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CB-3

Decisions involving cash inflows and outflows beyond the current year are called capital-budgeting
decisions. Managers encounter two (2) types of capital-budgeting decisions:

Acceptance-or-Rejection Decisions whereby managers must decide whether they should undertake
a particular capital investment project or not. In such a decision, the required funds are available or
readily obtainable, and management must decide whether the project is worthwhile.

Capital-Rationing Decisions whereby managers must decide which of the several worthwhile projects
makes the best use of limited investment funds.

So how do managers evaluate capital investment projects?

METHODS OF EVALUATING INVESTMENT PROPOSALS

I Methods that do not consider the time value of money


a. Payback Period (PP)
b. Payback Bailout Period (PBP)
c. Payback Reciprocal (PR)
d. Accounting Rate of Return (ARR) or ROI

II Methods that consider the time value of money


a. Discounted Payback Period (DPP)
b. Net Present Value (NPV)
c. Present Value Index (PVI)
d. Time Adjusted Rate of Return (TARR)

To be assured that investment proposals would be consistent with the company objectives and to avoid waste of
time, effort & resources criteria may include objective, relevance, compatibility with current business operations
and profitability.

INVESTMENT COST (for a project to be undertaken for the first time) refers to the initial outlay of resources & all
the additional investments in the future to sustain the project and bring in the desired annual cash returns. It
consists of the following:
** Purchases price of the asset
** Incidental costs such as freight-in, installation costs, etc.
** Working capital requirement to operate at the desired level.
** Market value of assets already owned (currently idle) which will be transferred to the project.

Investment situations often involve the introduction of a new product line or the expansion of facilities. If the
project is to be undertaken, it may have to be supported by an additional investment in current assets. This
required increment is part of the investment in the project because they must be held to support the project.

EXAMPLE : A new project requires an investment of P500,000 in new equipment and additional current assets
of P96,000 consisting of Cash, Accounts Receivable and Inventory:

Cost of new equipment ........................... P500,000


Add Additional Current Assets:
Cash ............................. P18,000
Accounts Receivable ...... 33,000
Inventory ........................45,000 96,000
NET INVESTMENT .................................. P596,000
========
REPLACEMENT OF FIXED ASSETS

When management is contemplating on replacing FA, the evaluation of a proposal should consider the following:
1. Additional Investment required
2. Expected increase in net income or in the annual cash returns

In computing for PP, net investment shall be determined as follows:


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CASH OUTFLOW REQUIRED:


Purchase Price of new asset ......................... Pxx
Incidental costs such as freight-in,
Installation costs, costs of test-runs.......... xx
Additional working capital requirement ............... xx Pxx
CASH INFLOW INCIDENTAL to the replacement:
Proceeds from sale of old asset, net of tax :
Sales price (or fair MV) of old asset Pxx
Add Tax savings on loss xx
Less Tax on gain (xx)
Savings, net of tax :
Avoidable cost of immediate repairs xx
Less: Tax on avoidable cost of repairs xx xx
NET INVESTMENT Pxx
====

EVALUATION OF CAPITAL INVESTMENT PROPOSALS

An after-tax cash flow is the cash flow expected after all tax implications have been taken into account. Each
financial aspect of a project must be examined carefully to determine its potential tax impact.

Let us assume that management is considering the purchase of an additional delivery truck. The sales manager
estimates that a new truck will allow the company to increase annual sales by P110,000 which will be received in
cash during the year of sale. Any credit sales will be paid in cash within a short time period. This annual
incremental sales will result in an increase of P60,000 per year in cost of goods sold. Moreover, the additional
merchandise sold will be paid for in cash during the same year as the related sales. Thus, the net incremental
cash inflow resulting from the incremental sales is P50,000 per year (P110,000 - P60,000). Hence, the firms
incremental cash inflow from the additional sales is only P30,000.
Incremental Sales net of CGS ....................................................P 50,000
Less: Incremental tax P50,000 x 40% ........................................ (20,000)
After-tax cash flow (net inflow after taxes) .................................. P 30,000
=======
A quick method for computing the after-tax cash inflow from incremental sales is: P50,000 (1 40%). If the
additional delivery truck will involve hiring of an additional employee whose annual compensation and fringe
benefits will amount to P30,000, the companys incremental cash outflow is only P18,000. A quick method for
computing the after-tax cash outflow from an incremental cash expense is: P30,000 x (1 40%)

Let us assume that a proposal has been made to effect the replacement of a machine and the following data are
given:
Book value of old machine ........................ P6,000
Fair value of old machine ........................ 4,000
Income tax rate .................................. 30%
Cost of new machine .............................. 8,500
Freight in, installation cost, cost of test runs.. 500
Cost of immediate repairs needed on old machine .. 800

