CHAPTER 11: CAPITAL BUDGETING

  • decision making process of selecting and
    evaluating long term investments.
  • Requires a firm to make decisions with respect to investment in fixed assets investments.
  • Initial outlay : Refers to the immediate cash outflows required by a firm to a start a project

Types of capital investment

  1. For expansion - occurs when the company wants to introduce a new product, to penetrate into new market, to open up new branch or increase production capacity by buying more machines.
  1. For replacement - a company is replacing an existing asset with a new asset, old machine will be disposed off.
  1. Safety and environmental project

Types of project :

  • independent projects
    (Projects with cash flows, which are independent or unrelated to one another)
  • mutually exclusive projects
    (Projects where decision is made to choose only one project from the many being considered)
  1. Payback period
  • Measures how quickly the firm can recover its
    initial outlay.
  • It is the number of years needed for a projects
    to return its initial investment.
  • The earlier the better.

Decision criteria :

  • independent project :Accept – if its payback period is less than or equal to the firm’s maximum desired payback period.
  • mutually projects : Accept the projects with the shortest payback period
  1. NPV - Using formula
  • Accept the projects with the shortest payback
    period.
  • Alternatively it can be rephrased
    NPV = CF1 + CF2 + CF3 +….+ CFn - Initial Outlay
    (1+i)1 (1+i)2 (1+i)3 (1+i)n

NPV - Using PVIF Table

NPV = ∑ CF(PVIF i,n) - Initial Outlay

Decision Criteria : - independent project - Accept - both projects if NPV ≥ 0 (positive) - mutually projects - accept the projects with the highest NPV.

  1. 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)

IRR Uneven cash flow

  • More complexes and a tedious process
  • Use trial and error method

Decision criteria : - independent project - accept - both project if IRR for both projects > than required rate of return (cost of capital) - mutually project - accept the projects with the highest IRR

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 – both project if PI for both projects > than 1
  • mutually projects - Accept the projects with the PI > 1