Chapter 11

Capital Budgeting
Prepared by: Dr Rafiatul Adlin Binti Hj Mohd Ruslan
Learning Objectives
 Discuss the importance of capital budgeting
 Explain and apply the guidelines of capital budgeting
 Identify relevant cash flows
 Understand and able to calculate the capital budgeting
techniques (Payback Period, Net Present Value and Internal
Rate of Return)
Introduction
 Capital budgeting is one of the primary activities of a
company.
 Capital budgeting is a decision making process of selecting
and evaluating long-term investments.
 Companies may expand or diversify by introducing a new
product or entering new business line.
 To make investment decisions regarding new fixed
asset (i.e. capital projects)
Capital Budgeting Process
 Capital budgeting involves the following:
 Generating long term investment proposal
 Estimating the relevant after-tax incremental cash flows for the
project proposals.
 Evaluating cash flows using capital budgeting tchniques
 Select the project that will maximize shareholders’ wealth
 Reevaluating the project from time to time.
Type of Projects

Mutually Exclusive
Independent projects
projects
The projects where a decision
Unrelated projects, can choose
is made to choose only one
both projects
project.
 Capital Budgeting Techniques
 To evaluate two or more projects, and to select the Best Projects.
 Categorized as: • Payback
Non
discounted

 Non-discounted cash flow method, Period

cash flow
method

Categories
-not consider time value of money, capital
budgeting
-Method commonly used are Payback Period techniques
 Discounted cash flow method • NPV and
Discounted
cash flow
IRR
-Uses the Time Value of Money concept,
method

-Future cash flows are discounted to present

-Methods use are Net Present Value (NPV) & Internal Rate of Return
(IRR)
Capital Budgeting Techniques

Evaluation Techniques
Payback Period

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index
Capital Budgeting Techniques
To illustrate the Capital Budgeting Technique, consider the
following projects A & B

     
Project A
  Projects & Cash Flows Annuity Cash Flow
Year A B (annuity is a stream
of equal value cash flows
1 30,000 20,000
2 30,000 30,000 Project B
3 30,000 40,000 Uneven Cash Flow

4 30,000 40,000 Need to Use Different

5 30,000 50,000 Approach
Payback Period
 Payback period measures how quickly the firm can recover its
initial outlay.
 Initial outlay refers to the amount required to start a business or
a project.
 Number of years needed for a project to return its
investment.
 Shorter Payback Period is preferred as the initial outlays are
recovered earlier and reduces risk
 Even/Annuity Cash
Flows
EXAMPLE
 A firm is evaluating a project with an initial outlay of
RM200,000. The project is expected to generate RM60,000
every year for the next five years. Determine the payback
period of the project.
 Solution:
PP = Initial outlay____
Annual cash flow
PP = = RM200,000
RM 60,000
= 3.33 years (3 years and 4 months)
EXAMPLE
Assume the firm in previous example is considering another
project. The relevant cash flows are as given:
RM
Initial outlay 500,000
Uneven Cash
After-tax differential cash flows: Flows
Year 1 to 3 150,000
Year 4 to 5 200,000

Calculate the payback period of the project.

Solution:
Step 1: Calculate the accumulated cash flows
Year Cash flows Accumulated cash
flows

1 150,000 150,000
150,000 + 150,000
2 150,000 300,000 = 300,000

3 150,000 450,000 300,000 + 150,000

= 450,000
4 200,000 650,000

5 200,000 850,000
 Initial outlay RM500,000
METHOD A
Year Cash flows Accumulated cash flows

0 (500,000)
1 150,000 150,000
2 150,000 300,000
3 150,000 450,000

4 200,000 650,000

5 200,000

Payback period = 3 + (RM500,000-RM450,000)

RM200,000
= 3.25 years.
 METHOD B

Year Cash flows

0 (500,000) (500,000)

1 150,000 350,000 500,000 - 150,000

= 350,000
2 150,000 200,000 350,000 - 150,000
= 200,000
3 150,000 50,000 200,000 - 150,000
= 50,000
4 200,000 50,000/200,000 = 0.25
5 200,000 Not used in the decision.

Payback period = 3 + 0.25

= 3.25 years
Jati Corporation is evaluating two mutually exclusive projects.
Below is the after-tax cash flows for both projects. Even/Annuity Cash
Flows
YEAR PROJECT C (RM) PROJECT D (RM)

0 (500,000) (480,000)
Uneven
1 50,000 Cash 132,000
Flows
2 150,000 132,000
3 250,000 132,000
4 200,000 132,000
5 100,000 132,000
Calculate the payback period for each project.
Solution (Method A)
Payback Period Project C (uneven cash flows)
Step 1: Calculate accumulated cash flows
YEAR PROJECT C (RM) Accumulated CF

0 (500,000) PPc= 3 + (RM500,000-RM450,000)

RM200,000
1 50,000 50,000 = 3.25 years.
2 150,000 200,000

3 250,000 450,000

4 200,000 650,000

5 100,000 750,000
Solution (Method B)
YEAR

0 (500,000)

1 50,000 450,000

2 150,000 300,000

3 250,000 50,000

4 200,000 50,000/200,000 = 0.25

5 100,000 Not used in the decision.

