CAPITAL BUDGETING

- The procedure of analyzing potential fixed assets investments or long term investment
- decision making process related to investment in fixed assets
- An investment is worth taking if it creates value for its owners

2 types of projects:
(i) Independent projects
- project that has no bearing on the adoption of other project whether to accept or reject
- acceptance of one project has no effect on the acceptance/rejection of the other project

(ii) Mutually exclusive projects

- project that only one project can be accepted/selected
- acceptance of one project has an effect on the acceptance/rejection of the other project

3 elements to be considered when accepting any investment proposals:

(i) net outlay / initial investment/ project cost
(ii) cash inflows
(iii) economic life

Capital budgeting techniques:

Techniques Explanation Decision rule

Payback period - refers to how long (the length of time) it takes
for the cash flows generated by a project to
cover the initial investment
- accept project that gives lower
payback period or accept project
if its calculated payback period is
less than some prespecified
number of years

Net present value - Measure of how much value is created or - accept project that gives the
added by undertaking an investment highest NPV
- The difference between an investment’s
market value and its cost Accept if NPV > 0 and reject if
- This method finds the present value of the NPV < 0
future cash flow of a project discounting the
cash flow at a cost of the capital and subtract
from it the initial net outlay/investment of the
project
- NPV = total of present value of future cash
flow – initial investment

Internal rate of return - it is the discount rate which equates the total - accept project if IRR > cost of
PV of cash inflows to the initial investment capital and reject if IRR is <
- IRR is the point where NPV is equal to 0 or cost
total of present value equal to initial of capital
investment
PV (inflow) = initial investment or NPV = 0

Profitability index - the present value of an investment’s future - accept project that gives the
cash flows divided by its initial cost highest PI or accept if PI > 1 and
- it is the benefit cost ratio reject of PI < 1
PI = PV of cash flows / initial cost

1
 Example:

Assume there are 2 different projects:

Project A: Uneven/varies cash flows Project B: Constant cash flows

Year 0 (RM100,000) Year 0 (RM100,000)
Year 1 RM60,000 Year 1 RM40,000
Year 2 RM30,000 Year 2 RM40,000
Year 3 RM40,000 Year 3 RM40,000

Cost of capital / discount rate / required rate of return / WACC = 10%

Uneven cash flows Constant cash flows

Payback period: Payback period:

CF (RM) Acc. CF(RM) Payback period = initial outlay

Yr 1 60,000 60,000 Annual cash flows
2 30,000 90,000 2 yrs = 100,000
3 40,000 need 10,000 = 0.25 40,000
40,000 = 2.5 yrs

Payback period = 2 + 0.25 = 2.25 yrs

Net Present Value: Net Present Value:

= Total PV – Initial outlay = Total PV – Initial outlay
= Cash flow (PVIFA 10%,3) – initial outlay
Year Cash flow (PVIF = 40,000 (2.4869) – 100,000
10%,n) = 99,476 – 100,000
1 RM60,000 0.9091 54,546 = (524)
2 RM30,000 0.8264 24,792
3 RM40,000 0.7513 30,052
Total PV 109,390
Initial outlay - 100,000
NPV 9,390

Profitability Index: Profitability Index:

PI = Total PV PI = Total PV
Initial outlay Initial outlay
= 109,390 = 99,476
100,000 100,000
= 1.0939 = 0.99476

2
 Internal Rate of Return:

A point where NPV = 0 or total PV is equal to

initial outlay

Step 1
= Cash flow (PVIFA IRR,3) = initial outlay
= 40,000 (PVIFA IRR,3) = 100,000
(PVIFA IRR,3) = 100,000
40,000
= 2.5000

Find 2.5000 from the PVIFA table (n = 3 years), it

falls between 9% and 10%.

Step 2
Do interpolation to get the exact rate.

9% 2.5313
IRR 2.5000
10% 2.4869

IRR – 9% = 2.5000 – 2.5313

10% - 9% 2.4869 - 2.5313
IRR – 9% = - 0.0313
1% - 0.0444
IRR – 9% = 0.7050
1%
IRR = ( 0.7050 x 1% ) + 9%
IRR = 0.0971 or 9.71%

CONCLUSION:

Based on the above calculations, it can be concluded that Project A should be chosen based on the
following reasons:

i) Lower payback period

ii) Positive Net Present Value
iii) Profitability Index is more than 1.00
iv) Internal Rate of Return is higher than the cost of capital