capital budgeting

2. At the end of the lesson, the students should be able to:-
4.1 Discuss the capital budgeting
4.2 Explain the capital budgeting process
4.3 Analyze the calculation of capital budgeting techniques:
a) Non discounted payback period
b) Non discounted Accounting Rate of Return (ARR)
c) Net Present Value (NPV)
d) Profitability Index (PI)
e) Internal Rate of Return (IRR)
4.4 Determine the acceptance criteria of project:
a) Non discounted payback period
b) Non discounted Accounting Rate of Return (ARR)
c) Net Present Value (NPV)
d) Profitability Index (PI)
e) Internal Rate of Return (IRR)
4.5 Provide the calculation on the types of investment projects:
a) Independent investment projects
b) Mutually exclusive investment projects
4.6 Provide the explanation and calculation the incremental Cash Flow
4.6.1 explain the guidelines for capital budgeting
4.6.2 calculate project’s free cash flow
a) Initial outlay
b) Annual cash flows
C) Terminal cash flow

3.  Decision making process of selecting and evaluating
long-term investments. Examples include the
decision to replace equipment, to develop new
product, or to build new shop at a new branch of
operations
 It is very crucial for companies to make the right
decisions because these projects require a huge
amount of cash outflow committed for many years.
A right decision will increase the firm’s value as
well as the shareholders’ wealth. A wrong decision
will result in a drop in firm value as well as
shareholders’ wealth.

4.  Capital expenditures are expenditures
creating future benefits.
 A capital expenditure is incurred when a
business spends money either to buy fixed
assets or to add to the value of an existing
fixed asset with a useful life that is longer
than the taxable year.
 Capital expenditures are used by a company
to acquire or upgrade physical assets such as
equipment, property, or industrial buildings.

5.  Capital expenditures is commonly found on the
Cash Flow Statement as "Investment in Plant
Property and Equipment" or something similar in
the Investing subsection.
 The process of planning and managing a firm’s
long-term investments is called capital
budgeting.
 Example of capital budgeting decision:
 TESCO or GIANT decide whether or not to open another
store.
 QS decides whether or not to buy a new photocopy machine.

6. Replacement
Decision
Expansion
Decision
Independent
Project
Mutually
Exclusive
Project

7. Step 1: Identify potential capital investment
Step 2: Forecast future net cash flow
Step 3: Analyze potential investment
i. Screen out undesirable investment using payback or ARR
method
ii. Further analysis using NPV or IRR method.
Step 4: Choose among alternative investment when the
resources are not sufficient to fund all profitable project
Step 5: Perform post-audits after making capital investment.

8. Profitability index(PI)
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period (PP)
Accounting Rate of Return (ARR)

9.  The acceptance of a project does not affect the
acceptance of any other project. A company can
choose to invest in more than one project
because it has more capital.
 Example:
You have RM200,000 in the bank. You decide to
buy a car that costs about RM70,000 and a new
stereo system for your house that costs
RM10,000. The decision to buy the car does not
affect the decision to buy the stereo. You can
decide either to buy one of it or both, as long as
it not over the amount you have.

10.  The decision to invest in one project affects
other projects. Only one project can be choosed
because of limited capital.
 Example:
You have RM200,000 in the bank. You have two
admired cars. One is the Nissan Livina that cost
you RM90,000 and the other one is the Toyota
Wish that cost you RM150,000. In this case, you
can buy only one car. If you decide to buy the
Nissan Livina, automatically you decide not to
buy the Toyota Wish.

11.  The payback period represents the length (amount) of
time that it takes for a company to recover its initial cost
(initial investment or initial outlay) of the project.
 A project is acceptable if PP < PP given or project life.
 Formula 1 =
 Formula 2 = Initial Outlay / Annual Cash flow
Year before IO can be fully
recovered
+
IO – Cumulative Cash flow
before IO fully paid
Cash flow after year IO fully
paid

12.  Independent project – if the firm’s maximum desired
payback period is 4 years, a project is ACCEPTED if
payback period is less than 4 years or equal to 4 years.
 Mutually exclusive project – ACCEPT the project with the
shortest payback period

