Capital Budgeting
Ch 9,page:272
1
The process of decision making with respect
to investment in fixed assets.
Importance to a manager
The decisions continue
for many years, must
make carefully.
May Lose the market to
competitors if it has
inadequate fixed assets
When???
 Replacement of fixed
assets
Expansion of existing
product or market
Expansion into new
product
2
Decision Criteria
Mutually Exclusive Projects
 Projects that compete with
another where only one decision
(project) can be accepted.
Independent Projects
 Project where cash
flows are unrelated or
independent of another.
The acceptance of ones
does not eliminate the
others.
3
Cross Over
Rate
Payback Period
Net Present
value
Proftability
Index
Internal Rate
of Return
Discounted
Payback Period
4
The number of years needed to recover the initial cash outlays.
1.Payback Period
Advantages
 Easy to visualize and
calculate
Decision Criteria
Independent Project
• Accept the project where
payback is less than the
maximum acceptable payback
period.
Disadvantages
 Ignore time value of
money
 Ignore the returns
beyond the payback
period
 A bad profitability
indicator
Mutually Exclusive Project
• Accept project with a shorter
payback period and less than
the maximum acceptable
period.
5
Example
Helang Sdn Bhd is considering a major expansion of its product line and has
estimated the following cash flow associated with the expansion. It has 2 mutually
exclusive products that will be considered for expansion. The initial outlay would
be RM 170, 000. Both projects would generate the following cash flow. The
appropriate require rate of return is 10%. Given the following cash flow. Determine
which product should be accepted.
Product X
Product Y
(RM 170, 000)
(RM 170, 000)
1
50, 000
20, 000
2
50, 000
80, 000
3
50, 000
90, 000
4
50, 000
90, 000
Initial Outlay
Year
6
Payback Period X =
=
=
Initial Outlay
Cash Flow
RM 170, 000
RM 50, 000
3.4 years
7
Product Y
Product Y
Cumulative
(RM 170, 000)
(RM 170, 000)
1
20, 000
(150,000)
2
80, 000
(70,000)
3
90, 000
20,000
4
90, 000
110,000
Initial Outlay
Year
8
The method that finds the present value of the future cash flow of a project
by discounting the cash flow at the cost of capital and subtract it from the
initial net outlay of the project
2.Net Present
Value
Decision Criteria
NPV = PV Cash Flow – Initial
Outlay
Independent Projects
Mutually Exclusive Projects
 Accept all project that
have a positive NPV
Accept project with a higher
NPV
9
Example
Helang Sdn Bhd is considering a major expansion of its product line and has
estimated the following cash flow associated with the expansion. It has 2 mutually
exclusive products that will be considered for expansion. The initial outlay would
be RM 170, 000. Both projects would generate the following cash flow. The
appropriate require rate of return is 10%. Given the following cash flow. Determine
which product should be accepted.
Product X
Product Y
(RM 170, 000)
(RM 170, 000)
1
50, 000
20, 000
2
50, 000
80, 000
3
50, 000
90, 000
4
50, 000
90, 000
Initial Outlay
Year
10
Given, required rate of return = 10%
NPV = PV of cash flow – Initial Outlay
Product X
NPV = PV of Cash Flow – Initial Outlay
= using financial calculator
= (RM11, 506.7277)
NPV = PV (PVIFA i,n) - IO
=RM50000(PVIFA 10%,4) - RM170,000
=RM50000(3.1699) - RM170,000
= (RM11,505)
11
Product Y
Year
C/Flow
PVIF 10%
PV
1
20, 000
0.9091
18, 182
2
80, 000
0.8264
66, 112
3
90, 000
0.7513
67, 617
4
90, 000
0.6830
61, 470
RM 213, 381 -170,000
NPV = PV of Cash Flow – Initial Outlay
= using financial calculator
= RM43, 387.0637
12
Decision
Payback Period
Net Present Value
Product X
Product Y
3.4 years
2.7 years
(RM11, 505)
RM43, 381
Not choose
Choose
Helang Sdn Bhd should choose Product Y to
expand because product Y provide shorter
payback period and positive and higher net
present value (NPV).
