred. The income Tax rate for corporations is 32%. If the new truck is
purchased, the net cost of investment for decision-making purposes is?
Capital Budgeting Process
Solution:
1. Net Cash Investment or Net Investment
Cash Outflows:
3. Net Returns
Refers to the accounting net income or annual net cash inflows (ANCI). This
return should be AFTER TAX cash inflows. Refer to the next slide for illustration.
Capital Budgeting Process
Things to know in estimating cash flows:
Net Returns / ANCI
Illustration:
A company is investigating the possibility of acquiring a machine that will cost
P12,000 and will have annual depreciation for tax purposes of P2,400 for 5years.
The machine is expected to result in a cash saving from operations of P4,000 per
year. If the tax rate is 30%, what is the annual net cash inflows?
Solution:
Capital Budgeting Process
Things to know in estimating cash flows:
Net Returns or ANCI
Illustration:
A company is investigating the possibility of acquiring a machine that will cost
P12,000 and will have annual depreciation for tax purposes of P2,400 for 5years.
The machine is expected to result in a cash saving from operations of P4,000 per
year. If the tax rate is 30%, what is the annual net cash inflows?
Solution:
Method 1
Net Cash Savings P 4,000
Less: Depreciation 2,400
Earnings Before Tax (EBT) 1,600
Less: Tax (30%xP1,600) 480
Earnings After Tax (EAT) 1,120
Add back: Depreciation 2,400
ANCI 3,520
Capital Budgeting Process
Things to know in estimating cash flows:
Net Returns / ANCI
Illustration:
A company is investigating the possibility of acquiring a machine that will cost
P12,000 and will have annual depreciation for tax purposes of P2,400 for 5years.
The machine is expected to result in a cash saving from operations of P4,000 per
year. If the tax rate is 30%, what is the annual net cash inflows?
Solution:
Method 1 Method 2
Net Cash Savings P 4,000 P 4,000
Less: Depreciation 2,400
Earnings Before Tax (EBT) 1,600
Less: Tax (30%xP1,600) 480 480
Earnings After Tax (EAT) 1,120
Add back: Depreciation 2,400
ANCI 3,520 3,520
Capital Budgeting Process
4. Evaluating Project Proposals
Solution:
Capital Budgeting Process
Techniques to solve Payback Period:
Solution:
Illustration:
Net Investment in Equipment P300,000
Estimated Useful of the Equipment 5 years
Annual Net Cash Inflows
Years 1 3 75,000
Years 4 5 100,000
Capital Budgeting Process
Techniques to solve Payback Period:
Illustration:
Net Investment in Equipment P300,000
Estimated Useful of the Equipment 5 years
Annual Net Cash Inflows
Years 1 3 75,000
Years 4 5 100,000
Solution:
NCI P300,000
Less: ANCI
Years 1 3 (P75,000 x 3) P225,000
Year 4, balance to full recovery 75,000 300,000
Therefore the payback is 3 year + fraction of:
(Fraction = P75,000 / P100,000) = 3.75 years
Capital Budgeting Process
Payback period (also known as Payoff and Payout Period)
Decision Rule:
The desirability of the project is determined by comparing the projects payback
period against the maximum acceptable payback period as predetermined by the
management.
Advantages:
1. It is easy to compute
2. It is used to measure the degree of risk associated with a project.
3. Generally, the longer the payback period, the higher the risk.
4. It is used to select projects which provide a quick return of invested funds.
Disadvantages:
1. It does not recognized time value of money
2. It ignores the impact of cash inflows after the payback period.
Capital Budgeting Process
Methods of Evaluating Capital Investment Projects:
a. Non-discounted cash flow - Methods that do not
consider time value of money
1. Payback period (Payoff and Payout Period) DONE
2. Bail-out Period
3. Accounting Rate of Return (ARR)
b. Discounted cash flows Methods that consider time
value of money
1. Net Present Value
2. Internal Rate of Return (Discounted Rate of Return)
3. Profitability Index
4. Discounted Payback Period
Capital Budgeting Process
2. Bail-out period (also known as Payoff and Payout
Period)
-measures the length of time required to recover
the amount of initial investment considering the
salvage value.
