Republic of the Philippines

DON MARIANO MARCOS MEMORIAL STATE UNIVERSITY

MID-LA UNION CAMPUS
COLLEGE OF GRADUATE STUDIES
City of San Fernando 2500, La Union
Telefax (072) 607-5798
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DAP 229 – Financial Management

Name: SHARON C. MINIEDA ___ Date: ____________

Course: MDA Major in Business Administration Professor:ROSA M. NOVENCIDO

CAPITAL BUDGETING TECHNIQUES / METHOD

Objectives:
1. To be able to know and understand the different techniques used in capital budgeting
2. To be able to know the advantages and disadvantages of the different capital budgeting
techniques

CAPITAL BUDGETING TECHNIQUES

 These are utilized by entrepreneurs in deciding whether to invest in a particular asset
or not. It has to be performed very carefully because a huge sum of money is invested
in Fixed Assets like machinery.
The analysis is based on 2 things:
1. The stream of expected cash flows generated by utilizing the asset
2. The initial / future outlays expected for acquiring the asset.

TWO (2) CRITERIA:

A. TRADITIONAL METHOD ( Non-Discount Method)

1. PAYBACK PERIOD

- Refers to the period in which proposal will generate cash to cover the initial investment
made

- It purely emphasizes on the cash inflows, economic life of the project and the investment
made in the project, with no consideration to time value of money.

- It tells how long it will take a project to break even.

 FORMULA:

Payback Period = Cash Outlay ( Investment ) / Annual Cash Iflow

EXAMPLE:

Project A – Project cost is 100,000

Project B – Project cost is 100,000

PROJECT A PROJECT B
Expected future Cash
Inflow
YEAR 1 25,000 25,000
YEAR 2 25,000 50,000
YEAR 3 25,000 25,000
YEAR 4 25,000 25,000
YEAR 5 100,000 25,000
TOTAL 200,000 165,000
PAYBACK 4 years 3 years

Analysis: Payback period of Project B is shorter than A, but Project A provides higher
returns. Hence, Project A is superior to B.
ADVANTAGES:
1. Simple to use and easy to understand
2. Quick solution
3. Preference to liquidity
4. Useful in case of uncertainty
DISADVANTAGES:
1. Ignores time value of money
2. Not all cash flows covered
3. Not realistic and ignores profitability
4. Neglects the project’s return on investment

2. AVERAGE / ACCOUNTING RATE OF RETURN (ARR)

- It is expressed as a percentage of the earnings of the investment in a particular project

- It takes into account the entire economic life of a project providing a better means of
comparison
- Ensures the compensation of expected profitability of projects through the concept of net
earnings
- Is one way for investors to learn about their options before deciding to commit money to a
particular investment.
 FORMULA:

ARR = Average Income / Average investment

EXAMPLE: Project A - Book value of Investment = Php 100,000.00

Profit after tax = Php 20,000.00

ARR = 20,000.00 = 20%

100,000.00

EXAMPLE: Project B - Book value of Investment = Php 100,000.00

Profit after tax = Php 30,000.00

ARR = 30,000.00 = 30%

100,000.00

Analysis: The higher the ARR, the more profitable the investment.
Required Rate of return is 25% : If ARR >= Required rate of Return – The project is acceptable
If ARR < Required rate of Return – The project is not acceptable
PROS
Calculating the average rate of return is easy. Managers can quickly see whether an
investment opportunity may be lucrative enough to justify doing further evaluation.

It takes into account the entire economic life of a project providing a better means of
comparison.

It ensures compensation of expected profitability of projects through the concept of net

earnings.

CONS

The biggest drawback in using the average accounting return method is it does not
take into account the time value of money. This is the concept that money is worth a known
amount today, but there is no certainty what the same amount of money will be worth in the
future. In other words, you know what you can buy today with a given amount of money. You
do not know what you can buy for the same amount of money tomorrow, and the longer it takes
you to earn back your investment, the greater the risk involved with sustaining the purchasing
power of that future money value.

It doesn’t consider the length of life of the projects.

B. MODERN METHOD (Discounted Method)

1. NET PRESENT VALUE

- It calculates the monetary value now of the project’s future cash flows.
- In this technique the cash inflow that is expected at different periods of time is discounted
at a particular rate. The present value of the cash inflow are compared to the original
investment.
- This simply concludes about a project to be worth doing when it finds the present value of
future cash flows greater than the initial investment and vice versa.
- One of the most reliable techniques because it is based on the discounted cash flow
approach.

