CAPITAL BUDGETING PART 2

ACC09 FINANCIAL MANAGEMENT

PART 2
 TOPICS
• Screening of capital projects (2)
• Refinements in capital budgeting

2
Project Appraisal – Discounted
Payback
• Variation of the Pay Back Period
• The number of years required to
return the original investment based
on cash flows which are discounted
at an appropriate cost of capital or
hurdle rate.

3
Exercise–Discounted Payback
Consider the following data in pesos:
Year Investment on Operating Cash Scrap Value
Equipment Inflow
1 4000 1000 2000
2 0 1200
3 2000 1000
4 2000 1000 800
5 500 500
6 3000 -
7 2000 -
8 2000 -

If the required rate of return is 14%, calculate

the discounted pay-back period.
Year PVIF@14% Year PVIF@14%
1 0.877 5 0.519
2 0.769 6 0.456
3 0.675 7 0.400
4 0.592 8 0.351
4
 Project Appraisal – NPV
• Present value of future cash flows,
discounted at an appropriate cost of
capital or hurdle rate, less the cost
of the investment

5
 Project Appraisal – NPV
The MCF Company is considering an investment of
P100,000 in new machinery that would have a useful life of
five years with a terminal salvage value of P10,000. The said
equipment is being depreciated using a method that
considers salvage value in computing for the depreciable
equipment cost. Annual cash earnings after income taxes
are expected to be P30,000 in the first two years, and
P40,000 in the last three years. Working capital will be
increased by P20,000 upon acquisition of equipment and an
additional P20,000 of tools inventory will be required at the
end of two years. Since the project is low-risk, the said
working capital additions would be fully recoverable at the
end of five years. Tax rate for MCF is 30%. The company’s
cost of capital is 15%.
Compute the net present value of the investment. Determine
whether this acquisition should be made by MCF.
Year 1 0.870 Year 3 0.658 Year 5 0.497
2 0.756 4 0.572
6
 Exercise–NPV
Consider the following data in pesos:
Year Investment on Operating Cash Scrap Value
Equipment Inflow
1 4000 1000 2000
2 0 1200
3 2000 1000
4 2000 1000 800
5 500 500
6 3000 -
7 2000 -
8 2000 -

If the required rate of return is 14%, calculate

the NPV.
Year PVIF@14% Year PVIF@14%
1 0.877 5 0.519
2 0.769 6 0.456
3 0.675 7 0.400
4 0.592 8 0.351
7
 Project Appraisal – IRR
• The interest rate that equates the
present value of future cash flows to
the investment expenditure.
– Discount Rate where Net Present
Value=0
• The IRR assumes reinvestment of
the intermediate cash flows at the
IRR.

8
 Project Appraisal – IRR
• Project A under consideration requires an
initial investment of P680,630 and is
expected to result in annual cash flow of
P298,000 after tax for three years.
• Project B which costs P60,000 in cash
has an anticipated life of three years. It is
expected to result in net cash benefits as
follows: first year, P10,000; second year,
P30,000, and third year, P50,000.

9
 Project Appraisal – NPV,IRR
• Requirement/s:
• 1. Determine the net present value of the two
projects using 18%. Using NPV method, which
is more acceptable?
• 2. At what discount rate will the two projects
yield the same NPV? (Give the range.) If at
14%, the difference of the two project’s NPV is
P5,629.60, by interpolation, what would be the
Fisher Rate for these two projects?
• 3. Compute the IRR of each project. If the cost
of capital to measure the risk of the two
projects is at 18%, which project(s) is(are)
acceptable? 10
 Project Appraisal – PI
• Variation of Net Present Value
• Present value of future cash flows,
discounted at an appropriate cost of
capital or hurdle rate, divided by the
cost of the investment.

11
 Project Appraisal - PI
• Project A under consideration requires an
initial investment of P680,630 and is
expected to result in annual cash flow of
P298,000 after tax for three years.
• Project B which costs P60,000 in cash
has an anticipated life of three years. It is
expected to result in net cash benefits as
follows: first year, P10,000; second year,
P30,000, and third year, P50,000.

