The Basics of Capital Budgeting

Chapter 12 Resume of Essential of Financial Management, 4rd Edition. Brighmam,

E.F., dan Houston, J.F. (2018).

Accounting and Finance, Kelompok 9

Mohammad Rizal, 42P20018
Muhtar Rasyid, 42P20019

Mei 2021
12.1 An Overview of Capital Budgeting

• Capital refers to long term assets used in production

• Budget is a plan that outlines projected expenditure during some future period
• Capital Budget is summart of planned investments in long term assets
• Capital Budgeting is the process of planning expenditure on assets with cash flows that are expected beyond one year.
• Strategic Business Plan : A long-run Plan that outlines in broad terms the firm’s basic strategy for the next 5 to 10 years

• Types of Capital Expenditure Projects/Analysis

1. Replacement : needed to continue current operations
2. Replacement : Cost Reduction
3. Expansion of existing products or market
4. Expansion of new Products or market
5. Safety and/or environtmental projects
6. Other projects
7. Merger

• Indicator/Criteria
• NPV (Nett Present Value)
• Internal Rate of Return (IRR)
• Modified Internal Rate of Return (MIRR)
• Regular Payback
• Discounted Payback

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12.2 Net Present Value (NPV)
Nett
  Present Value : A method of rangking investment proposals using the NPV, Which Equal to the present value of the
project’s free cash flows discounted at the cost of capital

Investment Criteria : NPV >0 / (+) /Positive

Example :

WACC (weighted average cost of capital ) 10%      

  Initial Cost After Tax, End of Year Cash Inflow CFt Total Inflows NPV
• If two project
Yearis Independent Projects
0 (project
1 cash
2 flow not3 affected 4each
  other) , then
  both projects would be accepted
because bothProject
have Spositive NPV
-1000 500 400 300 100 1300 78,82
• Project
If two project L
is Mutually -1000
Exclusive 100
Projects (a300 400 where
set of projects 675only one can
1475be accepted),
100,40 then Projects L would be
accepted because it has the larger positive NPV

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12.3 Internal Rate of Return (IRR)

 Internal Rater of Return (IRR) : is the discount rate that forces the PV of its inflows to equal its cost. This is equivalent to forcing
the NPV to equal zero. The IRR is an estimate of the projects rate of return and it is comparable to the YTM on a bond

Investment Criteria : IRR > WACC, if mutually exclusive chose the highest IRR and >WACC

Example :

WACC (weighted average cost of capital ) 10%      

  Initial Cost After Tax, End of Year Cash Inflow CFt Total Inflows NPV IRR
• If both project were Independent
Year 0 both
1 projects2 would be 3accepted because
4  both IRR  are greater  than the form WACC
• If twoProject S were Mutually
project -1000 500
Exclusive 400 then 300
Projects, 100
Projects S would be chosen1300because
Rp78,82
Its IRR 14,49%
is greater than Projects L
Project L -1000 100
and it is also greater than the firm WACC. 300 400 675 1475 Rp100,40 13,55%

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12.4 Multiple Internal Rates of Return

Multiple IRR : The Situation where a project has two or more IRR

Normal - + + + + + or - - - + + + + +
Non Normal - + + + + - or - + + + - + + +

• NPV Equal 0 when IRR 5% and IRR 85% (the project has
two IRR)
• Graph is constructed by plotting the project NPV at different
discount rate
• it can caused a dilemma, so NPV can better used rather than
IRR

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12.5 Reinvestment Rate Assumptions

NPV Calculation is based on the assumption that cash inflows can be reinvested at the project risk adjusted WACC, whereas the IRR
calculation is based on the assumption that cash flow can be reinvested at the IRR
Example : future value $100 and interest rate 5%
0 1 2 3
5% 5% 5%
• Going PV to FV PV = 100 105 110.25 115,76 =FV

0 1 2 3
5% 5% 5%
• Going FV to PV PV = 100 105 110.25 115,76 =FV

The NPV and IRR have different reinvestment rate assumptions. The NPV has no reinvestment rate assumption; therefore, the reinvestment
rate will not change the outcome of the project. The IRR has a reinvestment rate assumption that assumes that the company will reinvest cash
inflows at the IRR's rate of return for the lifetime of the project. If this reinvestment rate is too high to be feasible, then the IRR of the project
will fall. If the reinvestment rate is higher than the IRR's rate of return, then the IRR of the project is feasible.

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12.6 Modified Internal Rate of Return (MIRR)
 MIRR : The discount rate at which the present value of a projects cost is equal to the present value of its terminal value. Where the terminal
value is found as the sum of the future value of the cash inflows, compounded at the firm's cost of capital

Example :

WACC (weighted average cost of capital ) = 10%    

After Tax, End of Year Cash Inflow CFt
  Initial Cost ($) NPV IRR MIRR
Year 0 1 2
Project A -1000 1150 100 $ 128.10 23.12% 16.83%
• If both project were Independent NPV, IRR, and MIRR always reach the same accept/reject conclusion
• Project
If two project wereB Mutually Exclusive
-1000 Projects100
and they differ in1300 $ 165.29
size, conflict can 19.13%
arise. In such cases, 18.74%
the NPV is best because it
selects the projects that’s maximizes value
• The MIRR is superior to the regular IRR as an indicator of a project’s “true” rate of return but that NPV is better than IRR and MIRR when
choosing among competing projects.

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12.7 Net Present Value (NPV) Profiles
Nett Present Value Profiles : A graph showing the relationships between a project’s NPV and the firms cost of capital

Example :

IRR for A = 19,43%

IRR for B = 22,17%
Crossover Point = 11,8%

Crossover rate is the cost of capital at which the net present values of two projects are equal. It is the point at which the NPV
profile of one project crosses over (intersects) the NPV profile of the other project.

Crossover rate is useful in capital budgeting analysis because it tells the investing company about the cost of capital at which
both of the mutually-exclusive projects are equally good. If the company's cost of capital crosses the crossover rate, the
relative attractiveness of mutually-exclusive projects changes i.e. if Project A is preferable at a discount rate below the
crossover rate, Project B becomes feasible as soon as the cost of capital crosses the crossover rate. 8
12.8 Payback Period

Payback Period : The length of time required for an investments cash flows to cover its cost

Example :

WACC (weighted average cost of capital ) 10% 

  Initial Cost After Tax, End of Year Cash Inflow CFt
Year 0 1 2 3 4
Project S -1000 500 400 300 100
Cumulative CFS -1000 -500 -100 200 200

Project L -1000 100 300 400 675

Cumulative CFL -1000 -900 -600 -200 475

• Payback S = 2 + 100/300 = 2.33

• Payback L = 3 + 200/675 = 3.30

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12.8 Discounted Payback

Discounted Payback Period : The length of time required for an investments cash flows, discounted at the investment’s cost of capital to
cover its cost

Example : WACC (weighted average cost of capital ) = 10%

  Initial Cost After Tax, End of Year Cash Inflow CFt
Year 0 1 2 3 4
Project S -1000 500 400 300 100
Discount CFS -1000 455 331 225 68
Cumulative CFS -1000 -545 -214 11 79
           
Project L -1000 100 300 400 675
Discount CFL -1000 91 248 301 461
Cumulative CFL -1000 -909 -661 -360 101

• Payback S = 2 + 215/225 = 2.95

• Payback L = 3 + 361/461 = 3.78

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12.9 Conclusion on Capital Budgeting Methods

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