The amount of net investment is computed as follows :


Purchase price of new machine .................... P8,500
Installation cost, test-runs and freight in ...... 500 P9,000
Less: Cash inflow and savings incidental to the
decision to replace the old machine:

Proceeds from sale of old machine, net of tax:


Sales price of old machine ........... P4,000
Add: Tax savings on loss
30% x (P4,000 - 6,000) ............... 600 P4,600
Avoidable cost of immediate repairs,
net of tax
Immediate repairs ............ P800
Less; Tax benefit (30%) ..... 240 560 5,160
Net investment ........................................... P3,840
======
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If the old machine can be sold at a gain, say P7,500, net proceeds from its sale net of tax on gain must be equal
to:
Proceeds from sale of old machine ................. P7,500
Less: Tax on gain 30% (P7,500 - P6,000) 450
Proceeds from sale of old machine, net of tax ..... P7,050
======
If the acquisition of the replacement requires an increase in current assets of P5,000 and an increase in current
liabilities of P1,000, the required additional working capital of P4,000 will raise the net investment to P7,840. In as
much as the working capital requirement continues to exist until the completion or termination of a project, it may
be considered as an addition to the cash inflow at the end of the economic life of the asset.

Recovery of Investment The reason for purchasing an asset is an expectation that it will provide benefits in the
future. Thus, if you buy a new eqpt., you expect to have future operating-cost savings. For a capital investment
proposal to be accepted, the expected future benefits must be sufficient for the purchaser to recover the
investment and earn a return on the investment equal to or greater than the cost of acquiring capital.

Accounting Rate of Return (ARR) or ROI

ARR also known as book value rate of return, measures profitability from the conventional accounting standpoint
by relating the required investment to the future annual net income. Under this method, choose the project with
the highest rate of return. Accept the project if the ARR is equal to or greater than the cost of capital.

Accounting Rate of Return on Investment = Ave. NI after tax OR Net Cash Inflow - Dep'n
Ave. (or initial) investment Ave. (or initial) investment

Average Investment = Initial investment + Salvage or Scrap Value


2

Example # 1: ARR Computation WITH Salvage Value

Assume that X Co. has the opportunity to purchase a piece of automatic equipment. Details of the proposal
include:
Original Cost for eqpt. installed P 600,000
Salvage Value 50,000
Estimated Ave. Annual NI after tax 80,000
Estimated useful life 5 years

Compute the ARR based on: a) Original Investment b) Average Investment

a) ARR = Average Annual NI after tax P80,000 = 13.3% ARR = b) 80,000/325,000 = 24.6%
Net Investment P 600,000 ======

Example # 2: ARR Computation WITHOUT Salvage Value

(a) Rate of Return On Original Investment


DATA Asset A Asset B
Estimated investment (no scrap value) P100,000 P 80,000
Estimated life 10 years 10 years
Estimated annual net income before
depreciation and taxes P 40,000 P 24,000
Depreciation (straight line) - 10,000 - 8,000
Net income after depreciation P 30,000 P 16,000
Income tax @ 30% 9,000 4,800
Net income after depn. & Inc. Tax P 21,000 P 11,200
Investment P100,000 P 80,000

Return on original investment = 21% 14%


===== =====
(b) Rate of Return On Average Investment

Net Income after depreciation and taxes P 21,000 P 11,200


Average Investment 100,000/2 80,000/2
Return on Average Investment = 42% 28%
===== =====
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PAYBACK PERIOD (PP)

PP (also known as payoff and payout period), measures the length of time required to recover or payback the
investment or it is the time interval between the initial outlay and the full recovery of investment. This method will
be reliable only if the returns or cash inflows are evenly distributed over the years and if the investments to be
compared are equal in amount and have the same life estimates with little or no residual or salvage value. If PP
is used to evaluate investment proposals, management should select the one with the shortest PP. However, it
has 2 limitations:
1. It ignores the time period beyond the PP.
2. It ignores the time value of money.

PP evaluates only the rapidity with which an investment will be recovered. It does not indicate the profitability of
the investment. If 2 investments promise equal total returns, the one that generates the returns more quickly is
considered more desirable.

