PROBLEM 1 (NET INVESTMENT)

Bicol Company plans to replace a unit of equipment that was acquired three (3) years ago and is now recorded at a book value of
P65,000. This equipment can be sold now for P75,000. Tax rate is 25%.

New equipment can be acquired from Baguio Company at a list price of P200,000. Baguio will grant a 2% cash discount if the
equipment is paid for within 30 days from acquisition date. Shipping, installation and testing charges to be paid are estimated at
P14,000.

Other assets with a book value of P12,000 that are to be retired as a result of the acquisition of the new machine can be salvaged and
sold for P10,000.

Additional working capital of P18,000 will be needed to support operations planned with the new equipment.

The annual cash flow after income tax from the operation of the new equipment has been estimated at P50,000. The equipment is
expected to have a useful life of 5 years with a salvage value of P4,000 at the end of 5 years.

WHAT IS THE INITIAL INVESTMENTS FOR DECISION-MAKING PURPOSES?

CASH OUTFLOWS:

Tax – Gain on sale of old equipment (75k – 65k) X 25%) 2,500

Purchase price, net (P200,000 X 98%) 196,000
Shipping, Installation 14,000
Additional Working Capital 18,000 230,500

CASH INFLOWS:

Proceeds from sales of old equipment 75,000

Proceeds from sales of other assets 10,000
Tax savings – loss on sales O.A (10K-12K) X 25% 500 85,500
Net Investments 145,000

PROBLEM 2: Net Returns (Increase in Revenues)

The management of Star Cinema plans to install coffee vending machines costing P200,000 in its movie house. Annual sales of coffee
are estimated at 10,000 cups at a price of P15 per cup. Variable costs are estimated at P6 per cup, while incremental fixed cash costs,
excluding depreciation, at P20,000 per year. The machines are expected to have a service life of 5 years, with no salvage value.
Depreciation will be computed on a straight-line basis. The company's income tax rate is 30%.

Required: Assuming that the vending machines are installed, determine:

1. THE INCREASE IN ANNUAL NET INCOME?

2. THE ANNUAL THAT WILL BE GENERATED BY THE PROJECT?
3. TAX SAVINGS?

A.
INCREMENTAL CM (P15-6) X 10,000 P90,000
INCREMENTAL FIXED CASH COST (20,000)
INCREMENTAL DEPRECIATION (P200,000/5) (40,000)
INCREMENTAL NET INCOME BEFORE TAX 30,000
INCREMENTAL TAX (30%) (9,000)
INCREMENTAL NET INCOME AFTER TAX P21,000

B.
INCREMENTAL CM (P15-6) X 10,000 P90,000
INCREMENTAL FIXED CASH COST (20,000)
INCREMENTAL TAX (30%) (9,000)
INCREMENTAL NET CASH FLOWS 61,000

OR

INCREMENTAL NET INCOME AFTER TAX P21,000

ADD BACK DEPRECIATION EXPENSES 40,000
INCREMENTAL NET CASH FLOWS 61,000

C.
TAX SAVINGS – DEPRECIATION (P40,000 X 30%) P12,000 DEPRECIATION TAX SHIELD

PROBLEM 3: (COST SAVINGS)

Moon Corporation is planning to buy cleaning equipment that can reduce service cost and other cash expenses by an average of
P70,000 per year. The new cleaning equipment will cost P100,000 and will be depreciated for 5 years on a straight-line basis. No
salvage value is expected at the end of the equipment's life. Income tax is estimated at 32%.
Required: Determine the net cash inflows that will be generated by the project. 54,000

SOLUTION:

Cost savings, net (P70,000 x 68%) P 47,600

Depreciation tax-shield (P100,000/5) x 32% 6.400
Net cash inflows P 54,000

OR

COST SAVINGS 70,000

DEPRECIATION (100,000/5) (20,000)
NET INCOME BEFORE TAX 50,000
LESS: TAX 32% (16,000)
NET INCOME AFTER TAX 34,000
ADD: DEPRECIATION 20,000
NET CASH INFLOWS 54,000

