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CAPITAL BUDGETING

Process of identifying & selecting of project in long lived asset. CAPITAL BUDGETING. Indicate which capital expenditures are consistent With the firm’s goal-. Capital budgeting decision rules. payback. Discounted payback. Net present Value (NPV ). Internal rate

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CAPITAL BUDGETING

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  1. Process of identifying & selecting of project in long lived asset CAPITAL BUDGETING Indicate which capital expenditures are consistent With the firm’s goal-

  2. Capital budgeting decision rules payback Discounted payback Net present Value (NPV) Internal rate of return (IRR) Modified internal rate of return (MIRR)

  3. OPERATING EXPENDITURE short term Motives for Capital Expenditure CAPITAL EXPENDITURE long term

  4. Expansion (pengembangan). Tujuan Replacement (penggantian) Renewal (pembaharuan) Other purposes (tujuan lain)

  5. Langkah-langkahdalam ‘capital Budgeting Process’ Decision Making Review & Analysis Proposal Generation Follow-up Implementation

  6. 4 TERMONOLOGI ASAS Aliran tunai dalam sesebuah projek tidak akan mempengaruhi atau berkaitan dengan aliran tunai projek lain. Independent Mutually exclusive projects VS Penerimaan sesebuah projek akan menghalang projek yang lain.

  7. Firma boleh menerima kesemua independent projek yang mendatangkan keuntungan kerana modal tidak terhad. Unlimited Funds VS Capital Rationing Firma mempunyai peruntukan yang terhad untuk perbelanjaan modal dan sesebuah projek perlu bersaing untuk mendapatkan peruntukan tersebut.

  8. penilaian ke atas perbelanjaan modal menentukan projek tersebut boleh mencapai kriteria atau syarat minimum penerimaan firma itu. Accept-reject Ranking Approaches VS Kedudukan sebuah projek dinilai berdasarkan ukuran tertentu pulangan (ranking) pertama, pulangan kedudukanterakhir.

  9. Aliran keluar hanya Diikuti oleh siri aliran masuk sahaja. Conventional cash flow VS Nonconventional Cash flow Aliran keluar diikuti oleh siri aliran masuk dan keluar.

  10. Example Time line for Conventional Cash Flow $2,000 $2,000 2,000 2,000 2,000 $2,000 $2,000 $2,000 $2,000 0 Cash inflow Cash Outflows 1 2 6 7 3 4 5 -$10,000 End of Year

  11. Example Time line for Nonconventional Cash Flow $5000 $5000 $5000 $5000 $5000 $5000 $5000 $5000 $5000 0 Cash Inflows 5 1 2 3 4 6 7 8 9 10 Cash Outflows - $20000 - $8000 End of Year

  12. Payback Period how long for a project to get back its initial outlay Or net cash in flow Formula: (for equal cash inflow only!) PAYBACK =(initial investment outlay) / (annual cash earnings)

  13. Contoh: If a firm expect to purchase a house for RM420,000 and spend RM320,000 on renovation. After the renovation,the firm is expected to be able to lease the building out for RM100,000 per year. What is the payback period for this investment? P.PERIOD=(initial investment outlay) / (annual cash earnings) =RM740,000 / RM100,000 =7.4 year (antara thn 7 dan 8) Formula: (for UNEQUAL cash inflow only!) PAYBACK = Investment outlays - cumulative cash inflow when the cumulative cash flow RM0 = payback period

  14. Contoh: Rashid Bhd. was thinking to invest in project X & Y. Below is the data for both project:

  15. Solution: Project X

  16. Project Y Rashid Bhd will choose Project X because the shorter payback period than project Y

  17. The Decision Criteria Cut-off criterion FOR Payback Period ACCEPTED OR REJECTED PROJECT BASED ON WHETHER THE PP IS LESS OR EQUAL TO SPECIFIC MAIXIMUN PERIOD. Example: Chose Project X & Y if the specific period is 5 yrs

  18. Discounted payback period To measure the length of period taken by a project to payback the initial investment outlays using the discounted cash inflow.

  19. Example; Please find the discounted payback period for the project which have initial investment outlay = RM30,000 and the forecasted cashflow as below. Cost of capital is 10%,

  20. Discounted payback period for the project within 3 to 4 yr.

  21. Kekuatan & Kelemahan Payback Period & discounted Payback Period kekuatan Kaedah pengiraan mudah Boleh digunakan untuk screen project (hanya utk Payback Period) Ambil kira pasal time value of money (hanya utk discounted Payback Period) X menimbang kitaran keseluruhan pelaburan projek X menimbang risiko aliran tunai kelemahan Ukuran yang digunakan adalah kecairan tunai bukan dr segi keuntungan X menimbang bagaimana timing cash flow ditetapkan(payback period only)

  22. MEANING Compare the initial cost of project With the PV of the CF to be generated decision criteria NPV FORMULA EXAMPLE

  23. Formula NPV = – Initial investment + present value OF cash flow Discount rate=required return =cost of capital=opportunity cost

  24. Decision criteria Independent projects npv > 0 - Accept the project NPV < 0 – Reject the project Mutually exclusive projects Accept highest positive NPV

  25. EXAMPLE : • QUESTION Fitch industries is in process of choosing the better of two equal – risk, mutually exclusive capital expenditure projects – A and B . the relevant cash flows for each project are shown in the following table. The firm’s cost of capital is 14%.

