CAPITAL BUDGETING

NPV WITH EVEN NET CASH INFLOWS

STEP 1
PV of Cash Inflows (1) (2) (3) = (1) x (2)
Year Cash flows PV factor Present Value
Incremental Revenues / Annual net cash inflows xx xxx x.xx xxx
Cost Reduction xx xxx x.xx xxx
Salvage value xx xxx x.xx xxx
Release of Working Capital xx xxx x.xx xxx
PV of Cash Inflows xxx

STEP 2
PV of Cash Outflows (1) (2) (3) = (1) x (2)
Year Cash flows PV factor Present Value
Initial Investments xx xxx x.xx xxx
Incremental Operating costs xx xxx x.xx xxx
Working Capital xx xxx x.xx xxx
Repairs and Maintenance xx xxx x.xx xxx
PV of Cash Outflows xxx

STEP 3
Net Present Value (NPV)
PV of Cash Inflows xxxx
Less: Pv of Cash Outflows xxxx
Net Present Value (NPV) xxxx

Example:
Minorca Company has been contracted to provide parts of a large company for 5 years.
Related information regarding the contract:
Cost of equipment P 200,000
Working capital requirement 100,000
Relining equipment in 4 years 30,000
Salvage value of equipment in 5 years 5,000
Annual cash revenue and costs:
Sales revenue from parts 800,000
Costs of parts sold 400,000
Salaries, shipping, etc. 300,000

At the end of 5 years, the working capital will be released and can be used by the company elsewhere.
The discount rate is 12%
The entity uses 4 decimal places for the PV factor
Required: Should the contract be accepted? Use the NPV method

STEP 1
PV of Cash Inflows (1) (2) (3) = (1) x (2)
Year Cash flows PV factor Present Value
Incremental Revenues / Annual net cash inflows 1-5 100,000 3.6048 360,480
Salvage value 5 5,000 0.5674 2,837
Release of Working Capital 5 100,000 0.5674 56,740
PV of Cash Inflows 420,057
STEP 2
PV of Cash Outflows (1) (2) (3) = (1) x (2)
Year Cash flows PV factor Present Value
Initial Investments Now 200,000 1.0000 200,000
Working Capital Now 100,000 1.0000 100,000
Repairs and Maintenance 4 30,000 0.6355 19,065
PV of Cash Outflows 319,065

STEP 3
Net Present Value (NPV)
PV of Cash Inflows 420,057
Less: Pv of Cash Outflows 319,065
Net Present Value (NPV) 100,992
Decision: Accept the proposal since it is > than zero.

NPV WITH UNEVEN NET CASH INFLOWS PV of 1

Solution:
Year Cash inflow PV factor Amount
1 xxx x.xx xxx
2 xxx x.xx xxx
3 xxx x.xx xxx
Total PV of Cash Inflows xxx
Less: PV of Cash Outflows xxx
Net Present Value (NPV) xxx

Example:
Austin Company invested in a project.
Related data are: Solution:
Investment cost 2,500,000 Year Cash inflow PV facto Amount
Discount rate 12% Php 1,000,000
### 1 ###
Year Uneven Cash Inflow Php 1,200,000
### 1 ###
1 Php 1,000,000 Php 1,500,000
### 1 ###
2 Php 1,200,000 Total PV of Cash Inflows ###
3 Php 1,500,000 Less: Investment cost ###
Total Php 3,700,000 Net Present Value (NPV) ###
The entity uses 4 decimal places for PVF Decision: The project proposal is accepted with the NPV is at least zero or higher than zero.
Required: What is the NPV?

COMPARING COMPETING INVESTMENT PROJECTS

The related data are"

New Car Wash Old Car Wash
Annual revenues $ 500,000 $ 420,000
Annual cash operating costs 300,000 290,000
Annual net cash inflows $ 200,000 $ 130,000
Disount rate is 10%
If New Machine is installed: If old machine is remodelled:
Cost 870,000 Remodel Costs 590,000
Productive life 10 years Replace brushed at the end of 6 years 380,000
Salvage value of new equipment 25,000
Replace brushes at the end of 6 years 300,000
Salvage value of old equipment 10,000

The entity uses 4 decimal places for PV factor

Reminder: Under NPV, which project proposal should the entity choose?
TOTAL COST METHOD / TOTAL INCREMENTAL APPROACH
STEP 1. Compute for the incremental costs and benefits of the 2 proposals.