Capital Budgeting Process
Techniques to solve Bail-out Period:
Problem 1 (Bail-out):
Energy company is planning to spend P84,000 for a new machine, to be
depreciated on the straight-line basis over 10years. The related cash flow from
operations, net of income taxes, is expected to be P10,000 a year for each of the
first 6years and P12,000 for each of the next 4years. In addition, Energy
Company has also estimated the salvage value of the new machine at the end of
year 1 to be P64,000. Salvage Value will decline by P5,000 each thereafter. What
is bailout payback period?
Solution:
Capital Budgeting Process
Techniques to solve Bail-out Period:
Problem 1 (Bail-out):
Energy company is planning to spend P84,000 for a new machine, to be
depreciated on the straight-line basis over 10years. The related cash flow from
operations, net of income taxes, is expected to be P10,000 a year for each of the
first 6years and P12,000 for each of the next 4years. In addition, Energy
Company has also estimated the salvage value of the new machine at the end of
year 1 to be P64,000. Salvage Value will decline by P5,000 each thereafter. What
is bailout payback period?
Solution:
Investment 84,000.00
Test: Cumulative ANCI + Current SV of each period YEAR
1st yr (10,000 + 64,000) 74,000.00 X 1
2nd yr (20,000 + 59,000) 79,000.00 X 2
3rd yr (30,000 + 54,000) 84,000.00 STOP 3
Therefore, bail-out period is 3years
Capital Budgeting Process
Techniques to solve Bail-out Period:
Problem 2 (Bail-out):
An investment of P180,000 is expected to produce annual cash earnings of
P50,000 for 5 years. Its estimated salvage value is P70,000 during the first year
and this is expected to decrease by P15,000 annually. What is the bailout
payback period?
Solution:
Capital Budgeting Process
Techniques to solve Bail-out Period:
Problem 2 (Bail-out):
An investment of P180,000 is expected to produce annual cash earnings of
P50,000 for 5 years. Its estimated salvage value is P70,000 during the first year
and this is expected to decrease by P15,000 annually. What is the bailout
payback period?
Solution:
Investment 180,000.00
Test: Cumulative ANCI + Current SV of each period YEAR
1st yr (50,000 + 70,000) 120,000.00 X 1
2nd yr (100,000 + 55,000) 155,000.00 X 1
3rd yr (150,000 + 40,000)190,000.00 180,000.00 STOP 0.8
Solution:
Capital Budgeting Process
Problem (ARR):
Consider the following information about a proposed project:
Initial Investment Required P 65,000
Estimated Useful Life 20 years
Annual Net Cash Inflows (ANCI) P10,000
Salvage value of the asset at the end of 20 years 0
Straight-line method of depreciation will be used.
Solution:
Advantages:
1. It is easily understood by investors acquainted with financial statements.
2. It is used as a rough preliminary screening device of investment proposals.
Disadvantages:
1. It does not recognized time value of money.
2. It does not consider the timing component of cash inflows.
Capital Budgeting Process
Methods of Evaluating Capital Investment Projects:
a. Non-discounted cash flow - Methods that do not
consider time value of money
1. Payback period (Payoff and Payout Period) DONE
2. Bail-out Period DONE
3. Accounting Rate of Return (ARR) DONE
Advantages:
1. It is more reliable because the time value of money is taken into account.
2. Income over the entire life of the project is considered.
3. It is more objective and relevant because if focuses on cashflows.
Disadvantages:
1. It is not easily understood.
2. It is more complex and difficult to apply.
3. It requires detailed long-term forecasts of incremental cash flow data.
4. It requires pre-determination of the cost of capital or the discount rate to be
used.
Capital Budgeting Process
b. Methods of Discounted cashflow techniques
1. Net Present Value (NPV)
The excess of the present value (PV) of cash inflows
generated by the project over the amount of the
initial investment
Types of PV
a. PV of P1 = Yearly PV
b. PV of an Annuity of P1 = Accumulated PV
Note: Computation of PV is not discussed here. PV is provided in the
problem.
Solution:
Capital Budgeting Process
Problem 1 (NPV Uniform ATCF)
Assumed a certain company has an option to invest on a certain equipment
costing P600,000 to be depreciated 5 years annually. Such investment will give
the company an annual savings of P168,000 after tax. In order to buy such
equipment, the company needs to loan in a bank with an annual interest of 14%
for 5 years.
