CAPITAL BUDGETING
ILLUSTRATIVE EXERCISES and PROBLEM SOLVING
PAYBACK PERIOD
Even Cash Inflows
Problem 1: ABC Company invests P500,000 in new equipment, expecting it to generate P100,000
in annual net cash flow. What's the payback period?
Solution:
Payback Period = Initial Investment / Annual Net Cash Flow
Payback Period = P500,000 / P100,000 = 5 years
Problem 2: JBCs project requires an initial investment of P300,000 and is expected to generate net
cash flows of P50,000 per year. What is the payback period?
Solution:
Payback Period = P300,000 / P50,000 = 6 years
Problem 3: Lala Company is considering two projects:
Project A: Initial investment of P800,000, annual net cash flow of P160,000
Project B: Initial investment of P600,000, annual net cash flow of P100,000
Which of the two project shall the company invest?
Solution:
Project A: P800,000 / P160,000 = 5 years
Project B: P600,000 / P100,000 = 6 years
*Project A has a shorter payback period (5 years) compared to Project B (6 years).
Uneven Cash Inflows
Problem 4: Anita’s project has an initial investment of P1,000,000 and the following net cash
flows:
Year 1: P200,000,
Year 2: P300,000,
Year 3: P400,000.
What is the payback period?
Solution:
1. Get the cumulative cash flow:
Year 1: P200,000
Year 2: P200,000 + P300,000 = P500,000
Year 3: P500,000 + P400,000 = P900,000
2. Determine the year the payback occurs – when was the project reached or almost reached the
1M, (the initial investment) and that’s Year 2 and 3.
3. 1M was not reached up to year 3, next is to compute the fractional period (how many more
years, months, days is needed to recoup the 1M initial investment:
Unrecovered amount at the start of Year 3: P1,000,000 - P500,000 = P500,000
Fractional period: P500,000 / P400,000 = 1.25 years
4. Calculate the total payback period:
Total payback period = 2 + 1.25 = 3.25 years
Problem 5: Mickey’s project has an initial investment of P1,500,000 and the following net cash
flows:
Year 1: P200,000,
Year 2: P400,000,
Year 3: P600,000,
Year 4: P400,000.
What is the payback period?
Solution:
1. Get the cumulative cash flow:
Year 1: P200,000
Year 2: P200,000 + P400,000 = P600,000
Year 3: P600,000 + P600,000 = P1,200,000
Year 4: P1,200,000 + P400,000 = P1,600,000
2. Determine the year the payback occurs – when was the project reached or almost reached the
1.5M, (the initial investment) and that’s Year 3 and 4.
3. 1.5M was not reached up to year 3, but was reached in year 4; therefore the payback period is
year 4.
BAILOUT PERIOD
A project requires an initial investment of P100,000 and is expected to generate annual cash flows
of P30,000 for 5 years. The salvage value at the end of the project is P40,000.
Solution:
1. Calculate the Cumulative Cash Flow:
Year 1: P30,000
Year 2: P30,000 + P30,000 = P60,000
Year 3: P60,000 + P30,000 = P90,000
Year 4: P90,000 + P30,000 = P120,000
Year 5: P120,000 + P30,000 = P150,000
2. Identify the Bailout Period:
The bailout period occurs when the cumulative cash flow is equal to or greater than the initial
investment plus the salvage value.
Initial Investment: P100,000
Salvage Value: P40,000
Total Value to be Recovered: P100,000 + P40,000 = P140,000
3. Determine the Bailout Period:
By the end of year 5, the cumulative cash flow is P150,000, which is greater than P140,000.
Therefore, the bailout period is 5 years. In this case, the project would recover the initial
investment and salvage value by the end of year 5, even if the project were to be discontinued at
that point. This means that the project would become self-sufficient at that point, even if it were to
be abandoned.
ACCOUNTING RATE OF RETURN (ARR)
Problem 1: XYZ Company is looking to invest in some new machinery to replace its current
malfunctioning one. The new machine, which costs P420,000, would increase annual revenue by
P200,000 and annual expenses by P50,000. The machine is estimated to have a useful life of 12
years and zero salvage value.
