CH 12 Capital Budgeting

Chapter 12
Capital Budgeting
⚫ Concept of Capital Budgeting

⚫ Capital Budgeting Process
⚫ Capital Budgeting Techniques
(i.e. Payback Period, Net Present Value and
Internal Rate of Return)
Concept of Capital Budgeting
⚫ To make investment decisions regarding new
fixed asset (i.e. capital projects)
⚫ The fixed assets is expected to provide future
cash flow (i.e. income) to the firm
⚫ Firm need to evaluate the Investment so that
it can increase the Firm’s Value
⚫ By doing Capital Budgeting, Firm has an
Option whether to Accept or to Reject the
projects
Concept of Capital Budgeting
Types of Capital Projects
⚫ Replacement projects
⚫ Expansion projects
⚫ New projects
⚫ Projects required by law
Forms of Capital Projects

⚫ Independent Projects, accept-reject decision will not
affect other project
⚫ Mutually exclusive, need to choose between two
projects which is similar in nature
Capital Budgeting Techniques
⚫ To evaluate 2 or more projects, and to select the Best
Projects (i.e. increase Firm’s Value)
⚫ Categorized as:
⚫ Non-discounted cash flow method,
-not consider Time Value of Money,
-Method commonly used are Payback Period and
Average Rate of Return
⚫ Discounted cash flow method

-Uses the Time Value of Money concept,
-Future cash flows are discounted to present
-Methods use are Net Present Value (NPV), and
Internal Rate of Return (IRR)
Capital Budgeting Techniques
To illustrate the Capital Budgeting Technique, consider
the following projects A & B
Projects & Cash Flows Project A

Year A B Annuity Cash Flow
0 -100,000 -120,000
Project
1 30,000 20,000 Uneven Cash Flow
2 30,000 30,000
Need to Use Different
3 30,000 40,000 Approach
4 30,000 40,000
5 30,000 50,000
Payback Period
⚫ Payback period is the number of years
required to recover the Original investment
or the Initial Outlay (IO)
⚫ Shorter Payback Period is preferred as the
initial outlays are recovered earlier and
reduces risk
PP = IO - ∑ Cash flows (Uneven cashflows)

PP = IO / Annuity (Annuity cashflows)
Payback Period
Payback Period For Project A (i.e. Annuity)
= IO / Annuity
= 100,000/30,000 = 3.33 years @ 3 yr 4 mth
Payback Period For Project B

= 120,000 - (20,000 + 30,000 + 40,000)
= 30,000
= 3 yr + (30,000/40,000) = 3.75 years @ 3yr 9 mth
•Independent Projects, Accept Both Projects if PP

lower than Required PP
•Mutual Exclusive, choose the shortest PP
Net Present Value (NPV)
⚫ Is the Present value of Future Cash flows
⚫ Discounted at Required Rate Of Return
⚫ Cash Flows may be in Annuities or Uneven
⚫ Decision
⚫ Positive or Above Zero NPV, means Accept the
Project
⚫ Negative NPV, Reject the Project
NPV = PV of Cash flows – Initial Outlays
NPV = PVA cash flows – Initial Outlays

Net Present Value (cont)
⚫ Advantages of NPV
⚫ It uses cash flows
⚫ It uses Time Value Of Money
⚫ Consider the Risk Factors
⚫ Disadvantages of NPV
⚫ Difficult to understand
⚫ Estimation of cash flow with accuracy
⚫ Estimation of discount rate (ie required rate of return)
To illustrate, let say firm’s Cost of Capital is 10%
NPV For Project A (i.e. Annuity)
NPV = PVA of cash flows – IO

= Annuities of CF (PVIFA k,n ) – IO
= 30,000 (PVIFA 10,5 ) – 100,000
= 30,000 (3.7908) – 100,000
= RM 113,724 – 100,000
= RM 13,724
NPV For Project B (i.e. Uneven Cash flow)
NPV = PV of cash flows – IO
= Yearly CF (PVIF k,n ) – IO
= [20,000 (PVIF 10,1 ) + 30,000 (PVIF 10,2 ) +
40,000 (PVIF 10,3 ) + 40,000 (PVIF 10,4 ) +
50,000 (PVIF 10,5 )] – 120,000
NPV For Project B (i.e. Uneven Cash flow)
NPV = PV of cash flows – IO
= Yearly CF (PVIF k,n ) – IO
= [20,000 (0.9091) + 30,000 (0.8264) +
40,000 (0.7513) + 40,000 (0.6830) +
50,000 (0.6209)] – 120,000
= RM 131,391 – 120,000
= RM 11,391
•Independent Projects, Accept Both Projects because
NPV > 0 and Positive
•Mutual Exclusive, choose the Project A (i.e. Higher NPV)
⚫ Is the discount rate equating the PV of future cash
inflows and initial investment of the projects
⚫ Considered to be the Actual Rate of Return of a
projects (i.e. when NPV at Zero)
⚫ Decision
⚫ IRR > Cost of Capital , means Accept the Project
⚫ IRR < Cost of Capital, Reject the Project
PV of Cash flows = Initial Outlays

