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
 Net present value
 Internal rate of return
 Profitability index
 Discounted payback period
B. Non-discounted Cash- Flow (unadjusted) Approach
 Payback Period
 Bailout payback period
 Payback reciprocal
 Accounting rate of return (book value rate of return)
 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.
 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
 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 (Uniform Cash Inflows)

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:

Present value of cash inflows

(50,000 x 3.274) P163, 700
Less: Net investment 120,000
Net present value P 43,700
 Example 2 (Uneven Cash Inflows)
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
 Internal Rate of return

 The internal rate of return (IRR) is a metric used

in capital budgeting to estimate the profitability of
potential investments. The internal rate of return is
a discount rate that makes the net present
value (NPV) of all cash flows from a particular
project equal to zero. IRR calculations rely on the
same formula as NPV does.
 Steps in the Computation of the Internal Rate of
Return (IRR)
 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:
 Compute the Present Value factor by dividing Net Investment by
Annual Cash Returns.
 Trace the PV factor in the Table for Present Value of P1 received
annually using the life of the project as point of reference.
 The column that gives the closest amount to the PV factor is the
“Discounted rate of return”
 To get the exact Discounted rate of return, interpolation is
applied.
 Example 1 (Uniform Cash flow)
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%