CHAPTER SCREENING AND . SELECTING CAPITAL INVESTMENT PROPOSALS Expected Learning Outcomes After studying Chapter 17, you should be able to: 1. Understand the commonly used capital budgeting techniques under the Discounted Cash Flow Approach as well as the Non- discounted Cash Flow Approach. . Calculate the net present value, internal rate of return, profitability index and discounted payback period of an investment proposal. 3. Calculate the payback period, bailout z payback period, payback reciprocal and accounting rate of return of an investment proposal. 4. Recommend whether to “accept or reject” a particular investment proposal or praposed “select” from among alternative investment projects. . 5. Understand the principle of Capital Rationing and recommend an optimal capital budget. oooCHAPTER 17 1G AND SELECTING ‘SCREENIN' MENT PROPOSALS CAPITAL INVES INTRODUCTION tal budgeting process is evaluating or screening project has calculated the cost of capital for a project and whether or not to invest in that project basically “Is the project worth its projected future value?” The fourth step in the capi proposals. Once the firm estimated its cash flows, deciding boils down to asking the question: s0 the techniques are by their very nature, No one can perfectly predict the future, 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 Bailout payback period Payback reciprocal Accounting rate of return (book value rate of return) ek yypScreening and Selecting Capital Investment Proposals _431 CAPITAL BUDGETING TECHNIQUES A. DISCOUNTED CASH FLow (TIME-ADJUSTED) APPROACH 1, Net Present Value Method Net. ‘present value (NPV) is the excess of the resent values of a project’s cash inflows (net operating cash flows this net terminal cash) en the amount of the initial investment. The cash flows are discounted at the firm’s cost of capital, which is used as the minimum acceptable rate of return or the hurdle rate of return for investment projects of average risk. Tag NVP model implicitly assumes that the project’s net operating cash in i are reinvested at a rate equal to the firm’s cost of capital (discount The advantages of using the NPV are that it considers the magnitude and timing of cash flows, provides an objective criterion for decision making which maximizes shareholder wealth, and is the most conceptually correct capital budgeting approach. At its heart, ‘NPV model provides an absolute measure of a project’s worth because it measures the total present value of peso return. It also works equally well ‘for independent projects as it does for choosing-among mutually exclusive projects. . The disadvantages of using the NPV are that it is more difficult to compute than unsophisticated methods and its meaning is difficult to interpret because the NPV does not provide a measure of a project’s actual rate of | return. . _In independent projects, should be accepted if the NPV is zero or positive. In the latter case, the mutually exclusive project with the highest NPV should add the most wealth to the firm and so management should accept it over any competing projects. The NPV of a project is computed as follows: Present value of cash inflows computed based on minimum desired discount rate ‘Less: Present value of investment. Net present value ... Ek F432_Chapter 17 Decision Rule: ia “ect if it’ i iter than zero; otherwi, Accept the project if it's NPV is equal or grea! ise, th noe is rested, Ifa project's NPV is equal or greater than zero, the fj i will earn a return equal to or greater than its cost of capital. If the NPVs negative, it means the project does not meet the hurdle rate and it shouig be rejected as the funds that would be invested in it could earn a higher rate in some other investments. i ji ing similar sizes, lines and cash flow In ranking projects having similar sizes, Patterns th, project with the. higher positive NPV should be chosen because t maximizes the shareholder wealth. Illustrative Case 17-1. NPV Application: Uniform Cash Inflows 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 P50,000 by the present value interest factor for an annuity for five years discounted at 16%, and then subtracting the net investment. . P163,700 Present value of cash inflows (P50,000 x 3.274) Less: Net investment 120,000 P.43,700 Net present value 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.ls 433 Screening and Selecting Capital Investment Proposals Illustrative Case 17. 2. NPV Application: Uneven Cash Inflows Detdet Corp. plans to invest in a four: Dedeeee 0 iny IT-year project that will cost P750,000. Rise of capital is 8%, Additional information on the project is as Cash Flow from Present Value Year Operations, net of taxes of Pl at 8% 1 200,000 0.926 2 220,000 0.857 a 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%: Cash Inflows Year Amount PY factor PV 1 200,000 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 755,400 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%. Illustrative Case 17-3. Application of Net Present Value Method ial licensing arrangement, Javier Company has an Hanah Fic oumeron a ne product in Northern Luzon for a five-year period.’ The product would be purchased from the manufacturer, with Javier Company responsible for all costs of promotion and distribution. The licensing arrangement could be renewed at the end of the five-year period at the option of the manufacturer. After careful study, Javier434 Chapter 17 costs and revenues woulq te Company: has estimated that the follow! associated with the new product: P Cost of equipment needed. : an Working capital need : 00 000 haul of the equipment in fou , ona value of the equipment in five ye 100,000 ‘Annual revenues and co: Sales revenues 2,000,000 Cost of goods sold : 250,000 Out-of-pocket operating costs (for salaries, advertising, and other direct costs) 350,000 At the end of the five-year | for investment elsewhere if the mi ear period, the working capital would be released . anufacturer decided not to renew the licensing arrangement. Javier Company’s cost of capital is 20%. Would you recommend that the new product be introduced? Ignore income taxes, Solution: Amount of Cash 20% PVof Relevant Year(s) Flows: Factor Cash Flows Purchase of equipment Now P (600,000) 1.000 (600,000). Working capital needed Now (1,000,000) 1.000 (1,000,000) Overhaul of equipment 4 (50,000) 0.482" (24,100) ‘Annual net cash inflows from sales of the product line 1-6 400,000* 2991" 1,196,400 ‘Salvage value of the § 100,000 0.402" 40,200 equipment ‘Working capital released 5 1,000,000 0.402" 402,000 Net present value * From Table for the Present Value of PI * From Table for the Present Value of an Annuity of P! in arrears * Sales revenues. Less cos of