Payback is also useful as a measure of risk because in general, the longer it takes to get your money back, the
more risky it will be that the money will not be returned. As the time horizon lengthens, more uncertainties arise.
Inflation might ease, or it might get worse; interest rates could rise, or they could fall; new techniques might be
developed that would make the investment obsolete. Essentially, all this really means that a manager might
prefer a project that will pay back the investment in 2 years to one that would take ten years, eventhough the one
with the 10-year payback period might have a higher expected NPV and IRR. Whether you would choose to
invest in the 2-years or the 10-years opportunity would depend on your attitude about risk and return.

PP can be a rough screening device for investment proposals because a relatively long PP will usually mean a
low rate of return. As a practical matter, the PP is automatically computed in the process of calculating the time-
adjusted rate of return on an investment with equal annual cash inflows. A project would not be acceptable if the
computed PP exceeded the life of the project. A firm may set a limit on the PP beyond which an investment will
not be made.

An investment of P 20,000 is expected to produce annual returns or cash inflows of P 5,000 for 10 years. No
salvage recovery can be expected from the investment at the end of 10 years.

Payback Period = Initial Investment Net Investment


Annual Cash Inflow OR Annual Cash Inflow

PP = P 20,000/P 5,000 per yr. = 4 years


======
The investment is recovered in 4 years. The ratio of the investment to the annual return is 4:1. Expressed in
another way, using the Payback Reciprocal (PR) which refers to the fraction or percentage of the investment to
be recovered in one year computed as follows:

Payback Reciprocal = Annual Cash Inflow OR 1 Payback Period


Initial Investment or Net Investment

PR = P 5,000/P 20,000 OR 1 4 years


= 25% as the unadjusted rate of return
=====
When a project life is at least twice the PP and the annual cash flows are approximately equal, the PR may be
used to estimate the discounted rate of return. A project with an infinite life would have a discounted rate of return
exactly equal to its PR. The alternative with the shortest PP or the highest unadjusted rate of return is the most
acceptable, provided it meets the minimum standard set by the company. The PR can be used to determine a
usable measure of the rate of return if the ff. 2 conditions are present:

a) The net cash inflows over the life of the investment are uniform.
b) The economic life of the project is at least twice the PP.

If these conditions are met, the PR provides a reasonable approximation of the true rate of return.
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Example # 3: PP with EVEN or UNIFORM Cash Inflows


Allen Co. is considering 2 alternative investments that each requires an initial outlay of P 30,000.
P R O P O S AL
Y Z___
Annual cash inflow for:
5 years P 6,000
8 years P 5,000

Payback Period = P 30,000 P 30,000


P 6,000/yr. P 5,000/yr.
= 5 years = 6 years
But if the goal is to maximize income, proposal Z should be selected than proposal Y eventhough Z has a longer
PP. This is because Z will return a total of P 40,000 while Y simply recovers the initial P 30,000 outlay.

Example # 4: PP with UNEVEN Cash Inflows


Assume the ff. net cash inflows are expected in the first 3 yrs. from 2 capital projects:
PROJECT A PROJECT B
1st year P 15,000 P 9,000
2nd year 12,000 12,000
3rd year 9,000 15,000
P 36,000 P 36,000
========= =========
Assume that both projects have the same net cash inflows each year beyond the 3rd year. If the cost of each
project is P 36,000 then each has a PP of 3 years.

PP = Cost of project P 36,000


Ave. Annual Cash Inflows P36,000/3 yrs. or P 12,000/yr.

But common sense indicates that the projects are not equal because money has a time value and can be
reinvested to increase income. Since larger amounts of cash are received earlier under project A, it is the
preferable project.

Example # 5: Computation of NET CASH INFLOW for PP

The company has an opportunity to buy an additional plant for P300,000. Estimates indicate that the new
facilities will produce sales revenue of P200,000 per year for each of the 10 years that the plant will operate. Out-
of-pocket operating costs are expected to be about P150,000 per year. The plant has no scrap value at the end
of 10 years and depreciation will be taken on a straight line basis. Income tax rate is assumed to be @ 30%. The
company wishes to know how many years will be required for the plant to pay for itself.
SOLUTION:
Sales P200,000
Less: Operating cost P150,000
Depreciation* 300,000/10yrs. 30,000 180,000
Net income before income tax 20,000
Less: Income tax (30% x 20,000) 6,000
Net income after income tax 14,000
Add: Back depreciation * 30,000
Net cash inflow P 44,000
========
Payback Period P300,000
P44,000/yr. = 6.82 years
* Depreciation reduces the cash outflow for income tax. This reduction is a TAX SAVINGS made possible by a
depn. tax shield. Tax Shield is the amount by which taxable income is reduced due to the deductability of an item
which results to a tax savings.
OR
Sales P200,000
Less: Out-of-pocket cost 150,000
Net income before depreciation
and income tax P 50,000 P 50,000
Less: Depreciation (30,000)
Taxable income P 20,000
Less: Income tax (30% of P20,000) 6,000
Net Cash Inflow after tax P 44,000
========
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Example # 6: PP Computation
Assume the following cash flows for 2 alternative investment proposals and determine their payback period:
P R O P O S AL

