SHS

Business Finance

Q2 – Week 2

Business Finance Worksheets

 BUSINESS FINANCE
WORKSHEET #12

Lesson 12: Capital Budgeting

At the end of the lesson, you should be able to apply mathematical concepts and tools in computing for
finance and investment problems.

What’s New?

In the previous worksheet, you have learned about how to prepare a bond amortization table for discounts
and premiums. This time, we are stepping up the game as we try to apply mathematical concepts and
tools in solving problems in capital budgeting.

Every day, businesses are faced with finance decisions. One of the major decisions for businesses
requires them to choose among several alternatives. These decisions often require cost-benefit analysis
with the aid of mathematical concept and tools.

The following are some concepts in capital budgeting:

1. Independent vs. Mutually Exclusive Investments. Independent Projects are those whose cash
flows are independent of one another. The acceptance of one project does not eliminate the
others from further consideration. Mutually exclusive projects, on the other hand, are projects
which serve the same function and therefore compete with one another. The acceptance of one
eliminates all other proposals that serve a similar function from further consideration.

2. Unlimited Funds vs. Capital Rationing. The amount and availability of funds affects the
company’s decisions in capital outlays. If the company has unlimited funds, then all projects
which pass the risk-return criteria will be accepted and implemented. Otherwise, firms will operate
under capital rationing and will accept only projects which provide the best opportunity to increase
shareholder wealth.

3. Accept-Reject vs. Ranking Approaches. The Accept-Reject approach is usually done for
mutually exclusive projects where one project is favored over the others. The approach accepts
projects which pass a certain criteria. Ranking is done when there are several projects passing
the criteria and the company is only able to fund so much. The highest ranking projects will be
selected for implementation.

In this worksheet, you will learn how to analyze and choose the best investment decision for a business
using the three widely used tools: the payback period, the NPV, and the IRR.

1. PAYBACK PERIOD
The payback period refers to the amount of time it takes to recover the cost of an investment.
Simply put, the payback period is the length of time an investment reaches a break-even point.

Key Takeaways:

 The payback period refers to the amount of time it takes to recover the cost of an investment or
how long it takes for an investor to reach breakeven.
 Account and fund managers use the payback period to determine whether to go through with an
investment.

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  Shorter paybacks mean more attractive investments, while longer payback periods are less
desirable.
 The payback period is calculated by dividing the amount of the investment by the annual cash
flow.

Example:

Assume Company A invests ₱1 million in a project that is expected to save the company
₱250,000 each year. The payback period for this investment is four years—dividing ₱1 million
by ₱250,000.

Consider another project that costs ₱200,000 with no associated cash savings will make the
company an incremental ₱100,000 each year for the next 20 years at ₱2 million. Clearly, the
second project can make the company twice as much money, but how long will it take to pay the
investment back?

The answer is found by dividing ₱200,000 by ₱100,000, which is two years. The second project
will take less time to pay back and the company's earnings potential is greater. Based solely on
the payback period method, the second project is a better investment.

2. NET PRESENT VALUE (NPV)

Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows over a period of time. NPV is used in capital budgeting and
investment planning to analyze the profitability of a projected investment or project.

The NPV may be computed as:

NPV = TVECF − TVIC

where:
TVECF=Today’s value of the expected cash flows
TVIC=Today’s value of invested cash

A positive net present value indicates that the projected earnings generated by a project or
investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is
assumed that an investment with a positive NPV will be profitable, and an investment with a
negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule,
which dictates that only investments with positive NPV values should be considered.

Example:

Even Cash Flows:

Calculate the net present value of a project which requires an initial investment of ₱243,000 and it
is expected to generate a net cash flow of ₱50,000 each month for 12 months. Assume that the
salvage value of the project is zero. The target rate of return is 12% per annum.

1
1− ( )
(1+𝑖)𝑛
TVECF = 𝑃𝑉 = 𝐶𝐹 𝑥
𝑖
1
1− ( )
(1+.01)12
= 50,000 𝑥
.01

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 TVECF = ₱562,754
TVIC = ₱243,000
NPV ₱319,754

Since the NPV is positive, accept the project.

Uneven Cash Flows:

An initial investment of ₱8,320 thousand on plant and machinery is expected to generate net
cash flows of ₱3,411 thousand, ₱4,070 thousand, ₱5,824 thousand and ₱2,065 thousand at the
end of first, second, third and fourth year respectively. At the end of the fourth year, the
machinery will be sold for ₱900 thousand. Calculate the net present value of the investment if the
discount rate is 18%. Round your answer to nearest thousand pesos.

