1DISCOUNTED CASH FLOW METHODS 1. 2. 3. 4. 5. Net present value Profitability index Net present value index Present value payback Time adjusted rate of return Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 2 Principle of Time Value of Money 1. Present value (Discounting) 2. Future value (Compounding) Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 3 Present Value Factor of Annuity of 1 3. Present Value Factor of Annuity Due Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 4 .Principle of Time Value of Money 1. Present Value Factor of 1 2. Annuity – is any continuing payment with a fixed total amount Ordinary annuity – a series of equal payment made at the end of each period Annuity due – payment is made immediately or at the beginning of the period. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 5 . Example: Assume that a project can generate net annual cash inflows of Php 500.000 over the next 3 years and cost of capital of 10%. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 6 . Find the PV of the annual net cash flows. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 7 .000 3rd year. 600.000 2nd year.000 during the 1st year.Example: Assume that a project can generate net annual cash inflows of Php 500. Find the PV of the annual net cash flows. 650. NET PRESENT VALUE METHOD PV of cash inflows Less: PV of cash outflows PV of Cash inflows Less: PV of Cost of investment PV of cash inflows Less: Cost of investment Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 8 . A project that will cost Php 400. Cost of capital is 20%.000 annually for 5 years.Example: 1. Will this project be accepted? Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 9 .000 is expected to generate cash inflows of Php 150. 000 PVF .401878 72.83333 .000 .805 4 5 TOTAL PV LESS: COST NPV 150.000 104.000 48.592 Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 10 .ANSWER: YEAR 1 2 3 INFLOWS 150.282 448.167 86.338 60.000 150.57870 PV OF CASH 125.000 150.48225 .592 400.69444 .000 150. 000 Year 2 270. as follows: Year 1 Php 150.Example: 1.000 Year 3 120. A project that will cost Php 300.000 is expected to generate cash inflows.000 Cost of capital is 20% Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 11 . 000 81.000 120.57870 PV OF CASH 125.83333 .499 69.000 270.69444 .ANSWER: YEAR 1 2 3 TOTAL PV LESS: COST NPV INFLOWS 150.000 PVF .444 381.943 Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 12 .000 187.943 300. Will this project be accepted? Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 13 . Salvage value is Php 20.000 after 5 years. A project that will cost Php 400. Cost of capital is 20%.Example with Salvage value: 1.000 is expected to generate cash inflows of Php 150.000 annually for 5 years. 167 86.282 8.401878 104.810 LESS: COST NPV 400.48225 .810 Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 14 .000 20.000 2 3 4 5 Salvage Value TOTAL PV 150.000 PVF .ANSWER: YEAR 1 INFLOWS 150.000 150.000 150.000 150.805 72.83333 PV OF CASH 125.401878 .218 456.338 60.57870 .000 .000 56.69444 . Salvage value is Php 20.000.Example with Salvage value & WC: 1. Cost of capital is 20%.000 is expected to generate cash inflows of Php 150.000 annually for 5 years. Will this project be accepted? Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 15 . working capital of Php 20. A project that will cost Php 400.000 after 5 years. 57870 .48225 .000 104.000 20.000 150.000 .000 150.282 8.401878 .69444 .338 60.000 45.000 150.83333 .028 420.218 465.167 86.805 72.410878 125.ANSWER: YEAR INFLOWS PVF PV OF CASH 1 2 3 4 5 Salvage Value Working capita TOTAL PV LESS: COST (with WC) NPV 150.000 20.218 8.028 Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 16 .000 150.410878 . Considers cash flow over the entire life of the project 3. Use of discount rate should be carefully computed. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 17 . Considers time value of money 2.Net Present Value Method 1. Profitability Index • Present value index • Desirability index • Total present value index This is the ratio of the present value of cash inflows to the present value of the cash outflows. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 18 . an index of 1. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 19 .0 may be used as threshold point.Profitability Index Total Present value of Cash inflows Total Present value of Cash outflows In evaluating projects using profitability index. 000 5 years 10% 16.000 PROJECT 2 40.000 5 years 10% Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 20 . PROJECT 1 Cost of investment 20.EXAMPLE: Management has considered the following projects.000 Annual net cash inflows Economic life Cost of capital 8. PROJECT 1 PV of cash inflows (3.000 10.656 1.000 20.52 Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 21 .52 PROJECT 2 60.328 20.ANSWERS: .328 1.656 20.791) Cost of investment Net present value Profitability index 30. Net Present Value Index Net present value Present value of cash outflows A positive net present value index indicates that the project is acceptable. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 22 . EXAMPLE: Management has considered the following projects.000 5 years 10% Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 23 .000 5 years 10% 16. PROJECT 1 Cost of investment 20.000 Annual net cash inflows Economic life Cost of capital 8.000 PROJECT 2 40. 