INVESTMENT IN ASSETS

AND
REQUIRED RETURNS
INVESTMENT IN ASSETS AND
REQUIRED RETURNS

?
 INVESTMENT IN ASSETS
INVESTMENT DECISION
- Judgement about which assets to acquire to
achieve the company's stated objectives.
FINANCING DECISION
- Judgement regarding the method of raising
capital to fund an investment.
 CAPITAL BUDGETING

- The process of identifying, evaluating, planning, and financing

capital investment projects of an organization.

-deals with analyzing the profitability and/or

liquidity of a given project proposals.
 CHARACTERISTICS OF CAPITAL
INVESTMENT DECISIONS

1. Usually require large commitments of resources.

2. Involve long-term commitments.
3. Are more difficult to reverse than short-term decisions.
4. Involve so much risk and uncertainty.
 ISSUES IN CAPITAL BUDGETING

1. NET COST OF INVESTMENT

- how much is the cost of investment?
2. NET RETURNS
- how should the investment be returned?
3. COST OF CAPITAL
- how much is the cost of using the funds?
4. Project Evaluation Techniques (PETs)
- which investment proposal would give the
highest ROI, profitability wise and liquidity
wise.
 NET COST OF INVESTMENT
OR
NET INVESTMENT

Equals costs or cash outflows less cash inflows or savings

incidental to the acquisition of the investment projects.

CASH OUTFLOWS – CASH INFLOWS

 Sample problem:
Net investment
1. The management of Leonor Company plans to replace a machine that was acquired several years ago at a
cost of P500,000. It has been depreciated to its salvage value of P50,000, and can be sold now for P40,000.
A new sorter can be purchased to replace the old one for P800,000. If a new machine is not purchased,
Leonor Company will spend P150,000 to repair the old machine. The cost to repair the old machine can be
deducted in the first year to compute income tax. Moreover, the acquisition of the new machine will
require additional investment in working capital of P30,000. Income tax is estimated at 30% of the income
subject to tax.
Required:
Compute the net investment in the new machine for decision making purposes.
Cash outflows: cash inflows:
800,000 purchase price of new machine 40,000 proceeds from disposal of old asset
30,000 add’l working capital 150,000 total avoided cost
45,000 avoided cost of repairs 3,000 tax effect on disposal of old asset
875,000 tax effect: 150,000 x 30% 193,000 (40,000-50,000 = 10,000 x 30%)

net cost of investment = 682,000

 NET RETURNS (recovery)

1. Accounting net income

- denotes profitability

2. Net cash inflow

- denotes liquidity
- equals savings after tax but before depreciation
add tax savings due to depreciation
OR
- net income add depreciation
 Sample problem:
Net returns
The Paniki Corporation is planning to add a new product line to its present business. The new product will require a new equipment
costing P2,400,000 with a 5 year life, no salvage value.
The following estimates are made available:
Annual sales P12,000,000
Selling & Admin expenses 2,100,000
Materials 4,400,000
Income tax rate, 40%
Labor 2,200,000
Factory overhead (excluding
depreciation on new equipment) 1,300,000
Required: Compute the net income and the net cash inflows
Net income: Net cash inflow:
12,000,000 sales 912,000 net income
(7,900,000) cos (4.4 M + 2 M + 1.3M) 480,000 depreciation
4,100,000 gross profit 1,392,000
(480,000) depreciation (2.4 M / 5 yrs.)
(2,100,000) expenses
1,520,000 income b4 tax
(608,000) tax (1.52M x 40%)
912,000
 COMMONLY USED METHODS OF
EVALUATING CAPITAL INVESTMENT
PROJECTS

Traditional methods:
1. Payback Period
2. Accounting Rate of Return

Discounted methods:
1. Net Present Value
2. Profitability Index
3. Net Present Value Index
4. Discounted Cash Flow Rate of Return or Internal Rate of Return
 Traditional methods:
PAYBACK PERIOD
= net cost of initial investment / annual net cash inflows
 The length of time required by the project to return the initial cost of investment.

