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COMPUTATION OF NET INVESTMENT

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.

Purchase price of new machine ₱ 180,000


Installation and transportation costs ₱ 20,000
Additional net working capital ₱ 40,000
Net Investment ₱ 240,000

The depreciable basis of the machine is:

Purchase price of new machine ₱ 180,000


Installation and transportation ₱ 20,000
Depreciable basis ₱ 200,000

General format for computing the net investment:

Purchase price of new asset


Add: Installation and transportation costs
Add: Additional net working capital
Less: Proceeds from sale of old asset
Add/Less: Tax effects on disposal of old asset
And/or the purchase of new one
Net Investment
NET OPERATING CAS

Case 2 Determination of Ann


The management of Maingat Company plans to replace a sorting The Visayan Division o
machine that was acquired several years ago at a cost of P60,000. considering a new prod
The machine has been depreciated to its residual value of P10,000. materials costs by an e
The new method is als
A new sorter can be purchased for P96,000. The dealer will grant a of labor and overhead
trade-in allowance of P16,000 on the old machine. If a new machine is the estimated depreci
not purchased, Maingat Company will spend P10,000 to repair the old over a period of ten ye
machine. Gains and losses on trade-in transactions are not subject to of income before incom
income taxes. The cost to repair the old machine can be deducted in (or savings) expected f
computing income taxes. Income taxes are estimated at 40% of the
income subject to tax. Additional working capital required is P50,000. Solution:
Annual savings in direc
Required: Compute the net initial investment in this project. Annual savings in direc
Total savings before de
Solution: Less:
Purchase price of new sorter ₱ 96,000 Savings after depreciat
Add: Additional working capital ₱ 50,000 Less:
Total ₱ 146,000 Net increase in income
Less: Trade-in allowance on old sorter ₱ 16,000 Add:
Avoidable repairs cost on old sorter Net cash returns (savin
(net of increase in income taxes) ₱ 6,000 ₱ 22,000
Net Investment ₱ 124,000
NET OPERATING CASH FLOWS OR RETURNS

Determination of Annual Cash Savings


The Visayan Division of Marlow Supply Company has been
considering a new production method that can reduce
materials costs by an estimated amount of P52,000 a year.
The new method is also expected to result in an annual savings
of labor and overhead method amounting to P64,000 and
the estimated depreciation at P60,000 a year
over a period of ten years. Income taxes are estimated at 30%
of income before income taxes. What are the annual net returns
(or savings) expected from the new production method?

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

THOSE THAT DO NOT

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

THOSE THAT DO NOT CONSIDER TIME VALUE OF MONEY

Assume that Great Company is planning to spend P60,000 for a machine


which will be depreciated on a straightline basis over a ten-year period.
The machine will generate additional cash revenues of P12,000 a year.
Great will not incur additional costs except for depreciation. The income
tax rate is 35%.

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

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 Rate of Return=(𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)/(𝑁𝑒𝑡


𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)

Accounting Rate of Return 6.50%

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 Rate of Return=(𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)/(𝐴𝑣𝑒𝑟𝑎𝑔𝑒


𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)

Accounting Rate of Return 13%

Incremental Cash Revenues per year ₱ 12,000


Income tax ₱ 2,100
Annual Cash Flow after tax ₱ 9,900

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜�=(𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡)/(𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤


𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)

Payback Period 6.06 years

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑅𝑒𝑐𝑖𝑝𝑟𝑜𝑐𝑎𝑙=(𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)/(𝑁𝑒𝑡 4.1


𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡)
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑅𝑒𝑐𝑖𝑝𝑟𝑜𝑐𝑎𝑙=(𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥)/(𝑁𝑒𝑡
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡)

Payback Reciprocal 16.5%


16.5%

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:

Initial investment ₱ 60,000


Cash flows:
Year 1 ₱ 20,000
Year 2 ₱ 40,000
Year 3 ₱ 20,000
Year 4 ₱ 10,000

Payback could be computed as follows:


Net cash inflows
Year Initial Each year Cumulative
Investment Unrecovered cost
0 ₱ (60,000) 0 ₱ (60,000)
1 ₱ 20,000 ₱ (40,000)
2 ₱ 40,000 ₱ -
3 ₱ 20,000 ₱ 20,000
4 ₱ 10,000 ₱ 30,000

The payback period is exactly two years. But in some cases, the payback
period may not happen at an exact number of years.

Assume that instead of having an investment of P60,000 but P62,000,


payback will be presented as follows:

Net cash inflows


Year Initial Each year Cumulative
Investment Unrecovered cost
0 ₱ (62,000) 0 ₱ (62,000)
1 ₱ 20,000 ₱ (42,000)
2 ₱ 40,000 ₱ (2,000)
3 ₱ 20,000 ₱ 18,000
4 ₱ 10,000 ₱ 28,000

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:

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜�=2 𝑦𝑒𝑎𝑟𝑠+ 2,000/20,000


𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜�=2 𝑦𝑒𝑎𝑟𝑠+ 2,000/20,000

Payback Period 2.10 years

Payback Reciprocal 36.29%

Average CF ₱ 22,500
Divided by Net Investment cost ₱ 62,000
Payback Reciprocal 36.29%
6 Payback bailout period:

