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Chapter 11: Capital Budgeting, NUR ARISSA BINTI MOHAMAD 2019416444…
Chapter 11: Capital Budgeting
Decision making process of selecting and evaluating long term investments
Initial Outlay
Called as initial investment
Refers to the immediate cash outflows required by a firm to a start a project
Eg: purchase price, transportation charge, installation cost & other cost incurred from acquired this assets
Important
Right decision is needed with respects to the investments in fixed assets.
If right decision - the firm’s value increase, therefore will increase shareholders’ wealth
firms need to spend huge amount of money in order to stay in the industry or to be a market leader
If wrong decision – hard for firms to reverse the situation which involves large amount of losses, suffer financial distress, drop in firm value and of course shareholders’ wealth
Types of capital investment
For replacement of existing assets
Safety and environmental project
For expansion
Types of projects
Independent projects
Projects with cash flows, which are independent or unrelated to one another
The decision to accept one project will not affect the decision to accept another
Mutually exclusive projects
Projects where decision is made to choose only one project from the many being considered
The decision to accept one will automatically rejection of others
Capital budgeting techniques
Non-discounted cash flow methods
Payback period
It is the number of years needed for a projects to return its initial investment
The earlier the better
Measures how quickly the firm can recover its initial outlay
Advantages
Easy to calculate
Liquidity indicator
Disadvantages
Ignore time value of money
Ignores cash flows occurring after payback period
Discounted cash flow methods
Net present value (NPV)
the present value of annual cash flow minus Initial Outlay
Alternatively it can be rephrased
NPV = CF1 + CF2 + CF3
(1+i)1 (1+i)2 (1+i)3
PVIF Table
Advantages
It uses cash flow
It recognizes time value of money
Disadvantages
Requires detailed long term forecast of incremental benefits and costs
Internal rate of return (IRR)
Tries to determine the yield or the rate of return of an investment/project
Tries to calculate the rate of return that equates the initial outlay of a project with the present value of the future net cash inflows
In other words, will determine the return that will make the NPV = 0 or > 0(positive)
Uneven Cash Flow
More complexes and a tedious process
Use trial and error method
Advantages
It uses cash flow
It recognizes time value of money
Disadvantages
Requires detailed long term forecast of incremental benefits and costs
Profitability Index (PI)
It is relative measure that shows the present value of cash flows earned per Ringgit of initial cash invested
Present Value of Cash Flows /
Initial Investment (Outlay)
Decision criteria
Independent project
Accept if its payback period is less than or equal to the firm’s maximum desired payback period
Accept both projects if NPV ≥ 0 (positive)
Accept both project if IRR for both projects > than required rate of return (cost of capital)
Accept both project if PI for both projects > than 1
Mutually projects
Accept the projects with the shortest payback period
Accept the projects with the highest NPV
Accept the projects with the highest IRR
Accept the projects with the PI > 1
NUR ARISSA BINTI MOHAMAD 2019416444 KBA246A2 FIN420
