No. 125 Brgy.

San Sebastian
Lipa City, Batangas, Philippines
Mobile : 0927 283 8234
Telephone : (043) 723 8412
Gmail : icarecpareview@gmail.com

MS-09: CAPITAL BUDGETING – PART 2

“Companies normally prepare budgets to serve as a plan of operations for a certain period of time. Such budgets
normally guide companies as to how business will be done for the upcoming period. However, for a firm to sustain
growth and profitability, it must not only be capable of planning for current operations but also of making good
investment decisions. In order to aid management in their investment decision, capital budgeting analysis is normally
prepared. In this handout, various capital budgeting evaluation techniques will be discussed.”

CAPITAL BUDGETING EVALUATION

As managers want to evaluate various capital budgeting decisions, various techniques were designed and
developed to aid managers in their capital budgeting process. There are two general types of evaluation
techniques namely (1) non-discounted techniques and (2) discounted techniques. Non-discounted
techniques ignore the concept of time value of money and are relatively simpler to understand while
discounted techniques consider the concept of time value of money are relatively more complex.

NON-DISCOUNTED TECHNIQUES
Non-discounted techniques in capital budgeting ignore the concept of time value of money. Furthermore,
measures under this category normally make use of selective cash flows only and sometimes the use of
accounting income. These techniques are normally favored due to its simplicity and understandability.

Payback Period: It pertains to the number of period required for the company to recover its initial net
investment. It does not focus on how much earnings the company can earn on the decision but on how
long will it take for the company to “technically breakeven”. The payback period is favored due to its
simplicity ability to screen investments with faster investment recovery. However, note that its major
drawbacks are the following: (a) it ignores time value and (b) it ignores cash after the payback period and
(c) it ignores the salvage value.

Payback Period = Net Investment/Yearly Cash Flow after Tax; if even cash flows
Payback period = preparation of timeline and computation of fractional year; if uneven cash flows

Rule: If the payback period is within the acceptable limits of the company, accept the investment.
Furthermore, generally projects with shorter payback period are less risky and more liquid but not
necessarily more profitable.

Payback Bailout Period: it follows the same concept with payback period but this method works on the
assumption that the asset’s salvage value contributes to the recovery of the initial investment.

Payback bailout period = preparation of timeline and computation of fractional year; like uneven cash
flows

Rule: If the payback bailout period is within the acceptable limits of the company, accept the investment.
Furthermore, generally projects with shorter payback bailout period are less risky and more liquid but not
necessarily more profitable.

Accounting Rate of Return: it measures the profitability of a certain project based on accounting income.
It is relatively easy to understand but it ignores the time value of money. It may also be called as simple
rate of return, book value rate of return, approximate rate of return, financial statement rate of return, or
unadjusted rate of return.

Accounting Rate of Return = Average accounting income/Net Investment* (original or average)

Rule: If the accounting rate of return is greater than the minimum required return of the company, accept
the investment. Note that it pertains to profitability but not necessarily investment recovery.

1|P a g e JBUGATAN/JSARIPADA
 No. 125 Brgy. San Sebastian
Lipa City, Batangas, Philippines
Mobile : 0927 283 8234
Telephone : (043) 723 8412
Gmail : icarecpareview@gmail.com

DISCOUNTED TECHNIQUES
In order to overcome the weaknesses of the non-discounted techniques, various methods of evaluating
capital budgeting decisions were made to incorporate the time value of money. Specifically, it deals with
the use of weighted average cost of capital (or hurdle rate, cut-off rate, and minimum desired rate of return)
or internal rate of return. The discounted techniques are favoured as it takes into account time value of
money and all cash flows (not accounting income) are considered in the analysis. However, some
managers opt not to use it due to complexity, cash flow data until the end of the useful life are necessary
to be estimated, and it requires the use of a certain discount rate.

Net Present Value Method: the net present value method computes for the excess of the discounted
yearly net cash inflows and terminal cash inflow over the net investment. As such, it is a measure of the
total net savings to be earned discounted using a certain rate.

Net Present Value = Present Value of all cash flows after tax less the net investment

Rule: If the net present value is positive or zero, management may accept the investment.

Profitability Index: Profitability index is the ratio of present value of yearly net cash flow and terminal net
cash flow over the net investment. Mathematically, investments with positive NPV will have a profitability
index greater than 1, investments with zero NPV will have profitability index equal to 1, and investments
with negative NPV will have profitability index less than 1.

