COLLEGE OF COMMERCE

DEPARTMENT OF ACCOUNTANCY

MODULE 4 PACKET
AE 19 – FINANCIAL MANAGEMENT
MODULE 4 CAPITAL BUDGETING TECHNIQUES
Welcome to Module 4!

In this module, we will discuss the different capital budgeting techniques that may be
used in capital investment decisions of a company.
Consultation hours
Phone / messenger: 1:00 – 2:00 PM Mondays-Fridays

Virtual time: 2:00 – 3:30 PM; 5:00-6:30 PM Mondays & Tuesdays

Module 4: Learning Objectives

By the end of the module, students will be able to:

1. describe the importance of capital budgeting decisions and the general process that is
followed when making decisions about investing in capital assets.
2. explain how the net present value and internal rate of return techniques are used to make
capital budgeting decisions.
3. compare the NPV technique with the IRR technique.
4. explain other capital budgeting techniques used by businesses to make investment decisions
and which technique are used most often in practice.

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Module 4: Course Content:
Below is a schedule for Module 4:

Activity Description Time to

Complete

Video Presentation Capital Budgeting Techniques 28 minutes

https://www.youtube.com/watch?v=Sff3DxOHjJs&t=98s

Assigned Reading Capital Budgeting* 30 minutes

Lecture Discussion Capital Budgeting Techniques 30 minutes

ACTIVITY 4-1 PROBLEM SOLVING 90 minutes

ACTIVITY 4-2 CASE ANALYSIS 30 minutes

QUIZ Summative Quiz 120 minutes

*Suggested Readings:
Besley, Scott and Brigham, Eugene, Corporate Finance, Philippines Edition. Cengage Learning
Chapter 9 Capital Budgeting Techniques
Or any book or reading materials related to the topic.

Deadline for Module I is on in on October 16, 2020

LECTURE DISCUSSION

DEFINITION

CAPITAL BUDGETING is the process of evaluating and selecting long term investments that a
consistent with the firm’s goals of maximizing owner’s wealth.

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MOTIVES FOR CAPITAL BUDGETING

A capital expenditure is an outlay of funds by the firm that is expected to produce benefits over a
period of time greater than 1 year.

Operating expenditure is an outlay resulting in benefits received within 1 year.

The primary motives for capital expenditures are to expand operations, to replace or renew fixed
assets, and to obtain some other, less tangible benefit over a long period.

STEPS IN THE PROCESS

1. Proposal Generation
2. Review and analysis
3. Decision making
4. Implementation
5. Follow up

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BENNETT COMPANY’S RELEVANT CASH FLOWS

We will use one basic problem to illustrate all the techniques described here. The problem concern
Bennett Company, a medium-sized fabricator that is currently contemplating two projects with
conventional cash flow patterns. Project A requires an initial investment of $ 42,000, and project
B requires an initial investment of $ 45,000. The projected relevant cash flows for the two projects
are presented in Table 10.1 and depicted in Figure 10.1. Both projects involve one initial cash
outlay followed by annual cash inflows, a fairly typical pattern for new investments.

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1. Payback period. It is the time that it takes the firm to recover its initial investment in a
project, as calculated from the cash inflow.

Using the data in Table 10.1, payback period for project A is 3 years and project B is 2.5
years

2. Net present value (NPV). A sophisticated capital budgeting technique; found by

subtracting a project’s initial investment from the present value of its cash inflows
discounted at a rate equal to the firms cost of capital.

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Calculation of NPV of Bennett’s using the spreadsheet:

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3. Profitability index

Profitability index of Bennett’s

4. Internal Rate of Return (IRR). It is the discount rate that equates the NPV of an investment
opportunity with $ 0 (because the present value of the cash inflows equals the initial
investment; it is the rate of return that the firm will earn if it invests in the project and receives
the given cash inflows.

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 COLLEGE OF COMMERCE
DEPARTMENT OF ACCOUNTANCY

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Calculation of IRR of Bennett’s using the spreadsheet:

Activity 4-1 Multiple Choice/Problem Solving

1. The NPV method:

a. is consistent with the goal of shareholder wealth maximization.
b. recognizes the time value of money.
c. uses cash flows.
d. all of the above.

2. A project has an initial outlay of P4,000. It has a single payoff at the end of Year 4 of P6,996.46. What
is the IRR for the project (round to the nearest percent)?
a. 16%
b. 13%
c. 21%
d. 15%

3. ABC Service can purchase a new assembler for P15,052 that will provide an annual net cash flow of
P6,000 per year for five years. Calculate the NPV of the assembler if the required rate of return is
12%. (Round your answer to the nearest P1.)
a. P1,056
b. P4,568
c. P7,621
d. P6,577

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4. Given the following annual net cash flows, determine the IRR to the nearest whole percent of a
project with an initial outlay of P1,520.
Year Net Cash Flow
1 P1,000
2 P1,500
3 P 500
a. 48%
b. 40%
c. 32%
d. 28%

5. We compute the profitability index of a capital-budgeting proposal by:

a. multiplying the IRR by the cost of capital.
b. dividing the present value of the annual after-tax cash flows by the cost of capital.
c. dividing the present value of the annual after-tax cash flows by the cost of the project.
d. multiplying the cash inflow by the IRR.

