Chapter 29

SCREENING AND SELECTING CAPITAL INVESTMENT PROPOSALS

The fourth step in the capital budgeting process is evaluating or

screening project proposals. Once the firm has calculated the cost of capital
for a project and estimated its cash flows, deciding whether or not to invest in
that project basically boils down to asking the question; “Is the project worth
its projected future value?”

No one can perfectly predict the future, so the techniques are by their
nature, accompanied by uncertainty. That said, the commonly used capital
budgeting techniques include the following:

A. Discounted Cash Flow (time-adjusted) Approach

1.) Net present value

2.) Internal rate of return

3.) Profitability index

4.) Discounted payback period

B. Non-discounted Cash- Flow(unadjusted) Approach

1.) Payback Period

2.) Bailout payback period

3.) Payback reciprocal

4.) Accounting rate of return (book value rate of return)

1.) Net present value

Net Present Value (NPV) is defined as the present value of the future
net cash flows from an investment project. NPV is one of the main ways to
evaluate an investment. The net present value method is one of the most
used techniques; therefore, it is a common term in the mind of any
experienced business person.

Net present value can be explained quite simply, though the process of
applying NPV may be considerably more difficult. Net present value analysis
eliminates the time element in comparing alternative investments.
Furthermore, the NPV method usually provides better decisions than other
methods when making capital investments. Consequently, it is the more
popular evaluation method of capital budgeting projects.

When choosing between competing investments using the net present

value calculation you should select the one with the highest present value.
 If:

NPV > 0, accept the investment.

NPV < 0, reject the investment.
NPV = 0, the investment is marginal

Net Present Value Advantages

 Uses cash flow not earnings
 Eliminates time component
 Results in investment decisions that add value
Net Present Value Limitations
 Difficult to predict cash flows
 Assumes a constant discount rate over life of investment

The NPV of a project is computed as follows:

Present value of cash inflows computed based on minimum

desired discount rate Pxx

Less: Present value of investment xx

Net present value xx

Illustrative Case 29-1

Project A has a net investment of P120,000 and annual net cash inflows of
P50,000 for five years. Management wants to calculate Project A’s net
present value using a 16% discount.

Solution:

The annual net cash inflows of P50,000 for five years are an annuity. The NPV
is calculated by multiplying 50,000 by the present value interest for an
annuity for five years discounted at 16% and then subtracting the net
investment.

Present value of cash inflows (50,000 x 3.274) P163, 700

Less: Net investment 120,000

Net present value P 43,700

Project A should be accepted because it could earn more than the desired
minimum rate of return as indicated by the positive net present value.

Illustrative Case 29-2. NPV Application: Uneven Cash Inflows

DetDet Corp. plans to invest in a four year project that will cost P750,000.
Detdet’s cost of capital is 8%. Additional information on the project is as
follows:

Year Cash Flow from Present Value of PI at 8%

Operations, net of taxes

1 P200,000 0.926

2 220,000 0.857

3 240,000 0.794

4 260,000 0.735

Required:

Using the net present value method, determine whether the project is
acceptable or not.

Solution:

Present value of cash inflow after taxes at 8%

Year Amount Cash Inflows PV factor PV

1 P200,000 0.926 P185,200

 2 220,000 0.857 188,540

3 240,000 0.794 190,560

4 260,000 0.735 191,100

Total P755,400

Less: Present value of net investment: 750,000

Excess or net present value P 5,400

Conclusion: The project is acceptable because it will yield a return exceeding

the minimum desired rate of 8%.

2.) Internal Rate of return

IRR, also known as discounted rate of return and time-adjusted rate of

return is the rate which equates the present value of the future cash
inflows with the cost of the investment which produces them. It is also the
equivalent maximum rate of interest that could be paid each year for the
capital employed over the life of an investment without the loss on the
project.

Steps in the Computation of the Internal Rate of Return (IRR)

A. Cash inflows are evenly received:

If the cash returns or inflows are evenly received during the life
of the project, the computational procedures are as follows:

1.) Compute the Present Value factor by dividing Net

Investment by Annual Cash Returns.

