CAPITAL BUDGETING

To arrive at a long term decision, a firm needs to identify the following:

1. 2.
a. 3.
b.
c.

METHODS
Those that do not consider time value of money
1. Payback Period 2. Accounting Rate of Return

Those that consider time value of money

1. Discounted payback period 4. Modified internal rate of return
2. Net present value 5. Profitability Index
3. Internal rate of return

Payback Period
Even Cash Flow Uneven Cash Flow
Aquino plans to purchase a piece of Aquino plans to purchase a piece of
equipment which amounts to P210,000 in equipment which amounts to P210,000 in
accordance with an investment proposal from a accordance with an investment proposal from a
member of his staff. If the equipment is bought, it member of his staff. If the equipment is bought, it
is expected to generate an annual cash inflow of is expected to generate cash inflow as shown
P40,000. A five year payback period is acceptable below. A five year payback period is acceptable to
to Aquino. Aquino.
Year Cash Inflow Year Cash Inflow
1 40,000 1 P20,000
2 40,000 2 30,000
3 40,000 3 40,000
4 40,000 4 50,000
5 40,000 5 50,000
6 40,000 6 40,000

Accounting Rate of Return

Tina’s initial investment on Project A is P100,000. Its estimated useful life is 20 years. Cash inflow per
year is P17,500. What is the ARR?

Discounted Payback Period

Mr. Hopia plans to put up a small stall in front of his house. The overall cost of the construction is
P180,000. The stall is expected to generate cash inflow for 7 years as shown below. A four-year discounted
payback period is acceptable to Mr. Hopia. (WACC is 12%)

Year Annual Cash Returns PVf Discounted amount

1 50,000
2 50,000
3 50,000
4 50,000
5 50,000
6 50,000
7 50,000

Year Annual Cash Returns PVf Discounted amount

1 40,000
2 40,000
3 50,000
4 50,000
5 60,000
6 60,000
7 50,000
Net Present Value

Kim Corp invested P25,000 in a 4-year project. Kim’s cost of capital is 8%. Additional bits of
information on the project are as follows:

After tax Cash Inflow of

Year P1 PVf Present Value
1 10,000
2 15,000
3 18,000
4 16,000

Internal Rate of Return

Assume the following information from Kam’s Korner:
Initial Investment P100,000
Estimated life 10 years
Annual cash inflows P20,000
Cost of capital 12.0%

Modified Internal Rate of Return

A 5-year project with an initial outlay of P18,000 an d a cost of capital of 14% will produce an annual
cash return of P5,600. The IRR of the project is 16.80%.

Profitability Index

Compute for the PI in the problems in NPV and DPP

Mutually exclusive projects

Assume the following cash returns for Projects A and B with the cost of capital of 10%
Year Project A Project B
0 (P2,000) (P2,000)
1 200 900
2 400 700
3 600 600
4 700 400
5 900 200

Compute for the projects’ NPV and IRR (between 14% and 16%)

Capital Rationing (combination of acceptable projects)

Projects Initial Present NPV Profitability Ranking

Outlay Value Index
A 90,000 112,500 22,500 1.250
B 80,000 90,000 10,000 1.125
C 120,000 180,000 60,000 1.500
D 80,000 80,000 - 1.000
E 40,000 30,000 (10,000) 0.750
F 50,000 90,000 40,000 1.800

/RCR