13. EXAMPLE 1: Differential Cash flow every year
Assume BiorLe Bhd is deciding between two machines, Machine A and
Machine B in order to add capacity to its existing plant. The company
estimates the cash flows for each machine to be as follows:
Calculate the payback period of the two machines using the above cash
flows and decide which new machine BiorLe Bhd should accept.
YEAR MACHINE A
(RM)
MACHINE B
(RM)
0 - 5,000 - 2,000
1 500 500
2 1,000 1,500
3 1,000 1,500
4 1,500 1,500
5 2,500 1,500

14. SOLUTION 1
PRMA = 4 + [(5000 – 4000)/2500)] PRMB = 1 + [2000 – 500)/1500]
= 4.4 years = 2 years
Both machines are not exceed their life year. Machine B, however, has the shortest
payback period and should be accepted.
YEAR MACHINE A
(RM)
CUMULATIVE
CF
MACHINE B
(RM)
CUMULATIVE
CF
0 - 5,000 - 2,000
1 500 500 500 500
2 1,000 1,500 1,500 2,000
3 1,000 2,500 1,500 3,500
4 1,500 4,000 1,500 5,000
5 2,500 6,500 1,500 6,500

15. EXAMPLE 2: Annual Cash flow every year
A firm is evaluating a project with an initial outlay of RM300,000. The
project is expected to generate RM80,000 every year for next 5 years.
Determine the payback period of the project.
SOLUTION 2
PP = IO/ACF
= 300,000 / 80,000
= 3.75 years
If the project is independent project, the firm can choose to invest in
this project since the payback period is shorter than project life.

16. EXAMPLE 3:
Light & Easy Sdn Bhd is considering the following two mutually
exclusive projects, Project A and Project B. Both projects require
RM30,000 for initial investment. The annual after tax cash flows of
these 2 projects are as follows. Decide which project to choose.
Year Project A (RM) Project B (RM)
0 (30,000) (30,000)
1 9,000 15,000
2 9,000 14,000
3 9,000 13,000
4 9,000 12,000
5 9,000 11,000

17.  Simplicity in the calculation
easily to understand by most
user
 Stress on earlier returns. Often
used as an initial screening
process by firms to eliminate the
investment proposal whose
returns do not materialize until
later years
 Reflects the true timing of the
benefits & costs involved in the
capital budgeting project by
using cash flow and not
accounting profits
 Ignore the time value of money,
thus less accurate
 Ignore cash flow occurring after
the payback period
 Biased against long term projects

18.  NPV stress the timing of cash flows
 The cash flows of the project will be discounted at a
specific rate (discount rate, required rate of return
or cost of capital)
 NPV is the difference between the present value of
the project’s annual after tax incremental cash flows
and its initial investment

19.  Decision criteria:-
 Accept if NPV is higher or equal to zero (POSITIVE)
 Reject if NPV is NEGATIVE (project does not make
any profit or returns of project are less than the
discount rate)
 For mutually exclusive project, choose project
with highest NPV (in case both projects are
positive NPV)

20.  Uses cash flow and able to
reflect the true timing of the
flows involved
 Uses the time value of money
concept to compare the benefits
& cost of a project
 Allows the company to know the
exact impact of the project on
the firm’s value. Positive NPV
give increase in value of the firm
 Need to make long term
forecasts of future cash flows
 Need to determine the discount
rate to be used – time consuming

21. EXAMPLE 4:
Light & Easy Sdn Bhd is considering the following two mutually
exclusive projects, Project A and Project B. Both projects require
RM30,000 for initial investment. The company required a minimum
return of 10%. The annual after tax cash flows of these 2 projects
are as follows. Decide which project to choose.
Year Project A (RM) Project B (RM)
0 (30,000) (30,000)
1 9,000 15,000
2 9,000 14,000
3 9,000 13,000
4 9,000 12,000
5 9,000 11,000

22. SOLUTION
NPV PROJECT A RM 5,016.30
NPV PROJECT B RM 21,398.90
PROJECT B IS BETTER THAN PROJECT A
YE
AR
PROJEC
T A (RM)
CUMUL
ATIVE
CF (A)
PVIF PRESENT
VALUE
(A)
PROJECT B
(RM)
CUMULATIV
E CF (B)
PRESENT
VALUE (B)
0 (30,000) (30,000)
1 9,000 9,000 0.9091 8181.90 15,000 15,000 13,636.50
2 9,000 18,000 0.8264 8337.60 14,000 29,000 12,969.60
3 9,000 27,000 0.7513 6761.70 13,000 42,000 9,766.90
4 9,000 36,000 0.6830 6147.00 12,000 54,000 8,196.00
5 9,000 45,000 0.6209 5588.10 11,000 65,000 6,829.90
NPV
35,016.30
(30,000)
5,016.30 NPV
51,398.90
(30,000)
21,398.90

