CHAPTER CAPITAL BUDGETING DECISIONS I Questions A hotel may consider buying an item of equipment with a rapid payback rather than one with a high average rate of return if a) Management is risk-averse; that is, it does not want to assume risk of its money being tied up in an investment for a relatively long period of time b) Management believes that the equipment can be subjected to rapid obsolescence c) The company has obtained a loan to finance the equipment and it wants to repay the principal right away to avoid financing costs The money is worth more now than that same amount of money a year from now If the cash outlay today is P10,000 and the present value of the total cash returns were P9,500, one should not make the investment because this means that the investment will not yield the desired return on investment For the project to be acceptable, the present value of the returns should at least be equal to the present value of the investment Net Present Value is the excess of the present value of cash inflows generated by the project over the amount of the initial investment This is computed as follows: Present value of cash inflows computed based on minimum desired discount rate Less: Present value of investment Net Present Value Pxx xx Pxx Discounted Rate of Return, also known as internal rate of return (IRR) and timeadjusted 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 loss on the project If an independent project is being evaluated, then the NPV and IRR criteria always lead to the same accept/reject decision 9-2 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations For mutually exclusive projects (choosing among acceptable alternative) especially those that differ in scale (project size) and/or timing, a conflicts of ranking may arise That is, the IRR method may favor one alternative over another while the NPV method may indicate otherwise If conflicts arise, the NPV method should be used The NPV method assumes the cash flows will be reinvested at the firm’s cost of capital while the IRR method assumes reinvestment at the project’s IRR Because reinvestment at the cost of capital is generally a better (closer to reality) assumption, the NPV is superior to the IRR Comparison between the cash flows from operations before and after the landscaping is done may be made The purpose of the investment is to make the resort more attractive to patrons and guests Hence, when more resources are generated after the investment is made, it is an indication that the decision has been beneficial to the company Negative NPV would generally indicate that the investment proposal is not acceptable because the desired rate of return is not attainable It does not mean however that the project will be unprofitable Therefore if the prospective investor is willing to accept a lower rate of return, then the project may become acceptable II Practical Exercises and Problems A EXERCISES EXERCISE Requirement (a) Payback period: Machine A P25,800 P5,940 Machine B = 4.34 yrs P24,200 P7,800 = 3.10 yrs Requirement (b) Yes Machine B It is the more preferable investment because the recovery period of capital is shorter Capital Budgeting Decisions 9-3 EXERCISE Repayment schedule: End of Year Principal Payment Interest Total 4,500 4,500 4,500 4,500 4,500 2,250 1,800 1,350 900 450 6,750 6,300 5,850 5,400 4,950 Balance of Principal 22,500 18,000 13,500 9,000 4,500 B PROBLEMS PROBLEM Relevant Data Investment required Cash flows from operations Salvage value of furniture and equipment Net Present Value End of Period Cash In (Out) Flow Amount PVf at 13% Present Value P(205,000) 1.000 P(205,000) 37,500 43,800 46,300 50,000 60,000 0.885 0.783 0.693 0.613 0.543 33,188 34,295 32,086 30,650 32,580 18,500 0.543 10,046 P(32,155) The prospective investor should not make the investment because it would not yield the desired rate of return of 13% The negative net present value as shown in the computation indicates that the internal rate of return is lower than 13% Through Trial Computations, the IRR can be determined as follows: 5 Trial at 6% Cash In (Out) Flow Amount PVf PV (205,000 1.000 (205,000) ) 37,500 0.943 35,263 43,800 0.890 38,982 46,300 0.840 38,892 50,000 0.792 39,600 60,000 0.747 44,820 18,500 0.705 13,042 Trial at 8% Cash In (Out) Flow Amount PVf PV (205,000 1.000 (205,000 ) ) 37,500 0.926 34,725 43,800 0.857 37,537 46,300 0.794 36,762 50,000 0.735 36,750 60,000 0.681 40,860 18,500 0.681 12,599 9-4 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations 5,599 (5,767) To get the Internal Rate of Return closest to the exact rate, interpolation may be applied as follows: IRR = 6% + 5,599 – 5,599 – (5,767) = 6% + 5,599 11,366 = 6% + 0.98% = 6.98% x 2% x 2% Proof: Using 6.98% as the discount rate, the net present value will be as follows: End of Year 5 Amount P(205,000) 37,500 43,800 46,300 50,000 60,000 18,500 Net Present Value PVf at 13% 1.000 0.935 0.873 0.816 0.763 0.714 0.714 * Rounding off difference PROBLEM Requirement (a) Payback Period: Alternative Year Annual CF 4,200 5,800 8,500 11,500 12,000 Cumulative CF 4,200 10,000 18,500 30,000 42,000 Present Value P(205,000) 35,063 38,237 37,781 38,150 42,840 13,209 P 280 * Capital Budgeting Decisions 9-5 Payback Period = years + = 4.42 years 35,000 – 30,000 12,000 x year Alternative Year Annual CF 12,100 9,900 8,900 5,400 Cumulative CF 12,100 22,000 30,900 36,300 Payback Period = years + = 3.76 years 35,000 – 30,900 5,400 x year Requirement (b) Net Present Value – 10% discount rate End of Year Net Present Value Relevant Data Investment Cash Inflows Alternative Amount PVf PV P(35,000) 1.000 P(35,000) 4,200 0.909 3,818 5,800 0.826 4,791 8,500 0.751 6,384 11,500 0.683 7,855 12,000 0.621 7,452 P (4,700) Alternative Amount PVf PV P(35,000) 1.000 P(35,000) 12,100 0.909 10,999 9,900 0.826 8,177 8,600 0.751 6,459 5,400 0.683 3,688 4,000 0.621 2,484 P (3,193) No Both alternatives would not yield the desired rate of return of 10%  ...9-2 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations For mutually exclusive projects (choosing among acceptable... 50,000 0.735 36,750 60,000 0.681 40,860 18,500 0.681 12,599 9-4 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations 5,599 (5,767) To get the Internal Rate of Return closest... between the cash flows from operations before and after the landscaping is done may be made The purpose of the investment is to make the resort more attractive to patrons and guests Hence, when more