goods sold. go. 000 Gross margin Less out-of pocket costs for sal 750,000 foie wo oe 350,000Sore ‘ening and Selectin, Capital Investment Proposals 435 2. Internal Rate of Return rete repeated hich ScOunted rate of retum and time-adjusted rate of ith ithe cok Of the utes the present value of the future cash inflows i i it whi * equivalent maximum rate of went hich produces them. Tt is also the 8 interest that could be paid each ir for the capital employed over the life of an investment without loss onthe Project. The IRR technique is, by far, the most i ir : 1S, 1 Popular rate-based capital budgeting technique. The main reason for its Popularity is that, if one is considering a project with normal cash flows that is independent of other Projects, the Will give exactly the same accept/reject decision as the NPV Steps in the Computation of the Internal Rate of Return (IRR) A. Cash inflows are evenly received: Ifthe 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.Aas 436 Chapter 17 B, Cash inflows are not evenly received: The steps in computing for the discounted rate of return are: Cash Retums by dividi Compute the Average Annual Ca c ie of sho returns to be received during the life of the project bya total economic life of the project. 2. Divided Net Investment bythe Average Annual Cash Returns tg get the Present Value Factor. Je for Present Value of Pl received annually to give the closest factor to the computed 3. Refer to the Tabl determine the rate that will present value factor. 4. Using the rate obtained in Step No. 3, refer to the Table for Present Value of PI. Ifthe 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. ‘Add the present value of the annual returns and compare with the Net Investment. 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: Once the IRR has been calculated, it will then be compared to the relevant cost of capital for the project. The average rate of return to payback the project’s capital providers, gives the risk that the project represents. Accept Project if IRR > Cost of Capital Reject Project if IRR'< Cost of Capital In capital investment decisions, companies seek to choose projects that are worth more than what they pay for them, leaving room for economic profit. That is why all these capital budgeting rules are “>” and “<” signs. Firms would only want to invest in projects when the rate it expects 10 get (IRR) is larger than the required rate of return.Screening and Selecting Capital Investment Proposals _ 437 Illustrative Case 17-4, Calculation of Internal Rate of Return; Uniform Cash Flows An investment of PS0,000 will yield an average annual cash return of 77.500 8 Year for a period of 10 years. What isthe discounted rate of return? Solution: Let x - PV factor 1. Investment = ‘Annual Cash Returns (PV factor) 50,000 7,500 x x = 6.6667 2. Referring to the Table for Present Value of PI received annually for 10 years, the column that gives the nearest value to 6.6667 is the column for 8%. 3. To get the exact rate of return, interpolate between 8% and 10%. 8% - 6.710 } 0.043 2 = 6.667 0.565 10% - 6.145 Exact discounted rate of return 0.04: ~ m+ (2x2 8% + 0.15% = 8.15% Illustrative Case 17-5. Calculation of Internal Rate of Return; ‘Uneven Cash Flows An investment amounting to P100,000 is expected to yield cash returns as follows: Year Amount 1 P40,000 2 50,000 3 60,000 Required: Compute the discounted rate of return.Solution: 1. Average cash returns PV Factor Referring to the Table column that will give 150,000 3 50,000 100,000 50,000 2 438 Chapter 17 : for Present Value of PI received annually period 3, the the nearest value to 2 is the column for 22%, , sent Value of PI, column 22%, the cash returns are 4, Using the Table for Pre ji follows: discounted as follows: He ‘Amount of Cash PV of Cash Year Returns PV Factor Returns 1 40,000 0.820 32,800 2 50,000 0.672 33.600 3 60,000 0.551 33.060 ag 29,460 Trial at 20% 1 40,000 0.833 ~p 33300 2 50,000 0.694 34.700 3 60,000 0.579 34.740 Total p02.760 0 Discounted rate of return is 22%, Ifthe exact discount rate of return is required, interpolation may be necessary. Computation will be: 2% = 99,460 } 540 2 - 100,000 20% = - 102,760 Discounted rate of return 0 3,300 22% — 540 3,300 22% - 0.30% 21.20% xm |Screening and Selecting Capital Investment Proposals 439 Illustrative Case 17-6, IRR Determination ‘A company has to select one of the following two projects: P000's ‘ pena Project A Project B 0: 11,000 10,000 Cash inflows ; Year 1 6,000 1,000 Year 2 2,000 1,000 Year 3 1,000 _ 2,000 Year 4 5,000 10,000 Required: "Using the internal rate of return method, suggest which project is preferable. Solution: Factor in case of Project A = 11,000 / 3,500 = 3:14 Factor in case of Project B = 10,000 / 3,500 = 2.86 ‘The factor thus’ calculated will be located:in table given at the end of the book on the line representing number of years corresponding to estimated useful life of the asset. This would give the expected rate of return to be applied for discounting the cash inflows in finding the internal rate of return. : : In case Project A, the rate comes to 10% while in case Project B, it comes to 15%. Project A Year" Cash Inflows Discounting _ Present Value P000's Factor at 10% P000's 1 6,000 0.909 5,454 2 2,000 0.826 1,652 3 1,000 0.751 751 4 5,000 0.683 3,415 Total present value o PLL272440__Chapter 17 The present val P11,000M. Internal rate of retul In case more exactness is requi higher than 10% (since at investment) may be taken. 10% comes to PII bs /estment ; ue of 10% m may be taken approximately at 10% : this rate the 272M: The is red another trial rate which is slight present value is more than at Mea ete of 12%, the following reguiy would emerge: Cash Inflows Discounting Present Vay, Year Po00’s ‘Factor at 12% P000's ” 1 6,000 0.893 5,358" 2 2,000 0.797 11594 3 - 1,000 0.712 oh 4 5,000 0.636 _ 3.180 Total present value P10.844 ‘The internal rate of return is thus more than 10% but less than 12%. The exact rate may be calculated as follows: 11,000M PV required PV at 10% 11,272 (4272 © PV at 12% 10,844 (-) 156 Actual IRR = io+( Pact x 2] = 21% ” Project B Year Cash Inflows Discounting Present Value : P000’s' Factor at 15% P000's i 1,000 0.870 870 2. 