SAINT COLUMBAN COLLEGE

College of Business Education

Pagadian City

HANDOUT FIN-MAN 2307

CAPITAL BUDGETING PART 3 (DISCOUNTED)
DISCOUNTED TECHNIQUES

Technique Recovery Measurement Decision Criteria

1. Discounted Payback Period Net Cash Inflows Liquidity The shorter, the better.
If Positive = Accept
2. Net Present Value Net Cash Inflows Liquidity
If Negative = Reject
If Positive = Accept
3. Net Present Value Index Net Cash Inflows Liquidity
If Negative = Reject
Greater than 1 = Accept
4. Profitability Index Net Cash Inflows Liquidity
Less than 1 = Reject
5. Internal Rate of Return Net Cash Inflows Liquidity The higher, the better.

A. DISCOUNTED PAYBACK PERIOD

This is the period required for the discounted cumulative cash inflows on a project to equal the
discounted cumulative cash outflows which usually equals to the net investment. This has the same
concept with Payback Period except that the cash flows are DISCOUNTED at its present value.

Formula for Computation:

Whether the cash flows are even or uneven, the Discounted Payback Period should be solved
MANUALLY using the cash flows discounted at present value of 1 per year.

B. NET PRESENT VALUE

This is the excess of the present value of cash inflows over present value of cash outflows generated
by the project throughout its life.

Advantages:
▪ Emphasizes cash flows rather than net income.
▪ Recognizes the time value of money.
▪ Assumes discount rate as the reinvestment rate.

Disadvantages:
▪ It requires predetermination of the cost of capital or the discount rate to be used.
▪ The net present value of different competing projects may not be comparable because of
differences in magnitudes or sizes of the projects.

Interpretation:
Positive Result = Accept Investment Negative Result = Reject Investment

The rate of return for the project is greater than

The rate of return for the project is less than the
the hurdle rate and the investment should be
hurdle rate and the investment should not be
made. If the company has unlimited funds, all
made because it does not meet management's
projects with a net present value greater than
minimum rate of return.
zero should be accepted.

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FINANCIAL MANAGEMENT HANDOUT 2307
MYLENE P. ALFANTA, CPA
Formula for Computation:
Present Value of Cash Inflows:
Operating Cash Flows After Tax @ PV xx
Salvage Value or Net Proceeds @ PV of 1 xx
Working Capital @ PV of 1 xx
Total PV of Cash Inflows xx
Less: Present Value of Cash Outflows (Net Investment) (xx)
Net Present Value xx

Note: If the OCFAT is even, use the Present Value of Ordinary Annuity. If the OCFAT is uneven, use
the Present Value of 1.

C. NET PRESENT VALUE INDEX AND D. PROFITABILITY INDEX

The indexes are normally used to rank projects that are acceptable. The ranking of acceptable projects
is made when there is a constraint on resources such as money, manpower and materials. The
process of allocating available money to the most prioritized investment proposal is known as “capital
rationing”. In the ranking process, the project that has the highest index has the highest priority.

Formula for NPV Index:

NPV Index = Net Present Value / Present Value of Cash Outflows

Formula for Profitability Index:

1. Alternative Formula 1 = PV of Cash Inflows / PV of Cash Outflows
2. Alternative Formula 2 = (Net Present Value / Net Investment) + 1
3. Alternative Formula 3 = PV Factor of Discount Rate / PV Factor of IRR

E. INTERNAL RATE OF RETURN

This is the rate which equates the present value of cash inflows to present value of cash outflows.
Simply stated, it is the rate where present value is zero. Other terms include the following:
▪ Discounted Cash Flow Rate of Return
▪ True Rate of Return
▪ Time-Adjusted Rate of Return
▪ Sophisticated Rate of Return

Characteristics of IRR:
▪ At Internal Rate of Return, the following assumptions are correct:
✓ Present Value of Cash Inflows = Present Value of Cash Outflows
✓ Net Present Value is equal to zero.
✓ Profitability Index is equal to 1.
▪ Decision Criteria are as follows:
✓ If IRR > Cost of Capital or Discount Rate = Accept the Investment
✓ If IRR < Cost of Capital or Discount Rate = Reject the Investment
▪ If the IRR is higher than the cost of capital, then the NPV is positive.
▪ The higher the IRR, the better.
▪ The Internal Rate of Return can be easily computed using financial calculator or computer
excel. It can also be computed manually; however, it would take a long time since an
interpolation technique (trial and error) shall be used.