PV Factors:
Year 1 = 1 ÷ (1 + 18%)1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)4 ≈ 0.5158

The rest of the calculation is summarized below:

Year 1 2 3 4
Net Cash Inflow 3,411 4,070 5,824 2,065
Salvage Value 900
Total Cash Inflow 3,411 14,070 5,824 2,965
× Present Value
0.8475 0.7182 0.6086 0.5158
Factor
Present Value of
2,891 2,923 3,545 1,529
Cash Flows
Total PV of Cash
₱10,888
Inflows
− Initial Investment 8,320
Net Present Value ₱2,568

3. INTERNAL RATE OF RETURN (IRR)

The internal rate of return is a metric used in financial analysis to estimate the profitability of potential
investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all
cash flows equal to zero in a discounted cash flow analysis. IRR calculations rely on the same formula as
NPV does. IRR uses trial and error or the guess and check method to compute for the effective interest.

Key Takeaways:

 IRR is the annual rate of growth an investment is expected to generate.

 IRR is calculated using the same concept as NPV, except it sets the NPV equal to zero.
 IRR is ideal for analyzing capital budgeting projects to understand and compare potential rates of
annual return over time.

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 The formula is given for you but the discussion will be left to your higher accounting and finance
subjects.

Practice Makes Perfect

Note: Please answer all the activities on a separate answer sheet.

1. Given the cash flows above and a discount rate of 5%, compute the payback period and NPV of Project
Pizza.
2. If PHP50,000 is earned on the 3rd year of the project, what is the new NPV of the project? What is the
payback period?

Live It Out!

Performance Task 3: On a piece of a paper, answer the following problems. Show your solutions.

You are the investment manager of an appliance company. The industry is currently in the expansion
phase and the CEO would like to capture as much of the market share as possible. You asked your
analysts to submit project proposals as summarized below.

Decide and recommend which project should be prioritized by computing for the payback period and the
NPV of the projects. Rank them accordingly with 1 as the highest priority and 5 as the lowest.

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 Learning Check!

***\
\

1. If the opportunity cost of capital is 11%, which of these projects is worth pursuing? Find the NPV
of both projects.
2. Suppose that you can only choose one of these projects. Which is more favorable to the firm
given that the discount rate remains at 11%? (Which has the higher NPV)
3. Which project would you choose if the opportunity cost of capital were 16%?
4. What is the payback period for each project?

***END OF WORKSHEET 12***

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 BUSINESS FINANCE
WORKSHEET #13

Lesson 13: The Risk-Return Trade-off

At the end of the lesson, you should be able to explain the risk-return trade-off.

What’s New?

Every choice or decision that we make has a corresponding outcome that may be favorable or
unfavorable. The choice you make will also depend on your preferences or inclinations. With every
choice, you have to consider certain factors that would largely affect your decisions.

In this worksheet, you will be learning the concepts of risk and return and the relationship between these
two.

Preference is a technical term in psychology, economics and philosophy usually used in relation to
choosing between alternatives. For example, someone prefers A over B if they would rather choose A
than B. It also refers to the power or chance to choose.

In finance it is the uncertainty of returns the definition encompasses the possibility of both gains and
losses. This brings us to another basic concept in finance – the risk-return trade-off. It is the possibility
that future earnings and free cash flows will significantly be lower than expected.
“Individuals won’t take on additional risk unless compensated by an additional return”.

Risk Preference:
• It is a concept that explains what one person does when faced with a risky option and a safer
alternative; it is an important predictor.
• It is your tendency to choose a risky or less risky option.

RISK PREFERENCES

Three alternative views concerning the choice between a risky outcome and a certain outcome:
a. risk aversion;
b. risk neutrality; and
c. risk loving.

RISK AVERSION is the preference for a sure outcome over a risky outcome.
 In economics and finance, risk aversion is the behavior of humans (especially consumers and
investors), who, when exposed to uncertainty, attempt to lower that uncertainty
 Means that individuals maximize returns for a given level of risk or minimize risk if the returns are
the same.
 Risk-Averse-Individuals would require a higher return if the risk level increases when faced with
two investments with a similar expected return, prefer the lower-risk option. A risk-averse investor
would not consider the choice to risk P1,000 loss with the possibility of making P 50 gain to be
the same risk as a choice to risk only P 100 to make the same P 50 gain

RISK NEUTRALITY is an economic term that describes individuals' indifference between various levels of
risk.
 When confronted with a choice among different investment opportunities, risk-neutral decision
makers only take into account the expected value of the alternative and not the associated level of
risk.