1,000 0.756 756 : aie 0.658 1,316 Total present value " 2 Sit Since money covet 15% comes only to P8,662, a lower rate of ‘discount . Taking a rate of 10% the following will be the result.Screening and. Selecting Capital Investment Proposals 441 aoe Cash Inflows Discounting Present Value i P000's Factor at 10% P000's 2 1,000 - 0.909 909 a 1,000 0.826 826 4 rao00 0.683 cio Total present value , ae eas? 067 ited Present value at 10% comes to P10,067M which is more or less equal _ Ky ie initial investment, Hence, the internal rate of return. ‘may be taken as h. In order to have mote exacti I n ness to internal rate of retum, can be interpolated as done in case of Project A. PV required 10,000M PV at 10% 10,067 (67 PV at 15% 8,662 (1,338 at 67 Actual IRR = 1o+{ o=csw * 5] = 10.24% Analysis: Thus, internal rate of return in case of Project A is higher as compared to Project B. Hence, Project A is preferable. Relative Ranking of Projects: NPV vs. IRR The relative ranking of projects, using the different DCF methods will be considered initially in simple accept/reject situations. This will be extended later to a detailed assessment of situations where a choice has to be made between two or jmore alternatives. In simple accept/reject situations, a firm is able to implement all projects showing a return at or above the firms cost of capital. Both NPV and IRR would appear to be equally valid in the sense that they will both lead to accept or reject the same projects. Using NPV, all projects with a positive net present value, when discounted at the firm’s cost of capital, will be accepted. Using IRR, all projects which yield an internal rate of return in excess of the firms cost of capital will be chosen. Although NPV and IRR lead to the same442_Chapter 17 i the ranking of a set of proj » conclusion regarding peje *PH1. rap with that produced uxt i rt neces: F Raycom ae the ranking may vary according to particu. . Since, e merits of the relative rankinig ;, discount rate used. Arguments 2° te ned withthe question of ike simple accepUreject situation is ry the quality of the investment whit, Iris argued thatthe IRR he quality and the scale. This is because the NPV takes into account bolt Tye (Yo IRR) while the NPV provides IRR provides a relative meas “The IRR would rank, for examp| S fan absolute measure (P surplus). ( vderably higher th, ple, a 100% return on an investment of Re. 1 considerably higher than a 29% return on an investment of P!OM, whereas the ee would be true using NPV as long as the cost of capital is below 20%.) While one project may have a higher rate of profit per unit of Capital invested than another, if it has fewer units of capital invested in it, may make a smaller coniribution to the wealth of the firm. Thus, if the objective is to maximize the. firm’s wealth, then the ranking of project NPVs provides the correct measure. If the objective is to maximize the rate of profitability per unit of capital invested, then IRR would provide the correct ranking of projects, but this objective couid be achieved by rejecting all but the most highly profitable projects. This is clearly unrealistic and, therefore, one would conclude that NPV ranking is correct and IRR unsatisfactory as a measure of relative project value. When two investment proposals are mutually exclusive, both methods will give. , contradictory results. When two’ mutually exclusive projects are not expected to have the same life, NPV and IRR methods will give conflicting ranking. 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 investment. The index expresses the present value of cash benefits as to an amount per peso of investment in a project and is used as a means of ranking projects in a descending order of desirability. This is computed as follows: PV Index. = —PVofCash Inflows _ PV of Net InvestmentSe creening and. ‘Selecting Capital Investment Proposals 443 The PV Index is Decision Rule: The higher the PV Index the More desirable the project. Projects with index of lor Sreater than one should be accepted; otherwise the project is rejected. A project where PV Index is equal to or greater than one will maintain or enhance the wealth of the ‘Owners as reflected in the share price ° of the firm’s ordinary equity s hare. The advantages of using the PV Index are that |. Tt considers the magnitude and timing of cash flows; 2. It provides an objective criterion r for. decision making. which maximizes shareholder wealth; and 3. It provides a relative measure of return per peso of net investment. The disadvantage of using the PV Index is that conflict may arise with the NPV when dealing with mutually exclusive investment. Illustrative Case 17-7. Profitability Index XYZ Company has P200,000 funds available for investment. It is considering the following projects: A B c Present value of annual cash inflows 244,000 —-P130,000-—. P130,000 Less: Investment required 200,000 100,000 100,000 Net Present Value P.44,000 — P. 30,000 P_30,000 - Required: 1. Compute the profitability index of each project. 2. Rank each project on the basis.of the present value index. 3.. Which project(s) should be undertaken?Ne ene ee gat ale aS Solution: : 1. Computation of Profitability oF PV Index 244,000 Project A: = 200,000 a 12 fe 130,000 Project B= BOD a 130 on. 2 Bi30,000 Project C: = "100,000 aa 130 2, Ranking of Projects fat _Project_ ! BandC 2 A should invest in Projects B and C for the following reasons: Band C are higher than Project A. 3. ‘The company Projects B and C is higher than that a) The PV indexes of Projects b) The combined net present value o of Project A. ©) The company éan afford to invest in both A and B. 4, Discounted Payback Period (PB) Discounted payback period is a capital budgeting the length of time required for an investments cash flows, disc the investments cost of capital, to cover its cost. method that determines ounted at in a payback ropriate cost the present d at. It is a method that recognizes the time value of money i context. The periodic cash flows are discounted using an app! of capital rate. The payback period is computed by summing values of the cash flows until a cumulative sum of zero is arrive What bens shoud thf se ar geting he DPB? Management will set the DPB maximum allowable payback exogenously and 0"? _ again after arbitrarily,Screening and Sélect Capital Investment Proposals 445 Decision Rule: Accept Project if > Calculated DPB. Reject Project if > Maximum Allowable Calculated DPB Discounted Payback An advantage in using thé DPB is it’ compl. < g iplements the Payback (unadjusted) by Providing additional information to analyze capital budgeting decisions that is; it indicates the time necessary to recoup investment plus interest. Maximum Allowable Discounted Payback Tn One flow however of the DPB is that the decision statistics completely ignore any cash flows that accrue after the Project ‘reaches its respective type of payback benchmark. Ignoring this important information can have significant implications when managers choose between two mutually exclusive projects that have very similar paybacks but different cash flows after payback is achieved. Illustrative Case 17-8. Discounted Payback Period A project requiring an investment of P70,000 is expected to generate the * following cash inflows: Year Amount 60,000 60,000 60,000 60,000 60,000 WYN Required: ' 1. If the cost of capital is 15%, what is its discounted payback period? 