CAPITAL BUDGETING TECHNIQUES IN EVALUATING PROJECTS

Non-discounted methods - methods that do not consider the time value of money

a. Payback period method

b. Payback reciprocal method
c. Bail-out payback method
d. Accounting rate of return method

Discounted methods- methods that consider the time value of money

a. Net present value method
b. Profitability index method
c. Internal rate of return method
d. Present value payback method

Non-discounted methods:

A. The payback period in capital budgeting is the amount of time it takes for an investment to generate cash flows sufficient to
recover its initial cost. It is a straightforward way to assess the risk and liquidity of a project.

Formula (when cash flows are uniform):

Payback Period= Initial Investment

Annual Cash Inflow (after tax)

For uneven cash flows, it involves a more detailed year-by-year calculation.

Criteria for Accepting or Rejecting a Project:

Accept: If the payback period is less than or equal to the company's target payback period.
Reject: If the payback period exceeds the company's target.

Advantages of the Payback Period Method:

1. Simplicity: Easy to calculate and understand.

2. Risk Assessment: Focuses on the project's liquidity by emphasizing quick recovery of costs

Limitation:

1. Ignores Time Value of Money: Does not discount future cash flows, which undervalues money received in later years.

Payback period = Net initial cost of investment/Annual net after-tax cash inflows

Cost of investment P 100,000

Annual cash flows 25,000
PBP = COI / ACF
= P100,000/P25,000
= 4 years

PROBLEM:
The Graven Company is planning to spend P60,000 for a machine which will be depreciated on a straight-line basis over ten-year
period. The machine will generate additional cash revenues of P12,000 a year. Graven will incur additional costs except for
depreciation. The income tax rate is 32%.

REQUIRED:

1. Determine the after tax annual cash flow.

2. Compute the payback period

3. Compute the payback reciprocal.

SOLUTION:

1.

Cash revenues per year P12,000

Depreciation (6,000)
Income before tax 6,000
Income tax (6,000*.32% 1,920
NET INCOME 4,080
ADD: DEPN’ 6,000
ATCF P10.080

OR

Cash revenues per year (12,000 * 68%) 8,160

ADD: (TAX SHIELD 6,000*.32) 1,920
ATCF P10.080

2. Payback Period P60,000 ÷ P10,080 = 5.95 years

3.
Payback Reciprocal = P10.080 ÷ P60,000 = 16.8%
1÷5.95 = 16.80%

REQUIRED: Determine the payback period of the two proposals.

Solution:

Proposal A:

Payback period = P150,000 / P 75,000

= 2 years

Proposal B:

Payback period = 3 years + (P300,000 -P225,000(a)

P100,000 (b)
= 3.75 years

(a) P225,000 cumulative returns for 3 years

(b) P100,000 cash returns in the 4th year

Or

300,000
(75,000) 1
(75,000) 2
(75,000) 3
75,000
100,000 .75
=3.75

Illustration: Payback Period (With Uneven Cash Flows)

Pole Company has an investment opportunity costing P90,000 that is expected to yield the following cash flows over the next five
years: (assume a cut-off rate of 30%)

Year 1: P40,000 Year 2: P35,000 Year 3: P30,000 Year 4: P20,000 Year 5: P10,000

Required:
1. Payback period in months?

1) P90,000
(40,000) CF1
(35,000) CF2
P15,000-Unrecovered investment, beg. Of yr 3
/30.000
0.5
PBB = 2.5 year or 30 months

B. The payback reciprocal is a simplified way to estimate a project's rate of return (or approximate Internal Rate of Return, IRR) for
projects with constant annual cash inflows. It is calculated as the reciprocal of the payback period, expressed as a percentage.