A B

Net Investment P150,000 P300,000
Annual Cash Returns:
Year 1 to 3 75,000 75,000
Year 4 to 5 - 100,000
Salvage Value 15,000 15,000
Economic Life 3 years 5 years

300,0000 - 225,000 (a)


Payback Period = P150,000 = 3 years + ---------------------
P 75,000 100,000 (b)
= 2 years = 3.75 years
===== ========
a) Cumulative returns for 3 years
b) Cash returns in the 4th year

DISCOUNTED PAYBACK PERIOD (DPP)

As mentioned earlier, a disadvantage of the PP is that it does not consider the time value of money because the
investment is a present value while the annual cash inflow is a future value. It may be modified by considering the
discounted cash flow to arrive at the DPP. DPP refers to the number of years it will take to make the total of the
present value of net cash inflows equal to the present value of the investment.

Table I (Present Value of P1) is used when:

1. annual cash inflow is not uniform


2. inflow is received at the end of a specified period of time.

Table II (Present Value of an Annuity of P1) is used when:

1. annual cash inflow is uniform

Example # 7: DPP with UNEVEN Cash Inflows


An investment of P5,876 will bring in cash returns or cash inflows as follows:
First year P2,000
Second year 3,000
Third year 3,000
Fourth year 2,500
Fifth year 2,000
Required rate of return is 25%.

The DPP is computed as follows:


* Discount each of the annual cash inflow at the desired rate of return.
** Determine the accumulated amount of the discounted cash flows at the end of each year until it amounts to the
present value of the investment.

For the given example, the DPP is computed as follows:


Annual Present Value Present Value No. of
Cash Returns of 1 at 25% of Cash Returns Years
Year 1 P2,000 .800 P1,600 P1,600 1
Year 2 3,000 .640 1,920 1,920 1
Year 3 3,000 .512 1,536 1,536 1
Year 4 2,500 .410 1,025 820 .8*
Year 5 2,000 .327 654 ______________
P5,876 3.8
====== ====
* 820/P1,025 = .8

Take note that it will take 3.8 years to make the present value of the cash returns equal to the present value of the
investment so that the discounted payback period is this number of years.
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PAYBACK BAILOUT PERIOD (PBP)

In conventional payback computation, investments salvage value is usually ignored. An approach which
incorporates the salvage value in payback computations is the "Bail-out Period." Payback bailout period refers
to the length of period or number of years it will take to recover an investment considering both the annual cash
returns and the scrap value at the end of each year.

Example # 8: PBP w/ UNEVEN Cash Inflows & SCRAP VALUE @ THE END OF EACH YEAR

An equipment costing P30,000 with the following cash returns or cash inflows expected from its use:
Scrap Value
Cash Returns End of Year
First year P 6,000 P15,000
Second year 9,000 10,000
Third year 10,000 5,000
Fourth year 8,000 1,000
The total of the cash returns at the end of each year including scrap value are as follows:
Accumulated
Cash Returns Scrap Value Total
End of first year P 6,000 P15,000 P21,000
End of second year 15,000 10,000 25,000
End of third year 25,000 5,000 30,000
End of fourth year 33,000 1,000 34,000

The payback bailout period must be 3 years because if the asset is disposed of at the end of Year 3, the cash
returns realized by then of P25,000 (or P6,000 + 9,000 + 10,000) plus the scrap value of P5,000 would amount to
P30,000. This method ignores the time value of money and the cash inflow from operations beyond the payback
bailout period.

Example # 9: PBP w/ UNIFORM Cash Inflows & SCRAP VALUE @ THE END OF EACH YEAR

An investment of P150,000 is expected to produce annual cash earnings of P50,000 for 5 years. Its estimated
salvage value is P70,000 at the end of Year 1 and this is expected to decrease by P15,000 annually. Determine
the bailout payback period.