2, ‘Should the profit be accepted if the maximum allowable DPB is 3 years?446 Chapter 17 Solution: ined as follows: “The discounted payback period is determ! cash Vane Disounted Factor 15% Cas Flow hee Yer sao.) : (170,000). PCITO 08 0 60, 0870 52,000 we 2 60, 0.756 45,000 mann 3 60,000 0.658 39,000 oes 4 60,000 0572 34,000 ; |. The discounted payback period is 4 years. +. ifthe maximum allowable DPB is 3 years, the project should be rejected, B. NON-DISCOUNTED CASH FLOW (UNADJUSTED) APPROACH 1. Payback Period Payback period is the length of time required for a project’s cumulative net cash inflows to equal its net investment. It measures the time required for a project to break even. If the expected annual net cash inflows are equal (annuity form) the yyback is computed by dividing the net investment by the annual net cash inflows. Thus, the equation is: Payback Period with a Net Investment Equal Cash Flows Annual Net Cash Inflows 1a If the expected cash inflows are unequal, the payback is calculated by determining the length of time required for cumulative net cash inflows to equal the net investment. Payback” Number of Euoaniehal cost at Period ~ Yeats priorto + ——- SAO ¥eeE__ full recovery Cash flow during full recoveredScreening and Selecting Capital Investment Proposals _447 Decision Rule: , The desirability of the project i i sai ject’ i he project is determined by comparing the project’s payback Period against the maximum acceptable payback period as predetermined by management. The project with shorter payback period than the maximum will be accepted. In short: If; PB Period < Maximum allowed PB period; Accept If: PB period > Maximum allowed PB period; Reject Advantages of Payback Period Method It is easy to compute and understand. It is used to measure the degree of risk associated with a project. Generally, the longer the payback period, the higher the risk. It is used to select projects which provide a quick return of invested funds. TP rt Disadvantages of the Payback Period Method It does not recognize the time value of money. 2. It ignores the impact of cash inflows after the payback period. 3. It does not distinguish between alternatives having different economic lives. 4. The conventional payback computation. fails to consider ‘salvage value, if any. 5. It does not measure profitability - only the relative liquidity of the investment. 6. There is no necessary relationship between a given payback and investor wealth maximization so an investor would not know what an acceptable payback is. Illustrative Case. 17-9. Payback Period with Even Cash Flows The information provided below pertains to Project A of the Maharlika Corporation. The maximum payback period set by the firm is three years. Project A Net investment : P120,000 Annual net cash inflows 50,000 Estimated life 5 years448 Chapter 17 The payback period is: ~ p120,000_, Payback period with = L Q aul et flows 50,000 2A years simplicity, the net cash inflows are assumed to occy, i te pe ee ne assumption is’ strictly followed, Project would require three years ‘of cash flows before it ears its net investment because there would be no cash flows during the year. In practice, flows generally occur throughout the year. Thus, if cash flows are reasonably constant during the year, itis reasonable to use 2.4 years, rather than three years, as the payback period. i Project A should be accepted because the computed payback period of 24 years is less than the maximum payback of three years. Illustrative Case 17-10. Payback Period with Uneven Cash Flows Makinang Corporation is evaluating two projects with the following cash flows. The maximum payback period set by the firm is 3 years. Cash Flows Year Project X * Project Y 0 (P100,000) (P100,000) 1 20,000 50,000 2 30,000 40,000 3 40,000 10,000 4 50,000 5 70,000 ‘The payback period for each project is computed below. Hs Project Xs” sof Project Y= Year Net Cash Cumulative Net Net Cash. Cumulative Net ; Inflows Cash Inflows Inflows ° Cash Inflows : 20,000 20,000 P50,000 50,000 2 pan $0,000 40,000 90,000. x 0,000 10,000 100,000 4 50,000. 140,000 5 70,000 210,000Screening and Selecting Capital Investment Proposals 449 Payback _ 4/—P10.000 : Period P5000 aveals Notes: i roe X’s cumulative net cash inflows show that the project pays for If between three and four years. A total of P90,000 is recovered during the first three years and the remaining P10,000 during the fourth year. It takes 0.2 years (P10,000 / P50,000) to earn the additional P10,000. Hence, Project X’s payback period is 3.2 years. In three years, Project Y’s cumulative net cash inflows exactly ‘equal its net investment of P100,000. Makinang Company should accept Project Y over Project X because it has a shorter payback and pays for itself within the allowable maximum payback period of three years. 3. The payback period does not measure profitability because it ignores Project X’s cash flows after the payback period. From a profitability perspective, Project X is more attractive than Project Y. The payback also does not recognize the time values of the cash flows. Thus, use of the payback period may lead to incorrect accept-reject decisions when investment alternatives are evaluated on the basis of their time- adjusted profitability. Bail-out Period. In conventional payback computations, investment salvage value is usually ignored. An approach: which incorporates the salvage value in payback computations is the “Bail-out period”. This is reached when the | cumulative cash earnings plus the salvage value at the end of a particular year equals the original investment. : Illustrative Case 17-11. Determination of Bail-out Period An investment of P150,000 is expected to produce annual cash earnings of P50,000 for 5 years. Its estimated salvage value is P70,000 during the first year and this is expected to decrease by P15,000 annually. Required: What is the bail-out payback period?480 Chapter 17 » Solution: : : Bail-out payback period may be determined using the following table: Annual Cash Return Salvage Vat ie 50,000 P70,000 ° 2 50,000 55.000 3 50,000 40,000 4 50,000 25°00 5 50,000 10,000 Bail-out payback period 150,000 - P105,000 (a) = Lyear + ( 50,000 (b) x 1 year’ - 1 (a) Cash returns during the Ist year + Salvage value; 2nd year (b) Cash returns during the 2nd year Payback Reciprocal Payback reciprocal measures the rate of recovery of investment during the payback period. For projects with even cash flows, the payback reciprocal is computed as follows: 1 Payback Reci oes soleil Payback Period For projects with uneven cash flows, the payback reciprocal can be computed on an annual basis by dividing the Cash Inflows for the year by the net investment. An alternative way of expressing the payback period is as the “payback period reciprocal” which is expressed as: 100us, if @ project has a pay reciprocal would - back period of 2.5 years, then the payback Accounting Rate of Return Accounting rate of | return (ARR) or simple rate of return is a measure of a project’s Profitab lity from a conventional accounting standpoint by relating the required investment to the future annual net income. . Average annual net income is determined by summing the expected net incomes over the project’s life and dividing by the total number of periods in the life of the Project. Average net investment is assumed to be one-half of the net investment. 