Formula:

Payback Reciprocal= 1 / Payback Period ×100

This method works best for projects with equal annual cash inflows and when the project life significantly exceeds the payback
period.

Example Problem:

A company invests P100,000 in a project that generates constant annual cash inflows of 20,000 for 10 years.

Question:

1. Calculate the payback period.

2. Determine the payback reciprocal.
3. Estimate whether the project is acceptable if the company's required rate of return is 15%.

Solution:

1. Calculate the Payback Period:

The payback period is the time it takes for the investment to be recovered. Use the formula:

Payback Period= Initial Investment / Annual Cash Inflow

Payback Period=100,000 / 20,000 =5years

2. Determine the Payback Reciprocal:

Payback Reciprocal= 1 / Payback Period ×100

= 1 / 5 X 100 = 20%

Annual cash flow / initial investment

= 20,000 / 100,000
=20%

3. Compare the Payback Reciprocal with the Required Rate of Return:

1. The payback reciprocal of 20% represents an approximate annual return on investment.

2. Since the company's required rate of return is 15%, the project is acceptable, as the estimated return (20%) exceeds the
required return.

The payback reciprocal is a simple approximation method that suggests the project is worthwhile if the estimated return (20%) is
higher than the required return (15%). However, this method does not consider:

1. Time Value of Money: It doesn't discount future cash flows, so the real return may differ.

C, The bail-out period is a variation of the payback period used in capital budgeting. It calculates the time required for a project to
recover its initial investment, considering not only the project’s cash inflows but also any salvage value or residual value from the
sale of assets at the end of the project's life.

This concept becomes relevant when the project includes assets that can be sold, or when the company expects to recover a portion of
the investment through other means.
Criteria for Accepting or Rejecting a Project:

 Accept: If the bail-out period is less than or equal to the company's target period.
 Reject: If the bail-out period exceeds the acceptable threshold.

It is a modified payback period method wherein cash recoveries include the estimated salvage value at the end of each year of the
project life.

Illustration: Bail-out Payback Period

A project costing P180,000 will produce the following annual cash flows and salvage value:
Year 1 Cash Flows Salvage Value
1 P 50,000 P 65,000
2 P 50,000 P 50,000
3 P 50,000 P 35,000
4 P 50,000 P 20,000

Required: Compute for the bail-out payback period.

P180,000
(50,000) CF1
(50,000) CF2
P 80,000
(35,000) sv
P 45,000
(50,000) 0.9 CF3

2.9 YEARS

2 YRS + 180,000-(50,000+50,000)-35,000
50,000

0.9=YEARS

ACCOUNTING RATE OF RETURN (ARR)

Accounting Rate of Return or Simple Rate of Return,

Simple rate of return or Accounting rate of return (ARR) also known as book value rate of return, measures profitability
from the conventional accounting standpoint by relating the required investment to the future annual net income. This is
computed as follows:

ARR = Average Annual Net Income

Initial Investment or Average Investment

or, if a cost reduction project is involved, the formula becomes

ARR=Cost savings - Depreciation on new equipment

Initial Investment or Average Investment

Decision Rule:

Under the ARR method, choose the project with the highest rate of return. Accept the project if the ARR is greater than
the cost of capital. Thus:

If: ARR >= Required rate of return; Accept

If: ARR < Required rate of return; Reject

Advantages of using the ARR:

1. It is easily understood by investors acquainted with financial statements.

Disadvantages of using the ARR:

1. It ignores the time value of money by failing to discount the future cash inflows and outflows.

PROBLEM (ARR):

Green Company considers the replacement of some old equipment. The cost of the new equipment is P90,000, with a useful life
estimate of 8 years and a salvage value of P10,000. The annual pre-tax cash savings from the use of the new equipment is P40,000.
The old equipment has zero market value and is fully depreciated. The company uses a cost of capital of 25%.

