Financial Management - Capital Budgeting

1. Eunice Shertaria Bangun 1606 850 791
Galuh Wulandari 1606 938 290
Hanggara Surya Pratama 1606 938 321
Haniyah Nadhira 1606 850 892
Henny Khaerunnisa 1606 850 936
Herman Widjaja 1606 850 955

2.  Capital Budgeting
 Capital Budgeting Methods
 NPV (Net Present Value)
 Payback Period & Discounted payback
 IRR (Internal Rate of Return)
 PI (Profitability Index)
 Practice of Capital Budgeting
 Mini Case

3.  Process to determine & evaluate potential
investment projects, i.e. build a new plant,
invest in a long-term venture
 Purpose:
 Determine which project yield the most return
over an applicable period, given a limited amount
of capital

4.  Difference between present value of cash
inflows and the present value of cash outflows
NPV Rule:
Accept a project if the NPV is > 0
Reject a project if the NPV is < 0

5. The Alpha Corp. is considering investing in a riskless project
costing $100. The project receives $107 in one year and has no
other cash flows. The discount rate is 6%.
NPV = -$100 + $107 / 1.06
= $0.94
NPV > 0  Accept the project

6.  NPV is considered the most common and
effective valuation methods:
 Uses cash flows
 Uses all cash flows of the project
 Discount the cash flows properly

7. Definition
the length of time required to
recover the cost of an investment.
Decision Rule
Accept if the payback period is less
than some preset limit

8.  The project cost : $ 60.000
 Assume we will accept the project if it pays
back within two years.
 Accept or Reject? Why?
Year 1 : $60.000 – 30.000 = 30.000 >> still to recover
Year 2 : $30.000 – 20.000 = 10.000 >> still to recover
Year 3 : $10.000 – 20.000 = -10.000 >> project pays back

9.  Three project (initial cost $100) have the same three-year payback period
 PROBLEM 1: Timing of Cash flow within the Payback Period
 PROBLEM 2: Payment after the Payback Period
 PROBLEM 3: Arbitrary Standard for Payback Period
Year A B C
0 -100 -100 -100
1 20 50 50
2 30 30 30
3 50 20 20
4 60 60 60.000
Payback
period
3 3 3

10. Definition
the length of time until the sum of the
discounted cash flows is equal to the initial
investment
Rule
Accept the project if its discounted
payback is less than some prespecified
number of years

11.  The project cost : $100; discount rate 10%
 Assume we will accept the project if it pay
back on discounted basis in 3 years.
 Accept or Reject? Why?
Year 1 : $100 – 50/1.1 = $54.55 >> still to recover
Year 2 : $54.55 – 50/(1.1)2
= $13.23 >> still to recover
Year 3 : $13.23 – 20/(1.1)3
= -$1.8 >> project pays back

12. ADVANTAGES
 Include time value of
money
 Easy to understand
 Does not accept negative
estimated NPV investment
DISADVANTAGES
 May reject positive
investment
 Requires an arbitrary
cutoff point
 Ignores cash flows beyond
the cut off date

13. Definition
 IRR is a metric used in capital budgeting
measuring the profitability of potential
investments.
 Accept a project or an investment if the
IRR is greater than the minimum
required rate of return, typically the cost
of capital (discount rate)
Rules

14.  4 years project, that cost $500, with cash flow on table
 The IRR = 27.3%
 Notice that the Year 0 cash flow has a negative sign
represent the initial cost of the project
Year Cash Flow
0 -$500
1 100
2 200
3 300
4 400

15. Project A Project B Project C
Dates: 0 1 2 0 1 2 0 1 2
Cash flows -$100 $130 $100 -$130 -$100 $230 -$132
IRR 30% 30%
10 % and
20%
NPV @ 10% $18.2 -$18.2 0
Accept if
market rate
<30% >30%
>10% but
<20%
Financing or
Investing
Investing Financing Mixture
Project A has a cash outflow at date 0 followed by a cash inflow at date 1. its NPV is negatively related to the discount rate.
Project B has a cash inflow ate date 0 followed by a cash outflow at date 1. its NPV is positively related to the discount rate.
Project C has two changes of sign in its cash flows. It has an outflow ate date 0, an inflow at date 1, and outflow at date 2.
Project with more than one change of sign can have multiple rates of return.

