Capital Budgeting - Phase 2

8/12/2019 Capital Budgeting - Phase 2

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Capital BudgetingMANAGEMENT ADVISORY SERVICES PART 2 2

DISCOUNTED CASH FLOW METHODS

1. Net present value

2. Profitability index

3. Net present value index4. Present value payback

5. Time adjusted rate of return


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Principle of Time Value of Money

1. Present value (Discounting)

2. Future value (Compounding)


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Principle of Time Value of Money

1. Present Value Factor of 1

2. Present Value Factor of Annuity of 1

3. Present Value Factor of Annuity Due


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Annuity is any continuing payment with

a fixed total amount

Ordinary annuity a series of equal

payment made at the end of each period

Annuity due payment is made

immediately or at the beginning of theperiod.


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Example:

Assume that a project can generate net

annual cash inflows of Php 500,000 over

the next 3 years and cost of capital of10%.

Find the PV of the annual net cashflows.


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Example:

Assume that a project can generate net

annual cash inflows of Php 500,000

during the 1

st

year, 650,000 2

nd

year,600,000 3rdyear.

Find the PV of the annual net cashflows.



NET PRESENT VALUE METHOD

PV of cash inflows

Less: PV of cash outflows

PV of Cash inflowsLess: PV of Cost of investment

PV of cash inflowsLess: Cost of investment



Example:

1. A project that will cost Php 400,000 is

expected to generate cash inflows of Php

150,000 annually for 5 years. Cost of capital

is 20%. Will this project be accepted?



ANSWER:

YEAR INFLOWS PVF PV OF CASH

1 150,000 .83333 125,000

2 150,000 .69444 104,167

3 150,000 .57870 86,805

4 150,000 .48225 72,338

5 150,000 .401878 60,282

TOTAL PV 448,592

LESS: COST 400,000

NPV 48,592



Example:


expected to generate cash inflows, as

follows:

Year 1 Php 150,000Year 2 270,000

Year 3 120,000

Cost of capital is 20%



ANSWER:


1 150,000 .83333 125,000

2 270,000 .69444 187,499

3 120,000 .57870 69,444

TOTAL PV 381,943

LESS: COST 300,000

NPV 81,943



Example with Salvage value:



150,000 annually for 5 years. Salvage value

is Php 20,000 after 5 years. Cost of capitalis 20%. Will this project be accepted?



ANSWER:


1 150,000 .83333 125,000

2 150,000 .69444 104,167

3 150,000 .57870 86,805

4 150,000 .48225 72,338

5 150,000 .401878 60,282

Salvage Value 20,000 .401878 8,218

TOTAL PV 456,810LESS: COST 400,000

NPV 56,810



Example with Salvage value & WC:



150,000 annually for 5 years. Salvage value

is Php 20,000 after 5 years, working capitalof Php 20,000. Cost of capital is 20%. Will

this project be accepted?



ANSWER:


1 150,000 .83333 125,000

2 150,000 .69444 104,167

3 150,000 .57870 86,805

4 150,000 .48225 72,338

5 150,000 .401878 60,282

Salvage Value 20,000 .410878 8,218

Working capita 20,000 .410878 8,218

TOTAL PV 465,028

LESS: COST(with WC)

420,000

NPV 45,028



Net Present Value Method

1. Considers time value of money

2. Considers cash flow over the entire life of

the project

3. Use of discount rate should be carefullycomputed.



Profitability Index

Present value index

Desirability index

Total present value index

This is the ratio of the present value of cash

inflows to the present value of the cash

outflows.


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Profitability Index

Total Present value of Cash inflows

Total Present value of Cash outflows

In evaluating projects using profitability

index, an index of 1.0 may be used as

threshold point.


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EXAMPLE:

Management has considered the following projects.

PROJECT 1 PROJECT 2

Cost of investment 20,000 40,000

Annual net cash inflows 8,000 16,000Economic life 5 years 5 years

Cost of capital 10% 10%


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ANSWERS:

.

PROJECT 1 PROJECT 2

PV of cash inflows (3.791) 30,328 60,656


Net present value 10,328 20,656

Profitability index 1.52 1.52


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Net Present Value Index

Net present value

Present value of cash outflows

A positive net present value index indicates that

the project is acceptable.


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EXAMPLE:

Management has considered the following projects.

PROJECT 1 PROJECT 2


Annual net cash inflows 8,000 16,000Economic life 5 years 5 years

Cost of capital 10% 10%


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ANSWERS:

.

