… CAPITAL BUDGETING

NET PRESENT VALUE

Most people know that money you have in hand now is more valuable than money you collect in
the future. That is because you can use it to make more money by running a business, or buying
something now and selling it later for more, or simply putting it in the bank and earning interest.
Future money is also less valuable because inflation erodes its buying power. This is called the
time value of money.
Net present value is the present value of the cash flows at the required rate of return of your
project compared to your initial investment.
“By looking at all of the money you expect to make from the investment and translating those
returns into today’s dollars, you can decide whether the project is worthwhile.”
Why Are Cash Flows Discounted?
The cash flows in net present value analysis are discounted for two main reasons, (1) to adjust
for the risk of an investment opportunity, and (2) to account for the time value of money.
The first point (to adjust for risk) is necessary because not all businesses, projects, or investment
opportunities have the same level of risk. Put another way, the probability of receiving cash flow
from Treasury bill is much higher than the probability of receiving cash flow from a young
technology startup.
To account for the risk, the discount rate is higher for riskier investments and lower for safer one.
The treasury bill for example is considered to be the risk-free rate, and all other investments are
measured by how much more risk they bear relative to that.
The second point (to account for the time value of money) is required because due to inflation,
interest rates, and opportunity costs, money is more valuable the sooner it is received.
Problem:
Consider company SML who is determining whether they should invest in a new project. SML
will expect to invest P500,000 for the development of their new product. The company estimates
that the first year cash flow will be P200,000, the second year cash flow will be P300,000, and
the third year cash flow to be P200,000. The expected return of 10% is used as the discount rate.
Solution

Year Cash Flow Discount Factor Present Value

1 200,000.00 0.9091 181,820.00
2 300,000.00 0.8264 247,920.00
3 200,000.00 0.7513 150,260.00
580,000.00

Present Value of Inflows 580,000

Present Value of Outflows (500,000)
Net Present Value 80,000

Therefore, SML should invest in the new project since the net present value (NPV) is positive.
 INTERNAL RATE OF RETURN
Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a
project zero. It means that at this rate, the present value of the project’s cash inflow is equal to
the present value of the cash outflow. In simpler way, it is the rate at which the project breaks
even.
Once the internal rate of return is determined, it is typically compared to a company’s minimum
required rate of return. The minimum required rate of return is set by management. Most of
the time, it is the cost of capital of the company.
If the IRR is greater than or equal to the cost of capital, the company would accept the project
(assuming this is the sole basis for the decision – In reality there are many other quantitative and
qualitative factors that are considered in an investment decision.), and if it’s lower than the cost
of capital it would be rejected.

Problem:
Suppose you are offered a project with an initial investment of P10,000 and with the following
inflows:
Year Cash Flow
1 P 4,300
2 3,900
3 3,200
4 1,200
If the company’s minimum required rate of return is 10%, would you accept the project?

Solution

Year Cash Flow PV Factor @ 12% PV of Cash Flow PV Factor @ 11% PV of Cash Flow
1 4,300.00 0.8929 3,839.47 0.9009 3,873.87
2 3,900.00 0.7972 3,109.08 0.8116 3,165.24
3 3,200.00 0.7118 2,277.76 0.7312 2,339.84
4 1,200.00 0.6355 762.60 0.6587 790.44
9,988.91 10,169.39

IRR = 11 + 10,169.39 – 10,000

10,169.39 – 9,988.91

= 11.94%
Therefore, the project should be accepted since the IRR is greater than the cost of capital of 10%.
PROFITABILITY INDEX
The Profitability Index (PI) measures the ratio between the present value of future cash flows
and the initial investment. The index is a useful tool for ranking investment projects and showing
the value created per unit of investment.

Profitability Index = Present Value of Future Cash Flows

Initial Investment Required

Decision Rule
The breakeven value of a ratio is equal to 1. If a project has a profitability index greater than 1, it
should be accepted; if lower than 1, it should be rejected. The value of 1 is the point of
indifference regarding whether to accept or reject the project. In terms of net present value, a
ratio greater than 1 means that the project’s NPV is positive and it should be accepted, and a
value lower than 1 means a negative NPV.

Problem:
Company C is considering projects with the same initial cost of P20,000,000 and cost of capital
of 11%. Detailed information about the projects’ future cash flows is presented in the table
below.
Year Project X Project Y
1 P 9,000,000 P 4,000,000
2 8,000,000 5,000,000
3 7,000,000 7,000,000
4 5,000,000 9,000,000
5 4,000,000 10,000,000

Solution
Project X

Year Cash Flow PV Factor @ 11% PV of Cash Flow

1 9,000,000.00 0.9009 8,108,100.00
2 8,000,000.00 0.8116 6,492,800.00
3 7,000,000.00 0.7312 5,118,400.00
4 5,000,000.00 0.6587 3,293,500.00
5 4,000,000.00 0.5935 2,374,000.00
25,386,800.00

Profitability Index = 25,386,800

20,000,000

= 1.27
Therefore, Project X must be accepted since the profitability index is greater than 1.
Project Y

Year Cash Flow PV Factor @ 11% PV of Cash Flow

1 4,000,000.00 0.9009 3,603,600.00
2 5,000,000.00 0.8116 4,058,000.00
3 7,000,000.00 0.7312 5,118,400.00
4 9,000,000.00 0.6587 5,928,300.00
5 10,000,000.00 0.5935 5,935,000.00
24,643,300.00

Profitability Index = 24,643,300

20,000,000

= 1.23
Therefore, Project Y must be accepted since the profitability index is greater than 1.
In case of mutually exclusive projects, Company C should accept Project X and reject Project Y.

Mutually exclusive projects are projects in which acceptance of one project excludes the others
from consideration. In such a scenario the best project is accepted.