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09.1 Module in Financial Management 09
09.1 Module in Financial Management 09
09.1 Module in Financial Management 09
Learning Objectives
Capital Budgeting
Look at the two words “Capital Budgeting”. With your partner, breakdown
the meaning of the two words.
Capital
means___________________________________________________
Budgeting
means________________________________________________
Now, combine the two words and try to come up with your own definition
of capital budgeting:
Presentation of Contents
CAPITAL BUDGETING
The process of identifying, evaluating, planning, and financing capital
investment projects of an organization.
Cost of Capital – the cost of using funds; it is also called the hurdle rate of
Advantages:
1. Payback is simple to compute and easy to understand. There is no need
to compute or consider any interest rate. One just has to answer the
question: “How soon will the investment cost be recovered”?
2. Payback gives information about the project’s liquidity.
3. It is good surrogate for risk. A quick payback period indicates a less
risky project.
Disadvantages:
1. Payback does not consider the time value of money. All cash receive
during the payback period is assumed to be equal value in analyzing the
project.
2. It gives more emphasis on liquidity rather than on profitability of the
project. In other words, more emphasis is given on return of investment
than the return on investment.
3. It ignores the cash flows that may occur after the payback period.
Bail-out Period
Cash recoveries include not only the operating net cash inflows but also the
estimated salvage value or proceeds from sale at the end of each year of the
Advantages:
1. The ARR computation closely parallels accounting concepts of income
measurement and records.
2. It facilitates re-evaluation of projects due to the ready availability of data
from the accounting records.
3. This method considers income over the entire life of the project.
4. It indicates the projects profitability.
Disadvantages:
1. Like the payback and bail-out methods, the ARR method does not
consider the time value of money.
2. With the computation of income and book value based on the historical
cost accounting data the effect of inflation is ignored.
Advantages:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Assumes discount rate as the reinvestment rate
4. Easy to apply.
Disadvantages
1. It requires predetermination of the cost of capital or the discount rate to
be used.
2. The net present values of different competing projects may not be
comparable because of different magnitudes or sizes of the projects.
Profitability Index
When the cash flows are uniform, the IRR can be determined as follows:
1. Determine the present value factor (PVF) for the internal rate of return
(IRR) with the use of the following formula:
When the cash flows are not uniform, the IRR is determined using trial-and-
error method.
Advantage:
1. Emphasizes cash flows
2. Recognizes the time value of money
3. Computes the true return of the project
Disadvantages:
Payback Reciprocal
A reasonable estimate of the internal rate of return,
Feedback
a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each
project.
b. Assuming the projects are independent, which one(s) would you
recommend?
c. If the projects are mutually exclusive, which would you recommend?
d. Notice that the projects have the same cash flow timing pattern. Why is
there a conflict between NPV and IRR?