CHAPTER 8

CAPITAL BUDGETING
 What is Capital Budgeting?
• Capital - fixed asset used in production
• Budgeting - a plan of detailed cash inflows and outflows during a
period of time
• Capital budgeting is a decision-making process of selecting
and evaluating long-term investments in non-current assets
(fixed asset)

Types of Projects

i) Independent Projects
 The projects are unrelated to one another
 Decision to accept one project will not affect the decision to
accept another
ii) Mutually Exclusive Projects
 These are projects where a decision is made to choose only one
project from many being considered.
 A decision to accept one will automatically mean a rejection of the
others

Types of Capital Budgeting Decisions

1. Expansion projects
 When a company wants to introduce a new product, penetrate a
new market, open new branch or increase production capacity by
buying more machines

2. Replacement of existing assets

 A company is replacing an existing asset with new asset
Cash Flow can be group into three categories
i) Initial outlay/ Net outlay/ Net investment
 immediate cash outflow required by a company to start a project
 The amount of cash investment that must be made to start off the
project
ii) the differential cash flows over the project life
iii) terminal cash flow – these cash flow occur only at the project
termination

WHY CAPITAL BUDGETING IMPORTANT TO MANAGER

• If the firm has inadequate fixed assets, it may lose the market to
competitors
• An error in forecast of asset can have a serious impact on the firm’s
fund
 TYPES OF CAPITAL BUDGETING TECHNIQUE
• It can be divided into two types:

i) Non-discounted cash flows

• The most popular method is payback period

 Payback Period
 It measures how quickly the firm can recover its initial outlay
 It’s the number of years needed for a project to return its initial
investment
 This is a technique to determine the length of time or the number of
years required to recover the cost of investment
 The earlier payback, the better it is.
Calculating Period:-
a) If cash flow is constant for all year during the life of the project (annuity)

Payback Period = Initial outlay

Annual Cash Inflow

b) If cash flow varies, the cumulative cash flow must be determined for each
consecutive year and be compared to the initial investment

ii) Discounted Cash Flow

 Cash inflows and outflows will be discounted according to the time value of
money concept
Decision Criteria
• Independent Project
 A project will be accepted if its payback period is less or equal to the firm’s
maximum desired payback period
 Mutually exclusive project
 A project will only accept the project with the shortest payback period
 Net Present Value (NPV)
 It stresses the timing of cash flows
 The cash flows of the project will be discounted at a specified rate,
called either a discount rate, required rate of return or cost of capital
 The project earns a return equal to discount rate or minimum
required rate , the value of the firm will remain the same
 NPV is the difference between the present value of the project’s
annual after-tax incremental cash flows and its initial investment
NPV = PV cash flows – Initial Investment
Decision Criteria
i)Accept project if the NPV is higher or equal to zero (positive)
ii) Reject a project if the NPV is negative
• If the NPV positive, the project return are more than discount rate
and vice versa
• By accepting a project , its shareholders’ wealth and share price
will increase by the amount of the NPV
• i.e: If the NPV of project RM50,000 and a company has 100,000
common shares outstanding, the share price will increase by
RM50,000/100,000 shares, that is RM0.50 per share
 Profitability Index
 Also known as the benefit/cost method
 It measures the value that a project creates per dollar of
investment

Profitability Index = PV cash flows

Initial Investment

 A positive NPV project will have a PI of more than 1

 A negative project will have a PI of less than 1

Decision Criteria
 Accept a project if the PI is more or equal to 1
 i.e: PI of the project is 1.35. It means that for every one ringgit of
investment, they obtain a 35% return. The higher the PI, the higher
is the return on our investment
 SELF-TEST PROBLEM
• Ning Sdn Bhd is considering major expansion of its product
line and has estimated the following cash flow associated with
the expansion. It has two mutually exclusive products that will
be considered for expansion. The initial outlay would be RM
170,000.Both projects would generate the following cash
flow. The appropriate required rate of return is 10%. Given
the following cash flow, assume that you as investment
analyst for the company will evaluate the cash flow and help
determine which product should be accepted for the
expansion.
 SELF-TEST PROBLEM
Product X Product Y
Initial Outlay RM 170,000 RM 170,000
Cash flows
Year 1 RM 50,000 RM 20,000
Year 2 RM 50,000 RM 80,000
Year 3 RM 50,000 RM 90,000
Year 4 RM 50,000 RM 90,000

Calculate:
i) Payback Period for Product X and Y
ii) NPV
iii) Profitability Index