PREPARED BY: MS SHAZ

Learning Outcomes
• Understand the importance of capital budgeting and decision making, and explain
inputs used in capital budgeting
• Use the accounting rate of return and payback period methods to make capital
investment decisions
• Understand the time value of money and compute the present and future values
• Use the net present value (NPV) and internal rate of return (IRR) methods to make
capital investment decisions
• Understand the advantages and disadvantages of various capital budgeting methods
• Understand the risks in capital budgeting
 What is Capital Budgeting?
• Capital budgeting is a decision that involves broad strategic aspects
of the company, in which managers analyze alternative long-term
investments.
• Examples of capital budgeting decisions:

Launch a new plant or plant expansion

Purchase new machinery
Equipment replacement
Equipment selection
 What is Capital Budgeting? (cont.)

• Nature of a capital budgeting decision:

(a) Outlays of large amounts of resources
(b) Non-reversible
(c) Strategic and risky
Capital Budgeting Evaluation Process
a) Identify potential capital investments
b) Forecast future net cash flow
c) Analyze potential investment
d) Choose among alternative investments
when the resources are not sufficient to
fund all profitable projects
e) Perform post-audits after making capital
investment
Capital Budgeting Evaluation Process
(cont.)
There are two main types of
capital budgeting decisions:

Screening Decisions Preference Decisions

Pertain to whether or Attempt to rank

not some proposed acceptable
investment is alternatives from the
acceptable; these most to least
decisions come first. appealing.
 Capital Budgeting Decisions

a. Accounting b. Payback
rate of return period

Methods used to evaluate

capital expenditure decisions

c. Net present d. Internal rate

value of return
Capital Budgeting Decisions (cont.)
Mattel is evaluating a proposal to invest in a new children’s
MP3 product that would require an up-front investment of
$1,000,000. The product’s estimated life cycle is five years,
Mattel estimates the new product’s income over the next five
years as follows:
Sales Revenue $ 700,000
Less: Cash Operating Costs (320,000)
Depreciation (200,000)
Pre-Tax Income 180,000
Less: Taxes @ 30% (54,000)
Net Income $ 126,000

Should Mattel invest in this project?

 Accounting Rate of Return

Average Initial Accounting

Annual ÷ Investment = Rate of
Net Income /2 Return

$1,000,000 /
$126,000 ÷ 2 = 25.2%

Average Annual
Net Income
Accounting Rate of Return (cont.)

Decision rule:
Accept the project if its ARR is greater than
the company’s target rate of return;
otherwise, reject it.
 Accounting Rate of Return (cont.)
Pros Cons
 Simple  The time value of money is
ignored.
 Intuitive
 The accounting rate of
return is based on net
income instead of cash
flow.
 Alternative accounting
methods may have an
impact on reported net
income.
Payback Period
• Using cash flow numbers rather than accrual accounting operating incomes.

Typical Cash Outflows Typical Cash Inflows

The initial investment Incremental revenues

Additional amount of working capital Reduction in costs

Repairs and maintenance Salvage value

Additional operating costs Release of working capital

 Capital Expenditure Decisions

Mattel is evaluating a proposal to invest in a new children’s

MP3 product that would require an up-front investment of
$1,000,000. The product’s estimated life cycle is five years,
Mattel estimates the new product’s income over
the next five years as follows:

Sales Revenue $ 700,000

Less: Cash Operating Costs (320,000)
Depreciation (200,000)
Pre-Tax Income 180,000
Less: Taxes @ 30% (54,000)
Net Income $ 126,000
Cash Flow vs. Accounting Net Income
Non-cash
expense After-Tax
Cash Flow

=
Net Income Depreciation Net Cash Flow
$126,000 + $200,000 $326,000

$1,000,000 ÷ 5 years = $200,000 per year

 Payback Period
• The payback period is the length of time it takes for an
investment project to recoup its own initial cost out of the
cash receipts that it generates.
• The basic premise of this method is that the more quickly
the cost of an investment can be recovered, the more
desirable is the investment.
• Decision rule: Accept the project if its payback period is
shorter than the company’s target payback period.
 Payback Period (cont.)
Equal Annual Cash Flow
Annual
Initial
Investment ÷ Net Cash = Payback
Period
Flow