2.) Trace the PV factor in the Table for Present Value of P1

received annually using the life of the project as point of
reference.

3.) The column that gives the closest amount to the PV

factor is the “Discounted rate of return”

4.) To get the exact Discounted rate of return, interpolation

is applied.
B. Cash inflows are not evenly received.

The steps in computing for the discounted rate of return are:

1.) Compute the Average Annual Cash Returns by dividing

the sum of the returns to be received during the life of
the project by the total economic life of the project.

2.) Divided Net Investment by the Average Annual Cash

Returns to get the Present Value Factor.

3.) Refer to the Table for Present Value of PI received

annually to determine the rate that will give the closest
factor to the computed present value factor.

4.) Using the rate obtained in Step No. 3, refer to the Table
for Present Value of P1. If the returns are increasing, use
a discount rate lower than the rate obtained in Step No.3,
If the returns are decreasing, use a higher rate. Compute
the present value of the annual cash returns.

5.) Add the present value of the annual returns and compare
with the Net Investment.

6.) If the result in Step No.5 does not give equality of

present value of returns and net investment, try at
another rate.

7.) Interpolate to get the exact discounted rate of return

Decision Rule:

Accept Project if IRR > Cost of Capital

Reject Project if IRR < Cost of Capital

3. Profitability Index

The profitability index (P1) also known as benefit/cost ratio present value
desirability index) is the ratio of the total present value of future cash inflows
divided by its net income.

PV index =PV of Cash inflows

PV of net Investment

4. DISCOUNTED PAYBACK PERIOD (DPB)

Is a capital budgeting method that determines the length of the required for
an investments cash flows, discounted at the investment cost of capital, to
cover its cost.

B. NON-DISCOUNTED CASH FLOW (UNADJUSTED) APPROACH

1. Payback Period
Is the length of time required for a project’s cumulative net cash inflows to
equal its net investment. It measured the time required for a project to
break even.

Net Investment
Payback period with equal cash flows =
Annual Net Cash Inflows

Payback Number of Unrecovered cost at

Period = Years prior to + start of year
full recovery Cash flows during full recovered

If: PB period ≤ Maximum allowed PB period; Accept

If: PB period > Maximum allowed PB period; Reject

2. Bail-out Period
In conventional payback computations, investment salvage value is usually
ignored. An approach which incorporates the salvage value in payback
computation is the “bail-out period”
3. Payback Reciprocal
measure the rate recovery of investment during the payback period. For
projects with even cash flows, the payback reciprocal is computed as
follows:
1
payback Reciprocal =
Payback Period

1
Payback Period Peciprocal × 100
Payback Period

4. Accounting Rate of Return

Accounting rate of return (ARR) or simple rate of return is a measure of a

project’s profitability from a conventional accounting standpoint by relating
required investment to the future annual net income.

ARR is computed as follows:

ARR= Average Annual Net Income

Initial Investment or Average Investment

Or, if a cost reduction project is involved, the formula becomes:

ARR=Cost saving-Depreciation on new equipment

Initial Investment or Average Investment

If ARR ≥ Required rate of return; Accept

If ARR < Required rate of return; Reject

CONCLUSION ON CAPITAL BUDGETING METHODS

Capital budgeting techniques, NPV is the single best criterion because it

provides a direct measure of value the project adds to shareholder wealth
NPV works equally well with even as well as uneven cash flows and with
independent or mutually exclusive project.
SELECTION PROBLEMS

The three types of capital budgeting decision are:

1. Accept-reject decisions
2. Mutually exclusive project decisions
3. Capital rationing decisions

1. ACCEPT-REJECT DECISIONS
this occurs when an individual project is accepted or rejected without
regards to any other investment alternatives.

2. MUTUALLY EXCLUSIVE PROJECTS DECISION

These are competing investment proposals that will perform the same
function or task. The acceptance of one or a combination of projects
eliminates the others from further consideration.

3. CAPITAL RATIONING DECISION

Optimal capital budget is the annual investment in long-term assets that
maximizes the firms value.