EVALUATION OF INVESTMENT

PROPOSAL

LESSON 8 :THE PAYBACK PERIOD

LESSON 9 : THE AVERAGE RATE OF
RETURN
LESSON 10: NET PRESENT VALUE
LESSON 11 : INTERNAL RATE OF
RETURN
 I. THE PAYBACK PERIOD
INTRODUCTION
  

 The length of time necessary for a payback period

on an investment is something to strongly consider
before embarking upon a project - because the longer
this period happens to be, the longer this money is
"lost" and the more it negatively it affects cash flow
 until the project breaks even, or begins to turn a profit.
 
This lesson tackles payback period and how

it is typically used to evaluate projects or
investments before undergoing them, by
evaluating the associated risk.
 SAMPLE INVESTMENT PROPOSAL

Purchase of a New Machine

 Acquisition Cost Php. 1,000,000.00
 Economic Life 10 years
 Salvage Value 10,000.00
 TAX RATE 31%
 COST OF CAPITAL 16%
Estimated Earnings and Cost per year
if New Machine is purchased:
Income Php. 500,000.00
Expenses (200,000.00)
Gross Profit 300,000.00
Less: Depreciation (100,000.00)
Income before tax 200,000.00
Less: Income tax (31%) (62,000.00)
Average
Net Income per year 138,000.00
 The Payback Period
Payback Period - determines the number of years
required to recover the cash investments made on a
project.
PAYBACK PERIOD = COST/ ANNUAL CASH
INFLOW
P.P. = 1,000,000.00/ 238,000.00
P.P. = 4. 2 YEARS
DECISION FACTOR = THE SHORTER P.P. THE
BETTER.
= BASED ACCORDING TO INDUSTRY AVERAGE
 Compute the annual cash inflow using the
information below and determine which project to
accept using the PAYBACK PERIOD.

PROJECT COST INCOME/ EXPENSE/ SALVAGE TAX % LIFE

YR YR V.
MACHINE A 600,000 450,000 180,000 30,000 20% 10
(COST OF CAPITAL IS YEARS
14%)
MACHINE B 800,000 500,000 250,000 40,000 22% 5
(COST OF CAPITAL IS YEARS
16%)
AVERAGE RATE OF RETURN &
ACCOUNTING RATE OF RETURN

 INTRODUCTION
  

The average rate of return method allows for a

simple comparison between different types of
investments. Since it results in a single
percentage, investors can an investment's returns
if produces its average rate of return in the future.
This information is useful when investors must
also consider the level of risk for an investment
and the total cost of investing. The method's
simplicity allows it to play a part in the complex
process of selecting the right investment.
 Average Rate of Return
 AVG. RATE OF RETURN = ANNUAL CASH INFLOW/ ACQUISITION
COST

= 238,000/ 1,000,000.00

= 23.8% OR 24%

ACCOUNTING RATE OF RETURN = NET INCOME / ACQUISITION

COST

= 138,000/ 1,000,000

= 13.8% OR 14%

 DECISION FACTOR = Accept proposal if ARR is greater than cost of capital

or interest rate. In comparing two proposals both with ARR greater than the
cost of capital, choose the proposal with higher ARR.
Compute the annual cash inflow using the information below and determine which project
to accept using the average rate of return and accounting rate of return.
PROJECT COST INCOME/YR EXPENSE/YR SALVAGE TAX % LIFE
V.
MACHINE A 600,000 450,000 180,000 30,000 20% 10
(COST OF CAPITAL IS YEARS
14%)
MACHINE B 800,000 500,000 250,000 40,000 22% 5 YEARS
(COST OF CAPITAL IS
16%)
 NET PRESENT VALUE
INTRODUCTION

Money in the present is worth more than the same amount in

the future due to inflation and to earnings from alternative
investments that could be made during the intervening time.
 
Net present value (NPV) is the calculation used to find
today’s value of a future stream of payments. It accounts for
the time value of money and can be used to compare
investment alternatives that are similar. 
 
