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Transcript of Upload - Capital Budgeting Technique
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CAPITAL BUDGETING TECHNIQUE
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CAPITAL BUDGETING TECHNIQUE
Capital budgeting is the process of evaluating and selecting long-term
investments that are consistent with the firms goal of maximizing owners
wealth.
Capital expenditure is an outlay of funds by the firm that is expected to
produce benefits over a period of time greater than 1 year.
Operating expenditure is an outlay of funds by the firm resulting in benefits
received within 1 year.
The capital budgeting process :
1. Proposal generation.
Proposals for new investment projects are made at all levels within a
business organization and are reviewed by finance personnel.
2. Review and analysis.
Financial managers perform formal review and analysis to assess the
merits of investment proposals.
3. Decision making.
Firms typically delegate capital expenditure decision making on the basis of
dollar limits. Generally, the board of directors must authorize expenditures
beyond a certain amount. Often plant managers are given authority to
make decisions necessary to keep the production line moving.
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4. Implementation.
Following approval, expenditures are made and projects implemented.
Expenditures for a large project often occur in phases.
5. Follow-up.
Results are monitored, and actual costs and benefits are compared with
those that were expected. Action may be required if actual outcomes differ
from projected ones.
TERMINOLOGY
Types of Project :
Independent Projects are those whose cash flows are unrelated to (or
independent of) one another; the acceptance of one project does not
eliminate the others from further consideration.
Mutually Exclusive Projects are those that have the same function and
therefore compete with one another. The acceptance of one BASIC
Teliminates from further consideration all other projects that serve a
similar function.
The availability of funds for capital expenditures
Unlimited Funds The financial situation in which a firm is able to accept all
independent projects that provide an acceptable return.
Capital Rationing The financial situation in which a firm has only a fixed
number of dollars available for capital expenditures, and numerous
projects compete for these dollars.
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Basic approaches to capital budgeting decisions
AcceptReject Approach The evaluation of capital expenditure proposals
to determine whether they meet the firms minimum acceptance criterion.
(Mutually exclusive projects)
Ranking Approach The ranking of capital expenditure projects on the basis
of some predetermined measure, such as the rate of return.
CAPITAL BUDGETING TECHNIQUES
1. Payback Period (PP)
The amount of time required for the firm to recover its initial
investment in a project, as calculated from cash inflows.
The payback period can be found by dividing the initial investment by
the annual cash inflow. For a mixed stream of cash inflows, the yearly
cash inflows must be accumulated until the initial investment is
recovered.
1
Payback Period
2
Net Present Value
3
Profitability Index
4
Internal Rate of Return
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Decision Criteria :
If the payback period is less than the maximum acceptable payback
period, accept the project.
If the payback period is greater than the maximum acceptable payback
period, reject the project.
(the maximum acceptable payback period is determined by
management)
2. Net Present Value (NPV)
Found by subtracting a projects initial investment (CF0) from the
present value of its cash inflows (CFt) discounted at a rate equal to the
firms cost of capital (r).
NPV = Present value of cash inflows - Initial investment
Decision Criteria :
If the NPV is greater than $0, accept the project. (Positive)
If the NPV is less than $0, reject the project. (Negative)
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3. Profitability Index (PI)
Simply equal to the present value of cash inflows divided by the initial
cash outflow.
Decision Criteria :
If the index is greater than 1, accept the project.
If the index is less than 1, reject the project.
4. Internal Rate of Return (IRR)
The discount rate that equates the NPV of an investment opportunity
with $0 (because the present value of cash inflows equals the initial
investment). It is the rate of return that the firm will earn if it invests in
the project and receives the given cash inflows.
*before calculate, find out I2 > I1 and NPV must be negative.
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Decision Criteria
If the IRR is greater than the cost of capital, accept the project.
If the IRR is less than the cost of capital, reject the project.
PROBLEMS
1. Fennicia Inc. is considering two mutually exclusive projects. Each requires
an initial investment of $100,000. The company has set a maximum
payback period of 4 years. The after tax cash inflows associated with each
project are:
Initial Investment $100,000 $100,000
Cash Inflows (CF)
Year
1 $10,000 $24,000
2 $20,000 $24,000
3 $30,000 $24,000
4 $40,000 $24,000
5 $20,000 $24,000
Determine the payback period of each projects. Which project should the
company invest in?
