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Metalanguage: Utilize The Various Techniques in Evaluating Capital Investments
Metalanguage: Utilize The Various Techniques in Evaluating Capital Investments
to:
a. utilize the various techniques in evaluating capital investments.
b. understand the financial aspect of the feasibility study.
Metalanguage
In this section, the most essential terms relevant to the topic and to demonstrate ULOa will be
operationally defined to establish a common frame of reference as to how the texts work in your
chosen field or career.
Capital budgeting – is the process of deciding whether or not to commit resources to
projects.
Capital expenditures – are long – term commitments of resources to realize future
benefits and budgeting them is one of the most important areas of managerial decision.
Essential Knowledge
Capital budgeting is used to describe actions relating to the planning and financing
capital outlays. It is an investment concept, since it involves a commitment of funds now
in order to receive some desired return in the future.
The capital budgeting process may vary among firms, but such process generally
involves the following:
I. Identification of potential projects
II. Estimation of costs and benefits
III. Evaluation of proposed projects
IV. Development of the capital budget
V. Reevaluation of proposed projects
Sample problem:
Key Corp. plans to replace a production machine that was acquired several years ago.
Acquisition cost is P450,000 with salvage value of P50,000. The machine being
considered is worth P800,000 and the supplier is willing to accept the old machine at a
trade-in value of P60,000. Should the company decide not to acquire the new machine,
it needs to repair the old one at a cost of P200,000. Tax-wise, the trade-in transaction
will not have any implication but the cost to repair is tax-deductible. The effective
corporate tax rate is 35% of net income subject to tax. For purposes of capital
budgeting, the net investment in the new machine is?
Net cash inflows – involves only the cash revenues, costs and expenses. It
is computed by deducting from cash inflows to be generated from operating
the project all the cash outflows to be incurred for the project’s operations.
This is computed as follows:
In some cases, the proposed projects are not expected to generate cash inflows,
but they will yield returns in the form of cash savings. These cost savings should
be treated as income or return that may be derived from the project. The cost
savings, after being adjusted from tax effects, will represent the net return from
the project to be evaluated. This is computed as follows:
Sample problem:
The Lino Company, a calendar company, purchased a new machine for P280,000 on
January 1. Depreciation for tax purposes will be P35,000 annually for eight years. The
accounting (book value) rate of return (ARR) is expected to be 15% on the initial
increase in required investment. On the assumption of a uniform cash inflow and the
tax rate is 30%, this investment is expected to provide annual cash flow from
operations, net of income taxes, of?
Cost of capital (also called as cut-off rate, minimum desired rate, minimum
acceptable rate, target rate, standard rate and hurdle rate) – is the cost of using
funds, which serve as the standard rate with which comparison are to be made.
Examples of cost of capital are interest and dividends. When financing can be
traced directly to a specific source, the cost of capital is determined as follows:
IV. Economic
Life is the period of time during which the asset can provide economic benefits or
positive cash inflows. The concept of economic life is different from the so
called useful life – the period of time between the date if acquisition of the asset
up to the time that the asset can no longer serve the purpose for which it is
determined. In many instances, the economic life is shorter than the useful life,
since at a certain point in time, an asset can still be used (still within the useful
life) but it can no longer provide income or net cash inflow for the firm (already
beyond the economic life).
V. Terminal value
Terminal value (or end of line recovery value, salvage value) – refers to the net
cash proceeds expected to be realized at the end of the project’s economic life.
This should be considered as cash inflow at the end of the project’s life, for
purpose of evaluating capital investment projects. In most cases, however, this
amount is simply assumed to be zero, because of the difficulty of estimating a
reasonable amount that could be realized in the future. The terminal value is
computed as follows:
Methods of Evaluation
The various methods used in evaluating capital investment projects may be grouped
into two major classifications:
1. Methods that do not consider the time value of money (non-discounted cash
flow) approach
a) Payback period
b) Bail-out period
c) Accounting rate of return
d) Payback reciprocal
2. Methods that consider the time value of money (discounted cash flow) approach
a) Net present value
b) Profitability index
c) Discounted payback period
d) Discounted cash flow rate of return
Under the discounted cash flow techniques or present value approach, cash
outflows and cash inflows are discounted to their present value using an
appropriate rate of interest.
a) Payback period
Payback period (also known as payoff and payout period) – measures the
length of time required to recover the amount of initial investment (a measure
of liquidity). Since payback means recovery of investment costs, a quick and
short payback period indicates less risky project.
Decision rule:
The acceptability of the project is determined by comparing the project’s
payback period against the maximum acceptable payback period as
predetermined by management. If the project’s payback period is shorter
than the maximum payback period, the decision should be to accept the
project. On the other hand, if the project’s payback period is longer than the
maximum payback period, the decision should be to reject the project.
Sample problem:
If an asset costs P35,000 and is expected to have a P5,000 salvage value at the end of
its ten-year life, and generates annual net cash inflows of P5,000 each year, the cash
payback period is?
P 35,000
Payback period =
P 5,000
= 7 years
The bail-out period is arrived at when the cumulative cash earnings plus the
salvage value at the end of a particular year equals the original investment.