FORMULA:

NPV = Present Value of benefits (PVB) – Present Value of Costs (PVC)

Require the Three (3) Inputs:

a. Net after-tax Cash Flow – Equals total cash inflow during a period including salvage
value if any, less cash outflows (including taxes) from the project during the period.

b. Initial investment outlay – Represents the total cash outflow that occurs at the
inception (time 0) of the project.

c. The present value of net cash flows is determined at a discount rate which is relative of
the project risk.

Thus we have the following two formulas for the calculation of NPV:

 When net cash flows are even, i.e. when all net cash flows are equal:
 NPV = R × 1 − (1 + i)-n − Initial Investment ( I )

R is the net cash inflow expected to be received in each period;

i is the required rate of return per period (i.e. the hurdle rate, discount rate);

n are the number of periods during which the project is expected to operate and
generate cash inflows.

EXAMPLE:

Calculate the net present value of a project which requires an initial investment of
Php243,000 and it is expected to generate a net cash flow of Php50,000 each month for 12
months. Assume that the salvage value of the project is zero. The target rate of return is 12%
per annum.

Initial Investment = Php243,000

Net Cash Inflow per Period = Php50,000

Number of Periods = 12

Discount Rate per Period = 12% ÷ 12 = 1%

Net Present Value

= 50,000 × ( (1 − (1 + 1%)-12) ÷ 1%) − 243,000

= 50,000 × ( (1 − 1.01-12) ÷ 0.01 )− 243,000

= 50,000 × ( (1 − 0.89) ÷ 0.01) − 243,000

= 50,000 × ( 0.11 ÷ 0.01) − 243,000

= 50,000 × 11 − 243,000

= 550,000 − 243,000

= 307,000

 When net cash flows are uneven, i.e. when net cash flows vary from period to period:

NPV = R1 + R2 + R3 + ... − Initial Investment

(1+i)1 (1+i)2 (1+i)3

 i is the hurdle rate (also called discount rate);

R1 is the net cash inflow during the first period;

R2 is the net cash inflow during the second period; R3 is the net cash inflow during the
third period, and so on ...

EXAMPLE:

An initial investment of Php 832,000 on plant and machinery is expected to generate

net cash flows of Php 341,100, Php407,000, Php 582,400 and Php 206,500 at the end of first,
second, third and fourth year respectively. At the end of the fourth year, the machinery will be
sold for Php900,000. Calculate the net present value of the investment if the discount rate is
18%.

PV Factors:

Year 1 = 1 ÷ (1 + 18%)1 = 0.8475

Year 2 = 1 ÷ (1 + 18%)2 = 0.7182

Year 3 = 1 ÷ (1 + 18%)3 = 0.6086

Year 4 = 1 ÷ (1 + 18%)4 = 0.5158

YEAR 1 2 3 4
Net Cash Flow 341,100 407,000 582,400 296,500
X Present Value 0.8475 0.7182 0.6086 0.5158
PV of CF 289,082 292,307 354,448 152,934
Total PV OF CF 1,088,771

Total PV of Cash Inflows 1,088,771 – 832,000

Net Present Value 256,771

Decision rule:

In case of standalone projects, accept a project only if its NPV is positive, reject it if its NPV is
negative and stay indifferent between accepting or rejecting if NPV is zero.

NVP (+): It means that the cash inflows from a project will yield a return in excess of the
cost of capital, so project should be undertaken
NVP (-) : It means that the cash inflows from a project will yield a return below the cost
of capital, so project should not be undertaken
NPV (0): It means that the cash inflows from a project will yield a return which is exactly
the same as the cost of capital.
 In case of mutually exclusive projects (i.e. competing projects), accept the project with
higher NPV.

NVP ADVANTAGES & DISADVANTAGES:

ADVANTAGES:
1. Considers all of the cash flows in the computation
2. Uses the time value of money
3. Provides the answer in peso terms, which is easy to understand
4. Usually provides a similar answer to the IRR computation
DISADVANTAGES:
1. Requires the use of the time value of money, thus a bit more difficult to compute
2. Projects that differ by orders of magnitude in cost are not obvious in the NPV final figure

2. INTERNAL RATE OF RETURN (IRR)

- It is the rate at which the net present value of the investment is zero. The discounted cash
inflow is equal to the discounted cash outflow
- It depends solely on the outlay and proceeds associated with the project and not any rate
determined outside the investment
- Extrapolating and interpolating method

FORMULA:
There is no direct algebraic expression in which we might plug some numbers and get the
IRR.