Project A
Year Cash Inflows Investment
Balance
0 ($100,000)
1 $10,000 -90,000
2 20,000 -70,000
3 30,000 -40,000
4 40,000 0
5 20,000
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Payback Period of Project A is 4 years -> acceptable project
Project B
Year Cash Inflows Investment
Balance
0 ($100,000)
1 $24,000 -76,000
2 $24,000 -52,000
3 $24,000 -28,000
4 $24,000 -4000
5 $24,000
Payback period = 4 + = 4, 167 or 4 years 2 months ->
reject project
Based on the minimum payback acceptance criteria of 4 years set by
Fennica Inc, project A should be accepted. Company should invest in
Project A.
2. Aulia Dewi company can purchase a fixed asset for a $15,000 initial
investment. The asset generates an annual after tax cash inflows of $4,000
for 4 years.
a. Calculate the net present value (NPV) of the asset, assuming that the
company has a 10% cost of capital. Is the project acceptable?
b. Determine the maximum required rate of return that the firm can
have and still can have accept the asset.
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Year Proceeds df : 10% PV
1 $5,000 0.909 $4,545
2 $5,000 0.826 $4,130
3 $5,000 0.751 $3,755
4 $5,000 0.683 $3,415
Total PV $15,845
Io $16,250
NPV ($405)
a. NPV < 1 -> Reject Project
b. $16,250 = $4,000 x (PVIFAk%,n)
PVIFAk%,4 = $16,250 $5,000 PVIFAk%,4 = 3,25 k = 9%
9% is the maximum required return that the firm could have for the
project to be acceptable. Since the firms required return is 10% the
cost of capital is greater than the expected return and the project is
rejected.
3. Heni manufacturing is attempting to choose the better of two mutually
exclusive projects for expanding the firm. The relevant cash flows for the
projects are shown in the following table.
Project X Project Y
Initial Investment $500,000 $335,000
Year
1 $100,000 $140,000
2 $120,000 $120,000
3 $150,000 $95,000
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4 $190,000 $70,000
5 $250,000 $50,000
Calculate the IRR if the firms cost of capital is 15%. Which project, on the
basis, is preferred?
Project X
Initial Investment $500,000
Year df : 15% PV df : 16% PV
1 $100,000 0.870 $87,000 0.862 $86,200
2 $120,000 0.756 $90,720 0.743 $89,160
3 $150,000 0.658 $98,700 0.641 $96,150
4 $190,000 0.572 $108,680 0.552 $104,880
5 $250,000 0.497 $124,250 0.476 $119,000
Total PV $509,350 Total PV $495,390
Io $500,000 Io $500,000
NPV $9,350 NPV -$4,610
IRR > Cost of Capital or 15,67% > 15% -> acceptable project
Project Y
Initial Investment $335,000
Year df : 15% PV df : 16% PV
1 $140,000 0.870 $121,800 0.862 $120,680
2 $120,000 0.756 $90,720 0.743 $89,160
3 $95,000 0.658 $62,510 0.641 $60,895
4 $70,000 0.572 $40,040 0.552 $38,640
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5 $50,000 0.497 $24,850 0.476 $23,800
Total PV $339,920 Total PV $333,175
Io $335,000 Io $335,000
NPV $4,920 NPV -$1,825
IRR > Cost of Capital or 15,73% > 15% -> acceptable project
Project Y, with the higher IRR, is preferred, although both are acceptable.
4. Using 14% cost of capital, calculate the net present value for each of the
independent projects shown in the following table, and indicate whether
each is acceptable.