Net Income + Depreciation

$1,000,000 ÷ $326,000 = 3.07 years

$126,000 + $200,000
 Payback Period Method

Pros Cons
1. Fails to consider the 1. Provides a simple and
time value of money. intuitive tool for roughly
screening investments.
2. Does not consider a
2. For some firms, it may be
project’s cash flows
essential that an
beyond the payback investment recoup its
period. initial cash outflows as
quickly as possible.
 Time Value of Money

One ringgit received today is

worth more than one ringgit
received a year from now
because the dollar can be
invested to earn interest.

For example RM1,000 today,

invested at 10%, will be worth
RM1,100 in one year.
Discounted Cash Flow Methods

Now let’s look at capital budgeting methods

that consider the time value of cash flows:

Net Present Internal Rate

Value (NPV) of Return (IRR)
 Net Present Value (NPV)

Net present value analysis emphasizes on

discounted cash flows.

The reason is that accounting net income is

based on accruals that ignore the timing of
cash flows into and out of an organization.
 Net Present Value (NPV) (cont.)

 Choose a discount rate k – the

minimum required rate of return.

 Calculate the present

value of annual net cash flows CFt.

CF1 CF2 CFn n

CFt
NPV = CF0 + +
(1 + k )1 (1 + k ) 2
+  + =∑
(1 + k ) n t =0 (1 + k )t
Net Present Value (NPV) (cont.)
Decision Rule under NPV
If the Net Present
Value is . . . Then the Project is . . .
Acceptable, since it promises a
Positive . . . return greater than the required
rate of return (discount rate).

Acceptable, since it promises a

Zero . . . return equal to the required rate of
return (discount rate).

Not acceptable, since it promises

Negative . . . a return less than the required rate
of return (discount rate).
Net Present Value (NPV) (cont.)
Let’s return to Mattel’s MP3 proposal. Recall that the up-front
investment is $1,000,000, and the product’s estimated life is
5 years. Mattel’s required rate of return, or hurdle rate,
is 12%. Mattel estimates the new product’s income
over the next five years as follows:

Sales Revenue $ 700,000

Less: Cash Operating Costs (320,000)
Depreciation (200,000)
Pre-Tax Income 180,000
Less: Taxes @ 30% (54,000)
Net Income $ 126,000
Net Present Value (NPV) (cont.)
Equal Annual Cash Flow

Year Cash Flow PV Factor Present Value

0 $ (1,000,000) $ (1,000,000)
1 326,000 × 0.893 = 291,085
2 326,000 × 0.797 = 259,887
3 326,000 × 0.712 = 232,047
4 326,000 × 0.636 = 207,173
5 326,000 × 0.567 = 184,972
Net Present Value = $ 175,165

Since the NPV is positive, we know the rate of return

is greater than the 12 percent discount rate.
 Net Present Value (NPV) (cont.)
Equal Annual Cash Flow

Year Cash Flow PV Factor Present Value

0 $ (1,000,000) $ (1,000,000)
1-5 326,000 × 3.6048 = 1,175,165
Net Present Value = $ 175,165

Year PV Factor
1 0.893
2 0.797
3 0.712 The present value of an annuity of $1
4 0.636 for 12%, 5 years is the sum of the present
5 0.567 value of $1 factors for 12%, 5 years.
Total 3.605
Internal Rate of Return (IRR)

The internal rate of return is the true economic

return earned by the asset over its life. It is computed by
finding the discount rate that makes…