PROJECT 1 PROJECT 2

PV of cash inflows (3.791) 30,328 60,656


Net present value 10,328 20,656

Profitability index 1.52 1.52NPV index .52 .52


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Capital Rationing

The process of ranking prospect projects.

The highest index has the highest priority.


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Example:

ABC Corporation availed of bank loans of Php 12

million to invest to various capital projects, as follows:

Which among these projects should the Company

invest?

PROJECT COST PV OF INFLOWS

A 4,000,000 4,850,000

B 6,000,000 7,200,000

C 5,000,000 5,500,000

D 3,000,000 3,470,000


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Drills (RS):

An equipment costing Php 800,000 will produce

annual net cash inflows of Php 300,000. At the end

of its useful life of 5 years, the equipment will have

a residual value of Php 20,000. The desired rate ofreturn is 18%.

Calculate:

1. NPV2. Profitability index

3. NPV index


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Present Value Payback

Cash flows to be used are converted to their

present values.


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Example:

Let us consider the following data:

Cost of investment Php 500,000

Annual net cash inflows 125,000Cost of capital 5%

Payback period 4 yearsPresent value payback ???


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Discounted Cash flows

Time adjusted rate of return

Internal rate of return (IRR)

Discounted rate of return

Discounted cash flow rate of return

IRR > cost of capital, project should be

accepted

OBJECTIVE: NPV SHOULD EQUAL COST


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PV OF CASH INFLOWS = COST OF

INVESTMENT


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Example (even cash flows):

1. FGU Management wants to buy a new

equipment amounting to Php 1 million, with

economic life of 4 years. Annual net cash

inflows amounted to Php 375,000. The rateof return is 14%. How much is the internal

rate of return?


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PV OF CASH INFLOWS = COST OF

INVESTMENT

PV factor (375,000) = 1,000,000

PV factor = 2.667

18% to 20%


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Drills (RS) (even cash flows):

Grop Corporation has the opportunity to buy a

new machine at Php 520,000. This machine is

expected to have a useful life of 4 years with no

residual value and will yield an annual net cashinflow of Php 200,000. The companys rate of

return is 10%


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Example (uneven cash flows):

Compute for IRR.

Cost of investment Php 2,800,000Salvage Value 100,000

Year 1 1,200,000

Year 2 950,000

Year 3 800,000

Year 4 600,000

Year 5 500,000

Ave. cash inflows 830,000


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Drills (RS) (uneven cash flows):

A new equipment costing Php 800,000 with five

years useful life and Php 40,000 residual value

at the end of five years. The following net cash

inflows:

Year 1 350,000

Year 2 300,000

Year 3 250,000Year 4 150,000

Year 5 80,000


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Herman Company acquired an asset at a cost of P46,600. It had an

estimated life of ten years. Annual after tax cash benefits are estimated

at P10,000 at the end of each year. The following amounts appear in

the interest table for the present value of an annuity of P1 at year-end

for ten years.

16%-4.83 18%-4.49 20%-4.19

REQUIRED:

Determine the maximum interest rate (time-adjusted rate of return) that

could be paid for the capital employed over the life of this asset withouttoss, on this project.


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NPV Company is considering to buy a new machine which cost

P50,000. It will be a labor saving investment which will reduce payroll

by P13,500 per year. Its useful life is 8 years and it will have zero

salvage value. A minimum desired rate of return of 18% is used for

capital investment decisions. Information on present value factors is as

follows:

Present value of P1 for 8 periods at 18% .266

Present value of an annuity of P1 for 8 periods 4.078

Should the machine be acquired?


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C it l B d ti

Drills (RS) (uneven cash flows):

The Cap Company is considering the replacement of Machine A with

Machine B that will cost P160,000 and will result in annual savings of P40,000

before income taxes because of the expected increase in operating efficiency.

Machine B has an estimated useful life of 10 years and salvage of P10,000.

Machine A has a book value of P16,000 and a disposal value of P20,000 now.

Straight-line depreciation is used and the company has an averageincome tax rate of 35%. The minimum desired rate of return on this investment

is 20% The present value of an ordinary annuity of P1 in arrears for 10 periods

at 20% is 4.192. The present value of P1 for 10 periods at 20% is 0.162

REQUIRED:

1. Determine the Net Investment.

2. Determine the annual cash flow net of income tax.

3. What is the net present value of the investment.

Capital Budgeting - Phase 2

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