Project A Project B Project C Project D Project E
Initial Investment (CFo)
$ 25,000
$ 550,000
$ 180,000
$ 1,000,000
$ 85,000
Year (t) Cash Inflows (CFt)
1 $
4,500 $
100,000 $
20,000 $
240,000 $ -
2 $
4,500 $
120,000 $
19,000 $
240,000 $ -
3 $
4,500 $
140,000 $
18,000 $
240,000 $ -
4 $
4,500 $
160,000 $
17,000 $
240,000 $
30,000
5 $
4,500 $
180,000 $
16,000 $
240,000 $
40,000
6 $
4,500 $
200,000 $
15,000 $
240,000 $ -
7 $
4,500 $
14,000 $
240,000 $
50,000
8 $
$ $ $
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4,500 13,000 240,000 60,000
9 $
4,500 $
12,000 $
70,000
10 $
4,500 $
11,000
Project A :
NPV = {PMT x (PVIFA14%,10 yrs.)} Io
= {($4,500 x 5,216) - $25,000)
= $ (1,528)
NPV < 0 Reject Project
Project B :
Project B
CFt df 14% PV
$ 100,000 0.877 $ 87,700
$ 120,000 0.769 $ 92,280
$ 140,000 0.675 $ 94,500
$ 160,000 0.592 $ 94,720
$ 180,000 0.519 $ 93,420
$ 200,000 0.456 $ 91,200
PV $ 553,820
Io $ 550,000
NPV $ 3,820
NPV > 0 Accept Project
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Project C
Project C
CFt df 14% PV
$ 20,000 0.877 $ 17,540
$ 19,000 0.769 $ 14,611
$ 18,000 0.675 $ 12,150
$ 17,000 0.592 $ 10,064
$ 16,000 0.519 $ 8,304
$ 15,000 0.456 $ 6,840
$ 14,000 0.4 $ 5,600
$ 13,000 0.351 $ 4,563
$ 12,000 0.308 $ 3,696
$ 11,000 0.27 $ 2,970
PV $ 86,338
Io $ 180,000
NPV $ (93,662)
NPV < 0 Reject Project
Project D
NPV = {PMT x (PVIFA14%,8 yrs.)} - Io
= ($240,000 x 4,369) - $1,000,000
= $ 113,360
NPV > 0 Accept Project
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Project E
Project E
CFt df : 14% PV
$ - 0.877 0
$ - 0.769 0
$ - 0.675 0
$ 30,000 0.592 $ 17,760
$ 40,000 0.519 $ 20,760
$ - 0.456 0
$ 50,000 0.4 $ 20,000
$ 60,000 0.351 $ 21,060
$ 70,000 0.308 $ 21,560
PV $ 101,140
Io $ 85,000
NPV $ 16,140
5. Payback Period, Net Present Value, Profitability Index, Internal Rate of
Return - Independent Projects. Clarivtika Inc. has prepared the following
estimates for a long-term project it is considering. Using a 15% cost of
capital, Which of these projects would be acceptable under those cost of
capital under those cost circumstances? all projects is independent with
total budget $250,000.
Project A Project B Project C
Initial investment (Io) $85,000 $60,000 $130,000
Year Net Operating After Tax (NOPAT)
1 $45,000 $30,000 $30,000
2 $45,000 $40,000 $40,000
3 $45,000 $50,000 $50,000
Deprectiation using MACRS 3 years recovery year (33%, 45%, 15%, 7%)
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a. Calculate payback period of each project
b. Calculate NPV of each project, using cost of capital of 14% and Rank
acceptable projects
c. Calculate Profitability Index of each project
d. Calculate the IRR of each project
e. Evaluate the accepability of each project using Payback periode, NPV,
IRR, and PI.
f. What recommendation would you make relative to implementation of
the project? Why?
*remember this exercise is independent projects
PROJECT A
Io $ 85,000
Year NOPAT Depretiation Cash Flow
1 $ 45,000 $ 28,050 $ 73,050
2 $ 45,000 $ 38,250 $ 83,250
3 $ 45,000 $ 12,750 $ 57,750
4 $ 5,950 $ 5,950
PROJECT B
Io $ 60,000
Year NOPAT Depretiation Cash Flow
1 $ 30,000 $ 19,800 $ 49,800
2 $ 40,000 $ 27,000 $ 67,000
3 $ 50,000 $ 9,000 $ 59,000
4 $ 4,200 $ 4,200
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PROJECT C
Io $ 130,000
Year NOPAT Depretiation Cash Flow
1 $ 50,000 $ 42,900 $ 92,900
2 $ 50,000 $ 58,500 $ 108,500
3 $ 60,000 $ 19,500 $ 79,500
4 $ 9,100 $ 9,100
PROJECT Y
Year CF PVIF (14%,4)
Year CF PVIF (79%,4)
0 ($60,000)
($60,000.00) 0 ($60,000)
($60,000)
1 $49,800 0.877 $43,674.60 1 $49,800 0.559 $27,821.23
2 $67,000 0.769 $51,523.00 2 $67,000 0.312 $20,910.71
3 $59,000 0.675 $39,825.00 3 $59,000 0.174 $10,287.10
4 $4,200 0.592 $2,486.40 4 $4,200 0.097 $409.11
Total PV $137,509.00
PV $59,428.14
NPV $77,509.00
Io ($60,000)
PI 1.15
NPV ($571.86)
PP 1.75
IRR 78.52%
PROJECT X
Year CF PVIF (14%,4)
Year CF PVIF (70%,4)
0 ($85,000)
($85,000.00) 0 ($85,000)
($85,000)
1 $73,050 0.877 $64,064.85 1 $73,050 0.588 $42,970.59
2 $83,250 0.769 $64,019.25 2 $83,250 0.346 $28,806.23
3 $57,750 0.675 $38,981.25 3 $57,750 0.204 $11,754.53
4 $5,950 0.592 $3,522.40 4 $5,950 0.12 $712.40
Total PV $170,587.75
PV $84,243.74
NPV $85,587.75
Io ($85,000))
PI 2.01
NPV ($756.26)
PP 1.14
IRR 69.51%
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RANKING
Ranking Project Payback Period
1 Y 1.14
2 X 1.15
3 Z 1.34
Ranking Project NPV
1 Z $ 93,959.50
2 X $ 85,587.75
3 Y $ 77,509.00
Ranking Project IRR
1 Y 78.52%
2 X 69.51%
3 Z 54.15%
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Ranking Project PI
1 Y 2.29
2 X 2.01
3 Z 1.72
Kesimpulan : karena project bersifat independen dengan budget $250,000
maka project yangdapat diterima adalah project Y dan project X dengan
total budget $180,000 ($60,000 +$130,000). Karena project X dan Y
menghasilkan IRR dan PI paling besar.