NPV = 0
CF1 CF2 CFn
= CF0 + 1
+ 2
+ +
(1 + IRR) (1 + IRR) (1 + IRR ) n
n
CFt
=∑
t =0 (1 + IRR ) t
Internal Rate of Return (IRR) (cont.)
Decision rule under IRR
Internal Required Positive
>
then
Rate of Rate of NPV
Return Return
Internal Required
=
then Zero
Rate of Rate of
NPV
Return Return

Internal Required
<
then Negative
Rate of Rate of
NPV
Return Return
 Internal Rate of Return Method
Equal Annual Cash Flow
• Find the discount factor:
Investment required
= Present value factor
Net annual cash flows
$1,000,000
= 3.067
$326,000

The present value factor (3.067) is located on the table of

present value of annuity. Scan the 5-year row and locate
the value 3.067. The internal rate of return is
somewhere between 18% and 20%.
Comparing the NPV and IRR Methods
Net Present Value
 The required rate of return
is used as the actual
discount rate
 Any project with a
negative net present
value is rejected
 Easier to adjust for risk
Internal Rate of Return
The required rate of return is
compared to the internal rate
of return on a project
To be acceptable, a project’s
rate of return must be greater
than the cost of capital
Assumes that cash flows are
reinvested at the IRR
 Profitability Index

Project A Project B Project C

Present Value of
Future Cash Flows $ 600,000 $ 810,000 $ 1,200,000
Initial Investment 300,000 450,000 800,000
Net Present Value 300,000 360,000 400,000

Mattel is trying to decide how to prioritize their limited

research and development budget. They are
considering these three independent projects.

How should Mattel prioritize these three projects?

 Profitability Index (cont.)

The profitability index (PI) is an additional tool to

help managers compare investment projects with different sizes.

Profitability Present Value of Initial

Index = Future Cash flows ÷ Investment

Decision rule:
The higher the PI, the more desirable the project.
 Ranking Investment Projects

Project A Project B Project C

Present Value of
Future Cash Flows $ 600,000 $ 810,000 $ 1,200,000
Initial Investment 300,000 450,000 800,000
Net Present Value 300,000 360,000 400,000
Profitability Index 2.0 1.8 1.5

Based on the profitability index, Project A

should be first, followed by Project B, then C.
 Additional Considerations
1. Intangible benefits:
• Increased quality
• Improved safety
• Greater employee loyalty
• More favorable social influence
Additional Considerations
1. Risk issues in capital budgeting
(a) Sensitivity analysis
- Risk arise due to the uncertainty with future financial results.
- Key Input to monitor the project changes
i. Initial outlay for the machine
ii. Sales volume and selling price
iii. Relevant operating costs
iv. Life of the project
v. Financing costs (cost of capital)

(b) How to deal with risky projects

 Post-audit of Investment Projects
• A post-audit is a follow-up evaluation after the project has
been approved to see how well a project’s actual performance
matches the original projections.
• A post-audit is important because:
a) Managers are more likely to submit reasonable and accurate data
when they make investment proposals.
b) The company can dynamically assess the projects and determine
whether to continuously support or terminate existing projects.
c) Managers will improve future investment proposals and
implementation.
IRR FORMULA
REVIEW QUESTION 1
• A company is considering the purchase of a copier that costs
$5,000. Assume a cost of capital of 10 percent and the following
cash flow schedule:

• Year 1: $3,000
• Year 2: $2,000
• Year 3: $2,000
• Determine the project's NPV and IRR.
ANSWER 1
• to determine the NPV, enter the following:
• PV of $3,000 in year 1 = $2,727, PV of $2,000 in year 2 = $1,653,
PV of $2,000 in year 3 = $1,503.
• NPV = ($2,727 + $1,653 + $1,503) − $5,000 = 883.
• You know the NPV is positive, so the IRR must be greater than
10%.
• [3000 ÷ (1 + 0.2)1 + 2000 ÷ (1 + 0.2)2 + 2000 ÷ (1 + 0.2)3] − 5000 =
46 This result is closer to zero (approximation) than the $436
result at 15%. Therefore, the approximate IRR is 20%