(to find the Rate that Equate the Two)
⚫ Advantages of IRR
⚫ Easy to understand
⚫ It uses Time Value Of Money
⚫ Consider the Risk Factors
⚫ Disadvantages of IRR
⚫ can lead to confusion when dealing with uneven
cash flows
⚫ lead to improper decision particularly mutual
exclusive projects
To illustrate, the Cost of Capital is 10%
IRR For Project A (i.e. Annuity)
0 = PV of cash flows – IO
IO = Annuities of CF (PVIFA IRR,n )
100,000 = 30,000 (PVIFA IRR,5 )
3.3333 = (PVIFA IRR,5 )
From PVIFA table, look at Year 5, the factor of 3.3333 is in

between 15% & 16%
To solve
Trial & Error Process (i.e. Interpolation)
At 15%, the factor is 3.3522
At 16%, the factor is 3.2743
IRR = 15 % + (0.0189/0.0779) (16 – 15)

= 15. 24%
Where,
0.0189 = 3.3522 – 3.3333
0.0779 = 3.3522 – 3.2743
IRR For Project B (i.e. Uneven Cash flow)
Let say we take 14% as the IRR
PV of cash flows
= Yearly CF (PVIF IRR,n )
= [20,000 (PVIF 14,1 ) + 30,000 (PVIF 14,2 ) +
40,000 (PVIF 14,3 ) + 40,000 (PVIF 14,4 ) +
50,000 (PVIF 14,5 )]
= RM 117, 283
With IRR of 14%, the PV of Cash flow is RM 117,283 which

is Smaller than IO of RM 120,000
You need to use Smaller rate to get higher PV of cash

flows, which is 12%
Apply 12% as the IRR to find the PV of Cash flows
PV of cash flows
= Yearly CF (PVIF IRR,n )
= [20,000 (PVIF 12,1 ) + 30,000 (PVIF 12,2 ) +
40,000 (PVIF 12,3 ) + 40,000 (PVIF 12,4 ) +
50,000 (PVIF 12,5 )]
= RM 124,036
With IRR of 12%, the PV of Cash flow is RM

124,036 which is Higher than IO of RM 120,000
Trial & Error Process (i.e. Interpolation)
At 12%, the value is RM 124,036
At 14%, the value is RM 117, 283
IRR = 12 % + (4,036/6,753) (14 – 12)

= 13.19%
Where,
4,036 = RM 124,036 - RM 120,000
6,753= RM 124,036 – RM 117, 283
•Independent Projects, Accept Both Projects because

IRR > Cost of Capital (i.e. 10%)
•Mutual Exclusive, choose the Project A (i.e. Higher IRR)
Summary
Methods Project A Project B Select
Payback 3 yr 4 mth 3 yr 9 mth Project A
NPV RM 13,724 RM 11,391 Project A
IRR 15.24% 13.19% Project A

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CH 12 Capital Budgeting

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Chapter 12

⚫ Concept of Capital Budgeting

Forms of Capital Projects

⚫ Discounted cash flow method

Projects & Cash Flows Project A

PP = IO - ∑ Cash flows (Uneven cashflows)

Payback Period For Project B

•Independent Projects, Accept Both Projects if PP

NPV = PV of Cash flows – Initial Outlays

NPV = PVA cash flows – Initial Outlays

NPV = PVA of cash flows – IO

PV of Cash flows = Initial Outlays

From PVIFA table, look at Year 5, the factor of 3.3333 is in

IRR = 15 % + (0.0189/0.0779) (16 – 15)

With IRR of 14%, the PV of Cash flow is RM 117,283 which

You need to use Smaller rate to get higher PV of cash

With IRR of 12%, the PV of Cash flow is RM

IRR = 12 % + (4,036/6,753) (14 – 12)

•Independent Projects, Accept Both Projects because

Methods Project A Project B Select

Payback 3 yr 4 mth 3 yr 9 mth Project A

NPV RM 13,724 RM 11,391 Project A

IRR 15.24% 13.19% Project A

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