Important Notes:
▪ If the PVF of Discount Rate > PVF of IRR = Discount Rate < IRR
▪ If the PVF of Discount Rate < PVF of IRR = Discount Rate > IRR

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FINANCIAL MANAGEMENT HANDOUT 2307
MYLENE P. ALFANTA, CPA
Interpolation Technique Formula for Even Cash Flows:
1. Determine the PV Factor Annuity (PVFA) of the project, where PVFA = Net Investment /
Operating Cash Flows After Tax.
2. Using Trial and Error, find the lower and higher discount rate where the PVFA of the project is
in between the PVFA of the two rates.
3. Compute for the IRR using either of the following formulas:

(PVFA LR – PVFA)
IRR = LR + (HR – LR) x
(PVFA LR – PVFA HR)

(PVFA – PVFA HR)

IRR = HR – (HR – LR) x
(PVFA LR – PVFA HR)

Interpolation Technique Formula for Uneven Cash Flows:

1. Using Trial and Error, find the lower and higher discount rate where the PVFA of the project is
in between the PVFA of the two rates.
2. Compute for the IRR using either of the following formulas:

(PVCI LR – PVCO)
IRR = LR + (HR – LR) x
(PVCI LR – PVCI HR)

(PVCO – PVCI HR)

IRR = HR – (HR – LR) x
(PVCI LR – PVCI HR)

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FINANCIAL MANAGEMENT HANDOUT 2307
MYLENE P. ALFANTA, CPA
 SAMPLE PROBLEMS

PROBLEM 1: DISCOUNTED PAYBACK PERIOD

A new machine costing P40,000 with 3 years useful life and no salvage value at the end of its useful
life is acquired by KIDDIE Company. The machine is expected to bring in a cash flows after tax of
P30,000 for year 1, P20,000 for year 2, and P10,000 for year 1. The cost of capital is 20%. Compute
for the Discounted Payback Period.

PROBLEM 2: DISCOUNTED PAYBACK PERIOD

SUMMER COMPANY purchased a new machine on January 1 of this year for P380,000, with an
estimated useful life of 5 years and a salvage value of P20,000 at the end of its useful life. The
machine will be depreciated using the straight-line method. The expected after-tax cash inflows and
the estimated salvage values for each year during the life of the project are as follows:

Year Net Cash Inflows Salvage Value

1 140,000 40,000
2 120,000 35,000
3 100,000 30,000
4 90,000 25,000
5 80,000 20,000

Requirement: Compute for the Discounted Payback Period assuming the discount rate is 10%.

PROBLEM 3: DISCOUNTED PAYBACK PERIOD

WINTER Corporation is considering to invest in the following project opportunities assuming a 16%
discount rate:

Project X Project Y
Net Cost of Investment 5,000,000 5,000,000
Net Cash Inflows After Tax:
Year 1 2,000,000 3,500,000
Year 2 2,000,000 2,500,000
Year 3 2,000,000 1,500,000
Year 4 2,000,000 500,000

Requirements:
1. Compute the Discounted Payback Period of Project X.
2. Compute the Discounted Payback Period of Project Y.

PROBLEM 4: NET PRESENT VALUE

SPRING COMPANY is planning to acquire a new asset with the following expectations:
Annual expected sales volume 80,000 units for five years
Selling price P 15.00
Unit variable cost P 6.00
Cost of required machinery P 550,000
Salvage value P 50,000
Annual cash fixed costs P 100,000
Increase in receivables P 60,000
Increase in inventory P 40,000

The increase in working capital will be returned in full at the end of the five years. The tax rate is
30% and cost of capital is 12%. How much is the project’s Net Present Value?

