PROGRAM

MODULE
TUTORIAL
SESSION
TOPIC 6

Outline
BBA, BIM, BHRM, BAC, BEC, BMKT, BTRM, BHM
BBPW3103
FINANCIAL MANAGEMENT I
T3
Criteria of Capital Budgeting
Subtopics:
1. Capital Budgeting
2. Payback Period
3. Net Present Value
4. Profitability Index
5. Internal Rate of Return

TOPIC 7

Cash Flow of Capital Budgeting

Subtopics:
1. Guidelines in Estimating Cash Flow for Capital Budgeting
2. Initial Outlay
3. Operating Cash Flow
4. Terminal Cash Flow
5. Application of Cash Flow for Capital Budgeting in Decision Making

LEARNING
OUTCOMES

Topic 6:

Determine the acceptability of a new project based on the payback period,

net present value, profitability index and internal rate of return

Explain the advantages and disadvantages of each capital budgeting

technique
Topic 7:

Apply the guidelines for estimation of cash flow

Differentiate between sunk cost and opportunity cost

Apply the capital budgeting techniques in decision making

INSTRUCTIONAL
ACTIVITIES

Topic 6:

Explain the purpose and need for capital budgeting.

Explain payback period, net present value, profitability index and internal
rate of return as techniques of capital budgeting.

Demonstrate by using relevant examples on how to calculate the followings:

payback period, net present value, profitability index and internal rate of
return

Topic 7:

Distinguish the various costs that must be evaluated in a capital budgeting

decision.

Demonstrate by using relevant examples on how to apply the guidelines for

Notes

DIAGNOSTIC
EXERCISE
(5-10 minutes to
ensure basic
understanding
of topic)

estimation of cash flow

Demonstrate by using relevant examples on how to calculate for operating
cash flow and terminal cash flow.

Topic 6:
1. What distinguishes a capital investment from other investments?
2. Explain the advantages and disadvantages of the following capital budgeting
methods: payback period, net present value, profitability index and internal
rate of return.
3. Megah Sdn. Bhd. is considering a new project that will cost RM450,000. The
project is expected to generate positive cash flows over the next four years in
the amounts of RM250,000 in year one, RM125,000 in year two, RM110,000
in year three, and RM80,000 in year four.
What is the payback period of this project?

Topic 7:
1. What is meant by sunk cost and opportunity cost? Provide an example for
each said cost.
2.

You are given the following information:

Purchase price of new machine
RM8,000
Delivery expenses
RM2,000
Market value of old machine
RM2,000
Decrease in inventory if new machine is installed
RM1,000
Increase in account receivable if new machine is installed RM500
Tax rate
34%
What is the initial outlay?

Or other
exercises
prepared
by face to
face
tutors

WORKED EXAMPLES FOR TOPIC 6

Questions & Answers

Extra Notes
Menara Sdn. Bhd. utilises the payback method to evaluate
the following investment proposals.
Project A:
Initial Outlay = RM100,000
Year

Cash Inflows (RM)

1
2
3
4
5
6
7

25,000
25,000
25,000
25,000
25,000
10,000
5,000

Project B:
Initial Outlay = RM500,000
Year

Cash Inflows (RM)

1
2
3
4
5
6
7

125,000
250,000
300,000
225,000
100,000
25,000
0

Required:
a) Calculate the payback period for each project.
b) Based on your answer in part (a) above, which project
should be accepted? Explain.
c) List the limitations of payback period method.
Method/ Solution:
Project A:
PBP = 100,000 = 4 years
25,000
Project B:
PBP = 2 + 125,000 = 2.42 years
300,00

b)

Project B because the payback period is shorter i.e.