16.  Investing or Financing?
Project A : General rule apply
Project B : The opposite of the general rule apply
 Multiple Rates of Return
Project C
NPV Rule : Accept the project if the discount rate is between 10%
and 20%, and reject it if the discount rate is lies outside this range
MIRR (modified IRR) : Which handles the multiple IRR problem
by combining cash flows until only one change in sign remains.

17. Modified internal rate of return (MIRR) assumes that positive cash flows are
reinvested at the firm's cost of capital, and the initial outlays are financed at the
firm's financing cost.
By contrast, the traditional internal rate of return (IRR) assumes the cash
flows from a project are reinvested at the IRR. The MIRR more accurately reflects
the cost and profitability of a project.
 Advantage of Modified Internal Rate of Return (MIRR)
The MIRR allows project managers to change the assumed rate of reinvested
growth from stage to stage in a project. The most common method is to input
the average estimated cost of capital, but there is flexibility to add any specific
anticipated reinvestment rate.

18. Flows Number of IRRs IRR Criterion NPV Criterion
First cash flow is negative and all I Accept if IRR > R Accept if NPV > 0
remaining cash flows are positive Reject if IRR < R Reject if NPV < 0
First cash flow is positive and all I Accept if IRR < R Accept if NPV > 0
remaining cash flows are negative Reject if IRR > R Reject if NPV < 0
Some cash flows after first are
positive
May be more No valid IRR Accept if NPV > 0
and some cash flows after first are
negative
than I Reject if NPV < 0

19.  The Scale Problem
This Bussiness poposition illustrates a defect with the IRR criterion. The basic IRR rule indicate the selection of Opportunity I
because the IRR is 50%. The IRR for opportunity II only 10%.
The problem with IRR is that it ignores issues of scale. Although opportunity I has a greater IRR, the investment is much
smaller. In other words, the high percentage return on opportunity I is more than offset by the ability to earn at least a
decent return on much bigger investment under opprtunitu II
 The Timing Problem
It arises when mutually exclusive project have different cash flow timing
Cash flow at
Cash flow at End of
Class
NPV IRR
Beginning of Class (90 minutes later)
Opportunity I -$1 + $1.5 $ 0.5 50%
Opportunity II -$10 + $11 $ 1 10%

20.  The Timing Problem
It arises when mutually exclusive project have different cash flow timing

21. Profitability Index (PI) =
Present Value of Future Cash Flows
Initial Investment Required
VIDEO PI

22.  Hiram Finnegan Inc. (HFI), applies 12% discount rate to 2 investment project.
Initial
Investment
CF
1st year
CF
2nd year
1 -$20 $70 $10 $70,5 3,53 $50,5
2 -$10 $15 $40 $45,3 4,53 $35,3
1 - 2 -$10 $55 -$30 $25,2 2,52 $15,2
Profitability
Index
NPV at 12% disc rate
($ 000,000)
PV at 12% disc rate
($ 000,000)
Cash Flows ($ 000,000)
Project
CF 1st year CF 2nd year
1 + disc rate (1 + disc rate)
2
$70 $10
1,12 (1,12)
2
PV of Future
Cash Flows
+
+
=
=
PV of Future
Cash Flows
PV of Future
Cash Flows
= $70,5
$70,5
$20
Profitability
Index
= = 3,53
PV of Future Cash Flows
Initial Investment
Profitability
Index
=

23.  Independent projects  General Rules of PI
 Mutually exclusive projects
 Incremental cash flows (between 2 projects)
$25,2
$10
Profitability
Index
=
PV of Future Cash Flows
Initial Investment
Profitability
Index
= = 2,52

24.  Capital Rationing  i.e: budget investment $ 20 million
Initial
Investment
CF
1st year
CF
2nd year
1 -$20 $70 $10 $70,5 3,53 $50,5
2 -$10 $15 $40 $45,3 4,53 $35,3
3 -$10 -$5 $60 $43,4 4,34 $33,4
Project
Cash Flows ($ 000,000)
PV at 12% disc rate
($ 000,000)
Profitability
Index
NPV at 12% disc rate
($ 000,000)
 If cash constraint forces the firm to choose either
Project 1 or Project 2 & 3.
 Choose the higher PI  Project 2 & Project 3.