Profitability index = Present value of cash flows after tax/Net Investment

Rule: Profitability index greater than or equal to 1, management may accept the investment. Furthermore,
this technique allows comparison of differently sized investments. This is used in ranking various
investments for capital rationing.

Internal Rate of Return: Internal rate of return is the rate of return that will result in a net present value of
zero or profitability index of 1.

PVIF = Net Investment/Annual cash flow after tax; interpolate rate to get PVIF; for even cash flows
PV

Rule: If the IRR is greater than the cost of capital, management may accept the investment.

Discounted Payback Period: The discounted payback period/breakeven time works with the same
principle of the payback period. However, the cash flows are discounted using the cost of capital to
incorporate time value of money.

EVALUATION ANALYSIS UNDER DIFFERENT PROJECTS

 INDEPENDENT PROJECTS (ACCEPT OR REJECT DECISIONS)

In an independent project decision, management is only bound to accept or reject a project
depending on their capital budgeting rules and guidelines as set. It must be noted that independent
projects are evaluated using the methods discussed above.

 MUTUALLY EXCLUSIVE PROJECTS – INCREMENTAL ANALYSIS

In a mutually exclusive capital budgeting decision, a manager is confronted with two options that
are not bound to be accepted together. Thus, the acceptance of the first option would automatically
invalidate the second option. In this instance, the use of NPV and IRR may produce different
decisions due to its differing assumptions. Note that NPV analysis work on the assumption that
cash flows are reinvested at the cost of capital while IRR works on the assumption that cash flows
are reinvested at the internal rate of return. Certain authors would note that the use of NPV is more
preferable as it uses a realistic hurdle rate. Furthermore, NPV is assumed to be the value of
additional wealth being contributed by the project to the company.

 CAPITAL RATIONING DECISIONS

Capital rationing decisions pertain to those that require proper allocation of resources to various
investments. Note that this work on the assumption that cash is not sufficient to invest in all
desirable projects. In deciding, NPV, IRR and Profitability index may result in different project
rankings. As such, projects to be chosen must be based on NPV because it would yield to the
highest addition in shareholder’s wealth. Potential project combinations must also be considered.
Qualitative factors must also be considered.

2|P a g e JBUGATAN/JSARIPADA
 No. 125 Brgy. San Sebastian
Lipa City, Batangas, Philippines
Mobile : 0927 283 8234
Telephone : (043) 723 8412
Gmail : icarecpareview@gmail.com

PROBLEM 1
In 2021, a massive flood followed by a 6.7 magnitude earthquake dealt a huge damage to an old machinery
of one of the factories of RONCILLO CORPORATION located in Calatagan, Batangas. The operations of
the said factory halted for a week leading to the management of the company to call for an emergency
meeting. After a long hour of serious discussion, the following proposals are presented to the management:

PROPOSAL 1:
Charlene, the Finance Head, suggested that it would be more viable for the company to make an overhaul
of the old machinery to bring it back to its original state before the disaster. The said overhaul is estimated
to be P1,000,000 and expected to bring the asset to its workable condition for the next 5 years.

The book value of the machinery at the time of disaster was P1,000,000, with the remaining useful life of 5
years, which was reduced to NIL due to the significant damage caused by the flood and earthquake. Some
valuable components of the said machinery can still be scrapped at P100,000. Under its original working
condition, annual production is maintained at 50,000 units. The selling price per unit is P15 and the variable
cost ratio is 60%.

PROPOSAL 2:
EJ, the Marketing Head, suggested that it would be right to just replace the old machinery with a new one.
This new machinery costs P5,000,000 with a salvage value of P500,000 at the end of its useful life of 5
years. This asset is expected to increase the annual production to P75,000. Further, the use the said
machinery will reduce variable cost ratio to 50% but would require additional working capital amounting to
P750,000.

Due to the heated arguments between the two departments heads, the President had asked you to provide
a capital investment evaluation of both proposals. The company’s minimum rate of return is 10% and the
tax rate is 30%.

