and COST

ANALYSIS
 CAPITAL BUDGETING
• Is the process of making long-
run planning decisions for
invesments in project.
• Analysis of potential projects.
• Very important to firm’s future.
• There are five stages to the
capital budgeting process.
5 Stages of Capital Budgeting
 Stage 1 : Identify Projects

Identify potensial capital investments that

agree with the organization’s strategy.
 Stage 2 : Obtain Information
Gather information from all parts of the
value chain to evaluate alternative projects.
 Stage 3 : Make Predictions
Forecast all potensial cash flow attributable to
the alternative projects
Continued >>>

 Stage 4 : Make Decisions by Choosing Among

Alternatives
Determine which investment yield the greatest
benefit and the least cost to the organization
 Stage 5 : Implement the Decision, Evaluate
Performance, and Learn
Given the Complexities of capital investment
decisions and the long time horizon they span.
Steps in Capital Budgeting
• Estimate cash flows (inflows & outflows).
• Assess risk of cash flows.
• Determine appropriate discount rate (r = WACC)
for project.
• Evaluate cash flows. (Find NPV or IRR etc.)
• Make Accept/Reject Decision
Capital Budgeting Project Categories
• Replacement to continue profitable operations
• Replacement to reduce costs
• Expansion of existing products or markets
• Expansion into new products/markets
• Contraction decisions
• Safety and/or environmental projects
• Mergers
• Other
Normal vs. Nonnormal Cash
Flows
• Normal Cash Flow Project:
 Cost (negative CF) followed by a series of positive cash inflows.

 One change of signs.

• Nonnormal Cash Flow Project:

 Two or more changes of signs.
 Most common: Cost (negative CF), then string of positive CFs,
then cost to close project.
 For example, nuclear power plant or strip mine.
Inflow (+) or Outflow (-) in
Year
Capital Budgeting
Evaluation Methods

• Payback
• Discounted Payback
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
What is the payback period?
The number of years required to
recover a project’s cost,

or how long does it take to get the

business’s money back?
Strengths and Weaknesses of Payback

• Strengths:
 Provides an indication of a project’s risk and liquidity.
 Easy to calculate and understand.

• Weaknesses:
 Ignores the TVM.
 Ignores CFs occurring after payback period.
 No specification of acceptable payback.
 CFs uniform??
Expected Net Cash Flows
Year Project X Project Y
_________________________________________________
• 0 (100) (100)
• 1 10 70
• 2 60 50
• 3 80 20
Payback for Project X

0 1 2 2.4 3

CFt -100 10 60 80
Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/ 80 = 2.375 years

Payback for Project Y

0 1 1.6 2 3

CFt -100 70 50 20

Cumulative -100 -30 0 20 40

PaybackS = 1 + 30/50 = 1.6 years

Discounted Payback Period

 payback period approach but it considers time value of

money (TVM)
 The amount of time needed to recover initial investment base
on the present value (PV) of cash inflows
 0 1 2 3
10%

CFt -100 10 60 80

PVCFt -100 9.09 49.59 60.11

Cumulative -100 -90.91 -41.32 18.79

Discounted
payback = 2 + 41.32/60.11 = 2.7 years

Recover investment + capital costs in 2.7 years.

Net Present Value (NPV)
 Is calculated the expected monetary gain or loss
from a project by discounting all expected future
cash inflows and outflows back to the present
point in time using the required rate of return.
NPV: Sum of the PVs of All Cash Flows
N CFt
NPV = Σ
(1 + r)t
t=0

Cost often is CF0 and is negative.

N CFt
NPV = Σ – CF0
(1 + r) t
t=1
NPV Method
• NPV = PV inflows – Cost
• This is net gain in wealth, so accept project if
NPV > 0.
• Choose between mutually exclusive projects on
basis of higher positive NPV. Adds most value.
• Risk Adjustment: higher risk, higher cost of
capital, lower NPV
Case Project X and Y
PV Project X

0 1 2 3
CFs: 10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPV
• PV Project Y

0 1 2 3
CFs: 10%

-100.00 70 50 20

63.63
41.32
15.03
19.98 = NPV
Which project(s) should be accepted?

• If project X and Y are mutually exclusive, accept Y

because NPV(y) > NPV(X).
• If X & Y are independent, accept both; NPV > 0.
• NPV is dependent on cost of capital.
Internal Rate of Return: IRR
Is calculates the discount rate at which an
investment’s present value of all expected
cash inflows equals the present value of its
expected cash outflows.

