CHARTERED FINANCIAL

MANAGEMENT ANALYST
(MODULE 4)

JOHN ANTHONY M. LABAY

CPA, MBA, CAP, CFMA
 CAPITAL BUDGETING
✓ TIME VALUE OF MONEY
✓ CAPITAL BUDGETING TECHNIQUES
 CAPITAL BUDGETING

The term capital budgeting is used to describe

how managers plan significant cash outlays on
projects that have long-term implications, such
as the purchase of new equipment and the
introduction of new products.
 CAPITAL BUDGETING

Capital budgeting analysis can be used for any decision

that involves an outlay now in order to obtain some future
return. Typical capital budgeting decisions include:
- Cost reduction decisions. Should new equipment be
purchased to reduce costs?
- Expansion decisions. Should a new plant or
warehouse be purchased to increase capacity and
sales?
 CAPITAL BUDGETING

- Equipment selection decisions. Which of several

available machines should be purchased?
- Lease or buy decisions. Should new equipment be
leased or purchased?
- Equipment replacement decisions. Should old
equipment be replaced now or later?
 TIME VALUE OF MONEY

The time value of money concept recognizes that a peso

today is worth more than a peso a year from now.
Therefore, projects that promise earlier returns are
preferable to those that promise later returns.
 CAPITAL BUDGETING TECHNIQUES

The capital budgeting techniques that best recognize the

time value of money are those that involve discounted
cash flows.
- Net present value method compares the present value
of a project’s cash inflows with the present value of its
cash outflows. The difference between these two streams
of cash flows is called the net present value.
 CAPITAL BUDGETING TECHNIQUES

The net present value is interpreted as follows:

*If the net present value is positive, then the project is
acceptable.
*If the net present value is zero, then the project is
acceptable.
*If the net present value is negative, then the project is
not acceptable.
 CAPITAL BUDGETING TECHNIQUES
-Internal rate of return is the rate promised by an
investment project over its useful life. It is sometimes
referred to as the yield on a project. The internal rate of
return is the discount rate that will result in a net present
value of zero.
*If the internal rate of return is equal to or greater
than the minimum required rate of return, then the
project is acceptable.
*If it is less than the required rate of return, then the
project is rejected.
 CAPITAL BUDGETING TECHNIQUES

-Profitability index can be computed as the net present

value of the project divided by the investment required.
*The higher the profitability index, the more desirable
the project.
 CAPITAL BUDGETING TECHNIQUES

Other methods of making capital budgeting decisions:

-Payback method focuses on the payback period, which is

the length of time that it takes for a project to recoup its
initial cost out of the cash receipts that it generates.

-Simple rate of return method (also known as the

accounting rate of return or the unadjusted rate of return)
does not focus on cash flows; rather it focuses on
accounting net operating income.
SAMPLE PROBLEMS

16
 PROBLEM 1
The following data concern an investment project:
Investment in equipment P 16,000
Annual Net cash inflows P 3,600
Working capital required P 4,500
Salvage value of the equipment P 2,000
Life of the project 12 years
Discount rate 14%

The working capital will be released for use elsewhere at the

conclusion of the project.
 PROBLEM 1

Required:
Compute the project's net present value.

Item Years Amount 14% Factor Present Value

Investment now P(16,000) 1.000 P (16,000)
Annual Cash Inflows 1-12 3,600 5.660 20,376
Working Capital Required now (4,500) 1.000 (4,500)
Working Capital Released 12 4,500 0.208 936
Salvage Value - equipment 12 2,000 0.208 416
Net Present Value P 1,228
 PROBLEM 2

The management of Sem Corporation is considering the

purchase of a machine that would cost P41,110 and would have
a useful life of 6 years. The machine would have no salvage
value. The machine would reduce labor and other operating
costs by P10,000 per year.
 PROBLEM 2
Required:
Determine the internal rate of return on the investment in the new
machine.

Factor of the internal rate of return = Investment required ÷ Net annual cash inflow
= P41,110 ÷ P10,000
= 4.111

The factor of 4.111 for 6 years represents an internal rate of return of 12%.
 PROBLEM 3

XY Company is considering the purchase of a machine that promises

to reduce operating costs by the same amount for every year of its
6-year useful life. The machine will cost P83,150 and has no salvage
value. The machine has a 20% internal rate of return.
 PROBLEM 3

Required:
What are the annual cost savings promised by the machine?