1: Compute the Average Annual Profit
Annual Revenue Cash Inflows (200,000*12) - P2,400,000
Less: Annual Expenses (50,000*12) -P600,000
Less: Depreciation -P420,000
Total Profit P1,380,000
Average Annual Profit (1,380,000/12) P115,000
2: Compute the Average Investment
Average Investment (P420,000 + P0)/2 = P210,000
3: Compute the ARR
ARR = P115,000/P210,000 = 54.76%
This means that for every peso invested, the investment will return a profit of about 54.76 cents.
Problem 2:
XYZ Company is considering investing in a project that requires an initial investment of P100,000
for some machinery. There will be net inflows of P20,000 for the first two years, P10,000 in years
three and four, and P30,000 in year five. Finally, the machine has a salvage value of P25,000.
1: Compute the Average Annual Profit
Net Inflows, Years 1 & 2 (20,000*2) P40,000
Net Inflows, Years 3 & 4 (10,000*2) P20,000
Net Inflow, Year 5 P30,000
Less: Depreciation (100,000-25,000) -P75,000
Total Profit P15,000
Average Annual Profit (15,000/5) P3,000
2: Compute the Average Investment
Average Investment (P100,000 + P25,000) / 2 = P62,500
3: Compute the ARR
ARR = P3,000/P62,500 = 4.8%
This means that for every peso invested, the investment will return a profit of about 4.8 cents.
NET PRESENT VALUE (NPV)
Example Problem 1: Single Cash Flow
ABC Company is considering a project (improvement of old machinery) requiring an initial
investment of P100,000, with a projected cash inflow of P120,000 in one year. If the discount rate
is 10%, what is the NPV?
Solution:
Calculate the present value of the future cash inflow:
PV of 1 @ 10% = (1.1//= 0.90909090909)
PV = P120,000 x 0.909091
PV = P109,090.91
Calculate the NPV:
NPV = Present Value of Future Cash Flows - Initial Investment
PV of cash inflows – 109,090.91
Cash outflows Initial Investment – (100,000)
NPV = P9,090.91
If the “result” of NPV is positive, it is suggesting the project is a profitable investment.
Example Problem 2: Multiple Cash Flows
A2Z Inc. has a project (replacement of old equipment) has the following projected cash flows:
Year 0: -P50,000 (Initial Investment),
Year 1: P20,000,
Year 2: P30,000,
Year 3: P40,000.
If the discount rate is 8%, what is the NPV?
Solution:
Calculate the present value of each cash flow:
Year 1: P20,000 x 0.925926 = 18,518.52
Year 2: P30,000 x 0.857339 = 25,720.17
Year 3: P40,000 x 0.793832 = 31,753.28
Total cash inflows = 75,991.97
Cash outflows: Initial Investment = (50,000.00)
Total Net Present Value = 25,991.97
If the “result” NPV is positive, it is suggesting that the project is a profitable investment.
PROFITABILITY INDEX
Example Problem 1: Single Cash Flow
ABC Company is considering a project (improvement of old machinery) requiring an initial
investment of P100,000, with a projected cash inflow of P120,000 in one year. If the discount rate
is 10%, what is the NPV?
Solution:
Calculate the present value of the future cash inflow:
PV of 1 @ 10% = (1.1//= 0.90909090909)
PV = P120,000 x 0.909091
PV = P109,090.91
Calculate the PI:
Present Value of Cash Inflows / Present Value of Cash Outflows
PV of cash inflows 109,090.91
Cash outflows Initial Investment 100,000
PI = 1.09
Example Problem 2: Multiple Cash Flows
A2Z Inc. has a project (replacement of old equipment) has the following projected cash flows:
Year 0: -P50,000 (Initial Investment),
Year 1: P20,000,
Year 2: P30,000,
Year 3: P40,000.
If the discount rate is 8%, what is the NPV?
Solution:
Calculate the present value of each cash flow:
Year 1: P20,000 x 0.925926 = 18,518.52
Year 2: P30,000 x 0.857339 = 25,720.17
Year 3: P40,000 x 0.793832 = 31,753.28
Total cash inflows = 75,991.97
Cash outflows: Initial Investment = (50,000.00)
PI = 1.5198
Decision Rule:
If the PI is greater than 1, the project generates value and the company may want to
proceed with the project.
If the PI is less than 1, the project destroys value and the company should not proceed with
the project.
If the PI is equal to 1, the project breaks even and the company is indifferent between
proceeding or not proceeding with the project.
The higher the profitability index, the more attractive the investment.