REQUIRED: Compute for the net investment, annual net cash inflows after tax, payback period, accounting
rate of return, net present value, profitability index and internal rate of return for the following scenarios:

1. Assuming the company is contemplating to overhaul the asset and disregarding the effects of
efficiencies of the alternative, evaluate proposal 1 using various capital budgeting techniques

2. Assuming the overhaul is expensed outright for tax purposes, evaluate proposal 2 using various capital
budgeting techniques considering the opportunity costs of the alternative

3. Assuming the overhaul is a capital expenditure for tax purposes, evaluate proposal 2 using various
capital budgeting techniques considering the opportunity costs of the alternative

PROBLEM 2
The following are the after-tax annual net cash inflows of independent projects brought for discussion in
the annual meeting of KARASUNO Incorporated:

After-tax Cash flows Hinata Tobio Tanaka Nishinoya Tsuki

Year 1 P1,000,000 P500,000 P1,000,000 – P2,500,000
Year 2 1,000,000 500,000 – – 1,500,000
Year 3 1,000,000 750,000 1,000,000 – 1,000,000
Year 4 1,000,000 750,000 – 4,000,000 (500,000)
Year 5 1,000,000 1,250,000 2,000,000 4,000,000 (500,000)

The net investment and the acquisition costs of these projects amounted to P2,000,000. The company’s
cost of capital is 9% and the tax rate is 40%.

REQUIRED: Compute the following under each scenario

1. Undiscounted payback period
2. Payback reciprocal
3. Accounting rate of return
4. Net present value
5. Benefit cost ratio

3|P a g e JBUGATAN/JSARIPADA
 No. 125 Brgy. San Sebastian
Lipa City, Batangas, Philippines
Mobile : 0927 283 8234
Telephone : (043) 723 8412
Gmail : icarecpareview@gmail.com

PROBLEM 3
1. Uesugi Company purchased a new machine on January 1 of this year for P1,800,000, with an estimated
useful life of 5 years and a salvage value of P200,000. The machine will be depreciated using the
straight-line method. The machine is expected to produce after-tax cash flow from operations, of
P720,000 a year in each of the next 5 years. The new machine’s salvage value, net of tax is P400,000
at the end of year 1, P325,000 at the end of year 2, and P250,000 in years 3 and 4. Compute the
bailout period.

2. Kirigiya, Inc. is planning to purchase a new machine that will take six years to recover the cost. The
new machine is expected to produce after-tax cash flows from operation of P360,000 a year for the first
three years of the payback period and P280,000 a year of the last three years of the payback period.
Depreciation of P12,000 a year shall be charged to income of the six years of the payback period. How
much shall the machine cost?

3. A company is considering putting up P1,000,000 in a three-year project. The company’s expected rate
of return is 10%. The present value of P1.00 at 10% for one year is 0.9091, for two years is 0.8264,
and for three years is 0.7513. The after-tax cash inflow are as follows: P300,328 for the first year and
P425,123 for the second year. Assuming that the rate of return is exactly 10%, the cash flow, net
of income taxes, for the third year would be:

REQUIRED: Answer each scenario based on the specified requirements

PROBLEM 4
On December 31, 2021, Kanna Company is considering to replace its old machine acquired at an original
cost of P1,500,000 with a total estimated useful life of 8 years. The machine has been four years
depreciated as of December 31, 2021 with no estimated salvage value. If the company decides to not to
replace the old machine, it must be repaired for P200,000. On the other hand, if the company decides to
replace the old machine, the company can sell it for P500,000. The annual cash operating costs of the old
machine is P1,030,000.

The new machine being considered has a cost of P1,800,000 with an estimated useful life of 4 years.
Freight and installation cost must also be incurred to put the asset into operation amounting to P50,000.
Additional working capital in the form of receivables and inventories are also necessary amounting to
P120,000. The annual cash operating costs of the new machine is P557,000. At the end of the useful life,
the new machine has a salvage value of P200,000 (which is ignored in computing depreciation) and the
company must incur cost to remove the new machine amounting to P20,000.

The company uses a tax rate of 30%, discount rate of 12%, payback period of 2.5 years or less, accounting
rate of return of 15% and above, net present value greater than zero, internal rate of return greater than
12%, profitability index of greater than 1, and discounted payback period of 2.5 years or less.

REQUIRED: Compute for the following items:

1. Net present value – P157,585
2. Profitability index – 1.13
3. Net present value index – 0.13
4. Internal rate of return. – 17.32%
5. Discounted payback period – 3.995 years

4|P a g e JBUGATAN/JSARIPADA
 No. 125 Brgy. San Sebastian
Lipa City, Batangas, Philippines
Mobile : 0927 283 8234
Telephone : (043) 723 8412
Gmail : icarecpareview@gmail.com

MULTIPLE CHOICE: Choose the best answer from the choices provided

1. In choosing from among mutually exclusive investments, the manager should normally select the one
with the highest
a. NPV
b. IRR
c. Profitability index
d. Accounting rate of return

2. Which of the following combinations is possible?

Profitability Index NPV IRR

a. greater than 1 positive higher than cost of capital
b. greater than 1 negative less than cost of capital
c. less than 1 negative equals cost of capital
d. less than 1 zero less than cost of capital

3. In capital budgeting, sensitivity analysis is used

a. to determine whether an investment is profitable.
b. To see how a decision would be affected by changes in variables.
c. To test the relationship of the IRR and NPV.
d. To evaluate mutually exclusive investments.