13
The discount rate that equates the present value of the project’s
future free cash flow with the project’s initial outlay
3.Internal Rate of Return
How to determine IRR
Cash Flow Constant
PVIFA IRR, n = Initial Outlay
Annuity
PV (inflows) = PV (Initial Investment)
Uneven Stream of Cash Flows
Use a simulated annuity
The average cash flow of
the project
14
Mutually Exclusive Projects
•Accept project with higher
IRR
Independent Project
Accept all projects if IRR >
the required rate of return
R
Decision Criteria
Internal Rate of Return
Advantages
Use free cash flows
Recognize time value of
money
Consistent with the firm’s goal
of
shareholder
wealth
maximization.
Disadvantages
Requires detailed long term
forecast of project’s cash flows
Involve tedious calculation
Possibility of multiple IRR
15
Example:
Project X
IRR = IO / CF
= 170,000 / 50,000
= 3.4 yrs ( continue with fin calculator)
= 6.83%
Project Y
= 19.41%
16
Conflicts Between NPV and IRR
• NPV directly measures the increase in value to the
firm
• Whenever there is a conflict between NPV and
another decision rule, you should always use NPV
• IRR is unreliable in the following situations
– Nonconventional cash flows
– Mutually exclusive projects
17

Compute the present value of each cash flow and then
determine how long it takes to pay back on a discounted basis
4.Discounted Payback
Period

Advantages
Decision Rule - Accept the project if
it pays back on a discounted basis
within the specified time
Disadvantages
◦ Includes time value of money
◦ Easy to understand
◦ Does not accept negative
estimated NPV investments
when all future cash flows are
positive
◦ Biased towards liquidity
◦ May reject positive NPV investments
◦ Requires an arbitrary cutoff point
◦ Ignores cash flows beyond the cutoff
point
◦ Biased against long-term projects,
such as R&D and new products
18
Example:
Year
n
Cash Flow
CF
Present Value
Factor
n
PV$1=1/(1+i)
Discounted
Cash Flow
CF×PV$1
Cumulative
Discounted
Cash Flow
0
$ −2,324,000
1.0000
$ −2,324,000
$ −2,324,000
1
600,000
0.9009
540,541
− 1,783,459
2
600,000
0.8116
486,973
− 1,296,486
3
600,000
0.7312
438,715
− 857,771
4
600,000
0.6587
395,239
− 462,533
5
600,000
0.5935
356,071
− 106,462
6
600,000
0.5346
320,785
214,323
Discounted Payback Period
= 5 + |-106,462| / 320,785
≈ 5.32 years
19
Now calculate for Helang Sdn Bhd
Project X :
Project Y: ???
20
5.Profitability Index
•
•
•
•
•
•
Formula:
Total PV / Initial Outlay
Decision:
PI > 1.0 …. Accept
PI< 1.0 ….. Do not accept
Ind.project: accept as long as the answer is
greater than 1.0
• Mutually exclusive: accet PI>1.0 and highest
PI.
21
Advantages
Profitability Index
●Closely related to NPV,
generally leading to
identical decisions
Easy to understand and
communicate
Disadvantages
●May be useful when
available investment
funds are limited
May lead to incorrect
decisions in
comparisons of
mutually exclusive
investments
22
Example:
Project X
Project Y
PI = PV of CF / IO
= 158,495 / 170,000
= 0.93 times
PI = PV of CF / IO
= 213,381 / 170,000
= 1.26 times
Decision
Accept Project Y
Why???
23
6.Cross Over Rate
Year
Project X
Project Y
Different
0
(170,000)
(170,000)
0
1
50,000
20,000
(30,000)
2
50,000
80,000
50,000
3
50,000
90,000
40,000
4
50,000
90,000
40,000
24
Cross Over Rate
Step 1 : Find the difference between ABC and XYZ
Step 2 : Find the IRR and set the UPPER LIMIT and the LOWER LIMIT, find
IRR from (A-B) = 15.8119
so the upper limit = 16%, lower limit = 14%
Step 3 : Calculate NPV by using original C/Flows project ABC and XYZ by
using upper limit and lower limit
25
Decision
Lower Limit (14%)
Upper Limit (16%)
Project ABC
NPV = (RM 24,314.38)
Project ABC
NPV = (RM 30,090.97)
Project XYZ
NPV = RM 43,779.25
Project XYZ
NPV = RM 34,704.35
Choose Project XYZ
Choose Project XYZ
Why ? = Higher NPV
Why ? = Higher NPV
26
Now calculate Helang Sdn Bhd
• Project X
Project Y
27