LECTURE ON CAPITAL INVESTMENT DECISIONS:

u Capital Investment decisions is focused on:

1. Identification of relevant cash flows in capital investments
2. Techniques and methods for analysing project data

The present value tables are necessary for DISCOUNTING FUTURE CASH FLOWS to better understand
the TIME VALUE OF MONEY

Capital Budgeting - is the process of EVALUATING SPECIAL PROJECTS, ESTIMATING BENEFITS and
COSTS of the projects, and SELECTING which projects to FUND

Capital investment include the CASH OUTFLOW - which is the INVESTMENT----

and CASH INFLOW - which are the RETURNS on the INVESTMENT ----

** The typical investment project has cash outflows at the beginning, and
and cash inflows over the life of the project;

u CASH OUTFLOWS: CASH INFLOWS:

1. The cash cost of the INITIAL INVESTMENT plus 1. Incremental cash revenues received over the
any start-up costs project's life

2. Incremental cash operating costs incurred 2. Reduced operating expenses received over the
over the project's life project's life

3. Incremental working capital such as 3. Cash received from selling old assets being
inventories and accounts receivable replaced in the new project, net of tax impacts

4. Additional outlays needed to overhaul, 4. Released Working Capital, at the project's end
expand, or update the assets during the
project's life

5. Additional taxes owed on incremental 5. Salvage value realized from asset disposition at
taxable income the project's life end

DECISION CRITERIA: Winning projects generally have the HIGHEST rates of RETURN ON INVESTMENT.
Decisions are either: ACCEPT OR REJECT, or
SELECT: A, or B, or C, etc.

1. We decide whether the RETURN is acceptable or unacceptable

2. Preference or RANKING DECISION - Select the BEST CHOICE from a set of mutually exclusive projects;
** By picking A, we reject B or C; and any other choices. The other choices is to DO NOTHING

Generally, projects are ranked on a scale of HIGH to LOW returns. The highest ranking projects are
selected until the capital budget is spent;

u PRESENT VALUE u FUTURE VALUE

Converts future pesos into current peso Converts all pesos into equivalent pesos as of
equivalents some future date

= the investment principal plus COMPOUND interest

We need an interest rate and the number of time periods between TODAY and the FUTURE cash flows

Example: FV = (1 + i)n where: i = interest rate

n = number of years

u A. The future value of P100 in two years, with interest compounded at the rate of 10% annually?
1. FV of P 1 = 1.1 x 1.1 = 1.21
2. FV of P 100 = 100 x 1.21 = 121
LECTURE ON CAPITAL INVESTMENT DECISIONS:

u B. An alternative investment will earn a 15% ROR. Assuming certainty, the future value in two years of
the P 100 at 15% is:
1. FV of P 1 = 1.15 x 1.15 = 1.3225
2. FV of P 100 = 100 x 1.3225 = 132.25

u C. Comparing Projects A and B, the project earning 15 percent is preferred to the 10 percent project

Example: PV = 1/(1+1)n where: i = interest rate

n = number of years

u D. Assume that P 121 is needed in two years; and the rate of interest is 10%.
How much must be INVESTED TODAY to have P 121 after two years?
1. PV of P 1 for two years at 10 percent = 1/ (1.10)2 = 0.826446
2. Multiply No. 1 with the future value x 121

3. PRESENT VALUE (Today)………………………………………………………………. P 100

u E. TIME LINE
0 1 2
Year 1 Year 2

P 100 P 110 P 121

Present Value Future Value

u F. DISCOUNTING - is the process of reducing a FUTURE AMOUNT to a PRESENT VALUE

(DISCOUNTED VALUE)

DISCOUNT RATE - the rate of INTEREST

DISCOUNT FACTOR - Example: 0.826

EXAMPLE (1) A machine is sold at P 100,000. The buyer signs a 10-year contract with an interest rate
of 10 percent, paid annually. The contract specifies the following payments:
Interest Payment of Total Cash
Year @ 10% Principal Outflow
1 10,000 10,000
2 10,000 10,000
9 10,000 10,000
10 10,000 100,000 110,000

Suppose that the current market rate of interest is 12%. In this case, investors are not willing to buy
the contract at face value, because they could earn 12% elsewhere;