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FINANCIAL MANAGEMENT HANDOUT 2307
MYLENE P. ALFANTA, CPA
PROBLEM 5: NET PRESENT VALUE
ASHFALL Company wants to introduce a new product with the following:
Sales Volume Annually 300,000 units
Selling Price per Unit P 20.00
Variable Costs P 12.00

The new product requires a P50,000 increase in working capital, as well as the purchase of new
equipment costing P250,000 having 5 years useful life and no salvage value. Cash fixed operating
costs equal to P100,000. The cost of capital is 12% and the tax rate is 40%. How much is the Net
Present Value of ASHFALL Company?

PROBLEM 6: NPV, NPV INDEX, AND PROFITABILITY INDEX

QUALIFYING Corporation is considering the following investment alternatives for 12% discount rate:
1. Project 1 – An equipment costing P1,200,000 and additional working capital of P300,000 will
be needed to produce annual net cash inflows of P500,000. At the end of its useful life of 5
years, the equipment will have residual value of P100,000.
2. Project 2 and Project 3:
Year Project 2 Project 3
0 2,000,000 1,400,000
1 1,200,000 200,000
2 500,000 600,000
3 200,000 1,000,000
4 50,000 800,000
5 50,000 500,000
Residual Value 20,000 100,000

Requirements:
1. Compute the Net Present Value of Projects 1, 2, and 3.
2. Compute the NPV Index of Projects 1, 2, and 3.
3. Compute the Profitability Index of Projects 1, 2, and 3.
4. Which project shall be given the highest priority?

PROBLEM 7: PROFITABILITY INDEX

CHARADES Company is contemplating on the following projects:
Project 1 Project 2
Net Present Value P1,000,000 P500,000
Net Investment P10,000,000 P1,000,000

Requirement: Compute for the Profitability Index for both projects.

PROBLEM 8: NET PRESENT VALUE AND PROFITABILITY INDEX

Telephone Corp. is contemplating four projects: L, M, N, and O. The capital costs for the initiation of
each mutually-exclusive project and its estimated after-tax, net cash flow are listed below. The
company’s desired after-tax opportunity cost is 12%. It has P900,000 capital budget for the year. Idle
funds cannot be reinvested at greater than 12%.

PROBLEM 9: INTERNAL RATE OF RETURN

Twin Towers Company has the opportunity to buy a new equipment at P1 million. The machine is
estimated to have useful life of 4 years, no residual value and will yield an annual net cash inflows
after tax of P375,000 during its economic life. The company’s rate of return is 14%. Determine the
Internal rate of Return.

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FINANCIAL MANAGEMENT HANDOUT 2307
MYLENE P. ALFANTA, CPA
PROBLEM 10: INTERNAL RATE OF RETURN
VAMPIRE Company is considering to buy a new machine, requiring an immediate P500,000 cash
outlay. The new machine is expected to increase an annual net after-tax cash flows by P140,000 in
each of the next five years. The company desires a minimum return of 10% of invested capital.
Compute for Internal Rate of Return.

PROBLEM 11: INTERNAL RATE OF RETURN

A new equipment costing P2,800,000 with P100,000 salvage value at the end of five years and with a
cost of capital of 15% is expected to bring in the following net cash inflows:
Year 1 1,200,000
Year 2 950,000
Year 3 800,000
Year 4 600,000
Year 5 500,000

Requirements:
1. Compute the Net Present Value.
2. Compute the Internal Rate of Return.

PROBLEM 12: COMPREHENSIVE

Fill in the blanks for each of the following independent cases. Each investment has a useful life of ten
years and no salvage value.

Annual Net Net Internal Rate Net Present

Case Cost of Capital
Cash Inflow Investment of Return Value
1 P 45,000 P 188,640 14%
2 P 75,000 P 12% 18%
3 P P 300,000 16% P 81,440
4 P P 450,000 12% P 115,000

PROBLEM 13: COMPREHENSIVE

Fill in the blanks for each of the following independent cases. There are no salvage values for these
investments
Annual Cutoff Internal Net
Useful Net Profitability
Case Net Cash Rate of Rate of Present
Life Investment Index
Inflow Return Return Value
1 15 P 40,000 14% 1.109
2 8 P 448,470 16% 18%
3 P 80,000 P 361,600 12% 1.250

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FINANCIAL MANAGEMENT HANDOUT 2307
MYLENE P. ALFANTA, CPA