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 = Costsavings - Depreciation on new equipment Initial Investment or Average Investment Decision Rule: Under the ARR method, choose the project with the highest rate of return. Accept the project if the ARR is greater than the cost of capital. Thus: If} ARR 2 Required rate of return; Accept If} ARR < Required rate of return; Reject452 Chapter 17 Advantages of Using the ARR " . ~ 1. It is easily understood by investors acquainted with financiay statements. 2. It is used as a rough preliminary screening device of investmén, proposals. Disadvantages of Using the ARR 1. It ignores the time value of money by failing to discount the future cash inflows and outflows. 2. Itdoes not consider the timing component of cash inflows. Different averaging techniques may yield inaccurate answers, It utilizes the concepts of capital and income primarily designed for the purposes of financial statements preparation and which may not be relevant to the evaluation of investment proposals. Illustrative Case 17-12. Determination of Accounting Rate of Return Consider the following information about a proposed project:, Initial investment required P65,000 Estimated life 20 years Annual cash inflows P10,000 0 Salvage value of the asset at the end of 20 years Straight-line method of depreciation will be used. Required: Compute the Accounting rate of return (ARR) a) based on initial investment b) based on average investment. Solution: ARR on a) initial - _P10,000 - P3,250 investment 65,000 " 10.38%Screening and Selecting Capital Investment Proposals _ 453 ARR on 10,000 - P3250 by average 65,000 + PO investment 2 = 20.8% Salvage value of the Initial investment + - asset at the end of economic life Average investment = 2 IMustrative Case 17-13. Determination of Accounting Rate of Return Toronto Corporation is considering an investment in Project A based on the following information. Project A. Net investment P120,000 Annual net income 20,000 Estimated life 5 years Target ARR 25% The average annual net income is P20,000 (P100,000 / 5 years) and the average net investment is P60,000 (P120,000 / 2). The accounting rate of return is: Accounting rate _ _P20,000, _ of return P60,000 Toronto Corporation should accept the investment because the actual ARR. of 33.3 percent is greater than the target ARR of 25 percent. CONCLUSION ON CAPITAL BUDGETING METHODS In this chapter, we apply time value of money concepts to project valuation with the main goal of finding projects that convey enough control power to the acquirer that they are worth more than they cost, even taking into account the cost of capital. Of the 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 projects. However, additional capital budgeting techniques such as Internal Rate of Return, Payback Period, and Discounted Payback Period454 Chapter 17 ether to accept @ project or not. IRR fo 7 * i wh may provide supplementary eed tage rate of return wie , “lit ed as a percen instance, measures profitability ex! ee ink 2 N : ee ntains information con; interesting to decision makers. It also co! cerning the project’s “safety margin” and reinvestment rate assumption. rovide indications of a project’s liquidity ang back pI : estment pesos will be locked up for a Jon, Payback and discounted pay! risk. A long payback means that invest? os time, hence the project is relatively illiquid. In addition, a long payback means thar . far out into the future and that probably makes the cash flows must be forecasted project riskier than one with a shorter payback. A summary of the relevant attributes and strengths and weaknésses of the various own in Figure 17-1. capital budgeting techniques is sl ‘Suitable for choosing Suitable between Useful for Useful for for non- mutually — firms facing firms facing Unit of normal exclusive time capital Technique measurement cash flows projects. constraints constraints NPV Currency Y Y N Y Payback Time N N Y N Discounted . Time N N Y N Payback IRR Interest Rate N N N Y Profitability Interest Rate Y N N ¥ Index Accounting . Interest Rate Y N N Y Rateof Return Figure 17-1. Strengths and Weaknesses of Capital Budgeting Techniques As we can see, NPV does tend to be the most usefi i an see, q ul technique, but the others also have their place, particularly for firms facing either time or capital constraints. Recent surveys of prasitiones concerning: which capital budgeting techniques earrinoaly at toca ‘i d that i this idee, showing NEV ito Be He a cee i, and that practiti ; + aetioh with one of the other techniques vies one, use NPV in conjuncti 7 | Howe i fn of such other techniques indicates that practitioners tend t0 Ptually simpler techniques over the more complicated ones.Screening and Selecting Capital Investment Proposals _ 455 In summary, the different meas; it is not too difficult to calcul: tures provide different types of information. Since SELECTION PROBLEMS The three types of capital budgeting decisions are: 1. 2. 1. Accept — reject decisions 2. Mutually exclusive project decisions 3. Capital rationing decisions ACCEPT — REJECT DECISION This occurs when an individual project is accepted or rejected without regard to any other investment alternatives. Generally, as long as a firm has unlimited funds and only independent projects, all projects meeting the minimum investment criteria should be accepted. Independent projects are those for which the acceptance of one does not automatically eliminate the others from further consideration. Using sophisticated capital budgeting techniques, such as NPV, Pl, and IRR, to evaluate single, independent projects with conventional cash flow patterns always leads to identical accept-reject decisions and the maximization of shareholder wealth. The accept-reject decision rules for capital budgeting techniques under certairity have already been stated, that is, the decision maker knows in advance the future values of all information affecting the decision have already been discussed. 