Promise 1 P 100,000 x 0.322 10 periods @ 12% from Table 1 32,200

Promise 2 P 10,000 x 5.650 10 payments @ 12% from Table 2 56,500
Proceeds from sale of this contract 88,700
Discount (P 100,000 minus P 88,700) 11,300
The SP of the Machine 100,000

Note: The investor who purchases the contract from us at P 88,700 (with a discount of P 11,300) will earn
12%: Interest on the P 88,700 invested = P 11,300 = Yield
= Effective Interest

u G. Suppose the current market price is 8%, an investor shall pay a premium for a contract with a 10 percent
interest rate. The selling price and the premium is determined as follows:

Promise 1 P 100,000 x 0.463 10 periods @ 8% from Table 1 46,300

Promise 2 P 10,000 x 6.710 10 payments @ 8% from Table 2 67,100
Proceeds from sale of this contract 113,400
LECTURE ON CAPITAL INVESTMENT DECISIONS:
Discount (P 100,000 minus P 88,700) (13,400)
The SP of the Machine 100,000

u How To use The Tables?

THE PRESENT VALUE of a SERIES OF FUTURE CASH FLOWS
ANNUITY/EQUAL---------------- a series of EQUAL CASH FLOWS-------- TABLE 1
The present value of a series is the sum of all present
values of the individual amounts

UNEVEN (Cash inflows)------------------------------------------------------ TABLE 2

Example: The present value of five annual receipts of P 1,000 using a 10% discount rate is:

Year Cash flows Formula PV Factor PV Explanation

1 1,000 x (1/1.10)1 0.9091 909 PV of P1,000 received at end of Year 1
2 1,000 x (1/1.10)2 0.8264 826 PV of P1,000 received at end of Year 2
3 1,000 x (1/1.10)3 0.7513 751 PV of P1,000 received at end of Year 3
4 1,000 x (1/1.10)4 0.6830 683 PV of P1,000 received at end of Year 4
5 1,000 x (1/1.10)5 0.6209 621 PV of P1,000 received at end of Year 5

u H. Or multiply P 1,000 x 3.7908 3,791 PV of Annuity of P1,000 for 5 years

u I. USE OF THE TABLES:

@ 12 % @ 10% @ 8%
Table 1 Table 2 Table 1 Table 2 Table 1 Table 2
1 0.893 1 0.909 1 0.926
2 0.797 2 0.826 2 0.857
3 0.712 3 0.751 3 0.794
4 0.636 4 0.683 4 0.735
5 0.567 3.605 5 0.621 3.791* 5 0.681 3.993
*due to rounding
ILLUSTRATIONS:

v    A. EQUIPMENT REPLACEMENT AND CAPACITY EXPANSION:

QUARTS Timepieces, a Seattle Company is considering a device costing $ 100,000 to replace an

obsolete production device
1. The new device's expected life is FIVE YEARS and can be probably be sold at the end of Year 5
for P $ 10,000
2. The vendor recommends an updating in Year 3 at a cost of $ 20,000
3. Capacity will increase by 1,000 units per year. Each unit sells for $55 and has $30 variable costs
4. Additional inventory of $3,000 is needed and will be released at project's end
5. Operating costs will be reduced by $15,000 per year
6. The old machine can be sold for $8,000 now, which is its book value. But it could be used for
five years with no salvage or book value at that time

v    SOLUTION: QUARTS Timepieces ** Format for a Relevant Capital Investment Data

Life of the Project

** Today Year 1 Year 2 Year 3 Year 4 Year 5
Cash flows: (100,000)
New device
Salvage value 10,000
Sale of old device 8,000
Added inventory (3,000) 3,000
Added contribution margin 25,000 25,000 25,000 25,000 25,000
Operating cost savings 15,000 15,000 15,000 15,000 15,000
Updating costs (20,000)
Net cash investment (95,000)
NET CASH INFLOWS 40,000 40,000 20,000 40,000 53,000

≤ ≥
v    B. DISCOUNTED VALUE METHODS/PRESENT VALUE METHODS:
NET PRESENT VALUE METHOD (NPV)
includes the TIME VALUE OF MONEY by using INTEREST RATES that represent the DESIRED ROR or,
at least sets a MINIMUM ACCEPTABLE ROR