23.  Also known as the benefit / cost method
 PI equals the present value of the future cash flow
divided by initial outlay
 Measures the value that a project creates per dollar
of investment

24.  Positive NPV will have PI more than 1
 Negative NPV will have PI less than 1
 Decision criteria:-
 Accept a project if PI more than or equal to 1
 Independent project – can choose both as long PI
more than 1
 Mutually exclusive project – choose the highest PI

25. SOLUTION
NPV / IO
PROJECT A RM 5,016.30 / 30,000 = 0.17
PROJECT B RM 21,398.90 / 30,000 = 0.71
PROJECT B IS BETTER THAN PROJECT A
YE
AR
PROJEC
T A (RM)
CUMUL
ATIVE
CF (A)
PVIF PRESENT
VALUE
(A)
PROJECT B
(RM)
CUMULATIV
E CF (B)
PRESENT
VALUE (B)
0 (30,000) (30,000)
1 9,000 9,000 0.9091 8181.90 15,000 15,000 13,636.50
2 9,000 18,000 0.9264 8337.60 14,000 29,000 12,969.60
3 9,000 27,000 0.7513 6761.70 13,000 42,000 9,766.90
4 9,000 36,000 0.6830 6147.00 12,000 54,000 8,196.00
5 9,000 45,000 0.6209 5588.10 11,000 65,000 6,829.90
35,016.30
(30,000)
5,016.30
51,398.90
(30,000)
21,398.90

26.  Easy to understand &
communicate
 Uses of cash flows
 Apply time value of money
concept
 Suitable for companies with
limited investment resources
 May be misleading for mutually
exclusive projects

27.  ARR method favors project with high annual rate of
return over the asset’s life.
 ARR is the only method using accounting income
information.
ARR = Average operating income / Average investment

29.  IRR method is used to determine the yield or the
rate of return on an investment or a project
 Calculate the rate of return or the interest rate that
equates the initial outlay of a project cash flow with
the present value of the future net cash flow
 Determine the return when NPV = 0 20%+(3395.5)
12% 1491.55
 Interpolation of IRR
 Decision criteria – choose the project with highest
IRR
IRR =
Lowest
rate of
12%
return
+
+ve NPV – 0 1491.5 X2
0-
12
Highest rate of
return – Lowest
rate of return
+ve NPV – (-ve NPV)
1491.55-(-3395.5)

30. EXAMPLE 6:
Light & Easy Sdn Bhd is considering the following two mutually
exclusive projects, Project A and Project B. Both projects require
RM30,000 for initial investment. The company required a minimum
return of 10%. The annual after tax cash flows of these 2 projects
are as follows. Decide which project to choose.
Year Project A (RM) Project B (RM)
0 (30,000) (30,000)
1 9,000 15,000
2 9,000 14,000
3 9,000 13,000
4 9,000 12,000
5 9,000 11,000

31.  Uses cash flows & able to reflect
the true timing of the benefits &
cost involved with a project
 Applies the concept time value
of money thus allows comparison
of project cash flows in a logical
manner
 IRR is much related to NPV &
usually leads to identical
decisions
 Easy to understood – stresses the
rate of return a project earns
 Tedious & time consuming – trial
& error basic to determine the
IRR
 May result in a wrong decision in
the case of mutually exclusive
projects

32. 1. Payback Period
maximum payback period < PP: proposal accepted
maximum payback period > PP: proposal rejected
1. Net present value
NPV > 0: proposal accepted
NPV < 0: proposal rejected
1. Profitability index
PI > 1.0: proposal accepted
PI < 1.0: proposal rejected
1. Internal rate of return
IRR project > required rate of return : proposal accepted
IRR project < required rate of return : proposal rejected
1. Accounting rate of return
ARR > Benchmark = Accept
Mutual investment = choose highest ARR