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. The ranking of mutually exclusive projects may conflict based on accept-reject decision rules. Among the major reasons for conflicting rankings among mutually exclusive projects using sophisticated or advanced capital budgeting techniques are:456 Chapter 17 : 1. Difference in expected economic lives of the projects; . Differ 2, Substantially difference in net investments (size) of the projects, 3, Difference in timings of cash flows; ond at 4. Difference in reinvestment rate assumptions in discounted cash floy, techniques. When conflicting ranking occurs, the NPV is theoretically considered the superior technique. The reasons are: 1. NPV method provides correct rankings of mutually exclusive investment projects, whereas other DCF techniques sometimes do’ ‘Not, |. NPV implicitly assumes that the operating cash flows generated by the project are reinvested at the firm’s cost of capital which approximates R the opportunity cost for reinvestment. The IRR method assumes reinvestment at the IRR which may not be a realistic rate. Also, IRR uses different reinvestment rates for each competing alternatives, 3. NPV does not suffer from the weakness of either the IRR or PV Index and leads to maximizing shareholders’ wealth. 3: CAPITAL RATIONING DECISION Optimal Capital Budget is the annual investment in long-term assets that maximizes the firm’s value. For planning purposes, manager must forecast the total capital budget, because the amount of capital raised affects the Weighted Average Cost of Capital (WACC) and thus influences projects’ Net Present Values (NPVs). Itmay be reasonable to assume that large, mature firms with good track records can obtain financing for all its profitable projects. However, smaller firms, new firms and firms with dubious track records may have difficulties raising capital even for projects that the firm concludes would have highly positive NPVs. In such circumstances, the size of the capital may be constraint, a situation called capital rationing. Capital rationing'is a situation where a constraint or budget eee Placed on the total size of capital expenditures during a particularScreening and Selecting Capital Investment Proposals _ 487 ecting Capital Investment Proposals 487 Capital rationing can also be described a the sélection of the investment proposals in a situation of Constraint on availability of capital funds, to maxitnize the wealth of the company by selecting those projects which will maximize overall NPV (net present value) of the concern. In capital rationing situation, a company may have to forego some of the projects whose IRR (internal rate of return) is above the overall cost of the firm due to ceiling on budget allocation for the projects which are eligible for k Positive NPV projects it has identified because of shortage of capital. In terms of financing investment projects, the following important questions to be answered: ‘1. What would be the requirement of funds for capital investment decisions in the forthcoming planning period? How much quantum of funds are available for capital investment? How to assign the available funds to the acceptable proposals which Tequire more funds than are available? The answers to, the first and second questions are determined based on the capital investment appraisal decisions made by the top management. The third question is answerable using specific reference to the appraisal of investment decisions within the preview of capital rationing, Under capital rationing, management has to determine not only the profitable investment opportunities but also decides on the combination of profitable Projects which generates the highest NPV within the available funds by ranking them according to their relative profitability.458 Chapter 17 ital Rationing Scenarios of Capi ; Scenario 1- Projects ae pivisible and. Constraint is a Single Period One pany is considering five independent projects. XYZ Com| ir itic NPV at the je Required Initial . He a vestment Appropriate Cost of f Capital A 1,000,000 P20,000 B 3,000,000 35,000 Cc 500,000 16,000 D 2,000,000 25,000 E 1,000,000 30,000 available is P3,000,000.. Determine the optimal combination of Total fund ; hat the projects are divisible. projects assuming th Solution The following steps may be adopted for solving the problem under this situation: (a) Cal (b) Rank the projects on the basis of the profitabi (a) above. (c) Choose the optimal combination of the projects. Iculate the profitability index of each project. ility index calculated in Required _ NPVat the Profitability. Initial Appropriate Index [(3)/(2)] Project Outlay - Cost of Capital Rank () 2) i) 4 0) A 4,000,000 P20,000 02 3 8 3,000,000 36,000 0.4117 5 ce 500,000 16,000 0.32 1 D 2,000,000 25,000 0.125 4 1,000,000 30,00 = ~=—«03 2Screening and Selecting Capital Investment Proposals 459 Rank of investment Project Required Initial i c P 500,000 2 E 4,000,000 3 A 4,000,000 4 14th of D 500,000* joa 3.000.000 * 2,000,000 x 1/4 = P500,000 Therefore, the optimal combination of Projects is C, E, A and 1/4th portion of D. ‘Scenario Hi - Projects are Indivisible and Constraint is a Single Period One Using the same data used in the previous illustration, determine “he optimal Project mix on the basis of the assumption that the projects are indivisible. ‘Solution: The following steps to be followed for solving the problem under this situation are: (a) Construct a table showing the feasible combinations of the project (whose aggregate of initial outlay does not exceed the fund available for investment). (b) Choose the combination whose aggregaté NPV is maximum and consider it as-the optimal project mix. Feasible Combination Aggregate of NPVs AC P36,000 1D 45,000 AE 50,000 c,D 41,000 CE 46,000 DE 55,000 ACE 66,000 By a careful inspection of the feasible combinations constructed in the above table, we can conclude that the optimal project mix is A, C, and E because the aggregate of their NPVs is maximum.460 Chapter 7 UNEQUAL LIVES COMPARING PROJECTS WITH jsions involved comparing two In previous examples, replacement decisions involved. ee Fee peice? retaining the old i ae a new one. It ig pel uipment had a life equal to e remaining life’ th assumed that the new equip’ re deciding between two mutually exclu’ ‘equipment. However, if we wel ‘5 ee alternative with significantly different lives, an adjustment would be Necessary This problem may be dealt with using any one of these procedures, - 1.” The replacement chain method and 2. The equivalent annual annuity