12
 Project Appraisal
• Requirement/s:
• The company evaluating these two projects hold as a
policy that average risk investments are to be
evaluated using 10% interest, with low-risk ones,
minus 2 percentage points, and high-risk proposals,
plus 2 percentage points. Project A is characterized as
an average risk project and Project B is a high risk
project Compute for the profitability index of
these two projects using their respective
adjusted cost of capitals. Using PI method,
which is more acceptable?
• Compute for the NPV indices. Using NPV
Index method, which is more acceptable?
13
 Project Appraisal – MIRR
• The interest rate that equates the
cost of the investment with the
accumulated future value of the
intermediate cash flows that are
assumed to be reinvested at an
appropriate cost of capital, hurdle
rate, or average rate of return.

14
 Project Appraisal-MIRR
• Project A under consideration requires an
initial investment of P680,630 and is
expected to result in annual cash flow of
P298,000 after tax for three years.
• Project B which costs P60,000 in cash
has an anticipated life of three years. It is
expected to result in net cash benefits as
follows: first year, P10,000; second year,
P30,000, and third year, P50,000.

15
 Project Appraisal - MIRR
• Requirement/s:
• The company evaluating these two projects hold as a policy that
average risk investments are to be evaluated using 10% interest,
with low-risk ones, minus 2 percentage points, and high-risk
proposals, plus 2 percentage points. Project A is characterized as
an average risk project and Project B is a high risk project.
compute for the MIRR for each project. Refer to the following table
excerpts for the future value indices.
Future Value Index Factors of P1
n 10% 11% 12% 13% 14% 15% 16% 17% 18%
1 1.1000 1.1100 1.1200 1.1300 1.1400 1.1500 1.1600 1.1700 1.1800
2 1.2100 1.2321 1.2544 1.2769 1.2996 1.3225 1.3456 1.3689 1.3924
3 1.3310 1.3676 1.4049 1.4429 1.4815 1.5209 1.5609 1.6016 1.6430
Future Value Index Factors of Annuity of P1
n 10% 11% 12% 13% 14% 15% 16% 17% 18%
1 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
2 2.1000 2.1100 2.1200 2.1300 2.1400 2.1500 2.1600 2.1700 2.1800
3 3.3100 3.3421 3.3744 3.4069 3.4396 3.4725 3.5056 3.5389 3.5724 16
 Project Appraisal – EAR
• when unequal-lived projects are
“mutually exclusive”, the impact of
differing lives must be considered
because they do not provide service over
comparable time periods. This is
particularly important when continuing
service is needed from the projects
under consideration.
• The EAR or ANPV is an efficient method
of comparing unequal-lived projects.
Another method being proposed for this
type of comparison is the replacement
method. 17
 Project Appraisal – EAR
• Follow these steps to evaluate projects
using ANPV or EAR method:
• Calculate the NPV of each project over
its live using the appropriate cost of
capital.
• Divide the NPV of each positive NPV
project by the PVIFA at the given cost of
capital and the project’s lives to get the
ANPV for each project.
• Select the project with the highest ANPV.

18
 Project Appraisal – EAR
• Consider that BA Company is evaluating two
projects, A and B. The projects’ cash flows is
given below.
• Requirement: Compute for the
annualized NPV for each project using
the discount rate of 10%. And select the
project using the EAR or ANPV method.
Cash flows
Year Project A Project B
0 - 70,000 -85,000
1 28,000 35,000
2 33,000 30,000
3 38,000 25,000
4 - 20,000
5 - 15,000
6 - 10,000 19
 Project Appraisal – EAR
• Assume two mutually exclusive projects, both
requiring P500,000 investment, having the
following cash flows from operations, net of tax
(in hundred thousands of pesos):
End of Year Project X Project Y
1 300 200
2 550 250
3 300
4 250

• Assuming annualized NPV is used and that the

hurdle rate is 14%, which project will be
chosen?
• Assuming that replacement method is used by
the company, which project will be chosen.
Hurdle rate is 14%. 20