Investment required ÷ Net annual cash inflow = Factor of the internal rate of return
P83,150 ÷ Net annual cash inflow = 3.326
Net annual cash inflow = P83,150 ÷ 3.326
= P25,000
 PROBLEM 4

The management of an amusement park is considering

purchasing a new ride for P40,000 that would have a useful life
of 15 years and a salvage value of P6,000. The ride would
require annual operating costs of P22,000 throughout its useful
life. The company's discount rate is 12%. Management is unsure
about how much additional ticket revenue the new ride would
generate-particularly since customers pay a flat fee when they
enter the park that entitles them to unlimited rides. Hopefully,
the presence of the ride would attract new customers.
 PROBLEM 4

Required:
How much additional revenue would the ride have to generate
per year to make it an attractive investment?
Item Years Amount 12% Factor Present Value
Cost of Asset now P(40,000) 1.000 P (40,000)
Annual Operating Costs 1-15 (22,000) 6.811 (149,842)
Salvage Value 15 6,000 0.183 1,096
Net Present Value P (188,744)

P188,744 ÷ 6.811 = P27,712 additional revenue per year would be

necessary to justify the investment.
 PROBLEM 5

The management of Cont Corporation is considering the

following three investment projects:
Project A Project B Project C
Investment required P34,000 P60,000 P81,000
Present value of cash inflows P37,060 P61,800 P85,050

The only cash outflows are the initial investments in the

projects.
 PROBLEM 5

Required: Rank the investment projects in terms of preference.

Project A Project B Project C
Present value of cash inflows P37,060 P61,800 P85,050
Investment required (a) 34,000 60,000 81,000
Net Present Value (b) P 3,060 P 1,800 P 4,050

Profitability Index (b ÷ a) 0.09 0.03 0.05

Ranked by profitability index 1 3 2

Normally, the project profitability index used as a basis for

ranking.
 PROBLEM 6

The Company has an old machine that is fully depreciated but

has a current salvage value of P5,000. The company wants to
purchase a new machine which would cost P60,000 and have a
5-year useful life and zero salvage value.
PROBLEM 6
 PROBLEM 6

Required:
a. Compute the payback period on the new equipment.

Payback period = Investment required ÷ Net annual cash inflow

= (P60,000 - P5,000) ÷ (P18,000 + P12,000)
= 1.83 years
 PROBLEM 6

b. Compute the simple rate of return on the new equipment.

Simple rate of return = Incremental net operating income ÷ Initial investment

= [Incremental revenues - (Cash operating expenses + Depreciation)] ÷ Initial investment

= P18,000 ÷ P55,000
= 32.7%
 PROBLEM 7

The Company is considering purchasing a machine that would

cost P436,800 and have a useful life of 5 years. The machine
would reduce cash operating costs by P132,364 per year. The
machine would have no salvage value.
 PROBLEM 7

Required:
a. Compute the payback period for the machine.

Payback period = Investment required ÷ Net annual cash flow

= P436,800 ÷ P132,364
= 3.30 years
 PROBLEM 7

b. Compute the simple rate of return for the machine.

Annual Cost Savings P132,364

Less Annual Depreciation (P436,800/5yrs) 87,360
Annual Incremental NOI P 45,004

Simple rate of return = Annual incremental net operating income ÷ Initial investment
= (Cost savings - Depreciation) ÷ (Cost of New Machine – Scrap Value of Old Machine)

= P45,004 ÷ P436,800
= 10.30%
 PROBLEM 8
The management of Unt Company is considering an investment with the following cash flows:
Year Investment Cash Inflow
1 P 150,000 P 10,000
2 80,000 20,000
3 25,000
4 40,000
5 50,000
6 60,000
7 50,000
8 40,000
9 30,000
10 20,000
 PROBLEM 8
Required: Compute the payback period of the investment.

The payback period is determined as follows:

Year Investment Cash Inflow Unrecovered Investment
1 P150,000 P10,000 P 140,000
2 80,000 20,000 200,000
3 25,000 175,000
4 40,000 135,000
5 50,000 85,000
6 60,000 25,000
7 50,000 0
The investment in the project is fully recovered in the 7th year.
To be more exact, the payback period is approximately 6.5 years.
GOODLUCK &
GODBLESS!!!

jalcpa