Financial Management I BBPW3103

Chapter 6 Criteria of Capital Budgeting

Capital Budgeting

Is technique used for analyzing whether an investment in an asset or long-term project is profitable or not. There are 4 technique can be used

Payback period technique Net present value technique Profitability index technique Internal rate of return technique

Payback Period, PBP

Is the time period taken by a project to regain the sum of money invested in the beginning of the project. Example 6.1 : Projects A has the following cash flow. What is the PBP of this projects?

Payback Period, PBP (Cont.)

Year 0 : The cash flow is RM100,000 because the investment just stated Year 4 : The cumulative cash flow of RM100,000 is matching the cash outflow (initial capital) at year 0. So, the PBP of this project is 4 years

Payback Period, PBP (Cont.)

Example 6.2 : When the PBP is between two different time, we can assume that the distribution of cash flow is uniform. For example, the project of purchasing a grinding machine has a cash flow as follow:

Payback Period, PBP (Cont.)

Initial Outlay : RM200,000 Year 3 : Cumulative cash flow is RM170,000. The balance cash flow to generate is RM30,000 (RM200,000 RM170,000) So, the PBP is = 3 years + (RM30,000 RM70,000) years = 3.43 years

Payback Period, PBP (Cont.)

For the project that generate annuity cash flow (same cash flow every year), the formula bellow can be use: PBP = Initial Outlay Annual Cash Flow = IO ACF Example 6.3 : Suppose there is a project that involve cash flow outflow of RM700,000 and its expected to produce a cash inflow RM200,000 every year for 5 years. The PBP of the project is PBP = IO ACF = RM700,000 RM200,000 = 3.5 years

Payback Period, PBP (Cont.)

The PBP of the project can be shows as follow:-

Application of PBP

This technique used to make decision either to accept or reject a capital budgeting project Project that have a lower PBP value is better to the company Company must consider the target of PBP. If the result of PBP higher than the targeted PBP, the project must be reject. For example, if the company want to get the initial outlay in 3 years but the PBP analysis show the initial outlay will be colleted in 3.2 years, the project must be reject. Accept project if PBP < Targeted PBP Reject project if PBP > Targeted PBP

Advantages and PBP

Easy to calculate and understand Uses the cash flow and not accounting profit as a basis calculation more accurate and also clearly shows the time when the cash flow occurs The criteria of PBP are an indication of the liquidity for the project The criteria of PBP also take into account the risk of a project. Company can focus on a lower PBP to reduce risk

Disadvantages of PBP

PBP does not take into account the concept of the time value of money

Cumulative cash flow obtained by totaling the cash flow at different time. This can explain based on the table below

Disadvantages of PBP (Cont.)

PBP does not take into account the concept of the time value of money (Cont.)

Based on the concept Time Value of Money, we know the project A better than project B because it produces an extra cash flow of RM20,000 in the 1st year. This extra cash flow can be reinvest to generate same return for the company. So, the total return for Project A in 2 years more than Project B.

Disadvantages of PBP (Cont.)

PBP does not take into account the cash flow after the PBP

This technique disregards the cash flow after the PBP. Thus, the long-term projects cannot be valued accurately.

Disadvantages of PBP (Cont.)

PBP does not take into account the cash flow after the PBP (Cont.)

Based on the PBP technique, project A is better than project B because the PBP for project A (2 years) less than project B (more than 2 years). If the company targeted PBP is less than 2 years, the company will choose project A and reject project B even though project B generate cash flow after the targeted PBP.

Net Present Value, NPV

The decision made based o the criteria of net present value (NPV) The formula of NPV is

Where I = Initial cash flow CF = Cash flow for period t k = Cost of capital n = Project lifetime

Net Present Value, NPV (Cont.)

Example 6.7 : Below is the cash flow of a project that have 15% cost of capital

The calculation of NPV is = [RM40,000 (1 + 0.15)] + [RM80,000 (1 + 0.15)2] + [RM100,000 (1 + 0.15)3] + [RM100,000 (1 + 0.15)4] RM200,000 = RM18,280

Net Present Value, NPV (Cont.)

Calculation NPV using table = RM40,000(PVIF15%,1) + RM80,000(PVIF15%,2) + RM100,000(PVIF15%,3) + RM100,000(PVIF15%,4) - RM200,000 = RM40,000(0.870) + RM80,000(0.756) + RM100,000(0.658) + RM100,000(0.572) - RM200,000 = RM18,280

Net Present Value, NPV (Cont.)