Required: Assuming that the income tax rate is 40%, compute:

1. Payback period
2. Payback reciprocal
3. Accounting rate of return on original investment
4. Accounting rate of return on average investment

1. PBP = Investment / ACF*

= P90,000/P28,000
= 3.214 years

ACF before tax P 40,000

Dep exp (P90,000-P10,000)/8 (10,000)
NIBT P 30,000
Tax (40%) (12.000)
NIAT P 18,000
Dep exp 10,000
ACF after tax P 28,000

OR
ACF before tax (P 40,000* 60%) 24,000
Dep exp (P90,000-P10,000)/8 )*40% 4,000
ACF after tax P 28,000

2) PBR = 1/3.214
= 31.11%
I
3) ARR-orig. = NIAT /orig inv
= P18,000/P90,000
= 20%

4) ARR-ave = NIAT / ave investment

P18,000/
(P90,000 + 10,000)/2
= 36%

PRESENT VALUE

FV AND PV
10% 3 PERIODS
PROBLEM 1 (NET PRESENT VALUE)

The management of Arleen Corporation is considering the purchase of a new machine costing P400,000. The
company’s desired rate of return is 10%. The present value of P1 at compound interest of 10% for 1 through 5 years are 0.909,
0.826, 0.751, 0.683, and 0.621, respectively, and the present value of annuity of 1 for 5 periods at 10 percent is 3.79. In addition to
the foregoing information, use the following data in determining the acceptability in this situation:

Year Income from Operations Net Cash Flow

1 P100,000 P180,000
2 40,000 120,000
3 20,000 100,000
4 10,000 90,000
5 10,000 90,000

Solution:
Cash Flow PV Factor PV of annual net cash flows:
180,000 0.909 163,620
120,000 0.826 99,120
100,000 0.751 75,100
90,000 0.683 61,470
90,000 0.621 55,890
Total 455,200
Amount of investment 400,000
Net Present Value 55,200

PROBLEM 2 (NET PRESENT VALUE)

Consider a project that requires cash outflow of P50,000 with a life of eight years and a salvage value of P2,000. Annual cash inflow
amounts to P10,000 assuming a tax rate of 30% and a required rate of return of 8%. Salvage value is ignored in computing
depreciation.

10,000 *.70 = 7,000

(50,000/8)*.30 1,875
P8,875

ACF BEFORE TAX 10,000

DEPRECIATION 6,250
IBT 3,750
TAX (3750*30) 1,125
NET INCOME 2,625
ADD: 6250
ATCF P8,875

SOLUTION:
Present value of annual ATCF (P8,875 x 5.747) P51,000
Present value of after-tax salvage value (P1,400 x 0.54) 756
Total 51,756
Investment 50,000
Net present value P 1,756

Profitability Index

The Profitability Index, (also known as present value index, benefit-cost rate, desirability index), is the ratio of the total
present value of future cash inflows to the initial investment. The index expresses the present value of cash benefits as to
an amount per peso of investment in a project and is used as a measure of ranking projects in a descending order of
desirability. This is computed as follows:

PV index = PV of Cash Inflows

PV of Net Investment

Decision Rule:

The higher the profitability index, the more desirable the project. Projects with index of less than 1 are rejected. Thus:

If: PV Index ≥ 1; Accept

PV Index < 1; Reject
Illustrative Problem Profitability Index

Company XYZ has P200,000 funds available for investment. It is considering

the following projects:
A B C
Present value of annual cash inflows P244,000 P130,000 P130,000
Less: Investment required 200,000 100,000 100,000
Net Present Value P 44,000 P 30,000 P 30,000

REQUIRED:
1. Compute the profitability index of each project.
2. Rank each project on the basis of the present value index.
3. Which project(s) should be undertaken?

Solution: Company XYZ

1. Computation of Profitability or PV Index

Project A: = P244,000
P200,000
= 1.22

Project B: = P130,000
P100,000
=1.30

Project C: = P130,000
P100,000
=1.30

2. Ranking of Projects

Rank Project
1 B and C
2 A