CHAPTER 9

CAPITAL BUDGETING

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 The process of decision making with respect to
investment in fixed assets.

When???
Importance to a manager
➢ Replacement of fixed
➢The decisions continue for
assets
many years, must make
➢Expansion of existing
carefully.
product or market
➢Expansion into new
➢May Lose the market to
product
competitors if it has
inadequate fixed assets

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 Decision Criteria
Mutually Exclusive Projects
❖ Projects that compete with
another where only one
decision (project) can be
accepted.
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Independent Projects
❖ Project where cash
flows are unrelated or
independent of another.
❖The acceptance of ones
does not eliminate the
others.
 Payback Net Internal
Period Present Rate of
Value Return

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 The number of years needed to recover the initial cash outlays.

Payback Period
Disadvantages
Advantages ✓ Ignore time value of
✓ Easy to visualize and money
calculate ✓ Ignore the returns
beyond the payback period
✓ A bad profitability
Decision Criteria indicator

Independent Project Mutually Exclusive Project

• Accept the project where payback is • Accept project with a shorter
less than the minimum acceptable payback period and less than the
payback period. minimum acceptable period.
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 Example
Hanim Sdn Bhd is considering a major expansion of its product line and has estimated the
following cash flow associated with the expansion. It has 2 mutually exclusive products that
will be considered for expansion. The initial outlay would be RM 170, 000. Both projects
would generate the following cash flow. The appropriate require rate of return is 10%. Given
the following cash flow. Determine which product should be accepted.

Product X ProductY
Initial Outlay RM 170, 000 RM 170, 000
Year
1 50, 000 20, 000
2 50, 000 80, 000
3 50, 000 90, 000
4 50, 000 90, 000

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 Payback Period X = Initial Outlay
Cash Flow
= RM 170, 000
RM 50, 000
= 3.4 years

Payback Period Y =2 + RM 70, 000

RM 90, 000
= 2.7 years

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 The method that finds the present value of the future cash flow of a project by
discounting the cash flow at the cost of capital and subtract it from the initial net
outlay of the project

Net Present Value

NPV = PV Cash Flow – Initial

Decision Criteria
Outlay

Independent Projects
Mutually Exclusive Projects
❖ Accept all project that have
❖Accept project with a higher NPV
a positive NPV

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 Example
Hanim Sdn Bhd is considering a major expansion of its product line and has estimated the
following cash flow associated with the expansion. It has 2 mutually exclusive products that
will be considered for expansion. The initial outlay would be RM 170, 000. Both projects
would generate the following cash flow. The appropriate require rate of return is 10%. Given
the following cash flow. Determine which product should be accepted.

Product X ProductY
Initial Outlay RM 170, 000 RM 170, 000
Year
1 50, 000 20, 000
2 50, 000 80, 000
3 50, 000 90, 000
4 50, 000 90, 000

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 Given, required rate of return = 10%
NPV = PV of cash flow – Initial Outlay

Product X
NPV = PV of Cash Flow – Initial Outlay
= Annuity (PVIFA i, n) – Initial Outlay
= 50, 000 (PVIFA 10%, 4) – Initial Outlay
= 50, 000 (3.1699) – 170, 000
= 158, 495 – 170, 000
= (RM11, 505)

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 Product Y

Year C/Flow PVIF 10% PV

1 20, 000 0.9091 18, 182
2 80, 000 0.8264 66, 112
3 90, 000 0.7513 67, 617
4 90, 000 0.6830 61, 470

RM 213, 381

NPV = PV of Cash Flow – Initial Outlay

= 213, 381 – 170, 000
= RM43, 381

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 Decision

Product X Product Y
Payback Period 3.4 years 2.7 years
Net Present Value (RM11, 505) RM43, 381
Not choose Choose
Hanim Sdn Bhd should choose Product Y to expand because
product Y provide shorter payback period and positive and higher
net present value (NPV).

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 The discount rate that equates the present value of the project’s
future free cash flow with the project’s initial outlay

Internal Rate of Return

How to determine IRR PV (inflows) = PV (Initial Investment)

Cash Flow Constant Uneven Stream of Cash Flows

Use a simulated annuity

PVIFA IRR, n = Initial Outlay ❖The average cash flow of
Annuity the project
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 Mutually Exclusive Projects Independent Project
➢Accept project with highest IRR ➢Accept all projects with
than required rate of return. highest IRR than required rate of
return. IRR

Decision Criteria

Internal Rate of Return

Disadvantages
Advantages
➢Requires detailed long term
➢Use free cash flows
forecast of project’s cash flows
➢Recognize time value of money
➢Involve tedious calculation
➢Consistent with the firm’s goal of
➢Possibility of multiple IRR
shareholder wealth maximization.

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