method (EAA) Replacement Chain (Common Life) Approach This method compares project of unequal lines which assumes that each project can be repeated as many times as necessary to reach a common life span. The Net Present Values (NPVs) over this life span are then compared, and the project with the higher common life NPV is chosen: - To illustrate the application of this method we shall assume the following data on mutually exclusive projects, Project N and Project M. Project N Project M Investment required is . ‘Annual Cash inflows (400,000) (200,000) Year | 80,000 P70,000 Year 2 140,000 130,000 Year 3 130,000 120,000 Year 4 120,000 7 Year 5 110,000 a Year 6 100,000 : Net Present Value of the Cash Flows discounted : @1% P64,910 P51,550, Internal rate of retum 175% 25.2%Screening and Selecting Capital Investment Proposals _461 Observations and Analysis (a) Based on the NPV, Project N appears to the better project. This analysis is, however, incomplete and the decision to choose it, may not be correct. (b) If Project M is chosen, there will be an opportunity to make a similar investment in 3 years and if cost and revenue conditions continue, this investment will also be profitable. If Project N is chosen, there is no second investment opportunity. (c) To make a proper comparison of Project M and Project N, the replacement chain (common life) approach could be applied. For Project M, add in a second project to extend the overall life of the combined project to 6 years. Assuming that Project M’s investment cost and annual cash inflows will not change if the project is repeated in 3 years (Year 1: P70,000, Year 2: P130,000 and Year 3: P120,000) cost of capital will remain at 12%. The new NPV of this project will be P88,240 and IRR will be at 25.2%. (d) Since the P88,240 extended NPV of Project M over the common life of 6 years is greater than the P64910 NPV of Project N, selected. Project M should be Although the above illustrative case shows why an extended analysis is necessary if there are mutually exclusive project with different lines, the arithmetic is generally more complex in practice. However, even for mutually exclusive projects it is not always appropriate to extend the analysis to a common life. This should only be done if there is a high probability that the projects will actually be repeated at the end of their initial life.Equivalent Annual Annuity (EAA) Approach annual annuity (EAA) methog i equivalent Another procedure, known as the eq projects with different lives also be used in evaluating mutually exclusive s i i thod which cak Equivalent Annual Annuity (EAA) Method is a met Ww culates th annual payments a project would provide if it were 2 annuity. Generally, when comparing projects of unequal lives, the one with the higher equivalent annya| annuity should be chosen. To illustrate how this procedure is applied, let us assume the same data for the typ projects, Project M and Project Non page, 460: 1. Itis noted that Project M’s NPV = PS 1,550 Project N's NPV = P64,910 ‘The Expected Net Cash Flows for Projects N and M are computed as follows: Project M 0 1 12 3 (200,000) 70,000 730,000 120,000 62,500 _.8929 | 103,635 ©7972 TsAls 7118 aes est io 51550 NPV Project N 0 1 2 : (400,000) 80,000 71,430_.8929 | 140,000) = 190,000 11,607 7972 ‘ fst eran A‘Screening and Selecting Capital Investment Proposals _463 4 5 6 120,000 16,262, 6355 110,000 100,000 62,417°_.5674 50.6 1s cutscene 94,910 NPV 2. To find the value of EAA for Project M use the equation 51,550 = EAA (PV of an ordinary annuity for 3 periods at 12%) 51,550=EAA x 2.40183 EAA = P21,463 3. To find the value of EAA for Project N, the equation will be: 64,910=EAA x (PV ofan ordinary annuity for 6 periods at 12%) EAA= 64,910 4.11 EAA = P15,793 4. The project with the higher EAA will always have the higher NPV when extended out to any common life. Therefore, since Project M’s EAA larger than Project N, we would choose Project M. The EAA method is often easier to apply then the replacement chain method. *464 Chapter 17 Questions REVIEW QUESTIONS AND PROBLEMS back period ‘is calculated, and describe th le ibe how the pay’ Describe how the pt re provides about a sequence of cash flows information this. measure | What is the payback criterto What conceptual advantage does the discounted payback method i over the regular payback ‘method? Can the discounted payback cite be longer than the regular payback? Explain. Why is NPV considered a superior method of evaluating the cash flows from a project? Suppose the NPV for a project’s cash flows is computed to be P2,500. What does this number represent with respect to the firm’s shareholders? n decision rule? |. Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV? Explain. : j What is the relationship between the profitability index and NPV? Are there any situations in which you might prefer one method over the other? Explain. A project has perpetual cash flows of C per period, a cost of J, anda required return of R. what is the relationship between the project’s payback and its IRR? What implications does your answer: have for long-lived project with relatively constant cash flows? Explain why the NPV ofa relatively long-term project, defined as one for which a high percentage of its cash flows are expected in the distant future, is more sensitive to changes in the cost of capital than is the NPV of a short-term project.Screening and Selecting Capital Investment Proposals 465 Problems - Problem 1 What is the payback period for the following set of cash flows? Year —_—_—_ ast Flow 0 ~P6,400 1 1,600 ‘ 7 1,900 3 2,300 4 1,400 Problem 2 ‘An investment project has annual cash inflows of P74,000, and a discount rate of 14 percent. What is the discounted payback period for these cash flows ‘if the initial cost is P70,000? What if the initial cost is P100,000? What if it is P130,0007 42,000, P53,000, P61,000, and Problem 3 You are trying to determine whether to expand your business by building a new manufacturing plant. The plant has an installation cost of P15 million which will be depreciated straight-line to zero over its four-year life. If the plant has projected net income of P1,938,200; P2,201,600; P1,876,000; and P1,329,500 over these four years, what is the project’s average accountirig return (ARR)? Problem 4 A firm evaluates all of its projects by applying the IRR rule. If the required return is 16 percent, should the firm accept the following project? Year Cash Flow 0 = P34,000 L- 16,000 2 18,000 3 15,000 Problem 5 A project that provides annual cash flows of! 28,500. for nine years costs 138,000 today. Is this a good project if the required return in 8 percent? What it it is 20 Percent? At what discount rate would you be indifferent between’ accepting the Project and rejecting it?466 Chapter 17 z Problem 6 i 2, What is the IRR of the following set of cash flows? Cash Flow i = P19,500 1 9,800 2 10,300 3 8,600 Problem 7 m 6, what is the NPV ata discount rate of zero percent) For the cash flows in Proble N ; 10 percent? If it is 20 percent? If it is 30 percent? What if the discount rate is Problem 8 index for the following set of cash flows if the relevant What is'the profitability if the discount rate is 15 percent? If it is 22 discount rate is 10 percent? What percent? Year Cash-Flow 0 : =P 14,000 1 7,300 2 6,900 3 5,700 Problem 9 ‘An investment has an installed cost of P684,680. The cash flows f= oe 680. 