6. Which statement is true?

a. The IRR assumes that cash flows are reinvested at the cost of capital.
b. If the project’s payback period is greater than or equal to zero, the project should be accepted.
c. The NPV of a project will equal zero whenever the payback period of a project equals the required rate
of return.
d. If the NPV of a project is zero, then the profitability index should equal one.

7. What is the payback period for a P20,000 project that is expected to return P6,000 for the first two
years and P3,000 for Years 3 through 5?
a. 3 1/2
b. 4 1/2
c. 4 2/3
d. 5

8. Compute the payback period for a project with the following cash flows, if the company’s discount rate
is 12%.
Initial outlay = P450
Cash flows: Year 1 = P325
Year 2 = P 65
Year 3 = P100
a. 3.43 years
b. 3.17 years
c. 2.88 years
d. 2.6 years

9. Consider a project with the following cash flows:

After-Tax After-Tax
Accounting Cash Flow
Year Profits from Operations
1 P799 P 750
2 P150 P1,000
3 P200 P1,200
Initial outlay = P1,500
Terminal cash flow = 0

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Compute the profitability index if the company’s discount rate is 10%.
a. 15.8
b. 1.61
c. 1.81
d. 0.62

10. The ____________ is equal to the present value of inflows less the present value of outflows,
discounted at the cost of capital.
a. accounting rate of return
b. profitability index
c. NPV
d. IRR

11. Suppose you determine that the IRR of a project is 27.99%. What does that mean?
a. The project is acceptable.
b. The project is acceptable only if the IRR is greater than the discounted payback period.
c. The project would be acceptable if the project’s profitability index is positive.
d. The project would be acceptable if the IRR is greater than the firm’s discount rate.

12. Dieyard Battery Recyclers is considering a project with the following cash flows:
Initial outlay = P13,000
Cash flows: Year 1 = P5,000
Year 2 = P3,000
Year 3 = P9,000
If the appropriate discount rate is 15%, compute the NPV of this project.
a. P4,000
b. -P466
c. P27,534
d. P8,891

13. For the NPV criteria, a project is acceptable if the NPV is __________, while for the profitability index,
a project is acceptable if the profitability index is __________.
a. less than zero, greater than the required return
b. greater than zero, greater than one
c. greater than one, greater than zero
d. greater than zero, less than one

14. Which of the following is NOT an advantage of NPV?

a. It can be used as a rough screening device to eliminate those projects whose returns do not
materialize until later years.
b. All positive NPVs will increase the value of the firm.
c. It allows the comparison of benefits and costs in a logical manner.
d. It recognizes the timing of the benefits resulting from the project.

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15. Payback period:
a. ignores the time value of money.
b. deals with cash flows rather than accounting profits.
c. measures how quickly the project will return its original investment.
d. does all of the above.

Use the following information to answer questions 78 through 84. Below are the expected after-tax
cash flows for Projects Y and Z. Both projects have an initial cash outlay of P20,000 and a required
rate of return of 17%.

Project Y Project Z
Year 1 P12,000 P10,000
Year 2 P8,000 P10,000
Year 3 P6,000 0
Year 4 P2,000 0
Year 5 P2,000 0

16. Payback for Project Y is:

a. two years.
b. one year.
c. three years.
d. four years.

17. What is payback for Project Z?

a. Two years
b. One year
c. Zero years
d. Project Z does not payback the original investment.

18. Project Y’s NPV is:

a. less than zero.
b. P1,826.26.
c. P10,000.
d. P4,636.42.

19. Project Y’s IRR is:

a. less than zero.
b. less than 17%.
c. 22.51%.
d. 12.51%.

20. Which of the following is NOT a criticism of the payback period criteria?
a. Time value of money is not accounted for.
b. Returns occurring after the payback are ignored.
c. It deals with accounting profits as opposed to cash flows.
d. Time value of money is not accounted for and it deals with accounting profits.

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Activity 4-2 Case Analysis

Case 1
Convention Corporation is evaluating a capital budgeting project that will generate P600,000 per
year for the next 10 years. The project costs P3.6 million, and Conventional’s required rate of
return is 11%. Should the project be purchased?

Case 2
The CFO of HairBrain Stylists is evaluating a project that costs P42,000. The project will generate
P11,000 each in the next five years. HairBrain’s required rate of return is 9%. Should the project
be purchased?

REFERENCES:

Besley, Scott and Brigham , Eugene.(2019). Corporate finance. Cengage Learning Asia Ple Ltd.

Brigham, Houston, Chiang and Ariffin.(2016). Core concepts of financial management . Cengage
Learning Asia Ple Ltd.

Cabrera, Elenita.(2017). Financial management. Manila, Philippines: GIC Enterprises Inc.

Graham, John and Smart, Scott. (2017). Introduction to Financial Management, Third Edition.
Cengage Learning

Kretlow, William J., et.al. (2017). Financial management. Singapore: Cengage Learning Asia Pte
Ltd.

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