Decision Rule:
If PV of Incremental Net Cash INFLOWS is ≥ Incremental Investment CASH OUTFLOWS
APPROVE THE PROJECT

Project's ROR ≥ Minimum Acceptable ROR

If NPV is ZERO or POSTIVE, the project is ACCEPTABLE. When the sum is NEGATIVE, the
project's ROR is less than the discount rate

Decision Rule:
If PV of Incremental Net Cash INFLOWS is ≤ Incremental Investment CASH OUTFLOWS

Project's ROR ≤ Minimum Acceptable ROR

If NPV is NEGATIVE, the project should be REJECTED

v    Refer to QUARTS Timepieces: NPV

Life of the Project
Today Year 1 Year 2 Year 3 Year 4 Year 5
Net Cash Inflows (95,000) 40,000 40,000 20,000 40,000 53,000
PV factors @ 12% 1 0.893 0.797 0.712 0.636 0.567
PVs @ 12% (95,000)
Sum of the PVs from Y1 to Y5 137,331 35,720 31,880 14,240 25,440 30,051

NPV 42,331
v    C. THE INTEREST RATES:

1. COST OF CAPITAL - a Weighted Average Cost of LONG-TERM FUNDS. Only projects that can
earn at least what the firm pays for funds should be accepted

2. Minimum Acceptable ROR - a particular rate that is considered to be the LOWEST ROR that
management will accept

3. Desired ROR, Target ROR, or Required ROR - a rate that reflects management ROR expectations

4. Hurdle rate - a threshold that a project's ROR must "jump over" or exceed

5. Cut-off-rate - the rate at which projects with a higher ROR are accepted and those with
a lower ROR are often rejected; often the rate where all available investment
funds are committed

v    Refer to QUARTS Timepieces: If other discount rates had been selected, we would find the ffg. NPVs:

% Sample PVs of NCI INVESTMENT NPV

16% 34,480 124,328 95,000 29,328
20% 29,720 113,246 95,000 18,246
24% 12,820 103,713 95,000 8,713
28% 22,080 95,523 95,000 523
30% 25,228 91,797 95,000 (3,203)
124,328

Note: As the interest rate INCREASES, the PVs of the future cash flows DECREASE. At 30% a year, the
projects NPV is negative, and the project is unacceptable. The project's ROR must be between
28% and 30%

v    D. The INTERNAL ROR METHOD - is the project's ROR and is the rate where the:

NET INITIAL INVESTMENT CASH OUTFLOW = PV of the INCREMENTAL CASH INFLOWS

v    Refer to QUARTS Timepieces:

ROR NPVs COMPUTATIONS BY INTERPOLATION

28% 523 Base Rate 28%
30% (3,203) Plus the Product of:
2% DIFF 3,726 ABSOLUTE 2%
AMOUNT 523
3,726 14% 0.28%
Then ----the IRR is------------------------------------------------------------------------- 28.28%

v    E. ESTIMATING THE IRR

By using Table 2, and knowing certain projects variables, we can estimate other unknown variables
including a project's IRR. This estimate requires that the Annual Net Cash Inflows be an ANNUITY

ILLUSTRATION:
VARIABLE SAMPLE DATA
A = Initial Investment Cash Outflow $ 37,910
B = Life of project 5 years
C = Annual Net Cash Inflow $ 10,000 per year
D = Internal Rate of Return 10 percent
E = PV Factor at 10% - (Table 2) 3.791

Note: If we know any three of A, B, C, or D ----we can find E and the missing Variable

**DR = DECISION RULE

1. WHAT IS THE IRR of the project? Then: D = 10% Table 2
 If A, B AND C are known, Calculate E and find D

E = A 37,910
= 3.791
C 10,000

2. What Annual Cash Inflow will yield a 10% IRR from the project? Then: C = 10,000 per year
If A, B and D are known, we can find E and calculate C

E = 3.791 Table 2

C = A 37,910
= 10,000 per year
E 3.791

**DR We need $ 10,000 per year in cash inflow to earn a 10% IRR

3. What can we afford to invest if the project earns $ 10,000 each Then: A = 37,910
year for five years and want a 10% IRR?
If we know B, C and D, we can find E and then calculate A