ACCOUNTING RATE OF RETURN

= annual net income / Original investment
OR
= annual net income / Average investment
 Sample problem:
Payback period and Accounting rate of return
A piece of labor saving equipment has just come onto the market that Dikosan Electronics could use to reduce costs in one of
its plants. Relevant data relating to the equipment follow:
Cost of the equipment P800,000
Annual savings in cash operating costs
that will be provided by the equipment 200,000
Life of the equipment 10 years
Income tax rate 30%
Required:
1. Compute the payback period for the equipment. If the company requires a payback period of 5 years or less, would the
equipment be purchased?
2. Compute the ARR promised by the equipment based on (a) original investment and (b) average investment. Would the
equipment be purchased if the company’s required rate of return is 14%?
Solutions:
(1) 140,000 (200,000 x 70%) (2) ARR = 84,000 / 800,000 ARR = 84,000 / 400,000
24,000 (80,000 x 30%) = 10.5% = 21%
164,000 net cash inflow
(80,000)depreciation using original investment using average investment
84,000 net income
Payback period = 800,000 / 164,000
= 4.88 years
 Sample problem:
Payback period (uneven cash inflows)
An investment of P400,000 can bring in the following annual cash income, net of tax:

1st year, P40,000; 2nd year, P95,000; 3rd year, P85,000; 4th year, P140,000; 5th year, P86,000; 6th
year, P70,000

Required: Determine the payback period.

Solution:
cash to date
40,000 1 yr. 40,000
95,000 1 yr. 135,000
85,000 1 yr. 220,000 40,000 / 86,000 = 0.47
140,000 1 yr. 360,000
40,000 0.47 400,000
4.47 years
 Discounted models:

NET PRESENT VALUE

= Present value of cash inflows

less: Present value of cash outflows
Net Present Value
 Sample problem:
(EVEN)
Net present value
An equipment costing P800,000 will produce annual net cash inflows of P250,000. At the end of its useful life of 5 years, the
equipment will have a P20,000 residual value. Additional working capital of P200,000 is needed. The desired rate of return is
14%.
Required: Determine the NPV.
Solution: 250,000 x 3.433 858,250 COI = 800,000 + 200,000
20,000 x 0.519 10,380 = 1,000,000
200,000 x 0.519 103,800
TPVCI 972,430
COI (1,000,000)
NPV (27,570)
(UNEVEN)
An equipment costing P680,000, with a residual value of P8,000 at its useful life of five years, is expected to bring the
following net of cash inflows:
1st year, P350,000; 2nd year, P250,000; 3rd year, P150,000; 4th year, P100,000; 5th year, P50,000.
Required: Determine the NPV using a discount rate of 12%.
Solution: 350,000 x 0.893 312,550
250,000 x 0.797 199,250
150,000 x 0.712 106,800
100,000 x 0.636 63,600
50,000 x 0.567 28,350
8,000 x 0.567 4,536
TPVCI 715,086
COI (680,000)
NPV 35,086
 Discounted models:
PROFITABILITY INDEX

= Total present value of cash inflows / Cost of investment

NET PRESENT VALUE INDEX

= Net present value / Cost of investment

The indexes are normally used to rank projects that are acceptable.

CAPITAL RATIONING - the process of allocating available money to the most

prioritized investment proposals.
 Sample problem:
Profitability index, NPV index, and Capital rationing

M Corporation has P12 million available money for investment. It has

already evaluated several project proposals and now considers the
following acceptable projects based on the data presented below:

Project COI PVCI NPV PI NPVI Rank

A P5,000,000 P5,500,000 P500,000 1.10 0.10 4
B 6,000,000 6,900,000 900,000 1.20 0.20 2
C 4,000,000 4,850,000 850,000 1.21 0.21 1
D 3,000,000 3,470,000 470,000 1.16 0.16 3

Which project should the company invest?

 DISCOUNTED MODEL

INTERNAL RATE OF RETURN OR BREAKEVEN RATE

- It is the discount rate where the:

Present value of cash inflows = Cost of investment

Net present value = Zero
Profitability index = 1.00

PVF for DCFRR = Cost of investment / net cash inflows

 Sample problem:
Internal rate of return

Twin Towers Company has the opportunity to buy a new

equipment at P1,000,000. The machine is estimated to have a
useful life of 4 years, no residual value and will yield an
annual net cash inflow after tax of P375,000 during its
economic life. The company's rate of return is 14%.

Required: Determine the IRR

Solution: 1,000,000 / 375,000 = 2.667 PVFA Exact IRR is 18.46%

 PETs Summary
Traditional models
Model Concept of Focus of Decision
net returns measurementcriterion

Payback period NCI liquidity the shorter, the better

ARR Net income profitability the higher, the better

Discounted models
NPV NCI liquidity (+), accept; (-), reject
PI NCI liquidity > 1.0, accept; < 1.0 reject
NPV I NCI liquidity (+), accept; (-), reject
IRR NCI liquidity the higher, the better