Business Finance Worksheets

  The term used to describe the attitude of an individual who may be evaluating investment
alternatives. If the individual focuses solely on potential gains regardless of the risk, they are
said to be risk neutral.
 Such behavior, to evaluate reward without thought to risk, may seem to be inherently risky. Given
two investment opportunities the risk-neutral investor only looks at the potential gains of each
investment and ignores the potential downside risk.

RISK LOVING is the preference for an unsure outcome over a guaranteed outcome. A risk loving person
has increasing marginal utility of income. With increasing marginal utility of income, a risk loving person
obtains more utility from income involving risk than an equal amount of certain or guaranteed income.

 With risk, the utility from winning exceeds the utility from losing. Even though the expected income
is equal to the certain income, the utility obtained from the expected income exceeds the utility
obtained from the certain income. A risk loving person is better seeking out risk.
 In economics and finance, a risk-seeker or risk-lover is a person who has a preference for risk.
While most investors are considered risk averse, one could view casino-goers as risk-seeking.

In making investment decisions, financial managers take note of the risk and returns of the projects they
are entering.

Recall the story of Jack and the Beanstalk. In the story, Jack trades his cow for three magic beans. This
is a very risky move for Jack since these beans may be fake and therefore, worthless. Luckily those
magic beans grew into beanstalk that gave Jack the opportunity to gather riches beyond his wildest
dreams, while fighting with a giant along the way. Jack gambled in this transaction. Should Jack decide
not to sell the cow for magic beans and instead sold it at the current market value, the story would be
different. As we can see, the higher the risk, the higher the returns, but of course, if turned sour, the
higher the losses as well.

This situation is also true for making financial decisions. Taking a higher risk gives you the opportunity to
earn higher returns. Low risk investments like treasury notes, also called risk-free instruments, earn a low-
and steady-income flow. In making investment decisions, financial managers ensure that the proposed
business will earn more than the risk-free rate since they need to compensate for the risk the investment
will entail.

This introduces us to the Required Rate of Return. It is the minimum expected yield investors require in
order to select a particular investment.

What are investment returns?

 Investment returns measure the financial results of an investment.

 Returns may be historical or prospective (anticipated).
 Returns can be expressed in:
 Peso Terms
 Percentage (Rate)

Try this example:

What is the return on an investment that costs P1,000 and is sold after 1 year for P1,100?

Peso return = Peso Received - Peso Invested

₱1,100 – ₱1,000 = ₱100

Percentage return = Peso Return/Peso Invested

₱100/₱1, 000 = 0.10 = 10%

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What is investment risk?

• Typically, investment returns are not known with certainty.

• Investment risk pertains to the probability of earning a return less than that expected.
• The greater the chance of a return far below the expected return, the greater the risk.

Risk Return Trade-off

 The risk-return tradeoff states that the potential return rises with an increase in risk.
 Using this principle, individuals associate low levels of uncertainty with low potential returns, and
high levels of uncertainty or risk with high potential returns.
 According to the risk-return tradeoff, invested money can render higher profits only if the investor
will accept a higher possibility of losses.
 The risk-return tradeoff is the trading principle that links high risk with high reward.
 The appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk
tolerance, the investor’s years to retirement and the potential to replace lost funds.
 Time also plays an essential role in determining a portfolio with the appropriate levels of risk and
reward.
 It is a principle which states that potential return rises with an increase in risk. Low levels of
uncertainty or risks are associated with high potential returns, whereas high-levels of uncertainty
or risks are associated with high potential returns. According to the risk-return trade-off, invested
money can render higher profits only if the investor is willing to accept the possibility of losses.
 The appropriate risk-return trade-off depends on a variety of factors including risk tolerance, years
to retirement and potential to replace lost funds. Time can also play an essential role determining
a portfolio with the appropriate levels of risk and reward. For example, the ability to invest in
equities over the long-term provides the potential to recover from the risks of bear markets and
participate in bull markets, while a short time frame makes equities a higher risk proposition.
 For investors, the risk-return trade-off is one of the essential components of each investment
decision as well as in the assessment of portfolios as a whole. At the foundation of this
assessment, the consideration of the risk as well as the reward of an investment can determine
whether taking action makes sense or not. This risk-return trade-off can include assessments on
the concentration or the diversity of holdings and whether the mix presents too much rick or a
lower than desired potential for returns.
 In most cases, higher risks is associated with greater probability of higher return while lower risk
with a greater probability of smaller return. The investor options between risk and return when
considering investment decisions is called the risk return trade off.
 A portfolio is a grouping of financial assets such as stocks, bonds, commodities, currencies and
cash equivalents, as well as their fund counterparts, including mutual, exchange-traded and
closed funds.