656 20.52 Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 24 .52 .52 .000 20.791) Cost of investment Net present value Profitability index NPV index 30. PROJECT 1 PROJECT 2 PV of cash inflows (3.52 60.000 10.328 1.ANSWERS: .328 20.656 1. Capital Rationing The process of ranking prospect projects. The highest index has the highest priority. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 25 . 000 7.000 Which among these projects should the Company invest? Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 26 .000 3.000 3. as follows: PROJECT A B C D COST 4.000.000.470.000.000.000 PV OF INFLOWS 4.Example: ABC Corporation availed of bank loans of Php 12 million to invest to various capital projects.500.850.000 6.000 5.000 5.200. 000. NPV index Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 27 . At the end of its useful life of 5 years. Calculate: 1.000 will produce annual net cash inflows of Php 300.000.Drills (RS): An equipment costing Php 800. The desired rate of return is 18%. NPV 2. Profitability index 3. the equipment will have a residual value of Php 20. Present Value Payback Cash flows to be used are converted to their present values. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 28 . 000 125.Example: Let us consider the following data: Cost of investment Annual net cash inflows Cost of capital Payback period Present value payback Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 Php 500.000 5% 4 years ??? 29 . project should be accepted OBJECTIVE: NPV SHOULD EQUAL COST Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 30 .Discounted Cash flows • • • • Time adjusted rate of return Internal rate of return (IRR) Discounted rate of return Discounted cash flow rate of return IRR > cost of capital. PV OF CASH INFLOWS = COST OF INVESTMENT Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 31 . Annual net cash inflows amounted to Php 375. FGU Management wants to buy a new equipment amounting to Php 1 million. How much is the internal rate of return? Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 32 .Example (even cash flows): 1. with economic life of 4 years. The rate of return is 14%.000. 667 18% to 20% Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 33 .000.000) = 1.PV OF CASH INFLOWS = COST OF INVESTMENT PV factor (375.000 PV factor = 2. 000.Drills (RS) (even cash flows): Grop Corporation has the opportunity to buy a new machine at Php 520.000. The company’s rate of return is 10% Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 34 . This machine is expected to have a useful life of 4 years with no residual value and will yield an annual net cash inflow of Php 200. 000 500.000 600.800. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 35 .000 Compute for IRR.Example (uneven cash flows): Cost of investment Php 2.000 830.000 800.200.000 1.000 Salvage Value Year 1 Year 2 Year 3 Year 4 Year 5 Ave.000 950. cash inflows 100. 000 36 Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 .Drills (RS) (uneven cash flows): A new equipment costing Php 800.000 150.000 250.000 300.000 residual value at the end of five years.000 80. The following net cash inflows: Year 1 Year 2 Year 3 Year 4 Year 5 350.000 with five years useful life and Php 40. 000 at the end of each year.49 20%-4.600. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 37 .19 REQUIRED: Determine the maximum interest rate (time-adjusted rate of return) that could be paid for the capital employed over the life of this asset without toss. on this project. The following amounts appear in the interest table for the present value of an annuity of P1 at year-end for ten years.Drills (RS) (even cash flows): Herman Company acquired an asset at a cost of P46. It had an estimated life of ten years. Annual after tax cash benefits are estimated at P10. 16%-4.83 18%-4. A minimum desired rate of return of 18% is used for capital investment decisions.500 per year. Its useful life is 8 years and it will have zero salvage value.Drills (RS) (even cash flows): NPV Company is considering to buy a new machine which cost P50.266 4.000. Information on present value factors is as follows: Present value of P1 for 8 periods at 18% Present value of an annuity of P1 for 8 periods Should the machine be acquired? .078 Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 38 . It will be a labor saving investment which will reduce payroll by P13. Determine the Net Investment.162 REQUIRED: 1. Capital Budgeting MANAGEMENT ADVISORY SERVICES PART 2 39 . Straight-line depreciation is used and the company has an average income tax rate of 35%. The present value of P1 for 10 periods at 20% is 0. What is the net present value of the investment. 2.192.000.000 before income taxes because of the expected increase in operating efficiency. 3.000 now.000 and will result in annual savings of P40. Machine A has a book value of P16. Determine the annual cash flow net of income tax.Drills (RS) (uneven cash flows): The Cap Company is considering the replacement of Machine A with Machine B that will cost P160.000 and a disposal value of P20. Machine B has an estimated useful life of 10 years and salvage of P10. The minimum desired rate of return on this investment is 20% The present value of an ordinary annuity of P1 in arrears for 10 periods at 20% is 4.