Annual net cash inflows Cost SV of new equipment Repairs and maintenance SV of old equipment
New Car wash 200,000 870,000 25,000 300,000 10,000
Old Car wah 130,000 590,000 - 380,000 -
Differential 70,000 280,000 25,000 (80,000) 10,000

STEP 2. Compute the PV of cash inflows, PV of cash outflows and NPV

Year Cash Flows PV factor Present Value
PV of Cash Inflows:
Incremental annual net cash inflows 1-10 70,000 6.1446 430,122.00
Salvage value of new equipment 10 25,000 0.3855 9,637.50
Salvage value of old equipment Now 10,000 1.0000 10,000.00
449,759.50
PV of Cash Outflows:
Cost (net of remodel cost) Now 280,000 1.0000 280,000.00
Repairs & maintenance (net of old machine) 6 (80,000) 0.5645 (45,160.00)
234,840.00
Net Present Value (NPV) 214,919.50
Decision: Is to accept the installation of the new car wash machine since it will yield a net incremental benefit of P214,919.50

DIFFERENTIAL APPROACH
STEP 1. Compute for the NPV of the 1st proposal (installation of new car washer).

PV of cash inflow Year Cash Flows PV Factor Present Value

Annual net cash inflows 1-10 $ 200,000 6.1446 $ 1,228,920.00
Salvage of old equipment Now $ 10,000 1.0000 $ 10,000.00
Salvage of new equipment 10 $ 25,000 0.3855 $ 9,637.50
$ 1,248,557.50
Less: PV of cash outflow
Initial investment Now $ 870,000 1.0000 $ 870,000
Replace brushes 6 $ 300,000 0.5645 $ 169,350
$ 1,039,350
Net Present Value (NPV) $ 209,207.50

STEP 2. Compute for the NPV of the 2nd proposal (remodelled Old machine - NPV)
Year Cash Flows PV Factor Present Value
PV of cash inflow
Annual net cash inflows 1-10 $ 130,000 6.1446 $ 798,798.00
Less: PV of cash outflow
Remodelled costs Now 590,000 1.0000 590,000.00
Replace brushes 6 380,000 0.5645 214,510.00
Net Present Value (NPV) $ (5,712.00)

STEP 3. Compute for the differential of the two proposals.

Invest in new machine $ 209,207.50

Less:Remodelled old machine $ (5,712.00)
Differential $ 214,919.50

Under this differential approach, the decision is also the same with the incremental approach, which is to accept the proposal of the new car machine because
a differential benefit of P214,919.50 will be earned.
Regardless of the approach, you will have to arrive at the same answer.

PROJECT PROFITABILITY INDEX (PPI)

Formula:
NPV of the project xxx The highest PPI will be accepted, because the higher PPI, the more desirable the project is.
Divided by Investment xxx
PPI xxx

Example:
Sushimita Company has two project proposals:
Project A Project B
Net present value $ 500,000 $ 500,000
Investment required $ 200,000 $ 1,500,000
Profitability Index 0.25 0.33
Decision: Accept Project B, since it yields a higher PPI

INTERNAL RATE OF RETURN (IRR)

Rule: IRR should be higher than the cost of capital.

STEP 1. Determine the PV factor of an ordinary annuity

Investment cost xxx
divided by Annual net cash inflow xxx
Estimated PVF OA xxx

STEP 2. Interpolate a discount rate that is exact the determine PVF

If now exact PVF, then, interpolate for a rate that will give a higher PVF than the estimated PVF and another rate that will give a lower PVF than the estimated PVF.