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 Practice Makes Perfect

Understanding the relationship between risk and return will help you choose the right investments.
Generally speaking, investments that have greater investment upside also greater potential risk. Identify
the level of risk (low, medium, high) and the approximate rate of return of the following potential
investments. Justify your answer. Use the format below as a guide for your answers.

Approximate
Level of Risk Justifications
Rate of Return
1. Investing money in
a savings account
2. Investing a term
deposit
3. Investing in
shares/stocks
4. Investing in
government bonds
5. Investing in money-
market securities

Live It Out!

Performance Task 4
Being a Detective: A Case Analysis

You recently graduated from Senior High School with ABM Strand and decided to become a financial
consultant. A client comes up to you and presented you with the following scenarios:

Case 1: EasyMoneyPH is a company that solicits investment from the public in exchange for a referral
code. The starting investment for EasyMoneyPH is ₱1,000 and can be higher depending on the investor.
It promises safe and guaranteed returns which will double investments in 10 days. It also offers a
payment plan where the investor can earn ₱100 everyday by just signing in to their website. An investor
can also earn from direct commission from direct referral which is accepted into the organization through
their referral code. The company also claims that the investments are risk-free with high returns.
EasyMoneyPH is 3 months old.

Case 2: MBA Finance is an investment company which actively trades in the stock market for 10 years. It
offers investors different options depending on their risk preference: bonds, stocks, or a balanced fund.
Furthermore, it requires investors a holding period of at least five years to allow their money to earn. It
offers a 5% to 7% rate of return depending on the performance of the market. The investor may opt to pay
a one-time investment or to invest on a quarterly, semiannual or annual basis. The starting investment for
MBA Finance is ₱5,000 for mutual funds.

After reading the cases presented above, answer the following for your client:

1. Provide a brief description of the two companies.

2. How much is the capital needed to join the company?
3. How will your money earn? By how much? How long would it take for your investment to
earn?
4. If you were to advice a potential investor, which company would you suggest? Is investing in
that company worth the risk or not? Provide evidences for your choice.
5. How do you explain the relationship between risk and return to your client?

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 Learning Check!

With all the concepts you have learned from this worksheet, answer the question below:
1. In your own words, how do you understand the risk – return trade off? Discuss your
answer in not less than 5 sentences. Provide examples, if applicable.
Use the following rubrics to guide you in answering your assessment:
Criteria 4 3 2 1
Content Interesting content and Some interesting content; Unoriginal ideas or Cursory; gives the
presentation; ideas well- points not sustained or clichés; little supporting impression of writing
conceived and developed not fully developed. detail included. just to complete the
with sufficient examples. assignment.
Structure, Logical progression of Logical progression of Gaps in logic or no Disorganized;
Logic and ideas with well-executed ideas but often lacks transitions. appears to have been
Transitions transitions. transitions. written as thoughts
occurred to the writer.
Grammatical Appropriate level of Confined to simpler Errors frequently affect Message is largely
Accuracy complexity in syntax with sentences or structures comprehensibility, or incomprehensible due
very few errors, if any. with very few errors OR very basic types of to inaccurate
shows variety and errors (subject-verb grammar, which alters
complexity in syntax with agreement; noun- or obscures it, OR
errors that do not affect adjective agreement, reader must know
comprehensibility. etc.) English to
comprehend much of
the message.
Vocabulary/ Uses sufficient, Usually uses appropriate Often uses Uses only elementary
Word Choice appropriate, and varied vocabulary with some inappropriate, or non- vocabulary; creates
vocabulary variety; some errors in specific vocabulary; nonexistent words
usage that do not affect lack of variety in word from English
the message choice.
Number of 5 or more sentences 4 sentences 3 sentences 1-2 sentences
Sentences
Rating:

20 points – 100 16 points – 80

19 points – 95 15 points – 75
18 points – 90 12 – 14 points – 70
17 points – 85 11 points and below – 65

***END OF WORKSHEET 13***

Business Finance Worksheets