SOLUTION:
Annual Accumulated
Year Cash Return Cash Returns Scrap Value Total
1 P50,000 P 50,000 P 70,000 P120,000
2 50,000 100,000 55,000 155,000
3 50,000 150,000 40,000 190,000
4 50,000 200,000 25,000 225,000
5 50,000 250,000 10,000 260,000

Bail-out PP = 1 year + (P150,000 - P105,000 (a) X 1 year


P50,000 (b)
= 1.9 years
========
(a) Cash returns during the 1st year + salvage value, 2nd year
(b) Cash returns during the 2nd year

NET PRESENT VALUE (NPV) METHOD

Under this method, all expected after-tax cash inflows and outflows from the proposed investment are discounted
to their present values using the company's required minimum rate of return as discount rate. The firm's COST
OF CAPITAL is generally used to discount the future cash flows.

Present Value of Annual Net Cash Inflows


less: Present Value of the required cash outflows or Initial Investment
NET PRESENT VALUE of the proposed investment

In many projects, the only cash outflow is the initial investment & since it occurs immediately, the initial investment
does not need to be discounted. Other types of projects require that additional investment like a major repair be
made at later dates in the life of the project. In those cases, the cash outflows must be discounted to their present
value before they are compared to the present value of the net cash inflows.
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Example # 10: NPV w/ UNEVEN Cash Inflows & NO SCRAP VALUE

Assume that C Co. is considering a capital investment project that will cost P25,000. Net cash flows after taxes
for the next 4 years are expected to be P8,000; P7,500; P8,000 and P7,500 respectively. Management requires a
minimum rate of return of 14% and wants to know if the project is acceptable.
SOLUTION:
ANCI PV of P 1 Total
after tax @ 14% Present Value
1st year P8,000 X .87719 = P 7,018
2nd year 7,500 X .76947 = 5,771
3rd year 8,000 X .67497 = 5,400
4th year 7,500 X .59208 = 4,441
Present Value of ANCI ................. P22,630
less: Cost of Investment .................... 25,000
NET PRESENT VALUE ................... (P 2,370)
=======
Therefore the project is not acceptable. In general, a proposed capital investment is acceptable if it has a positive
NPV. In other words, if NPV is equal to or greater than zero, then ACCEPT the proposal.

Example # 11: NPV w/ UNEVEN Cash Inflows and SCRAP VALUE

Data:
Estimated investment (its scrap value is P5,000) P40,000
Estimated life 5 years
Estimated annual net cash inflow:
Ist year P30,000
2nd year 20,000
3rd year 12,000
4th year 8,000
5th year 5,000
Rate of return @ 20%
REQUIRED: Compute its NPV.

SOLUTION: Net Cash Inflow Uneven - Asset has scrap value of P5,000.
Present Value
Net Cash Present Value of Cash Inflow
Years Inflow of P1. at 20% at 20%
1 P30,000 P0.833 P24,990
2 20,000 0.694 13,880
3 12,000 0.579 6,948
4 8,000 0.482 3,586
5 10,000 0.402 4,020
Total present value of cash inflow P53,694
Less Investment 40,000
Net Present Value P13,694
=======
* The scrap value was added to cash of P5,000 on the 5th year.

UNIFORM NET CASH INFLOW - ASSET WITHOUT SCRAP VALUE

If the expected net cash inflows from the investment had been P10,000 per year for 4 years:
PV of ANCI P10,000 x 2.91371 = P29,137
less: Cost of Investment 25,000
NET PRESENT VALUE P 4,137
======
Therefore the investment proposal is acceptable. But there may be a competing project that has an even higher
NPV. When NPV method is used to screen alternative projects, the higher a project's NPV, the more desirable
the project is.

UNIFORM NET CASH INFLOW - ASSET WITH SCRAP VALUE

If an investment has scrap value at the end of its useful life, the expected recovery is added to the net cash inflow
of the last year in calculating present value and rate of return. The cash flows for most projects involving the
acquisition of fixed assets could be uneven because of the salvage values at the end of the useful lives of those
assets.
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Example # 12: NPV w/ UNIFORM Cash Inflows and NO SCRAP Value

Assume: An asset which will cost P55,000 will produce an annual net cash inflow of P20,000 per year for 5
years. This asset will have no scrap value at the end of the 5th year. The rate of return is for 20 percent.
Determine the net present value.
SOLUTION:
Present Value Present Value
Annual Net of an annuity of Cash Inflow
Years Cash Inflows of P1. at 20% at 20%
0-5 20,000 x 2.991 = P 59,820
Less Investment 55,000
Net Present Value P 4,820
=======
Example # 13: NPV w/ Net Cash Inflows and SCRAP Value

Using the same data in Example # 12, assume further that at the end of the 5th year, the asset will be scrapped
for P5,000. Calculate the NPV.
SOLUTION:
Present Value Present Value
Annual Net of an annuity of Cash Inflow
Years Cash Inflow of P1. at 20% at 20%
0-4 P20,000 P 2.589 P 51,780
5 25,000* .402 10,050
Total present value of cash inflow P 61,780
Less Investment 55,000
Net Present Value P 6,830
========
* If an investment has scrap value at the end of its useful life, the expected recovery is added to the net cash
inflow of the last year in calculating present value and rate of return.

