NON-DISCOUNTED CAPITAL BUDGETING TECHNIQUES

Assume that Great Company is planning to spend P60,000 for a machine which will be
depreciated on a straight-line basis over 10-year period. The machine will generate additional
cash revenues of P12,000 a year. Great will not incur additional costs except for depreciation.
Income tax rate is 35%.
Required:
1. Determine the net income after tax.

2. Determine for the accounting rate of return (ARR).

3. Determined the after tax annual cash flow.

4. Determine the payback period and the payback reciprocal.

5. Determine the payback bailout period.

End of Year Scrap Values End of the Year Scrap Values

1 40,000
2 35,000
3 30,000
4 25,000
5 20,000
6 15,000
7 10,000
8 5,000
9 2,000
10 0
DISCOUNTED CAPITAL BUDGETING TECHNIQUES
Discounted Payback Period The discounted payback period method refers to the number of
years in which the investment may be recovered at its discounted cash inflows.
Example: Mr. Justine plans to put a small stall in front of his house. The overall cost of the
construction is P150,000. The stall is expected to generate annual cash inflows of P40,000 for 7
year. A four-year discounted payback is acceptable to Mr. Justine. The cost of capital is 12%.

Net Present Value

The net present value (NPV) is obtained by getting the present value of all the cash inflows
using the cost of capital less the initial investment. Any positive NPV is acceptable.
PV of future cash inflows XX
Investment (XX)
Net Present Value XX

Example:
a. Elmer Corporation invested P6,854 in a 4-year project. Elmer’s cost of capital is 8%. The
after-tax cash inflows are: Year 1- P2,000; Year 2- P2,200; Year-3- P2,400; Year 4-
P2,600.

b. Elmer Corporation invested P6,854 in a 4-year project. Elmer’s cost of capital is 8%. The
after-tax cash inflows are P2,000.
Profitability Index (PI)
The profitability index is the ratio of the total present value of future cash inflows to the initial
investment. It is used to rank projects in descending order of attractiveness. If the profitability
index is greater than 1, the project is accepted.
𝑃𝐼 = 𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Example:
a. Elmer Corporation invested P6,854 in a 4-year project. Elmer’s cost of capital is 8%. The
after-tax cash inflows are: Year 1- P2,000; Year 2- P2,200; Year-3- P2,400; Year 4-
P2,600.

b. Elmer Corporation invested P6,854 in a 4-year project. Elmer’s cost of capital is 8%. The
after-tax cash inflows are P2,000.

Internal Rate of Return (IRR)

The internal rate of rate is the rate of return that equates the present value of all the cash
inflows to the initial investment. In other words, it is the interest rate that causes the net
present value to zero.
Decision rule:
If IRR < required rate of return - reject the project
If IRR > required rate of return - accept the project

Example:
Assume that: Initial investment P12,950; estimated life- 10 years; Annual cash inflows- P3,000;
Cost of capital- 12%.
Modified Internal Rate of Return (MIRR)

Where:

n- number of periods

FV- Future value of cash inflows

PV- Initial cash outlay

Example:

A 5-year project with an initial outlay of P18,000 and a cost of capital of 14% will produce an annual cash
return of P5,600. The IRR of the project is 16.8% and the net present value= 0.