End of 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 ₱ -

The completed table would show the following:


Year Net Annual Cumulative Scrap Value Total value
cash flow net cash inflow recovered
0
1 ₱ 9,900 ₱ 9,900 ₱ 40,000 ₱ 49,900
2 ₱ 9,900 ₱ 19,800 ₱ 35,000 ₱ 54,800
3 ₱ 9,900 ₱ 29,700 ₱ 30,000 ₱ 59,700
4 ₱ 9,900 ₱ 39,600 ₱ 25,000 ₱ 64,600
5 ₱ 9,900 ₱ 49,500 ₱ 20,000 ₱ 69,500
6 ₱ 9,900 ₱ 59,400 ₱ 15,000 ₱ 74,400
7 ₱ 9,900 ₱ 69,300 ₱ 10,000 ₱ 79,300
8 ₱ 9,900 ₱ 79,200 ₱ 5,000 ₱ 84,200
9 ₱ 9,900 ₱ 89,100 ₱ 2,000 ₱ 91,100
10 ₱ 9,900 ₱ 99,000 ₱ - ₱ 99,000

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:

Payback Bail-out Period 3.47 years No. of years prior to recovery


3.47 years Add
3.74 years
divided by
Total amount
recoverable
₱ (62,000)
₱ (12,100)
₱ (7,200)
₱ (2,300)
₱ 2,600
₱ 7,500
₱ 12,400
₱ 17,300
₱ 22,200
₱ 29,100
₱ 37,000

an exact Payback bail-out

. of years prior to recovery

Unrecovered cost at the beg. Of the period


(Total value recovered on the year of recovery - Total value recovered prior to recovery)
THOSE THAT DO CONSIDER TIME VALUE OF MONEY

DISCOUNTED PAYBACK PERIOD

Assume the following proposals were available to Company A:


PROJECT 1 PROJECT 2
Cost of Capital 10% 10%
Amount of invesment ₱ 1,000 ₱ 1,000
Yearly Net Cash Inflows
Year 1 ₱ 500 ₱ 100
Year 2 ₱ 400 ₱ 300
Year 3 ₱ 300 ₱ 400
Year 4 ₱ 100 ₱ 600
₱ 1,300 ₱ 1,400

𝐷𝐶�=𝐶�∗ 〖 (1+𝑖) 〗 ^(−𝑡)

Year Annual PV of 1 factor Discounted


cash flows cash flows
PROJECT 1
0 1.00
1 ₱ 500 0.91 ₱ 454.55
2 ₱ 400 0.83 ₱ 330.58
3 ₱ 300 0.75 ₱ 225.39
4 ₱ 100 0.68 ₱ 68.30
₱ 1,300 ₱ 1,078.82

Discounted Payback Period 2.95 years

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

Discounted Payback Period 3.88 years


DISCOUNTED CASH FLOW METHODS
NET PRESENT VALUE

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.

Year Cash Flow PV factor


PV of cash inflows 1 to 4 ₱ 2,000 3.1698654463
PV of cash outflows 0 ₱ (6,075) 1
Net Present Value

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

Present Value PV Factor 3.0375


₱ 6,339.73 IRR 12%
₱ (6,075.00)
₱ 264.73 Suppose the expected cash flow is P1,800 instead of P2,000.
Exact Rate 7% 8%
PV Factor 3.375 3.3872112565 3.31212684
IRR 7.16%

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:

Present Value Factors


At 7% 3.3872 3.3872
PV factor 3.375
At 8% 3.3121
Difference 0.0751 0.0122

Exact rate 7.16%

These computations become more complex if annnual cash inflows and outflows w
not uniform. Assume the following:

Initial investment ₱ 90,000


Cash inflows from operations for
Year 1 ₱ 20,000
Year 2 ₱ 40,000
Year 3 ₱ 60,000

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

Exact rate 13.35%


13.34%
USTED RATE OF RETURN

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

Table 2 If the cost of capital is less than the IRR

Year Loan Balance Cash flows


1 ₱ 1,000 ₱ 500
nnnual cash inflows and outflows were 2 ₱ 630.00 ₱ 400
3 ₱ 311.90 ₱ 300
4 ₱ 52.45 ₱ 100
₱ 1,300
₱ (90,000)
₱ 20,000 Table 3 If the cost of capital is greater than the IRR
₱ 40,000
₱ 60,000 Year Loan Balance Cash flows
1 ₱ 1,000 ₱ 500
At trial of 14% 2 ₱ 660.00 ₱ 400
Present Value Total Present 3 ₱ 365.60 ₱ 300
Factor Values 4 ₱ 124.10 ₱ 100
0.8771929825 ₱ 17,543.86 ₱ 1,300
0.7694675285 ₱ 30,778.70
0.6749715162 ₱ 40,498.29
₱ 88,820.85
PROJECT 2
10%

₱ (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)

than the IRR


Payment applied to
Rate Interest Principal Loan Balance
16.00% ₱ 160.00 ₱ 340.00 ₱ 660.00
16.00% ₱ 105.60 ₱ 294.40 ₱ 365.60
16.00% ₱ 58.50 ₱ 241.50 ₱ 124.10
16.00% ₱ 19.86 ₱ 80.14 ₱ 43.95