Capital Budgeting

2 types of projects:

1. Mutually exclusive=choose only 1 best answer

Project A
Project B
Project C

Project A accepted, Project B & C will be rejected.

2. Independent/indifferent=choose more than only 1 answer

Project A
Project B
Project C

Choose Project A & C, reject Project B.

4 method/measurement:

1. Payback Period
2. Net Present Value
3. Profitability Index
4. Internal Rate of Return

Cash flows (CFs)

Bracket (-ve symbol) CFs is going out=initial outlay=initial investment=money going out=CASH OUTFLOWS

+ve symbol CFs is coming in=money coming in=CASH INFLOWS

Example:

Gunung Ledang Berhad is considering two mutually exclusive projects. The cash flows (in RM) associated
with both projects are as follows:

Year Project Project

Hang Tuah Hang Jebat
0 -1,000 -1,000
1 500 350
2 400 350
3 300 350
4 200 350

The required rate of return on these projects is 15%(i),(k).

For each project, you are required to calculate:

a. Payback Period
b. Net Present Value
c. Profitability Index
d. Internal Rate of Return
e. Based on your calculation in part (a) to part (d), which project should Gunung Ledang Berhad
accept. Why?

Payback Period

Hang Tuah

Year CFs Accumulated CFs

0 -1,000 -1,000
1 500 -500
2 400 -100
3 300 200
4 200

Payback Period = BY + UC
CF
BY = the year before full recovery
UC = the unrecovered cost at start of year CF
= the cash flow during the year

Payback Period = 2 + 100

300
= 2 + 0.33
= 2.33 years

Hang Jebat

Year CFs Accumulated CFs

0 -1,000 -1,000
1 350 -650
2 350 -300
3 350 50
4 350

Payback Period = 2 + 300

350
= 2 + 0.86
=2.86 years
Net Present Value (NPV)

NPV=+ve, accept the project

NPV=-ve, reject the project

NPV =  Annual Cash Flow - Initial Investment

(1+k)t

Hang Tuah

Year CFs i=15%, table A3

0 -1,000 1.0000 -1,000
1 500 0.8696 434.80
2 400 0.7561 302.44
3 300 0.6575 197.25
4 200 0.5718 114.36
NPV +48.85

Hang Jebat

Year CFs i=15%, table A3

0 -1,000 1.0000 -1,000
1 350 0.869 304.36
6
2 350 0.756 264.64
1
3 350 0.657 230.13
5
4 350 0.571 200.13
8
NPV -0.74

OR

Year CFs i=15%, table A4

0 -1,000 1.0000 -1,000
1 350
2 350
3 350
4 350 2.8550 999.25
NPV -0.75

Profitability Index (PI)

PI > 1.00, accept

PI < 1.00, reject

PI = Present value of Future Net Cash Inflows

Initial Outlays
 Hang Tuah Hang Jebat
PV 1,048.85 999.25
Initial outlay 1,000 1,000
PI 1.05 0.99

Internal Rate of Return (IRR)

IRR > required rate of return, accept

IRR < required rate of return, reject

IRR = A + { a x (B – A)}
a–b

A = one of the discounting rate B

= the other discounting rate
a = the NPV at discounting rate A b
= the NPV at discounting rate B
Try and error:

Hang Tuah
Year CFs i=20%, table A3
0 -1,000 1.0000 -1,000
1 500 0.8333 416.65
2 400 0.6944 277.76
3 300 0.5787 173.61
4 200 0.4823 96.46
NPV -35.52

i NPV

A=15% +48.85=a
IRR? 0
B=20% -35.52=b

IRR = A + { a x (B – A)}
a–b

=15 +{ 48.85 x (20-15)}

48.85-(-35.52)

=15 + 2.89
=17.89%
 Hang Jebat

Year CFs i=10%, table A4

0 -1,000 1.0000 -1,000
1 350
2 350
3 350
4 350 3.1699 1,109.47
NPV +109.47

i NPV

A=10% +109.47=a
IRR? 0
B=15% -0.75=b

IRR = A + { a x (B – A)}
a–b

=10 + { 109.47 x (15-10)}

109.47+0.75
=10 + 4.97
=14.97%

Hang Tuah Hang Jebat

PP 2.33 yrs 2.86 yrs
NPV +48.85 -0.75
PI 1.05 0.99
IRR 17.89% 14.97%

Gunung Ledang Berhad should choose Project Hang Tuah since the payback period is shorter compared
to Project Hang Jebat. Project Hang Tuah has positive NPV, the PI is more than 1.00 and the IRR is more
than the required rate of return.

Scenario 1

Project A Project B
PP 1 yr 10 yrs
NPV +100 +1,000

ME projects. Which project that we are going to choose?

Choose Project B since NPV showed higher positive value compared to Project A.
Scenario 2

Project A Project B
NPV +100 +1,000

Indifferent projects. Which project/s that we are going to choose?

Choose both projects since both project showed positive NPV.

Scenario 3

Project A Project B
NPV +100 -100

Indifferent projects. Which project/s that we are going to choose?

Choose Project A since NPV showed positive value.

Scenario 4

Project A Project B
NPV -100 -100

ME projects. Which project that we are going to choose?

None of the project should be chosen since both projects showed negative value of NPV.

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