That is, the IRR is the discount rate that

makes NPV = 0
• IRR is an estimate of the project’s rate of return

N CFt
=0
Σ (1 + IRR)t
t=0

IRR = i1 + NPV1 x (i2 – i1)

NPV1 - NPV2
Case Project X for IRR = ?
Th Perkiraan DF 10% PV 10% DF 15% PV 15%
arus kas ____________________
0 (100) 1 (100) 1 (100)
1 10 0,9091 9,091 0,8696 8,696
2 60 0,8264 49,584 0,7561 45,367
3 80 0,7513 60,104 0,6575 52,597
18,779 6,662

IRR = 10% + 18,779 x 5%

(18,779 – 6,662)
= 10% + 1,5498 x 5%
IRR(x) = 17,75%
Case Project Y for IRR = ?
Th Perkiraan DF 10% PV 10% DF 15% PV 15%
arus kas ____________________
0 (100) 1 (100) 1 (100)
1 70 0,9091 63,637 0,8696 60,872
2 50 0,8264 41,320 0,7561 37,805
3 20 0,7513 15,026 0,6575 13,150
19,983 11,827

IRR = 10% + 19,983 x 5%

(19,983 – 11,827)
= 10% + 2,450 x 5%
IRR(y) = 22,25%
Decisions on Projects X
and Y per IRR

• If X and Y are independent, accept both: IRR(X) >

r and IRR(Y) > r.
• If X and Y are mutually exclusive, accept Y
because IRR(Y) > IRR(X).
• IRR is not dependent on the cost of capital used.
NPV and IRR: No conflict for independent
projects.
NPV

IRR > r r > IRR

and NPV > 0 and NPV < 0.
Accept. Reject.

IRR r (%)
Reinvestment Rate
Assumptions
• NPV assumes reinvest at r (opportunity cost of
capital).
• IRR assumes reinvest at IRR.
• Reinvest at opportunity cost, r, is more realistic,
so NPV method is best. NPV should be used to
choose between mutually exclusive projects.
Profitability Index

• The profitability index (PI) is the present value of

future cash flows divided by the initial cost.
• PV of Benefits / PV of Costs or
• PV of Inflows / PV Outflows
• PI > 1.0 = Accept
Project X’s PV of Future Cash Flows

Project X:
0 1 2 3
10%

10 60 80

9.09
49.59
60.11
118.79
Project X’s Profitability Index

PV future CF 118.79
PIx = =
Initial cost 100

PIx = 1.1879
Project Y:
0 1 2 3
10%

70 50 20

63,64
41.32
15.02
119.98
Project Y’s Profitability Index

PV future CF 119.98
PIy = =
Initial cost 100

PIy = 1.1998
Choosing the Optimal Capital Budget
• Finance theory says to accept all positive NPV
projects.
• Two problems can occur when there is not
enough internally generated cash to fund all
positive NPV projects:
• An increasing marginal cost of capital.
• Capital rationing
Capital Rationing
• Capital rationing occurs when a company chooses
not to fund all positive NPV projects.
• The company typically sets an upper limit on the
total amount of capital expenditures that it will
make in the upcoming year.
Continued >>

• Reason: Companies want to avoid the direct

costs (i.e., flotation costs) and the indirect costs
of issuing new capital.
• Solution: Increase the cost of capital by enough
to reflect all of these costs, and then accept all
projects that still have a positive NPV with the
higher cost of capital.
• Reason: Companies don’t have enough
managerial, marketing, or engineering staff to
implement all positive NPV projects.
• Solution: Use linear programming to maximize
NPV subject to not exceeding the constraints on
staffing.
• Reason: Companies believe that the project’s
managers forecast unreasonably high cash flow
estimates, so companies “filter” out the worst
projects by limiting the total amount of projects
that can be accepted.
• Solution: Implement a post-audit process and tie
the managers’ compensation to the subsequent
performance of the project.
Case :
 Kasus 1
Informasi:
Ada usulan investasi dalam suatu proyek
membutuhkan investasi sebesar Rp. 120.000.000, yang
diperkirakan mempunyai proceeds selama usianya
adalah sbb;
Tahun
1 60.000.000
2 50.000.000
3 40.000.000
4 30.000.000
5 20.000.000
6 10.000.000
Diminta: Hitunglah NPV nya!
Solusi
Perhitungan NPV atas dasar Discount rate 10 %

PV dari proceeds = 164.430.000

PV dari Outlays = 120.000.000 -
NPV = + 44.430.000
* Karena NPV positif maka investasi diterima