FFM

1. CHAPTER 5
CAPITAL BUDGETING

2. DEFINITIONS
 Long term planning for making and financing
proposed capital outlays
 Concerned with the allocation of the firms
source financial resources among the
available opportunities
 Consideration of investment opportunities
involves comparison of the expected future
streams of earnings from a project with the
immediate and subsequent streams of earning
from a project

3. IMPORTANCE OF CAPITAL
BUDGETING
 Huge investments ( requires huge investments
of funds, but available funds are limited, thus
need to control its capital budgeting)
 Long term ( long term and permanent in
nature; higher risks, need higher care in
planning)
 Irreversible (not changed back; once
purchased, different to dispose off the assets)
 Long term affect ( reduce cost and increase
revenue in long term, which will bring
significant changes in the profit of the

4. CAPITAL BUDGETING
PROCESS
 Identification of various investment proposals
 Screening or matching the proposals
 Evaluation
 Fixing property
 Final approve
 Implementing
 Performance review of feedbacks

5. EXAMPLES OF CAPITAL
EXPENDITURES
 Purchase of fixed assets such as land &
building, plant & machinery etc.
 The expenditure relating to addition
,expansion, improvement and alteration to
fixed assets
 The replacement of fixed assets
 Research and development project

6. METHODS OF CAPITAL
BUDGETING EVALUATIONS
 Payback period
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Modified IRR (MIRR)

7. PAYBACK PERIOD

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠
 Is the time required to recover the initial
investment in a project
 Advantages
 Easy to calculate and simple to understand
 Provides more further improvement over
accounting rate of return
 Reduce possibility of loss on account of
obsolescence

8. PAYBACK PERIOD
 Disadvantages
 Ignores the time value of money
 Ignores all cash inflows after the payback period
 Misleading evaluations of capital budgeting
 Accept/ Reject criteria ( if actual payback
period is less than pre-determined payback
period, the project will be accepted)

9. PAYBACK PERIOD
 Exercise 1 : Project cost is RM30,000 and the
cash inflows are RM10,000, the life of the
project is 5 years. Calculate the payback
period.
 Exercise 2: Project costs RM2,000,000 and
yields annually a profit of RM300,00 after
depreciation at 12.5% but before tax at 50%.
Calculate the payback period if the project is
for 5 years.

10. PAYBACK PERIOD
 Exercise 3: Projects require an initial cash
outflows of RM25,000. The cash inflows for 6
years are as below:
Year Cash Inflows
(RM)
1 5,000
2 8,000
3 10,000
4 12,000
5 7,000
6 3,000

11. Payback Period
 Mutually Exclusive projects –a set of projects
where only one can be accepted
 Independent projects –projects whose cash
flows are not affected by the acceptance or
nonacceptance of other projects

12. NET PRESENT VALUE
 Method of ranking investment proposals using
NPV, which equal to the PV of future net cash
flows, discounted at the marginal cost of capital
 Cash inflows are considered with the time value of
the money
 Summation of the present value of cash inflows
and present value of cash outflows
 NPV= PV of inflows – PV of outflows
 Advantage
 Recognize the time value of money
 Considers total benefits arising
 Best method for selecting mutually exclusive projects
 Helps to achieve the maximization of shareholders’
wealth

14. NET PRESENT VALUE
 Disadvantage
 Difficult to understand and calculate
 Need the discount factors
 Not suitable for the projects having different
effective lives
 Accept/reject criteria – PV cash inflows > PV
cash outflows

15. NET PRESENT VALUE
 Exercise 1: From the following information,
calculate the Net Present Value of the two
project and suggest which of the two projects
should be accepted a discount rate of 10%.
Year Project X Project Y
1 RM5,000 RM20,000
2 RM10,000 RM10,000
3 RM10,000 RM5,000
4 RM3,000 RM3,000
5 RM2,000 RM2,000
Project X Project Y
Initial investment RM20,000 RM30,000
Estimated life 5 years 5 years

16. NET PRESENT VALUE
 Exercise 2: The following are the cash inflows
and outflows of a certain project. Calculate the
Net Present Value with a discount factor of
10%.
Year Outflows Inflows
0 RM175,000 -
1 RM550,000 35,000
2 - RM45,000
3 - RM65,000
4 - RM85,000
5 - RM50,000

17. Internal Rate of Return
 Method of ranking investment proposals using
the rate of return on an investment, calculated
by finding the discount rate that equates the
PV of future cash inflows to the project’s cost.
 The discount rate that force the PV of a
project’s inflows to equal the PV of its costs.
 Forces NPV to be zero
 Hurdle rate –cost of capital ; discount rate that
the IRR must exceed if a project is to be
accepted

19. Modified IRR
 Discount rate at which the PV of a project’s
cost is equal to the PV of its terminal value
 Terminal value –sum of the FV of the cash
inflows, compounded at the firm’s cost of
capital

21. END OF
CHAPTERS