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CAPITAL BUDGETING

TECHNIQUES
Problems
COST OF INVESTMENT
The management of X Company plans to replace a sorting
machine that was acquired several years ago at a cost of
P850,000. The machine has been depreciated to its salvage
value of P90,000. A new sorter can be purchased for P2,940,000,
3/10, n/30. The dealer will grant a trade-in allowance of
P176,000 on the old machine. If a new machine is not
purchased, X will spend P745,000 to repair the old machine.
Gains and losses on trade-in are not subject to income tax. The
cost to repair can be deducted for tax purposes. Income tax
rate is 40%.
What is the net cost of investment?
P2,228,800
NET COST OF INVESTMENT
Cash Outflows Cash Inflows
Net purchase price of the new
asset (net of discount), whether Proceeds form sale or trade-
take or not. in allowance from disposal of
Additional or incidental costs old asset.
paid or incurred to prepare the
asset for use Tax savings from loss on sale
Additional taxes paid or of old asset
incurred in case of gain on
disposal of old asset. Savings from avoided repairs
Additional taxes paid from and maintenance, if the old
savings on avoided cost of asset is replaced.
repairs, if the old asset is
replaced.
Increase in working capital
base
PAYBACK PERIOD
Taggart Inc. is considering a project that has the following cash
flow data. What is the project's payback?

Year 0 1 2 3
Cash flows -P1,150 P500 P500 P500

Answer:
2.30 years
PAYBACK PERIOD
The amount of time required for a firm to recover its initial
investment in a project, as calculated from cash inflows

Decision criteria:
The length of the maximum acceptable payback period is
determined by management.
If the payback period is less than the maximum acceptable
payback period, accept the project.
If the payback period is greater than the maximum
acceptable payback period, reject the project.
PAYBACK RECIPROCAL
Payback Reciprocal = 1 / payback period
(using the same problem)
= 1 / 2.30
= 43.48%
The higher, the better
PAYBACK BAILOUT PERIOD
Includes the salvage value of the asset
**Using the SAME EXAMPLE

Year 0 1 2 3
Cash flows -P1,150 P500 P500 P500
Salvage Value P400 P200 P150
Answer:
1.90 years
PAYBACK PERIOD - ADVANTAGES
The payback method is widely used by large firms to evaluate
small projects and by small firms to evaluate most projects.
Its popularity results from its computational simplicity and
intuitive appeal.
By measuring how quickly the firm recovers its initial investment,
the payback period also gives implicit consideration to the
timing of cash flows and therefore to the time value of money.
Because it can be viewed as a measure of risk exposure, many
firms use the payback period as a decision criterion or as a
supplement to other decision techniques.
PAYBACK PERIOD - DISADVANTAGES
The major weakness of the payback period is that the
appropriate payback period is merely a subjectively
determined number.
It cannot be specified in light of the wealth maximization goal
because it is not based on discounting cash flows to determine
whether they add to the firms value.
A second weakness is that this approach fails to take fully into
account the time factor in the value of money.
A third weakness of payback is its failure to recognize cash
flows that occur after the payback period.
NET PRESENT VALUE
Warnock Inc. is considering a project that has the following
cash flow and WACC data. What is the project's NPV?

WACC: 10.00%
Year 0 1 2 3
Cash flows -P950 P500 P400 P300

Answer:
P60.52
NET PRESENT VALUE
A sophisticated capital budgeting technique; found by
subtracting a projects initial investment from the present value
of its cash inflows discounted at a rate equal to the firms cost of
capital.

NPV = Present value of cash inflows Initial investment

Decision criteria:
If the NPV is greater than P0, accept the project.
If the NPV is less than P0, reject the project.
PROFITABILITY INDEX
Profitability index = PV of Cash Flows / Cash Outlay

WACC: 10.00%
Year 0 1 2 3
Cash flows -P950 P500 P400 P300

P1,010.52 / P950
Answer:
1.06
INTERNAL RATE OF RETURN
The breakeven rate of return, where PV of Cash flows = Cost of
investment
NPV = P0, PI = 1.00
Using the same given, solve for IRR:
WACC: 10.00%
Year 0 1 2 3
Cash flows -P950 P500 P400 P300

Answer:
13.92%
DISCOUNTED PAYBACK PERIOD
Computes for number of years before an investment is
recouped.
Time Value of Money is considered in DPP.
WACC: 10.00%
Year 0 1 2 3
Cash flows -P950 P500 P400 P300
Answer:
2.73 years
DECISION CRITERIA SUMMARY
Model Concepts of Focus on Basis of Decision Criteria
Returns Measurement Recovery
Payback Period Net Cash inflows Liquidity Time The shorter, the better

Payback Reciprocal Net Cash inflows Liquidity Rate of Return The higher, the better

Payback bailout Net cash inflows Liquidity Time The shorter, the better

Net Present Value Net cash inflows Liquidity Amount Positive = Accept
Negative = Reject
Internal Rate of Net cash inflows Liquidity Rate of Return The higher, the better
Return
Profitability Index Net cash inflows Liquidity Rate of Return > 1 = accept

Discounted Payback Net cash inflows Liquidity Time The shorter, the better
method
SEATWORK
Carry Company is considering a project that has the following
cash flow and WACC data.
WACC: 12.00%
Year 0 1 2 3 4 5
Cash flows -P1,100 P400 P390 P380 P370 P360
Salvage Value P400 P300 P200 P150 P100
Solve for:
(a) Payback Period (b) Payback Reciprocal
(c) Payback Bailout Period (d) Net Present Value
(e) IRR (f) Profitability Index
(g) Discounted Payback
SEATWORK
Metro Corporation plans to replace its old machinery. The cost
of operating the old machinery is P138,600, excluding
depreciation, while the new machinery will be operated at
P91,300. The new machinery costs P160,000, net of trade
allowance with an estimated useful life of 8 years, no salvage
value. Income tax rate is at 40% while cost of capital is at 8%.
The old machinery is depreciated at 15,000 per year.
Solve for:
(a) Payback Period (b) Payback Reciprocal
(c) Discounted Payback Period (d) Net Present Value
(e) IRR (f) Profitability Index