4. These are projects that wherein the acceptance a project will result to the rejection of another.
a. Independent projects
b. Mutually exclusive projects
c. Dependent projects
d. Non-exclusive projects.

5. Which of the following methods uses income instead of cash flows in evaluating capital investment
decisions?
a. payback
b. accounting rate of return
c. internal rate of return
d. net present value

6. A firm is evaluating a project that has a net present value of P0 when a discount rate of 10% is used.
A discount rate of 9% will result in:
a. a negative net present value
b. a positive net present value
c. a net present value of P0
d. the question cannot be answered based upon the information.

7. A decrease in the discount rate

a. Will increase present values of future cash flows
b. Results from the risk of the project being low
c. Will always result to positive NPV
d. Choices A and B are correct

8. A company with a beta of 0 suggests

a. that the company’s stocks are more volatile than the market
b. that the company’s stocks are less volatile than the market
c. that the company’s stocks are as volatile as the market
d. that the company’s stocks are not affected by the market

9. Which of the following statements is false?

a. The discount rate does not need to be determined in advance for the IRR method
b. The discount rate does not need to be determined in advance for the NPV method
c. The discount rate does not need to be determined in advance for the payback method
d. The discount rate does not need to be determined in advance for the accrual accounting rate of
return method

10. As the number of periods increases for a project having uniform cash flows, the present value of each
future discounted cash flow becomes
a. Smaller
b. Does not change
c. Irrelevant
d. Larger

5|P a g e JBUGATAN/JSARIPADA
 No. 125 Brgy. San Sebastian
Lipa City, Batangas, Philippines
Mobile : 0927 283 8234
Telephone : (043) 723 8412
Gmail : icarecpareview@gmail.com

11. Kumoko is considering an investment in a new cheese-cutting machine to replace its existing cheese
cutter. Information on the existing machine and the replacement machine follow.

Cost of the new machine P40,000

Net annual savings in operating costs 9,000
Salvage value now of the old machine 6,000
Salvage value of the old machine in 8 years 0
Salvage value of the new machine in 8 years 5,000
Estimated life of the new machine 8 years

What is the expected payback period for the new machine?

a. 4.44 years
b. 8.50 years
c. 2.67 years
d. 3.78 years

12. Shirahori Corporation uses net present value techniques in evaluating its capital investment projects.
The company is considering a new equipment acquisition that will cost P100,000 fully installed and
have a zero salvage value at the end of its five-year productive life. Shirahori will depreciate the
equipment on a straight-line bases for both financial and tax purposes. Shirahori estimates P70,000 in
annual recurring operating cash income and P20,000 in annual recurring operating cash expenses.
Shirahori’s cost of capital is 12% and its effective income tax rate is 40%. What is the net present value
of this investment on an after tax basis?
a. P8,150
b. P28,840
c. P36,990
d. P80,250

13. The following information is available on a new piece of equipment:

Cost of the equipment ........................................P21,720

Annual cash inflows ..............................................P5,000
Internal rate of return …………………………………….16%
Required rate of return .................................................10%

The life of the equipment is approximately:

a. 6 years.
b. 4.3 years.
c. 8 years.
d. It is impossible to determine from the data given.

14. Itsuki Co. is considering an investment in a machine that would reduce annual labor costs by P30,000.
The machine has an expected life of 10 years with no salvage value. The machine would be depreciated
according to the straight-line method over its useful life. The company’s marginal tax rate is 30%.
Assume that the company will invest in the machine of it generates a pre-tax internal rate of return of
16%. What is the maximum amount the company can pay for the machine and still meet the internal
rate of return criterion?
a. P180,000
b. P210,000
c. P187,500
d. P144,996

15. Kawaki Corporation has estimated that a proposed project’s 10-year annual net cash inflow will be
P220,093 with an additional terminal benefit of P50,000 at the end of the project. Assuming that these
cash inflows satisfy Kawaki’s acceptable sophisticated rate of return of 8 percent, what is the net
investment?
a. P2,751,159
b. P1,476,840
c. P1,500,000
d. Cannot be determined

6|P a g e JBUGATAN/JSARIPADA