1 over the four-' i af the investment are projected to’ be P263,279; P294,060; 7227 608; a a oe rate is infinite, what is the NPV? At what discount rate ae ta oa to zero? Sketch the NPV profile for this investment based on Problem 10 PaO oe has a payback of seven years and a cost of . cash flows are conventional. .Multiple Choice Questions (f Which of the followin, a. Screening and Selecting Capital Investment Proposals _467 g Statements is TRUE? ial Payback method of project evaluation considers all the vant cash flows from a project but neglects the consideration - risk and time value of money. le payback period of a project i ject’ liquidity, Project is a measure of. the project’s The average rate of return (ARR) method of project evaluation considers all the relevant cash flows from a project but neglects the | Consideration of risk and time value of money. Using a discount rate of 12%, the present value of a project’s expected future cash flows is P1,000. The net investment cash outlay is P1,100. The IRR of this project is greater than 12%. Which of the following statements is FALSE? a. b. The IRR is the discount rate that equates the present value of a Project’s expected cash inflows with its net present value. The IRR is the discount rate that makes the net project equal to zero. The IRR is the maximum discount rate that will give a non- negative net present value. Consider an investment opportunity that costs P10,000 and promises to pay a single lump sum of P13,000 three years from now. In this situation, invested capital will increase over the life of the investment. present value of a Which of the following statements is TRUE? a. Consider an investment opportunity that costs P10,000 and promises to pay a single lump sum of.P13,000 three years from now. The IRR of this investment is 10%. Consider an investment opportunity that costs P1,500 and promises to pay P150 at the end of each year for four years. Along with the final P150 annual payment, the investment will also repay the P1,500 principal. The IRR of this investment is 10%. Consider an investment opportunity that costs P1,500 and promises, to pay P150 at the end of each year for twenty years. The IRR of this investment is 10%. : You are the financial manager for a small private college. A local business has proposed giving the school a mainframe computer, free of charge. If you accept the gift, your school will save468 Chapter I7 0 in charges for off-campus computer se. . 200,000 Perce the computer for 10 years and then done’. to use ri years § . eee ecnit cause. The IRR of this project is zero. itty . i i is FALSE? 4. Which of the following statements is. / a. L In general, for companies facing severe capital rationing reinvestment rate is high and exceeds the crossover ‘ns projects usually should be ranked by their Inge Consequently, u a b. If the IRR of a particular investment is 12% and the Npy of investment is zero, then the discount rate for the project Must be 12%. ; ; c. If the NPV of an investment is negative, then the IRR of the investment is greater than the discount rate used to compute the net present value. d: The ideal evaluation method for capital projects include all cash flows occurring during the entire life of the project. Questions 5 and 6 pertains to the following information: Gregory, Inc. manufactures mattress. The financial manager is considering a project proposal involving an expansion of productive capacity through the purchase of new manufacturing equipment. The purchase price of the equipment is P750,000. Assume that the equipment will be depreciated for tax purposes over three years at P250,000 per year. The project is expected to last for 3 years. At the end of this time, the project will be terminated. The equipment is expected to be worthless at that time. The project is expected to increase annual cash revenue by P450,000 and increase cash operating expenses by P150,000. Use a 34% marginal tax rate for your calculations. 5. Using the information given above, the payback period for this project is (a. Lessthan 1 year. b. Between | year and 2 years. c. . Between 2 years and 3 years. d. Mote than 3-years. 6. Using the information given above, the average rate of return for this project is nearest a 13.2% c. 39.6% b. 4.4% d. 8.8%Screening and. ‘Selecting Capital Investment Proposals _ 469 Questions 7 and 10 pertains to the followin, 1g information: ' , Inc. : : : ‘ Cnciisnng ae washing machines. The financial manager is Proposal involving an expansion of productive capaci through the purchase of new manufacturing ccpInenE The purchase price or the equipment is P750,000. The equipment will be depreciated using an ACRS class life of 3 years. The project is'expéctedito last for A)years. At the end of this time, the equipment is expected to be worthless. The project is expected to increase annual cash revenue by P300,000 and increase, cash operating expenses by P100,000. Use a 34% marginal tax rate for your calculations, 7. Using the information given above, the payback period for this project is - a. Less than | year. f b. © Between { year and 2 years. c. Between 2 years and 3 years. d. Between 3 years and 4 years. 8. Using the information given above, the average investment for this project (as it would be used in computing the average rate of return) is a. P750,000. c. P187,500. b. P375,000. d. P250,000. 9. Using the information given above, the earnings after taxes for the fourth year of this project (as it would be used in computing the average rate of return) is a. P132,000. c. P150,889. b. . P 95,333. d. P 49,111. 10. Using the information given above, the average rate of return for this project is nearest a. 1.75%. ec. 4.17%. b. 2.20%. d. 7.82%. 11. — Consider an investment project that has a net investment cash outflow of P1,500 and expected annual cash inflows of P150 to be received at the ends of the next 10 years. Along with the final P150 annual payment, the investment will alsorepay the P1,500 principal. The IRR. b. Zero. : d, 10%.