25. Source : CA N Raja Natarajan (2016)

26. 1st
Project 2nd
Project
NPV (+) NPV (+)
Short Payback Long Payback
High IRR Low IRR
All systems go, agree NPV
(+)
Good investment, but
getting conflicted signals.
Need further analysis

28.  Capital expenditures add up to enormous
sum for the economy of company as a whole
 Capital budgeting of large firms are more
sophisticated from small firm
 IRR & NPV are used more frequently than
payback period, in both firms

30. Disclaimer:
For academic purpose only.
Some data has been modified for
confidentiality reasons.

31. REVENUE
YEAR I YEAR II YEAR III YEAR IV YEAR V
FEE FEE FEE FEE FEE
ANNUAL INCREMENT 10,000 10,000 10,000 10,000
MONDAY 150,000 160,000 170,000 180,000 190,000
TUESDAY 150,000 160,000 170,000 180,000 190,000
WEDNESDAY 150,000 160,000 170,000 180,000 190,000
THURSDAY 150,000 160,000 170,000 180,000 190,000
FRIDAY 150,000 160,000 170,000 180,000 190,000
SATURDAY 200,000 210,000 220,000 230,000 240,000
SUNDAY 200,000 210,000 220,000 230,000 240,000
VISITORS GUESTS GUESTS GUESTS GUESTS GUESTS
MONDAY 120 140 140 140 140
TUESDAY 120 140 140 140 140
WEDNESDAY 120 140 140 140 140
THURSDAY 120 140 140 140 140
FRIDAY 200 220 220 220 220
SATURDAY 450 480 480 480 480
SUNDAY 500 540 540 540 540
ENTRANCE REVENUE
MONDAY 18,000,000 22,400,000 23,800,000 25,200,000 26,600,000
TUESDAY 18,000,000 22,400,000 23,800,000 25,200,000 26,600,000

32. YEAR I YEAR II YEAR III YEAR IV YEAR V
OTHER REVENUE
LEASING F & B AREA 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000
PARTY ROOM 32,000,000 32,000,000 40,000,000 40,000,000 40,000,000
TAX (property final) 10% -6,200,000 -6,200,000 -7,000,000 -7,000,000 -7,000,000
SPONSORSHIP 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000
MONTHLY
NET OTHER REVENUE AFTER
TAX
65,800,000 65,800,000 73,000,000 73,000,000 73,000,000
ANNUAL NET OTHER REV 789,600,000 789,600,000 876,000,000 876,000,000 876,000,000

33. OPERATING COST
EMPLOYEE COST
Cost Per Unit Per
Month (Gross)
Cost X Unit Per
Month
GM 1 35,000,000 35,000,000
Head of Finance 1 22,000,000 22,000,000
Head of Operation 1 22,000,000 22,000,000
Admin Staff 1 4,500,000 4,500,000
Finance Staff & Cashier 6 4,500,000 27,000,000
Marketing Staff 1 4,500,000 4,500,000
Trainer and Safety
Officer 10 4,500,000 45,000,000
Security 7 4,500,000 31,500,000
Cleaning Service 7 4,500,000 31,500,000
Driver 1 4,000,000 4,000,000
Other Contract Service 1 20,000,000 20,000,000
247,000,000
Utility (Electricity, Water, Internet & Telephone) 80,000,000
Other Expense 25,000,000
TOTAL MONTHLY OPERATING
COST 352,000,000
annual cost increment 8%

34. INVESTMENT
Equipment 8,000,000,000
annual depreciation (1,600,000,000)
NON DEPRECIATED SETUP COST
Consultant (building design) 50,000,000
Consultant (safety) 150,000,000
Others (graphic, legal, tax, permit) 200,000,000
Electricity 100,000,000
Renovation 700,000,000
1,200,000,000

35. area
size 3003m2
Monthly Rent
Per m2
Annual Rent
Expense
YEAR 1 Rp. 165,000 Rp. 5,945,940,000
YEAR 2 Rp. 165,000 Rp. 5,945,940,000
YEAR 3 Rp. 165,000 Rp. 5,945,940,000
YEAR 4 Rp. 175,000 Rp. 6,306,300,000
YEAR 5 Rp. 185,000 Rp. 6,666,660,000

