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CAPITAL BUDGETING
PAYBACK PERIOD AND NET PRESENT VALUE(NPV)
Reported by: Analyn “Anne” Grimaldo
PAYBACK PERIOD
is the amount of time required for the firm to recover its initial investment in a project are calculated from cash inflows.
Calculated as:
Payback Period=Cost of Project/Annual Cash Inflows
DECISION CRITERIA
• if the payback period is less than the maximum acceptable payback period accept the project.
• If the payback period is greater than the maximum acceptable payback period,reject the project.
Minacs Confidential 204/08/23
Table 10.1 Capital Expenditure
Project A Project B
Initial Investment P42,000 P45,000
Year Operating cash inflows
1 P 14,000 P28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000
Minacs Confidential 304/08/23
PAYBACK PERIOD
Payback Period
Project A
PBP = initial investment_
annual cash inflow
= 42,000
14,000
= 3 years
Minacs Confidential 404/08/23
PAYBACK PERIOD
Payback Period
Project B
PBP = initial investment_
annual cash inflow
= 45,000
14,000
= 3 years
Minacs Confidential 504/08/23
PROBLEM 1: PAYBACK PERIOD
You are financial analyst for Damon Electronics Company. The director of capital budgeting has asked you to analyzed two proposed capital investments,Project X and Y.
Each project has a cost of P10,000 and cost of capital for each project is 12 percent.
Minacs Confidential 604/08/23
Cont….PROBLEMS: PAYBACK PERIOD
EXPECTED NET CASH FLOWS
YEAR PROJECT X PROJECT Y
0 (10,000) (10,000)
1 6,500 3,500
2 3,000 3,500
3 3,000 3,500
4 1,000 3,500
Minacs Confidential 704/08/23
a. Calculate each projects payback period
b. Which project or projects should be accepted if they are independent?
c. Which project should be accepted if they are mutually exclusive?
d. Calculate each Projects the Net Present Value
Cont…SOLUTION: PAYBACK PERIOD
CUMULATIVE CASH FLOWS
YEAR PROJECT X PROJECT Y
0 (10,000) (10,000)
1 (3,500) (6,500)
2 (500) (3,000)
3 2,500 500
4 3,500 4,000
Minacs Confidential 804/08/23
Payback X=2 + 500 = 2.17 years 3000
Payback Y=2 + 3,000 =2.86 years 3,500
PAYBACK PERIOD
ADVANTAGES DISADVANTAGES
1. Payback period is quite simple to calculate
1. The major weakness is merely subjectively determined number.
2. It can be a measure how quickly the firm recovers its initial investment
2. Fails to take fully into account the time factor in the value of money.
3. It can be viewed as a measure of risk exposure.
3. Failure to recognize cash flows that occur after the payback period.
Minacs Confidential 904/08/23
NET PRESENT VALUE(NPV)
• This is done by discounting back the inflows over the life of the investment to determine whether they equal or exceed the required investment.
Calculated as:
NPV=Present Value of cash inflows-Initial Investment
04/08/2310
NET PRESENT VALUE(NPV)
Decision Criteria:
ACCEPT THE PROJECT REJECT THE PROJECT
If the NPV is greater than 0 If the NPV is less than 0
NET PRESENT VALUE
10,000 investment, 10 % discount rate
NET PRESENT VALUE
10,000 investment, 10 % discount rate
Microsoft Office PowerPoint 97-2003 Pres
NET PRESENT VALUE
Investment A Investment B Selection
Payback Method 2 years 3.8 years Quicker Payback: Investment A
Net Present Value 177 1,414 Higher Net Present value: Investment B
PROFITABILITY INDEX
A further possible refinement under the net present value method is to compute a profitability index.
Profitability index = Present value of the inflows
Present value of the outflows
PROFITABILITY INDEX
Investment A
PI = 10,177
10,000
= 1.0177
Investment B
PI = 11,414
10,000
= 1.1414
NPV and ECONOMIC VALUE ADDED (EVA)
• It is a PURE ECONOMIC PROFIT,a profit above and the beyond the normal competitive rate of return in a line of business.
• Calculated as:
• EVA=project cash flow-(cost of capital) x (invested capital)
Minacs Confidential 1804/08/23
Microsoft Office PowerPoint 97-2003 Pres
Thank you!
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