Chapter 29

SCREENING AND SELECTING CAPITAL INVESTMENT PROPOSALS

The fourth step in the capital budgeting process is evaluating or screening project
proposals. Once the firm has calculated the cost of capital for a project and estimated its
cash flows, deciding whether or not to invest in that project basically boils down to
asking the question; “Is the project worth its projected future value?”
No one can perfectly predict the future, so the techniques are by their nature,
accompanied by uncertainty. That said, the commonly used capital budgeting techniques
include the following:
A. Discounted Cash Flow (time-adjusted) Approach
1.) Net present value
2.) Internal rate of return
3.) Profitability index
4.) Discounted payback period
B. Non-discounted Cash- Flow(unadjusted) Approach
1.) Payback Period
2.) Bailout payback period
3.) Payback reciprocal
4.) Accounting rate of return (book value rate of return)

1.) Net present value

Net Present Value (NPV) is defined as the present value of the future net cash
flows from an investment project. NPV is one of the main ways to evaluate an investment.
The net present value method is one of the most used techniques; therefore, it is a
common term in the mind of any experienced business person.
Net present value can be explained quite simply, though the process of applying
NPV may be considerably more difficult. Net present value analysis eliminates the time
element in comparing alternative investments. Furthermore, the NPV method usually
provides better decisions than other methods when making capital investments.
Consequently, it is the more popular evaluation method of capital budgeting projects.
When choosing between competing investments using the net present
value calculation you should select the one with the highest present value.

If:
NPV > 0, accept the investment.
NPV < 0, reject the investment.
NPV = 0, the investment is marginal

Net Present Value Advantages

 Uses cash flow not earnings
 Eliminates time component
 Results in investment decisions that add value
Net Present Value Limitations
 Difficult to predict cash flows
 Assumes a constant discount rate over life of investment
The NPV of a project is computed as follows:
Present value of cash inflows computed based on minimum
desired discount rate Pxx
Less: Present value of investment xx
Net present value xx

Example 1
Project A has a net investment of P120,000 and annual net cash inflows of P50,000 for
five years. Management wants to calculate Project A’s net present value using a 16%
discount.

Solution:
The annual net cash inflows of P50,000 for five years are an annuity. The NPV is
calculated by multiplying 50,000 by the present value interest for an annuity for five
years discounted at 16% and then subtracting the net investment.
Present value of cash inflows (50,000 x 3.274) P163, 700
Less: Net investment 120,000
Net present value P 43,700

Project A should be accepted because it could earn more than the desired minimum rate
of return as indicated by the positive net present value.

Example 2
Twice corp. plans to invest in a four year project that will cost P700,000. Twice’s cost
of capital is 10%. Additional information on the project is as follows:
Year Cash Flow from Present Value at 10%
Operations, net of taxes
1 P200,000 0.909
2 220,000 0.826
3 240,000 0.751
4 260,000 0.683

Required:
Using the net present value method, determine whether the project is acceptable or not
 Solution:
Present value of cash inflow after taxes at 10%
Year Amount Cash Inflows PV factor PV
1 P200,000 0.909 P181,800
2 220,000 0.826 181,720
3 240,000 0.751 180,240
4 260,000 0.683 177,580
Total P721,340
Less: Present value of net investment: 700,000
Excess or net present value P 21,340

Conclusion: The project is acceptable because it will yield a return exceeding the
minimum desired rate of 10%.

2.) Internal Rate of return

IRR, also known as discounted rate of return and time-adjusted rate of return is the
rate which equates the present value of the future cash inflows with the cost of the
investment which produces them. It is also the equivalent maximum rate of interest
that could be paid each year for the capital employed over the life of an investment
without the loss on the project.

Steps in the Computation of the Internal Rate of Return (IRR)

A. Cash inflows are evenly received:
If the cash returns or inflows are evenly received during the life of the
project, the computational procedures are as follows:
1.) Compute the Present Value factor by dividing Net Investment by
Annual Cash Returns.
2.) Trace the PV factor in the Table for Present Value of P1 received
annually using the life of the project as point of reference.
3.) The column that gives the closest amount to the PV factor is the
“Discounted rate of return”
4.) To get the exact Discounted rate of return, interpolation is applied.
Decision Rule:
Accept Project if IRR > Cost of Capital
Reject Project if IRR < Cost of Capital
 Example 1
Consider Greg’s CD player project, which would cost 1,000, 000 and
result in five equal yearly cash inflows of 305,450. Rate of return a
company can expect (IRR)? -
Solution:
1 Investment = Amount of each equal net cash inflow * PV factor
2. 1,000, 000 = 305,450 *PV factor
3. 1,000, 000/ 305,450 = PV factor
4. 3.274 = PV factor (i=? , n = 5)
5. i=16%

Example 2

Consider Greg’s CD player project, which would cost 1,000, 000 and result
in five equal yearly cash inflows of 300,000. Rate of return a company can
expect (IRR)?

Solution:

1 Investment = Amount of each equal net cash inflow * PV factor

2. 1,000, 000 = 300,000 *PV factor

3. 1,000, 000/ 300,000 = PV factor

4. 3.333 = PV factor (i=? , n = 5)

5. To get the exact rate of return, interpolate between 15% and 16%

15%= 3.352 3.352 – 3.333 = 0.019

? = 3.333 3.352 –3.274 = 0.078

16% =3.274

15% +(0.019/0.078 *2%) =15% + 0.49% = 15.49%