PROFITABILITY INDEX OR PRESENT VALUE INDEX


(Also known as BENEFIT-COST RATE OR DESIRABILITY INDEX)

When investment projects costing different amounts are being compared, the NPV method does not provide a
valid or clear means by which to rank the projects in order of profitability or contribution to income or desirability
under limited financial resources. If investments of different amounts are being compared, the present values
must be supplemented by an index which is computed:

PI = PV of net cash inflows after tax


Initial Outlay or investment (or PV of Cash Outlays if future outlays are required)

OR

PI = PV of Annual Cash Returns discounted at the lowest acceptable rate


PV of the Investment

Only those proposals having a profitability index greater than or equal to 1.00 should be considered by
management. Proposals with a profitability index of less than 1 will not yield the minimum rate of return because
the PV of projected cash inflows will be less than the initial cost. The higher the ratio, the more profitable is the
project or the higher is the PV index, the higher must be the rate of return on the project under review. It is used
as a measure of ranking projects in descending order of desirability.

Example # 14: PI w/ UNEVEN Cash Inflows & NO SCRAP Value

Assume that a company is considering 2 alternative capital outlay proposal that have the ff. initial costs and
expected net cash inflows after taxes:
PROPOSAL X PROPOSAL Y
Initial Cost P 7,000 P 9,500
Expected net cash inflow (after taxes):
Year 1 P 5,000 P 9,000
Year 2 4,000 6,000
Year 3 6,000 3,000
Management's minimum desired rate of return is 20%.
P a g e | 10

SOLUTION:
PRESENT VALUE
PROPOSAL X PROPOSAL Y
YEAR 1 (net cash inflow in yr. 1 x .83333) P 4,167 P 7,500
YEAR 2 ( " " " " yr. 2 x .69444) 2,778 4,167
YEAR 3 ( " " " " yr. 3 x .57870) 3,472 1,736
Present Value of ANCI P10,417 P13,403
less: Initial Outlay 7,000 9,500
NET PRESENT VALUE P 3,417 P 3,903
======= =======
Profitability Index = P 10,417 P 13,403
P 7,000 P 9,500

= 1.49 = 1.41
==== ====
When NPVs are compared, proposal Y appears to be more favorable than X because its NPV is higher. But after
computing the PI, proposal X is found to be a more desirable investment because it has a higher profitability
index. The higher the profitability index, the more profitable the project per peso of investment. Proposal X is
earning a higher rate of return on a smaller investment than proposal Y.

DISCOUNTED CASH FLOW METHOD OR using the TIME-ADJUSTED RATE OF RETURN (TARR or IRR)

The time-adjusted rate of return is also called the internal rate of return (IRR), the discount rate, and the true rate
of return. The discounted rate of return is the rate at which an investment is earning. If the cash returns were
discounted at this rate, their present value would be equal to the present value of the investment.

It equates the PV of expected after-tax net cash inflows from an investment with the cost of investment by finding
the rate @ which the NPV of the project is zero. If the time-adjusted rate of return equals or exceeds the cost of
capital or target required rate of return, then the investment should be considered further. But if the proposal's
time-adjusted rate of return is less than the minimum rate, the proposal should be rejected. Ignoring other
considerations, the higher the time-adjusted rate of return, the more desirable the project.

Example # 15: TARR w/ UNIFORM Cash Inflows


Assume that Young Co. is considering a P 90,000 investment that is expected to last 25 years with no salvage
value. The investment will yield a P 15,000 annual after-tax net cash inflow. This P 15,000 is referred to as an
ANNUITY, which is a series of equal cash inflows.

