Capital Budgeting

Topic 5
 INTRODUCTION

 CAPITAL BUDGETING : PROCESS analyzing projects and DECIDING which one

to accept and thus include in capital budget
 important :generate future (L/term) CF= firm’s growth, remain competitive & survive
 same procedure with security valuation differ in 2 things :
1. Stock & bond in Security market BUT firm create CB project = involve project
creation by firm/mgmt.
2. Investor on share&bond no influence on cash flow on their investment BUT
firm/mgmt. hv influence the CB to ensure the project success and positive C/F
 CB – need to analyzing capital expenditure to ensure benefits can be gain &
analyzing capital expenditure involve cost (cash outflow)
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 CAPITAL PROJECTS CATEGORIES

1. Replacement needed to continue profitable operation

2. Replacement to reduce cost
3. Expansion of existing products or markets
4. Expansion to new products or markets
5. Contraction decision
6. Safety or/and environmental projects
7. Merger
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 CAPITAL BUDGETING PROCESS

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.

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1. Estimate CFs

 Depreciation
 Taxation of salvage
 Externalities
 Opportunity cost
 Other changes to the input
 Expected inflation in price & costs

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 2. Assess riskiness of CFs.

 Stand alone risk

 Corporate risk

 Market risk

*risk-adjusted COC = WACC

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 3.Determine the appropriate cost of capital.

 Decide cost of capital base on risk measurement

 Some option to be consider when in CB:

I. Investment timing option
II. Growth option
III. Abandonment option
IV. Flexibility option
V. Option value

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Things to be consider in CB process

• Independent projects: if the cash flows of one are unaffected by the

acceptance of the other.
• Mutually exclusive projects: if the cash flows of one can be
adversely impacted by the acceptance of the other.
• Normal cash flow stream: Cost (negative CF) followed by a series
of positive cash inflows. One change of signs.
• Nonnormal cash flow stream: Two or more changes of signs. Most
common: Cost (negative CF), then string of positive CFs, then cost
to close project. Examples include nuclear power plant, strip mine,
etc. DZMA Sem2, 2017/18 8
 CAPITAL BUDGETING TECHNIQUES

 Net Present Value (NPV)

 Internal Rate of Return (IRR)
 Modified Internal Rate of Return (IRR)
 Profitability Index (PI)
 Payback Period (PP)
 Discounted Payback Period (DPP)

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 Example : Project Cash flow

* WACC = 10%

Cash Flow
Year A B
0 -100 -100
1 10 70
2 60 50
3 80 20

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 NET PRESENT VALUE (NPV)

 Sum of the PVs of all cash inflows and outflows of a project:

N
CFt
NPV  
t 0 ( 1  r )t

NPV = PV of inflows – Cost = Net gain in wealth

• If projects are independent, accept if the project NPV > 0.
• If projects are mutually exclusive, accept projects with the highest positive NPV,
those that add the most value.
• **some companies use DCF
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NPV calculation:

Enter CFs into the calculator’s CFLO register.

CF0 = -100
CF1 = 10
CF2 = 60
CF3 = 80

Enter I/YR = 10, press NPV button to get NPVA =

$18.78.
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 INTERNAL RATE OF RETURN (IRR)

 IRR is the discount rate that forces PV of inflows equal to cost, and
N
CFt
the NPV = 0: 0
t0
t
(1  IRR)

 Solving for IRR with a financial calculator:

 Enter CFs in CFLO register.
 Press IRR; IRRA= 18.13% and
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Rationale for the IRR Method

• If IRR > WACC, the project’s return exceeds its costs and there is
some return left over to boost stockholders’ returns.
If IRR > WACC, accept project.
If IRR < WACC, reject project.
• If projects are independent, accept both projects, as both IRR >
WACC = 10%.
• If projects are mutually exclusive, accept S, because IRR B > IRRA.

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 NPV vs IRR

Reinvestment Rate Assumptions:

• NPV method assumes CFs are reinvested at the WACC.
• IRR method assumes CFs are reinvested at IRR.
• Assuming CFs are reinvested at the opportunity cost of capital is more
realistic, so NPV method is the best. NPV method should be used to
choose between mutually exclusive projects.
• Perhaps a hybrid of the IRR that assumes cost of capital reinvestment
is needed =MIRR

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 Critics on Capital Budgeting

-Base on Modigliani-Miller Theorem (M&M) = PERFECT CAPITAL MARKET

-hence affect the cost of capital (discounting rate) NPV
= BIAS
-Cost of equity measured by using CAPM === critics on CAPM = beta
-No TAX unleveraged firm =leverage firm but value of leverage =tax deductible &
high risk save in cost offset the high risk or others cost involve

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Other factors affecting Capital budgeting

Inflation rate
Future or forward contract
Multiperiod project (mutually exclusive
Project)
Different cost of capita for different
project
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dgeting has asked him to analyze two proposed capital investments, Project Car Rental and Project Homestay. Each project has a cost of RM200,000, and the cost of capital for each

Exercise:

(Karen is a financial analyst for Embun Company. The director of capital

budgeting has asked him to analyze two proposed capital investments,
Project Car Rental and Project Homestay. Each project has a cost of
RM200,000, and the cost of capital for each project is 12 percent. The
projects’ expected net cash flows are as follows;
ALIRAN TUNAI BERSH DIJANGKA (EXPECTED NET CASH
FLOWS)
Year Poject Car Rental Project Homestay
0 (RM200,000) (RM200,000)
1 130,000 70,000
2 60,000 70,000
3 60,000 70,000
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4 20,000 70,000