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Case 1
Kendra Enterprises plans to add a new machine to increase
production capacity. The machine cost P180,000 plus P20,000
for installation and transportation costs and requires P40,000
additional working capital.
Solution:
Annual savings in direct materials costs ₱ 52,000
Annual savings in direct labor and overhead costs ₱ 64,000
Total savings before depreciation ₱ 116,000
Depreciation ₱ 60,000
Savings after depreciation ₱ 56,000
Incremental income taxes (30%) ₱ 16,800
Net increase in income ₱ 39,200
Depreciation ₱ 60,000
Net cash returns (savings) ₱ 99,200
CONCEPT OF NET INVESTMENT COSTS CAPITAL BUDGETING
INVESTMENT PROPO
A company is considering to replace Machine A with Machine B. Assume that Great Com
Machine B will cost P150,000 and will result in annual savings of P40,000 which will be depreciate
before tax because of expected increase in operating efficiency. Machine B The machine will gener
has an estimated useful life of 10 years and salvage value of P10,000. Great will not incur add
Machine A has a book value of P16,000 and a disposal value of P20,000 now. tax rate is 35%.
Straight line depreciation is used and the company has an average income tax
rate of 35%. Required:
1
Required: Determine the Net Investment 2
3
Solution: 4
Net Investment: 5
Cost of Machine B ₱ 150,000
Adjustment: Solution:
Proceeds from disposal of Machine A ₱ (20,000) 1
Tax on gain ₱ 1,400
Net investment cost ₱ 131,400
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 Rate
if the problem is silent: 𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)
4 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜�=
𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)
5
CAPITAL BUDGETING TECHNIQUES IN EVALUATING CAPITAL
INVESTMENT PROPOSALS
Required:
Determine the net income after tax
Determine the accounting rate of return (ARR)
Determine the after tax annual cash flow
Determine the payback period and the payback reciprocal
Determine the payback bailout period.
Solution:
Incremental Cash revenues per year ₱ 12,000
Less: Annual depreciation ₱ 6,000
Taxable Income ₱ 6,000
Income tax ₱ 2,100
Net Income after tax ₱ 3,900
5.1
In some cases cash inflows are not equal throughout the life of investments.
In such cases the computation of payback period will be different from what
has been presented. Assume the following cash inflow patterns:
The payback period is exactly two years. But in some cases, the payback
period may not happen at an exact number of years.
Notice that on the second year, the initial investment was almost
recovered and only a small portion of the next year's cash inflow
is needed to fully recover the initial investment. Thus, the exact
payback can be computed using the following formula:
Average CF ₱ 22,500
Divided by Net Investment cost ₱ 62,000
Payback Reciprocal 36.29%
6 Payback bailout period:
Note that at year 3, initial investment is almost recovered. However, an exact Payback bail-out
could be computed similar to uneven returns as follows:
PROJECT 2 0 1.00
1 ₱ 100 0.91 ₱ 90.91
2 ₱ 300 0.83 ₱ 247.93
3 ₱ 400 0.75 ₱ 300.53
4 ₱ 600 0.68 ₱ 409.81
₱ 1,400 ₱ 1,049.18
Assume that a certain project will cost P6,075 and will earn cash inflows,
after tax, of P2,000 for four years with a minimum desired rate of return of 10%
Determine whether the project is acceptable or not by using the net present valu
(NPV) method.
0 ₱ (6,075) ₱ (6,075)
1 ₱ 2,000 ₱ 1,800
2 ₱ 2,000 ₱ 1,800
3 ₱ 2,000 ₱ 1,800
Cumulative 4 ₱ 2,000 ₱ 1,800
Unrecovered cost
₱ (1,000)
₱ (545.45)
₱ (214.88)
₱ 10.52
₱ 78.82
₱ (1,000)
₱ (909.09)
₱ (661.16)
₱ (360.63)
₱ 49.18
INTERNAL RATE OF RETURN OR TIME ADJUSTED RATE OF RETURN
ll earn cash inflows, Using the same example, the PV factor is determined as follows:
sired rate of return of 10%
y using the net present value
P6,075 = P2,000 x PV Factor
Looking in the PV factor table for the period Year 4, 3.375 is closest to 7%
which is 3.3872 and 8% which is 3.3121. The two interest rates where the
factor is between will be used as the guide in determining the IRR. So we
could say that the IRR is between 7% and 8%. However, to get an exact rate,
an interpolation of the two rates could be done as follows:
These computations become more complex if annnual cash inflows and outflows w
not uniform. Assume the following:
At trial of 12%
Cash Present Value Total Present
Year Inflows Factor Values
1 ₱ 20,000 0.8928571429 ₱ 17,857.14
2 ₱ 40,000 0.7971938776 ₱ 31,887.76
3 ₱ 60,000 0.7117802478 ₱ 42,706.81
₱ 92,451.71
To interpolate:
Total Present Values
At 12% ₱ 92,451.71 ₱ 92,451.71
At true rate ₱ 90,000
At 14% ₱ 88,820.85
Difference ₱ 3,630.86 ₱ 2,451.71
mined as follows:
PROJECT 1
Cost of Capital 10%
Yearly Net Cash Inflows
Year 0 ₱ (1,000)
Year 1 ₱ 500
Year 2 ₱ 400
Year 3 ₱ 300
ad of P2,000. Year 4 ₱ 100
₱ 1,300
IRR 14.49%
r 4, 3.375 is closest to 7%
wo interest rates where the Table 1 If the cost of capital is equal to IRR
termining the IRR. So we
However, to get an exact rate, Year Loan Balance Cash flows
1 ₱ 1,000 ₱ 500
2 ₱ 644.89 ₱ 400
3 ₱ 338.33 ₱ 300
4 ₱ 87.34 ₱ 100
₱ 1,300
₱ (1,000)
₱ 100
₱ 300
₱ 400
₱ 600
₱ 1,400
11.79%
Payment applied to
Rate Interest Principal Loan Balance
14.49% ₱ 144.89 ₱ 355.11 ₱ 644.89
14.49% ₱ 93.44 ₱ 306.56 ₱ 338.33
14.49% ₱ 49.02 ₱ 250.98 ₱ 87.34
14.49% ₱ 12.66 ₱ 87.34 ₱ (0.00)
Payment applied to
Rate Interest Principal Loan Balance
13.00% ₱ 130.00 ₱ 370.00 ₱ 630.00
13.00% ₱ 81.90 ₱ 318.10 ₱ 311.90
13.00% ₱ 40.55 ₱ 259.45 ₱ 52.45
13.00% ₱ 6.82 ₱ 93.18 ₱ (40.73)