6. Payback Period, Net Present Value, Profitability Index, Internal Rate of
Return - Mutually Exclusive Projects. Mediyanti is considering two
mutually exclusive projects, each with an initial investment of $ 400,000.
The company has set a maximum 5-year payback requirement and has set
its cost of capital at 12%. The cash inflows associated with the two projects
are shown below.
Year Project X Project Y
1 $120,000 $118,000
2 $120,000 $120,000
3 $120,000 $122,000
4 $120,000 $124,000
5 $120,000 $126,000
a. Calculate each projects payback period
b. Calculate NPV of each project at 12%
c. Calculate PI of each project
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d. Calculate the IRR of each project and use it to determine the highest
cost of capital at
which all of the projects would be acceptable
e. Rank the projects by each of the techniques used. Make and justify a
recommendation
a. Payback Period
Project X
Year 0
$ (400,000.00)
1 $120,000 $ (280,000.00)
2 $120,000 $ (160,000.00)
3 $120,000 $ (40,000.00)
4 $120,000 5 $120,000
Project Y
Year 0
$ (400,000.00)
1 $120,000 $ (280,000.00)
2 $124,000 $ (156,000.00)
3 $118,000 $ (38,000.00)
4 $126,000 5 $122,000
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b. NPV
PROJECT X
Project X
Initial Investment $400,000 Year
df : 12% PV
1 $120,000 0.893 $107,160
2 $120,000 0.797 $95,640
3 $120,000 0.712 $85,440
4 $120,000 0.636 $76,320
5 $120,000 0.567 $68,040
Total PV $432,600
Io $400,000
NPV $32,600
PROJECT Y
Project Y
Initial Investment $400,000 Year
df : 12% PV
1 $120,000 0.893 $107,160
2 $124,000 0.797 $98,828
3 $118,000 0.712 $84,016
4 $126,000 0.636 $80,136
5 $122,000 0.567 $69,174
Total PV $439,314
Io $400,000
NPV $39,314
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c. . Profitability Index
d. IRR
Project X
Initial Investment $400,000 Year
df : 16% PV
1 $120,000 0.862 $103,440
2 $120,000 0.743 $89,160
3 $120,000 0.641 $76,920
4 $120,000 0.552 $66,240
5 $120,000 0.476 $57,120
Total PV $392,880
Io $400,000
NPV -$7,120
Project Y
Initial Investment $400,000 Year
df : 16% PV
1 $120,000 0.862 $103,440
2 $124,000 0.743 $92,132
3 $118,000 0.641 $75,638
4 $126,000 0.552 $69,552
5 $122,000 0.476 $58,072
Total PV $398,834
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Io $400,000
NPV -$1,166
e. Rank and Recommendation
RANKING PROJECT PP NPV PI IRR
1 X 3 tahun 10 bulan $32,600 1,0815 15,28%
2 Y 3 tahun 6 bulan $39,314 1,0983 15,88%
Dikarenakan project bersifat mutually exclusive maka Project Y sebagai
project yang diterima. Hal ini dikarenakan, Project Y memiliki PP yang
lebih kecil dan NPV, IRR, dan PI lebih besar daripada project X.