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16
How to Make Capital
Budgeting Decisions
1. Payback Period
The payback period is the length of time it will take the
business enterprise to recover its initial investment.
Example 16-1
Assume:
Cost of Investment
Annual after-tax cash savings
18,000
3,000
Example 16 2
Consider two projects with uneven after-tax
cash inflows. Assume each project costs
1,000.
Year
1
2
3
4
5
6
A(P)
B(P)
100
200
300
400
500
600
500
400
300
100
Example 16-4
Initial investment
12,950
Estimated life
10 years
Annual cash inflows
3,000
Cost of capital
12%
Present value of the cash inflows is :
PV = A T4(i , n)
= P3,000 T4(12%,10yrs)
= P3,000(5,650) P16,250
less: Initial Invesment 12,950
NPV
P 4,000
Example 16-5
Assume the same data given in Ex. 16-4, and
set the ff. equality(I = PV):
Profitability Index
The profitability index is the ratio of
the total present value of future cash
inflows to the initial investments, that
is, PV/I. It is used as a means of
ranking projects in descending order
of attractiveness.
Example 16-6
Same data in 16-4
PV = P 16,950 = 1.31
I
P 12,950
The profitability index has the advantage of
putting all projects on the same relative
basis regardless of size.
Example 16-15
Assume:
S= P 12,000
E= P 10,000
d= P 500 per year using the
straight-line method
t= 30%
Straight-Line Method
The most popular method of calculating
depreciation that results in equal periodic
depreciation deductions. It is also the most
appropriate when an assets use is uniform from
period to period, as is the case with furniture.
Formula:
Depreciation expense = Cost salvage value
# of years of useful life
Sum-of-the-Years-Digit Method
This method uses a ratio in which the
numerator is the number of years of
life expectancy in reverse order, and
the denominator is the sum of the
digits.
Formula:
SYD = (N)(N+1)
2
Double-Declining-Balance
Method
The depreciation expense is highest in the
early years of the assets life and
decreases in the later years. First, you
determine a depreciation rate by doubling
the straight-line rate. Second, you
calculate depreciation expense by
multiplying the depreciation rate by the
book value of the asset at the beginning of
each year.