Steps in computing discounted rate of return:


1. Determine the PP = P 90,000 = 6 years
P 15,000/yr.
2. Find the PV factor of an annuity that is nearest in amount to the PP of 6. Since the investment is expected to
yield returns for 25 years, look at that row in the table. In that row, the factor nearest to 6 is 5.92745 which
appears under 16.5% interest column. If the annual return of P15,000 x 5.92745 = P 88,912 which is just
below the cost of the project of P90,000. Thus, the actual rate of return is slightly less than 16.5%. When
the present value factor (which is the PP) is between 2 factors in the present value of an annuity table, the
time adjusted rate of return is computed by interpolation:

@ 16% 6.097 - 6 = .097


@ 18% 5.467 - 6 = .533
Difference 2% .630
===== =====
16% + .097
.630 X 2% = 16.307%
=======
18% - .533
.630 X 2% = 16.30%
======
Example No. 16: TARR w/ UNEVEN Cash Inflows
A proposed investment of P7,666 can bring in cash returns as follows:
1st year P 2,000
2nd year 1,000
3rd year 5,000
4th year 5,000
P13,000
======
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When cash inflows from operations are uneven, the time adjusted rate of return is determined as follows:

1) Determine the average annual cash inflows = P13,000 / 4 years = P 3,250 per year

2) Compute for the tentative payback period = P 7,666 / P3,250 per year = 2.36 yrs.

3) Locate PP in the PV of an annuity table, line 4 years. This is found in column 25%

4) Determine the time adjusted rate of return by trial and error method. If the PV of the annual cash returns
discounted at a certain rate is less than the investment, use the next lower rate (usually, this is in the left
column). The lower is the discounting rate the greater must be the present value. Repeat this until the present
value of the cash returns becomes equal to the investment.

Based on 25% rate of return, the PV of the cash returns is computed as follows:
1st year P2,000 X .800 = P1,600
2nd year 1,000 X (1.440 - .800) = 640
3rd year 5,000 X (1.952 - 1.440) = 2,560
4th year 5,000 X (2.362 - 1.952) = 2,050
P6,850
======
In as much as the present value of the cash returns as arrived at is less than the investment of P7,666, the
proposed investment must be earning at a lower rate. This is because the lower is the rate of return, the greater
must be the required investment to bring in the same cash returns. If the rates on the left side are tried one at a
time, one will find out that at 20% rate of return, the PV of the cash returns is equal to the investment of P7,666.
The computation is as follows:
1st year P2,000 X .833 = P1,666
2nd year 1,000 X (1.528 - .833) = 695
3rd year 5,000 X (2,106 - 1.528) = 2,890
4th year 5,000 X (2.589 - 2.106) = 2,415
P7,666
======
TARR or IRR must therefore be @ 20%.

SUMMARY EVALUATION OF METHODS

The critical difference between NPV and IRR methods and the payback and book rate of return methods is the
attention given to the timing of the expected cash flows. The first 2 methods called discounted cash flow (DCF)
techniques, consider the timing of the cash flows; the last two methods do not. Because they recognize the time
value of money, the DCF techniques are conceptually superior.

All of the 4 methods require about the same estimates. DCF methods require estimates of future cash flows and
the timing of those flows. The book rate of return method requires estimates of net income in each future year. It
also requires decisions about both the tax and the book methods of depreciation to be used. The payback
method requires estimation of cash flows but not of useful life. One point in favor of the payback method is that it
emphasizes near-term cash flows. Near-term cash flows are usually easier to predict than flows in later years.
Unless consideration is given to useful life, the payback method could lead to very poor decisions.

The NPV method does require an estimate of the cost of capital or a decision as to a minimum acceptable rate of
return; this is true also of the IRR method. But the book rate of return method requires such a decision also. And
the payback method requires a decision regarding the minimum acceptable payback period. Using the NPV
method (discounting at cost of capital or cutoff rate of return), any project having a positive NPV should be
accepted; others should be rejected. Using the time-adjusted rate of return method, a project having a rate of
return greater than the firm's cost of capital (or its cutoff rate) should be accepted. The relationship of the 2
criteria is as follows:

1. If the IRR is less than the cost of capital (or cutoff rate), the NPV will be negative.

2. If the NPV is greater than zero, the IRR is greater than the cost of capital (or cutoff rate).

When analyzing any single project for acceptance or rejection, both methods will lead to the same decision. As in
other decision areas, there may be qualitative factors that override a capital budgeting decision that seems best
solely on quantifiable data. A project may show a positive NPV and still be rejected by the firm. For example, a
firm committed to producing high-quality, high priced products may reject a project if the proposed product is
relatively cheap. Or a firm that manufactures toys might not make toy guns because of the personal convictions
of the president. On the other hand, a firm might undertake an investment that showed a negative NPV if the
project would bring the firm considerable prestige or perhaps enhance its image as an innovator. Where
P a g e | 12

qualitative reasons support the undertaking of a project, analysis of the quantitative factors should not be ignored,
because it will give managers a better idea of the cost to the firm of accepting a particular qualitative goal as
paramount.

Capital budgeting does not end with the evaluation of investment proposals and their implementation for it
includes control of those investments which in turn , requires that the actual returns or benefits therefrom be
monitored and compared with the expected returns so that discrepancies can be analyzed and prompt corrective
measures can be adopted.