 Net Present Value
Net Present Value = PV OF CASH INFLOW + PV OF SALVAGE VALUE -
ACQUISITION COST

 NPV = CASH INFLOW x + SV x - AC

NPV = 238,000(4.8332) + 10,000 (.2267) - 1,000,000

 NPV = 1,150,301.6 + 2267 - 1,000,000
 NPV = 152, 568.6
 DECISION FACTOR = Accept the proposal if there is a positive NPV. In
comparing two proposals with both positive NPV, choose the one with
greater NPV.
Compute the annual cash inflow using the information below and determine which project
to accept using the NET PRESENT VALUE analysis.
PROJECT COST INCOME/YR EXPENSE/YR SALVAGE TAX % LIFE
V.
MACHINE A 600,000 450,000 180,000 30,000 20% 10
(COST OF CAPITAL IS YEARS
14%)
MACHINE B 800,000 500,000 250,000 40,000 22% 5 YEARS
(COST OF CAPITAL IS
16%)
 Simplification of NPV using tables:
NPV = CASH INFLOW (TABLE IV PV ORD. ANN) + 10,000 ( TABLE II PV OF
SINGLE PAYMENT) - ACQUISITION COST
NPV = 238,000(4.8332) + 10,000 (.2267) - 1,000,000
NPV = 1,150,301.6 + 2267 - 1,000,000
NPV = 152, 568.6
INTERNAL RATE OF RETURN
INTRODUCTION

Companies take on various projects to increase their

revenues or cut down costs. A great new business idea
may require, for example, investing in the development
of a new product.
In capital budgeting, senior leaders like to know the
reasonably projected returns on such investments. The
internal rate of return is one method that allows them to
compare and rank projects based on their projected
yield. The investment with the highest internal rate of
return is usually preferred.
INTERNAL RATE OF RETURN
 Internal Rate of Return = This method and the NPV method
use the discount rate as a factor. The difference is that under
the internal rate of return, the discount rate is not given.
Rather, it becomes the object of computation. The discount
rate which will yield a net present value of zero or one
approximating zero is the correct discount rate.

 The acceptability of the proposal will depend on the

prevailing interest rate as compared with the computed correct
discount rate. If the prevailing interest rate is higher, the
proposal is rejected. If it is lower, the proposal is accepted.
 INTERNAL RATE OF
RETURN
BASE PERIOD IS 4.200 (PAYBACK PERIOD)
 n = 10 years economic life

TABLE IV PV (ORDINARY ANNUITY) Base Period = 4.200

20% = 4.1925 (4.200 n = 10 years)

16% =4. 8332 Therefore, internal rate of return is between 16% and 20%.
Desired rate is only 16% AND IRR is 16 - 20% hence the decision is to accept the
proposal.
 OUTPUT REQUIREMENT(Short bond paper,
handwritten with solutions)E-mail
PROBLEM-SOLVING: A. Analyze and fill out the missing items in the given tables below for 2 proposed investments.
GIVEN:
PROJECT Cost of COST INCOME/ EXPENSE/ SALVAGE TAX % Economic ANNUAL
Capital YR YR Value LIFE DEPRECIATION

MACHINE A 12 500,000 350,000 140,000 ? 20% 5 YEARS 90000

_______
MACHINE B 14 700,000 500,000 200,000 40,000 22% 7 YEARS ?
__________________

ESTIMATED NET INCOME PER YEAR ESTIMATED NET INCOME PER YEAR
FOR: MACHINE A FOR: MACHINE B
Gross Income Gross Income
Expenses Expenses
Gross Profit Gross Profit
Less: Depreciation Less: Depreciation
Income Before Tax Income Before Tax
Income Taxes Income Taxes
Avg. NET INCOME Avg. NET INCOME

ANNUAL CASH INFLOW: ANNUAL CASH INFLOW:

B. Using the evaluation tools, determine the payback period, average rate of return, accounting rate of return, net present value ,
and IRR of the two investments and determine whether to accept or reject the proposals