STEP 3. Get the Differences STEP 4. Compute for IRR

Higher PVF OA xxx Difference 1 xxx
Less: Estimated PVF OA xxx divided by Difference 2 xxx
Difference 1 xxx Ratio xxx
Multiplied by Rate Difference xxx
Higher PVF OA xxx Balance xxx
Less: Lower PVF OA xxx Add: Lower rate xxx
Difference 2 xxx Internal Rate of Return (IRR) xxx

NOTE:
The starting point in the interpolation of the discount rate is the cost of capital.
Again under IRR, the NPV is zero, which also means that the project proposal is acceptable

Example:
Mimi Corporation is looking for an investment proposal.
The related data are:
Investment cost 1,200,000
Annual net cash inflow 360,000
Cost of capital  12%
Estimated Useful life 5 years
Required: Using IRR, will the entity accept the investment proposal?  

Investment cost 1,200,000

divided by Annual net cash inflow 360,000
Estimated PVF OA 3.3333

Interpolate for a rate. Let us use the 12% cost of capital as a starting point.
From then on, we choose a rate that yields a higher PVF and rate with a lower PVF to the estimated PVF.

Rate PVF OA NOTE:

12% 3.6048 Since the 12% cost of capital yield at a PVF of 3.6048 and the estimates PVF is lower at 3.3333,
14% 3.4331 we have to choose a notch higher rate.
15% 3.3522
16% 3.2743

Based on the interpolation, we will be using 15% and 16%.

Higher PVF OA 3.3522 Difference 1 0.01887

Less: Estimated PVF OA 3.3333 divided by Difference 2 0.07790
Difference 1 0.01887 Ratio 0.24219084296106
Multiplied by Rate Difference 1%
Higher PVF OA 3.3522 Balance 0.00242190842961
Less: Lower PVF OA 3.2743 Add: Lower rate 15%
Difference 2 0.07790 Internal Rate of Return (IRR) 15.24%

Decision: Accept the proposal, since 15.24% IRR is higher than 12% cost of capital

PAYBACK PERIOD
Reminder: Payback period ignores the time value of money and the cash flow after the payback period
FORMULA:

A. For Even Net Cash Inflows

Investment xxx
Divided by Annual net cash inflow xxx
Payback Period xxx

B. For Uneven Cash Inflows

It is necessary to track the unrecovered investment year by year
(1) (2) (3)
Year Investment Cash Inflow Unrecovered Investment
xx xx xx xx

Unrecovered Investment = Previous unrecovered investment + Current year investment - Current year cash inflow

Example:
Annual cash revenue 12,000
Less: Cash fixed cost 2,000
Less: Cash variable cost 6,000
Annual net cash inflow 4,000

Investment required 5,000

divided by annual net cash inflow 4,000
Payback period 1.25 years
Hence, on the span of 1.25 years, the entity already recovered the investment

ACCOUNTING RATE OF RETURN (ARR) / SIMPLE RATE OF RETURN ON INVESTMENT

Formula:
Annual incremental net operating income xxx
divided by net investment xxx
Simple rate of return or ARR xxx

Annual incremental revenue xxx

Less: Annual depreciation xxx
Annual incremental net operating income xxx

Initial investment xxx

Less: Salvage value of old equipment xxx
Net Investment xxx

Example:
An initial investment costing P712,000 is expected to generate a sales revenue of P298,000 per year and operating expenses of P143,000 per year.
The useful life is 8 years and the salvage value is P12,000. What is ARR?

Solution:

Annual incremental net operating income 67,500 Sales revenue 298,000

divided by net investment 700,000 Less: OPEX 143,000
Simple rate of return or ARR 9.64% Annual incremental revenue 155,000

Annual incremental revenue 155,000 Cost 712,000

Less: Annual depreciation 87,500 Less: Residual Value 12,000
Annual incremental net operating income 67,500 Depreciable amount 700,000
Divided by Useful life 8
Initial investment 712,000 Annual depreciation 87,500
Less: Salvage value of old equipment 12,000
Net Investment 700,000
rable the project is.