D = 10 percent E = 3.791 (Table 2) B = 5 years

A = C x E = 10,000 x 3.791 = 37,910

**DR We can pay no more than $ 37,910 and still earn at least a 10% return

4. How long must the project last to earn at least a 10% IRR? Then: B = at least 5 years
If we know A, C and D, we can calculate E and find B

A = 37,910 C = $ 10,000 D = 10 percent

E = A 37,910
= 3.791
C 10,000

v    F. PROJECT RANKING:
(1) Rank projects by the amount of NPV each generates, but this ignores the relative size of the
INITIAL INVESTMENT

(2) PROFITABILITY INDEX (the extension of NPV)

PVs of a Project Net Cash Inflows (NCI) CASH IN

= =
Net Initial Investment CASH OUT

Example:
PVS of Initial Prof
Project NCI Invest NPV Index RANK
A 235,000 200,000 35,000 1.18 5
B 170,000 140,000 30,000 1.21 4
C 80,000 60,000 20,000 1.33 1
D 98,000 80,000 18,000 1.23 3
E 52,000 40,000 12,000 1.30 2

**DR The higher the ratio is, the more attractive the investment becomes. An acceptable project should
have a Profitability Index of at least 1.0 (Accept projects with the highest Profitability Index until
we exhaust the capital budget of the list of acceptable projects

v    G. PAYBACK PERIOD METHOD: How fast do we get out initial cash investment back?
(Quick and dirty)

No ROR is given, only a time period, If annual cash flows are equal, the payback period is:
 Net Initial Investment
Payback Period =
Annual Net Cash Inflow (EVEN)

Example: If the investment is $ 120,000 and annual Net Cash Inflow is $ 48,000, the payback
period is 2.5 years. We do not know how long the project will last nor what cash
flows exist after the 2.5 years. It might last 20 years or 20 days beyond the payback pt.

v    H. PAYBACK BAIL-OUT METHOD:

Example: If the Annual Cash Flows are UNEVEN, the payback period is found RECOVERING the
INVESTMENT cost year by year

v    Refer to QUARTS Timepieces:

Unrecovered Payback
Year Cash flows Investment Period
0 (95,000) 95,000 0
1 40,000 55,000 1
2 40,000 15,000 1
3 20,000 0 0.75 15/20
2.75

**DR In Year 3, the cost is totally recovered, using only $15,000 of Year 3's $ 20,000 (75%), Hence, the
Payback Period is 2.75 years

v    I. PAYBACK RECIPROCAL TO ESTIMATE IRR

Example: If a $ 40,000 investment earns $ 10,000 per year and could last 12 years, the payback
period is 4 years

a. Net Initial Investment 40,000

Payback Period = 4
Annual Net Cash Inflow (EVEN) 10,000

b. 1 1
Payback Reciprocal = 25%
Payback Period 4

c. From Table 2 for 12 years, the PV factor (payback period of 4 indicates a ROR between 22 and 24
percent.. The payback reciprocal will always overstate the IRR

**DR If the project's life is very long, say 50 years, the payback reciprocal is an almost perfect estimator
(See the PV factor of 4.000 for 25 percent and 50 periods on Table 2)

v    J. ACCOUNTING RATE OF RETURN (ARR METHOD):

1. Ignores Time Value of Money
2. Presumes Uniform Flows of income over the project's life
3. Includes depreciation expense and other accounting accruals in the calculation of project income
losing the purity of cash flows

**DR The ARR Method attempts to measure accrual net income from the project. The ARR subtracts
Depreciation expense on the incremental investment from the annual Net Cash Inflows.
Other accrual adjustments may also be made

Annual Operating Cash Inflow

ARR =
Less: Depreciation Expense on Incremental Investment
Average Investment

AVERAGE INVESTMENT:
* The denominator is the average of the net initial investment and the ending investment base
(0) if no salvage value exists). This is the average book value of the investment over its life

Some analysts prefer the use of the original cost of the investment or replacement cost as the
denominator.
 The numerator is the incremental accrual net income from the project

ILLUSTRATION: Initial investment 110,000

Annual Cash Inflow 35,000
Depreciation Expense 20,000 SV = P 10,000
Project Life 5 years

SOLUTION: ARR Numerator = 35,000 - 20,000 15,000

= 25%
Denominator = (110,000 + 10,000/2) 60,000