IRR is most commonly calculated using the hit-and-trial method, linear-interpolation

formula or spreadsheets and financial calculators.

Since IRR is defined as the discount rate at which NPV = 0, we can write that:

NPV = 0; or

PV of future cash flows − Initial Investment = 0; or

CF1 + CF2 + CF3 + ... − Initial Investment = 0

( 1 + r )1 ( 1 + r )2 ( 1 + r )3

Where, r is the internal rate of return;

CF1 is the period one net cash inflow;

CF2 is the period two net cash inflow,

 CF3 is the period three net cash inflow, and so on ...

We cannot isolate the variable r (=internal rate of return) on one side of the above
equation. Even though we can use the linear-interpolation formula, the simplest method is to
use hit and trial as described below:

STEP 1: Guess the value of r and calculate the NPV of the project at that value.

STEP 2: If NPV is close to zero then IRR is equal to r.

STEP 3: If NPV is greater than 0 then increase r and jump to step 5.

STEP 4: If NPV is smaller than 0 then decrease r and jump to step 5.

STEP 5: Recalculate NPV using the new value of r and go back to step 2.

EXAMPLE:

Find the IRR of an investment having initial cash outflow of Php213,000. The cash
inflows during the first, second, third and fourth years are expected to be Php65,200,
Php96,000, Php73,100 and Php55,400 respectively.

Assume that r is 10%.

YEAR 1 2 3 4
Net Cash Flow 65,200 96,000 73,100 55,400
X Present Value 0.9090 0.8264 0.7513 0.6830
Total PV of CF 59,266 79,338 54,920 37,838
Total PC 213,362
NPV at 10% discount rate = 213,362 – 213,000 = Php362

YEAR 1 2 3 4
Net Cash Flow 65,200 96,000 73,100 55,400
X Present Value 0.8772 0.7695 0.6750 0.5931
Total PV of CF 57,193 73,872 49,342 32,857
Total PC 213,264

NPV is greater than zero we have to further increase the discount rate, thus NPV

at 14% discount rate = Php264

YEAR 1 2 3 4
Net Cash Flow 65,200 96,000 73,100 55,400
X Present Value 0.8696 0.7561 0.6575 0.5717
Total PV of CF 56,697 72,585 48,063 31,672
Total PC 209,017

NPV at 15% discount rate = (Php3,983)

 Since NPV is fairly close to zero at 14% value of r, therefore IRR = 14%

Decision rule:

A project should only be accepted if its IRR is NOT less than the hurdle rate, the
minimum required rate of return. The minimum required rate of return is based on the
company's cost of capital (i.e. WACC) and is adjusted to properly reflect the risk of the project.

When comparing two or more mutually exclusive projects, the project having highest
value of IRR should be accepted.

If IRR > WACC then the project is profitable

If IRR > k (cost of capital) = accept

If IRR < k (cost of capital) = reject

ADVANTAGES

• Accounts for time value of money.

• Considers all cash flows
• It uses cash flows rather than accounting profits
• Managers feel more comfortable with a return measure

DISADVANTAGES

• Multiple IRR problem

• Difficulty in project rankings
• It may yield contradicting answers with NPV in mutually exclusive projects

3. PROFITABILITY INDEX ( Benefit to Cost Ratio )

- It is the ratio of the present value of future cash benefits, at the required rate of return to
the initial cash outflow of the investment

FORMULA:

PI = PV cash inflow / Initial cash outlay A

Equation :

PI = NPV (Benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted

 EXAMPLE:

Total PV of Cash Inflows Php 1,088,771

Initial Investment Php 832,000

PI = PV cash inflow / Initial cash outlay A

PI = 1,088,771 / 832,000
PI = 1.30

Therefore the project is accepted because it is greater than 1.0.

Decision rule:

Accept a project if the profitability index is greater than 1, stay indifferent if the
profitability index is 1 and don't accept a project if the profitability index is below 1.

PI ADVANTAGES & DISADVANTAGES:

ADVANTAGES:
• Accept or reject a project
• Projects in choosing projects that fit within the budget

DISADVANTAGES:
• Ignoring sunk cost
• Difficulty in determining required rate of return
• Optimistic projections
• Estimating opportunity cost
• Different lives of different projects
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