Sample problem:
An investment of P200,000 is expected to produce annual cash returns of P75,000 for 5
years. Its estimated salvage value is P120,000 during the first year and this is expected
to decrease by P20,000 annually. What is the bail-out period?
ARR (also known as book value rate of return, financial statement method,
average return on investment and unadjusted rate of return) – measures
profitability from the conventional accounting standpoint by relating the
required investment to the future annual net income. The formula of ARR is:
Decision rule:
Under the ARR method, if the ARR is greater than the required rate of return
(normally, the cost of capital), the project should be accepted; however, if the
ARR is lower than the required rate of return, the project should be rejected.
When two or more projects are being evaluated and their ARR’s are greater
than the cost of capital, the project with the highest rate of return is accepted.
Advantages of ARR:
1) It is easily understood by investors acquainted with financial
statements.
2) It is used as a rough preliminary screening device of investment
proposal.
Disadvantages of ARR:
1) It ignores the time value of money by failing to discount the future cash
inflows and outflows.
2) It does not consider the timing component of cash inflows.
3) Different averaging techniques may yield inaccurate answers.
4) It utilizes the concepts of capital and income primarily designed for the
purpose of financial statements preparation and which may not be
relevant to the evaluation of investment proposals.
Sample problem:
A piece of labor saving equipment that Marubeni Electronics Company could use to
reduce costs in one of its plants in Angeles City has just come onto the market.
Relevant data relating to the equipment follow:
Purchase cost of the equipment P432,000
Annual cost savings that will be provided by the equipment 90,000
Life of the equipment 12 years
P 54,000
ARR =
P 432,000
= 12.5%
d) Payback reciprocal
When economic life of the project is at least twice the payback period and the
annual net cash inflows are constant (uniform), the payback reciprocal may
be used to estimate the discounted cash flow rate of return (DCFRR). A
project with an infinite life would have a DCFRR exactly equals to its payback
reciprocal. The formula for the payback reciprocal is:
1
Payback reciprocal =
Payback period
Sample problem:
A piece of labor saving equipment that Marubeni Electronics Company could use to
reduce costs in one of its plants in Angeles City has just come onto the market.
Relevant data relating to the equipment follow:
Purchase cost of the equipment P432,000
Annual cost savings that will be provided by the equipment 90,000
Life of the equipment 12 years
NPV – is the excess of the present value of cash inflows generated by the
project over the present value of the initial investment. The NPV method
assumes that earning are reinvested at a rate of return equal to the firm’s cost
of capital. The formula of the NPV method is:
Present value of cash inflows P XXX
Present value of cash outflows (initial
XXX
investment)
Net present value P XXX
Decision rule:
If the NPV is positive or zero, accept the project. If the NPV is negative,
reject the project. When the NPV is positive, this means that the project will
earn greater than the discount rate (or hurdle rate). If the projects do not meet
the hurdle rate, they should be rejected.
Sample problem:
Consider a project that requires an initial cash outflow of P500,000 with a life of eight
years and a salvage value of P20,000 upon its retirement. Annual cash inflow before tax
amounts to P100,000 and a tax rate of 30 percent will be applicable. The required
minimum rate of return for this type of investment is 8 percent. The present value of 1
and the annuity of 1, discounted at 8 percent for 8 periods are 0.54 and 5.747,
respectively. Salvage value is ignored in computing depreciation. The net present value
amounts to?
b) Profitability index
The profitability index (also known as present value index, desirability index,
benefit-cost rate, total present value index) – is the ratio of the present value
of cash inflows to the present value of net investment (cash outflows). It is
used as a basis in ranking projects in descending order of desirability. The
formula for this index is:
PV of cash inflows
Profitability index =
PV of net investment (cash outflows)
Decision rule:
If the profitability index is equal or more than 1, the project is accepted. If
the profitability index is less than 1, the project is rejected. The higher the
profitability index, the more desirable the project is.
Sample problem:
A project has an initial cost of P100,000 and generates a present value of net cash
inflows of P120,000. What is the project's profitability index?
P 120,000
Profitability index =
P 100,000
= 1.2
28,700
DPP = 3 +
42,900
= 3 + 0.67
= 3.67 years
The discounted payback period is 3.67.
Decision rule:
If the DCFRR is equal to or greater than the minimum desired rate of return
or cost of capital, the project is acceptable. If the DCFRR is lower than the
minimum desired rate of return, the project is not acceptable.
Note: If the present value factor computed is present in the annuity table, the
corresponding rate is the DCFRR.
Sample problem:
Smoot Automotive has implemented a new project that has an initial cost, and then
generates inflows of P10,000 a year for the next seven (7) years. The project has a
payback period of 4.0 years. What is the project's internal rate of return (IRR)?
P 40,000
PV factor =
P 10,000
= 4.0
*refer to the table for Present value of an ordinary annuity of P1. The number of period
is equal to 7 years, within the row for the 7 period, look for the nearest value of the PV
factor 4.0; lower rate is 16% with PV factor of 4.0386 and the higher rate is 18% with
factor of 3.8115.
Self Help: You can also refer to the sources below to help
you further understand the lesson.