36. LOAN 8.000.000.000
Interest 10%
PRINCIPAL INTEREST PAYMENT OUTSTANDING
month 1 103.309.691 66.666.667 169.976.358 8.000.000.000
month 2 104.170.605 65.805.753 169.976.358 7.896.690.309
month 3 105.038.693 64.937.664 169.976.358 7.792.519.704
month 4 105.914.016 64.062.342 169.976.358 7.687.481.010
month 5 106.796.633 63.179.725 169.976.358 7.581.566.994
month 6 107.686.605 62.289.753 169.976.358 7.474.770.362
month 7 108.583.993 61.392.365 169.976.358 7.367.083.757
month 8 109.488.860 60.487.498 169.976.358 7.258.499.764
month 9 110.401.267 59.575.091 169.976.358 7.149.010.904
month 10 111.321.277 58.655.080 169.976.358 7.038.609.637
month 11 112.248.955 57.727.403 169.976.358 6.927.288.360
month 50 155.146.918 14.829.440 169.976.358 1.779.532.801
month 51 156.439.809 13.536.549 169.976.358 1.624.385.883
month 52 157.743.474 12.232.884 169.976.358 1.467.946.075
month 53 159.058.003 10.918.355 169.976.358 1.310.202.601
month 54 160.383.486 9.592.872 169.976.358 1.151.144.598
month 55 161.720.015 8.256.343 169.976.358 990.761.112
month 56 163.067.682 6.908.676 169.976.358 829.041.097
month 57 164.426.579 5.549.778 169.976.358 665.973.415
month 58 165.796.801 4.179.557 169.976.358 501.546.836
month 59 167.178.441 2.797.917 169.976.358 335.750.035
month 60 168.571.594 1.404.763 169.976.358 168.571.594
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37. (in Rupiah Millions) YEAR 0 YEAR I YEAR II YEAR III YEAR IV YEAR V FORMULA
y = 0 y = 1 y = 2 y = 3 y = 4 y = 5
CASH FLOW FROM LOAN & INVESTMENT
BANK LOAN a 8.000 -1.298 -1.434 -1.584 -1.750 -1.933
EQUIPMENT b -8.000 1.000
CASH FLOW FROM LOAN & INVESTMENT c 0 -1.298 -1.434 -1.584 -1.750 -933 c=a+b
CASH FLOW FROM OPERATION+INTEREST
INFLOW
Revenue From Entrance Fee d 13.666 15.865 16.708 17.550 18.392
Other Revenue e 790 790 876 876 876
SUB TOTAL INFLOW f 0 14.455 16.655 17.584 18.426 19.268 f=d+e
OUTFLOW
Set Up Expense g -1.200
Operating Expense h -4.224 -4.562 -4.927 -5.321 -5.747
Rental Expense i -5.946 -5.946 -5.946 -6.306 -6.667 0
Interest Expense j -742 -606 -455 -290 -106
Provisi (0.75% of Loan) k -60
Marketing & Promotion (5% of Fee Rev) l -683 -793 -835 -878 -920
SUB TOTAL OUTFLOW m -7.206 -11.595 -11.907 -12.524 -13.155 -6.773 m=g+h+i+j+k+l
CASH FLOW FROM OPERATION+INTEREST n -7.206 2.860 4.748 5.060 5.271 12.496 n=f+m
Depreciation Expenses o -1.600 -1.600 -1.600 -1.600 -1.600
PROFIT AFTER DEPRECIATION BEFORE TAX p -7.206 1.260 3.148 3.460 3.671 10.896
TAX (25%) q -315 -787 -865 -918 -2.724 q=25% x p
NET PROFIT AFTER TAX r -7.206 945 2.361 2.595 2.753 8.172 r=p+q
NET CASH FLOW s -7.206 1.247 2.527 2.610 2.603 8.838 s=c+n+q
DISCOUNTED NET CASH FLOW (16%) t -7.206 1.075 1.878 1.672 1.438 4.208 t=s/(1+12%)^y

38. IRR 28.5%
PAYBACK 3 years 4 months
DISCOUNTED PAYBACK (16%) 4 years 3 months
NPV (16%) Rp 3,065 (millions)
PROFITABILITY INDEX 1.43