CAPITALIZATION

METHODS OF ECONOMIC EVALUATION Since the primary objective of the company is to make profits, every business activity should be directed towards achieving this end. Capital investments are not exempted from this requirement. It is, therefore a requirement that investment proposals should be analyzed and determination of their economic value the firm should be made.

THREE BASIC ECONOMIC METHODS OF EVALUATING PROPOSALS

The payback method The average rate of return methods The discounted cash flow methods EXIHIBIT 3 A SAMPLE INVESTMENT PROPOSAL FOR THE PURCAHSE OF MACHINE Acquisition cost Economic life Salvage value Earning and cost per year Income Expenses Net income before tax and depreciation Less: depreciation (straight line) Net income tax Less: income tax Average net annual earnings 10,000,000 10 years 100,000 5,000,000 - 2,000,000 3,000,000 1,000,000 2,000,000 620,000 1,380,000

Cash inflows per year = net earning + depreciation=2,380,000

THE PAYBACK METHOD The payback method determines the number of years required to recover cash investment made on a project. The recovery of cash comes from the cash inflows generated from the project. Payback period=cost / annual cash inflow

Substituting the data from the exhibit 3, the payback period is presented as: Payback period=10,000,000/2,380,000=4.2 years The cost of the machinery is expected to be recovered in full after 4.2 years.

DISADVANTAGE OF PAYBACK METHOD

It does not consider the time value for money The accept-reject criterion is stated in terms of year rather than at a discount rate The firms attention is focused on cash flow rather than on rate of return Careful projection of timing of the investments outlays and the year by year projection of cash inflows over the entire life of the proposals are not encouraged. The salvage value of the proposal is not considered

THE AVERAGE RATE OF RETURN MEHODS The average return on investment The average return on average investment
Average return on investment this method is simple and is easy to compute. It shows the ratio of the average cash inflow to the investment. The formula is as follows: Average return on investment= annual cash inflow / investment outlay = 2,380,000/10,000,000= 24% The advantage of this method is that very easy to compute and the available accounting data may be readily used. Its main disadvantage is that it does not take into account the time value of money. Average return on average investment this method is similar to the average return on investment method except that the effect of the depreciation charge on the investment is taken into consideration. The formula is as follows: Average return on average investment =annual cash inflow / investment/2 =2,380,000/ 10,000,000/2

DISCOUNTED CASH FLOW METHODS The time value of money is recognized under the discounted cash flow method.

There are two approaches available: the net present value method the internal rate return method

Net present value under this method, a desired rate of return is used for discounting purposes. The term discounting is synonymous to the calculation of the present worth of future value as presented in chapter 3. The present value concept is applied to cash the flows of a proposal and is discounted at the desired rate of return for the periods involved. NPC=PVCI-PVCO WHERE: NPV= net present value (also the net value derived after deducting the discounted cash outflow from the discounted cash outflow from the discounted cash inflow) PVCI=discounted value of the anticipated cash inflows PVCO=discounted value of the anticipated cash outflows The formula for finding the present value of an expected cash inflows: PV=A/ (1+R) WHERE: A=expected cash inflow R=desired rate of return N=number of years the cash inflows is expected If the desired rate of return in exhibit 3 is 25%, the cash inflows for ten-year period may be computed to determine the present value for each year. PV of cash inflow, year 2 =2,380,000/ (1+.25) = 2,380,000/ (1.25) =1,523,200 Applying the present value formula, the present values of the cash flows indicated in exhibit 3 will appear as follows: Cash flows Outflow Inflow 1st year 2,380,000 1,904,000 future value present value 10,000,000

2nd year 3rd year 4th year 5th year 6th year 7th year 8th year 9th year 10th year 10th year (salvage value) TOTAL

2,380,000 2,380,000 2,380,000 2,380,000 2,380,000 2,380,000 2,380,000 2,380,000 2,380,000 100,000 23,900,000

1,523,200 1,218,560 974,840 779,870 623,900 499,120 399,290 319,430 255,550 10,000 8,504,490

To find the net present value of the proposal presented in the exhibit 3. The formula stated is applied as follows: NV=PVCI-PVCO =8,508,490 - 10,000,000 = - (1,491,510) INTERNAL RATE OF RETURN METHOD This method and the net present value method use the discount rate as a factor. The difference is that the internal rate of return method, the discount rate is not given .rather; it becomes the object of computation. The discount rate which will be yield a net present value of zero or one approximating zero is the correct discount rate. This means that the present value of the cash inflows is equal to the present value of the cash outflows. The correct discount rate may be determined by trial and error. The net present values at different discount rates may now be computed as follows: A. NPV at 22% discount rate=PCVI-PVCO =9,350,800-10,000,000 = - (649,200) B. NPV AT 21% discount rate =PVCI-PVCO =9,603,520-10,000,000 = - (396,480) C. NPV at 20% discount rate =PVCI-PVCO =9,994,080-10,000,000 = -(5,920)