TOPIC 7

TECHNIQUES IN CAPITAL BUDGETING

 CONTENTS

 What is Capital budgeting?

 Capital budgeting criteria
1. Payback period (PP)
2. Discounted payback period (DPP)
3. Net present value (NPV)
4. Profitability index (PI)
5. Internal rate of return (IRR)
 CAPITAL BUDGETING

 Capital budgeting: the decision making process with

respect to investment in fixed assets (long-term
assets)
 Example: Suppose our firm must decide whether to
purchase a new machine for RM125,000. How do
we decide?
 Will the machine be profitable?
 Will our firm earn a high rate of return on the investment?
 CAPITAL BUDGETING

 How do we decide if a capital investment project

should be accepted or rejected?
 We must do some evaluations on the project. The
ideal evaluation method should:
i. Include all cash flows that occur during the life of the
project
ii. Consider the time value of money
iii. Incorporate the required rate of return on the project
 CAPITAL BUDGETING

Firms invest in 2 categories of projects:

1) Independent projects
Do not compete with each other. A firm may accept none,
some or all from among a group of independent projects

2) Mutually exclusive projects

Compete against each other. The best project from among a
group of acceptable mutually exclusive projects is selected
 CAPITAL BUDGETING CRITERIA

 In determining the acceptance or rejection of capital

budgeting proposals, we can use these 5 capital
budgeting criteria:
1. Payback period (PP)
2. Discounted payback period (DPP)
3. Net present value (NPV)
4. Profitability index (PI)
5. Internal rate of return (IRR)
 1) PAYBACK PERIOD
 Meaning: Number of years needed to recover the initial cash
outlay of a capital budgeting project.

 Benefits:
• Uses cash flows rather than accounting profits
• Easy to compute and understand
• Useful for firms that have capital constraints

 Drawbacks:
• Ignores the Time Value of Money (TVM)
• Does not consider cash flows beyond the payback period
• Selection of the maximum acceptable payback period is
subjective
 EXAMPLE
Years Project A Project B
0 (RM500) (RM1,000)
1 RM150 RM350
2 RM150 RM450
3 RM150 RM500
4 RM150 RM550
5 RM150 RM600

 If you require a 3 years’ payback period, which project would

be accepted?
PROJECT A
450 (50) = remaining balance
(500) 150 150 150 150 150

0 1 2 3 4 5

PROJECT B
800 (200) = remaining balance
(1000) 350 450 500 550 600

0 1 2 3 4 5

Payback period A: 3 + 50/150 = 3.33 years

Payback period B: 2 + 200/500 = 2.4 years
 PAYBACK PERIOD

 Payback period A: 3 + 50/150 = 3.33 years

 Payback period B: 2 + 200/500 = 2.4 years

 ACCEPT if PP < or = maximum acceptable PP

 REJECT if PP > maximum acceptable PP

Thus, Project B would be accepted because it’s payback period

is less than 3 years (maximum acceptable payback period)
 EXERCISE
Calculate the payback period for each project.
Years Project A Project B
0 (RM10,000) (RM10,000)
1 RM2,000 RM4,000
2 RM3,000 RM4,000
3 RM4,000 RM4,000
4 RM5,000 RM4,000
5 RM6,000 RM4,000

If you require a 3 years payback period, which project

would be accepted?
 2) DISCOUNTED PAYBACK PERIOD

 The discounted payback period is similar to the

traditional payback period except that it uses
discounted free cash flows rather than actual
undiscounted cash flows.

 The discounted payback period is defined as the

number of years needed to recover the initial cash
outlay from the discounted free cash flows.
 2) DISCOUNTED PAYBACK PERIOD
Benefits:
• Uses cash flows rather than accounting profits
• Easy to compute and understand
• Considers time value of money (TVM)

Drawbacks:
 Does not consider cash flows beyond the payback period.
 Selection of the maximum acceptable discounted payback
period is subjective
 Selection of the maximum acceptable discounted payback
period is subjective
 EXAMPLE
Year Cash Flow Discounted Cash Flow
0 (500) (500)

1 250 / (1 + 0.14)1 219.30 (1 year)

balance = 500 - 219.30 = 280.70

2 250 / (1 + 0.14)2 192.37 (2 year)

balance = 280.70 - 192.37 = 88.33

3 250 / (1 + 0.14)3 168.74 (0.52 years)

 Required rate of return is 14%

 Discounted payback period is 2.52 years
 Accept if discounted payment < = maximum acceptable
discounted payback period
 Reject if discounted payback > maximum acceptable discounted
payment period
Table 10-2 shows the difference between traditional payback and discounted
payback methods.

With undiscounted free cash flows, the payback period is only 2 years while
with discounted free cash flows (at 17%), the discounted payback period is
3.07 years.