  26. SOLUTION : Project a(Even cash flows) Project A shows that cash flow of these project is RM 10,000 per year (annuity) or known as equal cash flow. Therefore, we can use the Present Value of Annuity Formula (PVIFA) are shown below: NPV = Initial investment + pv OF c/f NPV = - 28, 500+( 10, 000 x PVIFA 14%, 4yrs ) = - 28, 500 + ( 10, 000 x 2.914 ) = - 28, 500 + 29, 140 = RM 640.00

  27. Solution: PROJECT B(Uneven Cash flows) • Use (PVIF) for uneven cfS In these case (mutually exclusive project), project B is recommended, because it has the highest positive NPV compare with project A.

  28. Definition Indicate what rate of return does a project earn IRR- discount rate that makes the npv = 0 Irr Example Formula Decision criteria

  29. FORMULA : NPV = -IO +∑ CF (PVIF k,n) from NPV’s formula 0 = -IO +∑ CF (PVIF k,n) Therefore; IO = ∑ CF (PVIF k,n) uneven cash flow IO = CF (PVIFA k, n) even cash flow

  30. Decision criteria Independent projects IRR >than @ equal to required rate of return – accept IRR < than @ equal to required rate of return – reject Mutually exclusive projects Accept the single project with the highest IRR as long as its IRR is >than or equal to required rate of return.

  31. EXAMPLE 1 : Even annual cash flows • QUESTION A firm with a required rate of return or cost of capital of 10% is considering a project that involves an initial investment outlay of $54,666. If the investment project is taken, the after-tax cash flows are expected to be RM18,000 per annum over the project four-year life. WHAT is the IRR of this project?

  32. SOLUTION : Using present value table, IO = CF (PVIFAirr,n) RM 54,666 = R M 18,000 (PVIFA irr, 4) PVIFA irr, 4 = 54,666 18,000 = 3.037 (refer table PVIFA) * IRR = 12%

  33. Example 2:Uneven cash flows QUESTION Another firm with a required rate of return of 12% is considering a project that involves an initials investment outlay of $100,000. If the project is accepted and the expected after-tax annual cash flows are given below. The project is also expected to have a salvage value of $5,000 at the end of its 4 years economics life. What is the IRR of this project?

  34. SOLUTION : Years Annual Cash Flows 0 -$100,000 1 $30,000 2 $40,000 3 $50,000 4 $75,000 IO = ∑CF (PVIF irr,n) n = 4, IO = $100,000

  35. SOLUTION i) assume i =25% 100,000 = 30,000(PVIF25%, 1) + 40,000(PVIF25%, 2) + 50,000(PVIF25%, 3) + 75,000(PVIF25%, 4) 100,000 = 24,000+25,600+25,600+30,750 100,000 = 105,950 NPV = RM 5,950 ii) assume i=30% 100,000 = 30,000(PVIF30%, 1) + 40,000(PVIF30%, 2) +50,000(PVIF30%, 3)+ 75,000(PVIF30%, 4) 100,000 = 23,070 + 23,680 + 22,750 + 26,250 100,000 = 95,750 NPV = (4,250)

  36. SOLUTION • The IRR may be estimated through interpolation by using this equation: Where: i1 = the lower discount rate, i2 = the higher discount rate, NPV i1 = the NPV at the lower discount rate, NPV i2 = the NPV at the higher discount rate. IRR = 0.25 + (0.30-0.25) 5,950 (5,950 + 4,250) = 0.2792 = 27.92% IRR = i1 + ( i2 –i1) NPV i1 (NPV i1 – NPV i2)

  37. NPV vs IRR • On the purely theoretical basis, NPV is preferred over IRR because NPV assumes the more conservative reinvestment rate and does not exhibit the mathematical problem of multiple IRRs that often occurs when IRR are calculated for non conventional cash flows. • In the practice, the IRR is more commonly used because it is consistent with the general preference of business people for rates of return.

  38. conclusion • Capital budgeting is an analysis of the financial value of a a specific investment. • It enable us to estimate of all future cash flows, looking the nature and extent of risk associated with each sources of cash flow, estimate of proper discount rates to apply to cash flows • determine whether the project will cover the cost of financing or not.

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