Impact of Inflation
Most countries have experienced inflation to some degree over the past 30 years. Inflation is defined as a decline
in the general purchasing power of a monetary unit, such as a peso across time. Since capital budgeting
decisions involve cash flows over several time periods, it is worthwhile to examine the impact of inflation in
capital-budgeting analyses.

Inflation can be incorporated in a discounted-cash-flow analysis in either of two ways. Both approaches yield
correct results, but the analyst must be careful to be consistent in applying either approach. The two approaches
are distinguished by the use of either nominal or real interest rates.

Interest Rates

The real interest rate is the underlying interest rate, which includes compensation to investors for the time value
of money and the risk of an investment.

The nominal interest rate includes the real interest rate, plus an additional premium to compensate
investors for inflation. Suppose the real interest rate is 10 percent, and inflation of 5 percent is projected. Then the
nominal interest rate is determined as follows:

Real interest rate............................................................... .10


Inflation rate ...................................................................... .05
Combined effect (.10 x .05)............................................... .005
Nominal interest rate ........................................................ .155

Management Accountants Role

To use discounted-cash-flow analysis in deciding about investment projects, managers need


accurate cash-flow projections. This is where the managerial accountant plays a role. The
accountant often is asked to predict cash flows related to operating-cost savings, additional
working-capital requirements, or incremental costs and revenues. Such predictions are difficult
in a world of uncertainty. The managerial accountant often draws upon historical accounting
data to help in making cost predictions. Knowledge of market conditions,
economic trends, and the likely reactions of competitors also can be important in projecting
cash flows.

Post-audit
The discounted-cash-flow approach to evaluating investment proposals requires cash flow
projections. The desirability of a proposal depends heavily on those projections. If they are
highly inaccurate, they may lead the organization to accept undesirable projects or to reject
projects that should be pursued. Because of the importance of the capital budgeting process,
most organizations systematically follow up on projects to see how they turn out. This
procedure is called a postaudit (or reappraisal ).

In a postaudit, the managerial accountant gathers information about the actual cash flows
generated by a project. Then the projects actual net present value or internal rate of return is
computed. Finally, the projections made for the project are compared with the actual results. If
the project has not lived up to expectations, an investigation may be warranted to determine
what went awry. Sometimes a postaudit will reveal shortcomings in the cash-flow projection
process. In such cases, action may be taken to improve future cash-flow predictions.

Two (2) types of errors can occur in discounted-cash-flow analyses:


1. undesirable projects may be accepted, and
2. desirable projects may be rejected.
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The postaudit is a tool for following up on accepted projects. Thus, a postaudit helps to detect
only the first kind of error, not the second. As in any performance evaluation process, a
postaudit should not be used punitively. The focus of a postaudit should provide information to
the capital-budgeting staff, the project manager, and the management team.

One way management accountants can assist the management team is by assessing the
consequences of changes in an investment decision that may develop after the project has
been approved. In long-term projects, there is often considerable uncertainty about the future
cash flows, due to uncertainty about future economic, political, or cultural events. As a project
unfolds, management may decide to alter the course of the project or even postpone it.

Case # 1:
The Cebu City Council is considering the purchase of a site for a new sanitary landfill. The
purchase price for the site is P234,000 and preparatory work will cost P88,080. The landfill
would be usable for 10 years. The council hired a consultant, who estimated that the new
landfill would cost the city P48,000 per year less to operate than the citys current landfill. The
current landfill also will last 10 more years. For a landfill project, Cebu City can borrow money
from the national government at a subsidized rate. The citys hurdle rate is only 6% for this
project.
Required:
1. Compute the NPV of the new landfill. Should the board approve the project? Explain.

2. Calculate the landfill projects IRR. Should the board approve the project? Explain.

Case # 2:
The management of Sugbo Rural Bank is considering an investment in automatic teller
machines. The machines would cost P124,200 and have a useful life of seven years. The
banks controller has estimated that the automatic teller machines will save the bank P27,000
after taxes during each year of their life (including the depreciation tax shield). The machines
will have no salvage value.

Required:
1. Compute the payback period for the proposed investment.

2. Compute the net present value of the proposed investment assuming an after-tax hurdle
rate of:
( a ) 10 percent, ( b ) 12 percent, and ( c ) 14 percent.

3. What can you conclude from your answers to requirements (1) and (2) about the limitations
of the payback method?

4. Time is money! is an old saying. Relate this statement to the evaluation of capital
investment projects.