Payback Period Project D (even cash
flows)
PP = Initial outlay____
Annual cash flow
= 480,000
132,000
= 3.64 years

Therefore, the company should choose Project C because shorter period is

preferred.
PROBLEM 1
 Let’s say that the owner of Perfect Images Salon is
considering the purchase of a new tanning bed.
 It costs $10,000 and is likely to bring in after-tax cash inflows
of $4,000 in the first year, $4,500 in the second year, $10,000
in the 3rd year, and $8,000 in the 4th year.
 The firm has a policy of buying equipment only if the payback
period is 2 years or less.
 Calculate the payback period of the tanning bed and state
whether the owner would buy it or not.
SOLUTION (PROBLEM 1)
Cash Yet to be Percent of Year
Year flow recovered Recovered/Inflow

0 (10,000) (10,000)

1 4,000 (6,000)

2 4,500 (1,500)

0
3 10,000 (recovered) 15%
Not used in
4 8,000 decision

Payback Period
= 2.15yrs. Reject,  2 years
Net Present Value
 To analyse the profitability of a projected investment or
project.
 Decision criteria:
 Accept a project if the NPV is higher or equal to zero (positive).
 Reject a project if the NPV is negative.

NPV = PV of Cash flows – Initial Outlays

Jati Corporation is evaluating two mutually exclusive projects.
Below is the after-tax cash flows for both projects.

YEAR PROJECT C (RM) PROJECT D (RM)

0 (500,000) (480,000)
Uneven Even/Annuity Cash
1 50,000 Cash 132,000 Flows
Flows
2 150,000 132,000
3 250,000 132,000
4 200,000 132,000
5 100,000 132,000
The cost of capital is 10%. Calculate the net present value for
each project.
NPV Project C (Annuity/Even cash flows)
YEAR PROJECT C (RM) PVIF @ 10% Present Value

1 50,000 0.9091 45,455

2 150,000 0.8264 123,960
3 250,000 0.7513 187,825
4 200,000 0.6830 136,600
5 100,000 0.6209 62,090
Total PV 555,930
NPV = PV of Cash flows – Initial Outlays
= 555,930 – 500,000
= RM55,930
NPV Project C (Annuity/Even cash flows)
NPV = PV of Cash flows – Initial Outlays
= 132,000 (PVIFA k, n) – 480,000
= 132,000 (PVIFA 10%, 5) – 480,000
= 132,000 (3.7908) – 480,000
= 500,385.60 – 480,000
= RM20,385.60

Therefore, the company should choose Project C because it

has higher NPV than Project D.
Internal Rate of Return (IRR)
 Is used to determine the yield or the rate of return on
investment or a project.
 Used to evaluate the attractiveness of investment or a project.
 To determine the return that will make the NPV equal to zero.
 Decision criteria
 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)
Jati Corporation is evaluating two mutually exclusive projects.
Below is the after-tax cash flows for both projects.

YEAR PROJECT C (RM) PROJECT D (RM)

0 (500,000) (480,000)
1 50,000 132,000
2 150,000 132,000
3 250,000 132,000
4 200,000 132,000
5 100,000 132,000
The cost of capital is 10%. Calculate the internal rate of return
for project D. Do interpolation.
Internal Rate of Return (IRR)
PV of Cash flows = Initial Outlays
132,000 (PVIFA k, n) = 480,000
132,000 (PVIFA k, 5) = 480,000
PVIFA k, 5 = 480,000
132,000
PVIFA k, 5 = 3.64 years
Do interpolation: Look for the value 3.64 in the present value annuity (PVIFA)
table page 419. Refer to row n = 5 (because it is 5 years), the closest figure is
between 3.7908 and 3.6048 which is in column 10% and 12%. Therefore, do
interpolation to find the exact figure.
Interpolation: Formula
A=a 10% = 3.7980
x=b x = 3.6400
C=c
12% = 3.6048
A+ x
A= lower rate A+ x
x = rate that we want to find
C= higher rate
a = factor at lower rate 10% + x (12% - 10%)
b = factor that we get (x) = 11.64%
c = factor at higher rate
Profitability Index

For a project that has an initial cash outflow followed by cash

inflows, the profitability index (PI) is simply equal to the present
value of cash inflows divided by the initial cash outflow:

Total  N PV  of  Future Cash  Flows

PI=
Initial  Inves m ent

When companies evaluate investment opportunities using the PI,

the decision rule they follow is to invest in the project when
the index is greater than 1.0.
PROBLEM (PI)
Calculate the PI for each project. Assume the required rate of
return is 10%
Year Project A Project B

0 - 10,000 - 5,000

1 3,000 3,000

2 7,000 4,000

3 9,000 5,000
SOLUTION:
YEAR PROJECT A
CASH FLOW PVIF (10%) TOTAL PV
1 3,000
2 7,000
3 9,000
TOTAL NPV

Total  N PV  of  Future Cash  Flows

PI=
Initial  Inves m ent
SOLUTION:
YEAR PROJECT B
CASH FLOW PVIF (10%) TOTAL PV
1 3,000
2 4,000
3 5,000
TOTAL NPV

Total   N PV  of  Future Cash  Flows

PI=
Initial  Invesm ent
Problem 5
Year Cash Flow A Discounted at 10@ FV
PI a = 15,274/10000
1 3,000 0.90909 2727 = 1.5274
2 7,000 0.82645 5785
3 9,000 0.75132 6762
TOTAL FV 15,274

Year Cash Flow B Discounted at 10@ FV PI b = 9790/5000

1 3,000 0.90909 2727 = 1.958
2 4,000 0.82645 3306
3 5,000 0.75132 3757
TOTAL FV 9790