2.42 years

c)

Limitations:
i) PBP Does Not Take into Account the Concept of
Time Value of Money
ii) PBP Does Not Take into Account the Cash Flows
After the Payback Period

Angkasa Sdn. Bhd. expects to generate the following cash

flows from a RM1,000,000 investment:
Year
1
2
3
4
5

Net Cash Inflows (RM)

100,000
400,000
500,000
300,000
100,000

Required:
a) Calculate the net present value of the investment if
the firm estimates its cost of capital to be 10%.
Explain.
b) Calculate the profitability index of the investment.
Explain.
c) List the advantages and disadvantages of net present
value method.
Method/ Solution:
a)

Year

Cash flow

PVIF10%,n

100,000

400,000 x 0.826

= 330,400

500,000

x 0.751

= 375,500

300,000

x 0.683

= 204,900

100,000

x 0.621

x 0.909

Present value of cash inflow

- Initial outlay
Net present value

RM
=

90,900

62,100
1,063,800

1,063,800
1,000,000
63,800

The investment/ project should be accepted because the net

present value (NPV) is positive.

b)

PI =

Present Value of Cash Inflow

Initial Outlay
1,063,800 = 1.0638
1,000,000

The investment/ project should be accepted because the

profitability index (PI) is more/ greater than 1 and thus, will
increase the value of the firm.

c)

Advantages:
i. It uses the cash flow and not accounting profits.
ii. It takes into account the timing of cash flow by using
the discounted cash flow or the time value of money
concept.
iii. It takes into account all the cash flows of the project.
iv. The criteria of NPV are in accordance with the
concept of owners wealth where, in theory, NPV of a
project represents the explicit measurement of the
increase or decrease of a firms value and owners
wealth. Therefore, the NPV technique is the best
technique in the perspective of financial theory.

Disadvantages:
The calculation of NPV is rather complex compared to
PBP because it requires an in- depth understanding of
the concept and calculation of present value.
ii. The calculation of NPV requires information on the
cost of capital for the project that is sometimes
difficult to obtain.

i.

WORKED EXAMPLES FOR TOPIC 7

Questions & Answers

Extra Notes
Perdana Sdn. Bhd. is considering a new project. Based on the
following data, what is the project's Year 1 operating cash
flow?
Sales
Depreciation
Other operating costs
Tax rate

RM22,000
RM8,000
RM12,000
35%

Method/Solution:
Tax = (Sales Other operating costs Depreciation) x Tax rate
Tax = (22,000 12,000 8,000) x 35%
= 2,000 x 35%
= 700

OPERATING CASH FLOW = Sales Other operating costs - Tax

OPERATING CASH FLOW = 22,000 12,000 700
= 9,300
2

Given the following information, what is the initial outlay of

the project?
Purchase price of new machine
RM8,000
Installation charge
RM2,000
Market value of old machine
RM2,000
Book value of old machine
RM1,000
Inventory decrease if new machine
is installed
RM1,000
Accounts payable increase if new
machine is installed
RM500
Tax rate
35%
Cost of capital
15%
Method/Solution:
Changes in NWC = Inventory Accounts Payable
= -1,000 500
= -1,500 (inflow)
Increase in Tax = Tax rate (Selling price Book value)
= 35% (2,000 1,000)
= 350

Sales revenue after tax for old machine = Selling Price

Increase in tax
= 2,000 350
= 1,650
Initial outlay = 8,000 + 2,000 1,500 1,650 = 6,850

Exercises for Topic 6

BMB Sdn. Bhd. is considering a new project that will cost

RM900,000. The project is expected to generate positive cash flows
over the next four years in the amounts of RM500,000 in year one,
RM250,000 in year two, RM220,000 in year three, and RM160,000
in year four.
What is the payback period of this project?
Answer: 2.68 years

Putra Sdn. Bhd. is considering two mutually exclusive projects.

The cash flows associated with these two projects are as follows:

Initial Investment:
Cash Inflows:
Year 1
Year 2
Year 3
Year 4
Year 5

Project A
(RM 70,000)

Project B
(RM 100,000)

RM 20,000
RM 10,000
RM 15,000
RM 18,000
RM 4,000

RM 20,000
RM 20,000
RM 20,000
RM 20,000
RM 20,000

The required rate of return for the two projects is 6%.

a) Calculate the net present value for Project A and B?
b) Calculate the profitability index for Project A and B?

Answer:
a) -RM12,391 and -RM15,752
b) 0.8230 and 0.8425
Exercises for Topic 7

Given the following information, what is the initial

investment?
Purchase price of new machine
RM35,000
Delivery and Installation cost
RM6,000
Market value of old machine
RM17,000
Price of old machine (bought)
RM15,000
Book value of old machine
RM10,000
Inventory increase if new machine
is installed
RM5,000
Tax rate
30%

Answer: RM31,100