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Formula for the Net Investment

Cost of asset
Purchase price xxx
Delivery cost xxx
Installation cost xxx xxx
Incremental working capital xxx
Immediate cost savings (xxx)
Proceed from sale of an asset (xxx)
Taxes on sale of old asset gain xxx
or taxes on sale of old asset loss (xxx)
Net Investment xxx

Incremental Cash Returns
Increase in revenues xxx
Increase in cash charges xxx
Increase in depreciation xxx
Incremental cash returns xxx



Example
The following data are given on a new machine and an old one that is intended to be replaced:

New Old
Cost (life 5 years) P150,000
Book value (remaining life 5 years) P 60,000
Market value 48,000
Working capital requirement 50,000 20,000

Annual revenue 200,000 100,000
Annual out-of-pocket operating costs 100,000 80,000
Immediate repairs on old machine to
Operate efficiently 10,000
Income tax rate 35.0%

Required: Compute for the Net investment and incremental cash returns.

Net investment
Cash outflow:
Cost of new machine P150,000
Incremental working capital 30,000 P180,000
Cash inflow and savings
Net proceeds from sale of old
Machine Market value P 48,000
Add: Tax benefit on loss
(60,000 48,000) x 35% 4,200
Incremental cash returns
Incremental net income
Increase in annual revenue (P200,000 P100,000) P 100,000
Increase in out-of-pocket
Operating costs (P100,000 - 80,000) (20,000)
Increase in depreciation charges 150,000 - 60,000 (18,000)
5 years 5 years
Incremental income before income tax P 62,000
Incremental income tax (35%) (21,700)
Incremental net income P 40,300
Add: Incremental depreciation 18,000
Incremental cash returns P 58,300
P 52,200
Savings cost on immediate repairs
needed on old machine, net of tax
P10,000 x (1 35%) 6,500 58,700
Net Investment P121,300
















After getting the incremental cash return, the different capital budgeting methods may now be
applied.

For the purpose of illustration, let us use the NPV to determine the acceptability of the project.
Let us assume further that the cost of capital is 12%.


NPV = incremental cash return 1 - ( 1 + i )
-n
- net investment


i

= 58,300 1 (1.12)
-5
- P121,300
0.12

= 58,300 (3.6048) 121,300

= P88,859.84

Since the NPV is positive P88,859.84, then accept the project.


Capital Budgeting Decision on Projects With Unequal Lives

Decision making on projects that is independent with each other is a not so complex problem to
deal with. Decisions can be made independently as long as the project meets the demand of the
firm regardless of their respective lives. However, if a project is mutually exclusive and it has
unequal lives, the impact of different lives must be considered over comparable periods.

The approaches are as follows:
1. Replacement Chain (Common Life) Approach
2. Equivalent Annual Annuity Approach


Replacement Chain (common life) Approach

It is a process where projects with unequal lives are compared to their respective NPVs with the
assumption that at the end of the life of the project a replacement is made until the project
proposal arrives at a common terminal date. The same amount of initial investment, cash
inflows, cost of capital and life of the project are used. In replacement chain approach, the NPV
is determined for each proposal, and one or more iterations can be completed to create
comparable time frames for the proposals. Thus, the short-lived project proposal is reinvested at
the required rate of return until it already equates to the longer-lived project proposal. By
comparing the proposals over like-periods of time, accept-reject information for the various
proposals becomes more reliable.



Example
Cost of capital for both projects is 12% and it is mutually exclusive project.

Project A

0 1 2 3 4 5 6
-40,000 8,000 14,000 13,000 12,000 11,000 10,000

NPV = P6,491


Project B

0 1 2 3 1 2 3
-20,000 7,000 13,000 12,000

-20,000 7,000 13,000 12,000

NPV = P5,155 NPV = P5,155 (1.12)
-3


3,669
P8,824


Based on the given example, project B has a life of 3 years while project A has 6 years. Since
the two proposals have unequal lives and it is not proper to compare their NPVs based on the
original life of B, it is assumed that project B is replaced with a similar investment at the end
of 3 years. Thus, project B would be viewed as two project Bs. The first NPV of project B
was P5,155 and upon replacement it created the second NPV of P3,669. The figure was
obtained by getting the present value of the first NPV. Since the total NPV of project B is
P8,824 and project A has P6,941, therefore project B should be accepted because of a higher
NPV.

Let say that the life of project A is 10 years and project B is 6 years, the replacement cycle
for project A is 3 times and project B is 5 times being their least common denominator is 30.


Annualized Net Present Value (ANPV) Approach

The annualized Net Present Value (ANPV) method is used when comparing mutually exclusive
projects that have unequal duration. ANPV is an efficient method to convert NPVs of projects
with unequal duration into an ANPV for each specific project, which can then be compared.
ANPV is determined by dividing the NPV of each project over its life using the appropriate cost
of capital. For those projects with negative NPV shall be disregarded and those projects with
positive NPV shall be divided by the present value factor for an annuity at the given cost of
capital and the projects life in order to get the annualized NPV.. The project proposal with the
highest ANPV shall be chosen.


Example
Anna Pova Corporation has two mutually exclusive projects X and Y that it can invest in. Initial
investments investments required for project X and Y are P150,000 and P200,000 respectively.
The duration of project X is 4 years and of project Y is 3 years. The incremental cash return from
project X are P50,000 and from project Y is P90,000. The cost of capital of Anna Pova
Corporation is 9% and both projects have an average risk, which means that alteration for risk
adjusted discount rate is not required. The 9% for cost of capital should be used for both projects.

What is the ANPV for projects X and Y?


Answer
First, compute for the NPV of project X.

NPV
X
= incremental cash return 1 - ( 1 + i )
-n
- net investment


i

= 50,000 1 (1.09)
-4
- P150,000
0.09

= 50,000 (3.2397) 150,000

= P11,985


After getting the NPV of project X, compute for the value of its ANPV.

ANPV
X
= NPV
1 - ( 1 + i )
-n

i


= P11,985
1 (1.09)
-4

0.09

= P3,699.42





For project Y, get also the NPV.

NPV
Y
= incremental cash return 1 - ( 1 + i )
-n
- net investment


i

= 90,000 1 (1.09)
-3
- P200,000
0.09

= 90,000 (2.531) 200,000

= P27,790

After getting the NPV of project Y, get the ANPV.

ANPV
Y
= NPV
1 - ( 1 + i )
-n

i


= P27,790
1 (1.09)
-3

0.09

= P10,979.85


Since the ANPV of project Y is (P10,979.85) higher than that of project X (P3,699.42), project Y
should be selected.