Professional Documents
Culture Documents
CAPITAL BUDGETING
Capital Budgeting
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*Present value of
expected cash
inflows *Required
*Cost saving Investment
*Expected rate *Cost of capital
of return
Payback Period
Discounted Payback Period
Accounting Rate of Return
Net Present Value
Internal Rate of Return
Profitability Index
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Payback Period
Decision Rule:
If the payback period is < required payback Accept
If the payback period is > required payback Reject
Payback Period
Example (even cash inflow):
Mr. Uy plans to purchase a piece of equipment which
amounts to 180,000 in accordance with an investment
proposal from a member of his staff. If the equipment is
bought, it is expected to generate an annual cash inflow
of 30,000. A five year pay back period is acceptable to Mr.
Uy.
𝒊𝒏𝒗𝒆𝒕𝒔𝒎𝒆𝒏𝒕 − 𝑺𝒄𝒓𝒂𝒑 𝒗𝒂𝒍𝒖𝒆
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 =
𝑨𝒏𝒏𝒖𝒂𝒍 𝒂𝒇𝒕𝒆𝒓𝒕𝒂𝒙 𝒄𝒂𝒔𝒉 𝒔𝒂𝒗𝒊𝒏𝒈𝒔
𝟏𝟖𝟎, 𝟎𝟎𝟎
=
𝟑𝟎, 𝟎𝟎𝟎
= 𝟔 𝒚𝒆𝒂𝒓𝒔
Decision: reject the project ….
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Payback Period
Payback Period
Decision: accept
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Payback Period
Advantages
It is simple to compute and easy to understand.
It handles investment risk well.
Disadvantage
It does not recognize the time value of money
It ignores the impact of cash inflows received after
the payback period.
There is a possibility of lower return
There is no rational way of determining the
payback period.
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𝐴𝑅𝑅 =
Examples:
Initial investment : 8,000
Estimate life : 20 years
Cash inflows per year: 1,000
Depreciation per year : 400
1000 − 400
𝐴𝑅𝑅 = = 7.5%
8,000
Decision Rule:
If ARR is < required ARR Accept the project
If ARR is > required ARR Reject the project
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Advantages
It is simple to compute and easy to understand.
It recognize the profitability factor.
Disadvantage
It does not recognize the time value of money
It uses accounting income instead of cash inflows
It difficult to determine the minimum acceptable
rate or return.
It does not take into account the amount of
investment.
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Examples:
Z Corporation invested 6,854 in a 4-year project. Z
Corporation’s Cost of capital is 8%. Additional bits
of information on the project are as follows:
Year After –tax cash inflow of 1
1 2,ooo
2 2,200
3 2,400
4 2,600
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Example:
Assume that:
Initial investment 12, 950
Estimate life 10 years
Annual Cash Inflows 3,000
Answer : Trial Error
( . )
At 18% 3000 = 13,482.26
.
( . )
At 20% 3000 = 12,577.42
.
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by interpolation:
13,482.26 13,482.26 At 18%
12,950.00 Initial investment
12,577.42 At 20%
532.26 904.84 .2% 0.02
Y1+(X1-X)/(X1-X2)*(Y2-Y1)
IRR= .18+532.26 / 904.84(.02)
IRR= 19.18%
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Profitability Index
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