If a project have annuity case flow, the calculation is more easier Example 6.8 : Suppose a project involves the initial investment cost of RM1 million. It is expected to produce a cash flow of RM250,000 per year for 5 years. If the cost of capital is 12%, the NPV is = A(PVIFAi,n) IO = RM250,000(PVIFA12%,5) RM1,000,000 = RM250,000(3.605) RM1,000,000 = -RM98,750

Application of NPV

If the projects that are evaluated are independent projects, accept the project that have NPV>0 If the projects that are evaluated are mutually exclusive projects, accept the project that the highest NPV and NPV>0

Advantages of NPV

It use cash flow and not accounting profit It takes into account the timing of cash flow by using the discount cash flow or concept od Time Value of Money It takes into account all the cash flow of the projects The criteria of NPV are in accordance with the concept of owner wealth

Disadvantages of NPV

The calculation of NPV is rather complex compared to PBP The calculation of NPV requires information on the cost of capital for the project that is sometimes difficult to ascertain

Profitability Index, PI

Uses a discounted cash flow as the evaluation basis Formula of PI is

Based on the example 6.8, the PI is PI = RM901,250 RM1,000,000 = 0.90125

Profitability Index, PI (Cont.)

The criteria for acceptance or rejection are as follow

Accept the project if PI > 1 Reject the project if PI < 1 If PI=0, the rejection or acceptance will not have any affect on the company Used together with the NPV to make decision Takes into account the concept of Time Value of Money

Advantage of PI

Disadvantage of PI

Does not measure the total increase in wealth as measured by NPV

Internal Rate of Return, IRR

Defined as the rate of discount that balances the PV of cash inflow with the initial cash flow, or the rate of discount when the NPV is equal to zero The formula is

Internal Rate of Return, IRR (Cont.)

Example 6.9 : The two projects have the following cash flow

Internal Rate of Return, IRR (Cont.)

Thus, IRR of the project A is NPVA,IRR = [RM50,000 (1 + IRR)1] + [RM40,000 (1 + IRR)2] + [RM30,000 (1 + IRR)3] + [RM10,000 (1 + IRR)4] RM100,000 0 = [RM50,000 (1 + IRR)1] + [RM40,000 (1 + IRR)2] + [RM30,000 (1 + IRR)3] + [RM10,000 (1 + IRR)4] RM100,000

Internal Rate of Return, IRR (Cont.)

Suppose the IRR is 14%, the NPV is NPVA,14% = (RM50,000 1.141) + (RM40,000 1.142) + (RM30,000 1.143) + (RM10,000 1.144) RM100,000 = (50,000 x 0.877) + (40,000 x 0.769) + (30,000 x 0.675) + (10,000 x 0.592) - 100,000 = RM780

Internal Rate of Return, IRR (Cont.)

Suppose the IRR is 1%, the NPV is NPVA,15% = (RM50,000 1.151) + (RM40,000 1.152) + (RM30,000 1.153) + (RM10,000 1.154) RM100,000 = (50,000 x 0.870) + (40,000 x 0.756) + (30,000 x 0.658) + (10,000 x 0.572) - 100,000 = -RM800

Internal Rate of Return, IRR (Cont.)

So, the IRR is = 14% + [780 (780 + 800)][15% - 14%] = 14% + 0.49% = 14.49%

Internal Rate of Return, IRR (Cont.)

IRR for Project B

Suppose the IRR is 7%, the NPV is = [250,000 1.071] + [250,000 1.072] + [250,000 1.073] + [250,000 1.074] 1,000,000 = RM25,049.359 Suppose the IRR is 8% the NPV is = [250,000 1.081] + [250,000 1.082] + [250,000 1.083] + [250,000 1.04] 1,000,000 = -RM1,822.491

Internal Rate of Return, IRR (Cont.)

Rate (%) 7% NPV 8%

Value (RM) 25,049.359 0 1,822.491

So, the IRR is = 7% + [RM25,049.359 (RM25,049.359

+ RM1,822.491)] x [8% - 7%] = 7% + 0.932% = 7.932%

Internal Rate of Return, IRR (Cont.)

Application of IRR

If the projects evaluated are independent projects, accept the project that have IRR > cost of capital If the project evaluated are mutually projects, accept the project highest IRR and between the projects that have at least an IRR equal to the cost of capital

Internal Rate of Return, IRR (Cont.)

Advantages of IRR

Uses the cash flow and not accounting profits as the basis of calculation Takes into account the Time Value of Money in its calculation Provides solution that is parallel with the NPV technique

If k (cost of capital) > IRR, NPV < 0, reject the project If k < IRR, NPV > 0, accept the project If k = IRR, NPV = 0, accept the project

Internal Rate of Return, IRR (Cont.)

Disadvantages of IRR

The calculation more complicated compare to NPV Requires information on the cost of capital of the project which is rather difficult ascertain