PV of an Annuity, 14% at 5 years = 3.4331
PV of P1, 14%, 5th year = 0.519367
Compute the Net Present Value of the investment.
Solution:
PV of ATCF (P168,000 x 3.4331) P576,761
Less: Investment 600,000
NPV - 23,239
Capital Budgeting Process
Problem 2 (NPV Uneven ATCF)
JP Corp. plans to invest in a 4-year project that will cost P750,000. JPs cost of
capital is 8%. Additional information on the project is as follows:
Year ATCF PV of P1, 8%
1 P200,000 0.926
2 220,000 0.857
3 240,000 0.794
4 260,000 0.735
Required: Using the NPV method, determine whether the project is acceptable or
not.
Solution:
Capital Budgeting Process
Problem 2 (NPV Uneven ATCF)
JP Corp. plans to invest in a 4-year project that will cost P750,000. JPs cost of
capital is 8%. Additional information on the project is as follows:
Year ATCF PV of P1, 8%
1 P200,000 0.926
2 220,000 0.857
3 240,000 0.794
4 260,000 0.735
Required: Using the NPV method, determine whether the project is acceptable or
not.
Solution:
PV of ATCF 1 (P200,000 x 0.926) P185,200
2 (P220,000 x 0.857) 188,540
3 (P240,000 x 0.794) 190,560
4 (P260,000 x 0.735) 191,100
Total PV of ATCF P755,400
Less: Investment 750,000
NPV P 5,400
Capital Budgeting Process
NPV Decision Rule:
For independent project proposal, accept it if NPV is positive or zero and reject if
NPV is negative. If the NPV is positive, it means that the project will earn a
return greater than the discount rate also known as hurdle rate. Thus:
PI = PV of Cash Inflows
PV of Net Investment
Capital Budgeting Process
Problem 1 (PI)
Company XYZ has P200,000 funds available for investment. It is considering the
following projects:
A B C
PV of ATCF P244,000 P130,000 P130,000
Less: Investment 200,000 100,000 100,000
NPV P 44,000 P 30 ,000 P 30,000
Required: Compute the profitability index of each project. Which project/s should
be undertaken?
Solution:
Capital Budgeting Process
Problem 1 (PI)
Company XYZ has P200,000 funds available for investment. It is considering the
following projects:
A B C
PV of ATCF P244,000 P130,000 P130,000
Less: Investment 200,000 100,000 100,000
NPV P 44,000 P 30 ,000 P 30,000
Required: Compute the profitability index of each project. Which project/s should
be undertaken?
Solution:
Project A PI = P244,000/P44,000 = 1.22
Project B PI = P130,000 / P30,000 = 1.30
Project C PI = P130,000 / P30,000 = 1.30
The company should invest in Projects B and C, since their PV indexes are the
highest. The company can afford to invest in both A and B.
Capital Budgeting Process
PI Decision Rule:
The higher the profitability index, the more desirable the project. Projects with
index of less than 1 are rejected.
If PI = > 1; Accept
If PI < 1; Reject
Capital Budgeting Process
Methods of Evaluating Capital Investment Projects:
a. Non-discounted cash flow - Methods that do not
consider time value of money
1. Payback period (Payoff and Payout Period) DONE
2. Bail-out Period DONE
3. Accounting Rate of Return (ARR) DONE
Solution:
Capital Budgeting Process
Problem 1 (Discounted Payback Period)
A project requiring an investment of P70,000 is expected to generate the
following cash inflows:
Year Amount PV of P1, 15%
1 P60,000 0.870
2 60,000 0.756
3 60,000 0.658
4 60,000 0.572
5 60,000 0.497
Required: What is its discounted payback period?
Solution:
Year Cash Inflows Discounted Cash Flow Balance
0 P(170,000) P(170,000) P(170,000)
1 60,000 (60,000 x 0.870) 52,000 (118,000)
2 60,000 (60,000 x 0.756) 45,000 ( 73,000)
3 60,000 (60,000 x 0.658) 39,000 ( 34,000)
4 60,000 (60,000 x 0.572) 34,000 0
The discounted payback period is 4years.
Capital Budgeting Process
1. Finding Investment Opportunities
5. Selecting Projects
6. Implementation
7. Project Evaluation
Capital Budgeting Process
5. Selecting Projects (Decision)