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Basic

FINANCIAL
MANAGEMENT
For Engineers
Capital Investment Appraisal

Ismail Ab.Wahab
Edit by Bulan Abdullah (28 May 2017)
Summary of finance
formula
F = P (1 + i ) n (1 i ) n 1
P A for i 0
n
i (1 i )

i (1 i ) n
A P
(1 i ) n
1

Note- student are required to answer the finance solution


using relevant formula during assignment/ test/exam
Commonly used Symbols
t = time, usually in periods such as years or months
P = value or amount of money at a time t
designated as present or time 0
F = value or amount of money at some future time, such as at
t = n periods in the future
A = series of consecutive, equal, end-of-period amounts
of money
n = number of interest periods; years, months
i = interest rate or rate of return per time period; percent
per year or month

2012 by McGraw-Hill, New York, N.Y All Rights Reserved


Factors: How Time and Interest
Affect Money
1. F/P and P/F Factors
2. P/A and A/P Factors
3. F/A and A/F Factors
4. Factor Values
5. Arithmetic Gradient
6. Geometric Gradient
7. Find i or n
Single Payment Factors (F/P and P/F)
Single payment factors involve only P and F. Cash flow diagrams are as follows:

Formulas are as follows:

F = P(1 + i ) n P = F[1 / (1 + i ) n]

F = P (1 + i )n
Legend
F= FUTURE, P= PRESENT
i= interest, n = no of years
Example: Finding Future Value
A person deposits $5000 into an account which pays interest at a rate of
8% per year. The amount in the account after 10 years is closest to:
Solution:
The cash flow diagram is:

F = P (1 + i )n
F = 5000 (1 + 0.1 )8
= $10,794.50

2012 by McGraw-Hill, New York, N.Y All Rights Reserved


Example: Arithmetic Gradient Solution using formula

The present worth of $400 in year 1 and amounts increasing by $30 per year
through year 5 at an interest rate of 12% per year is closest to:
(A) $1532 (B) $1,634 (C) $1,744 (D) $1,829

DETERMINING THE NET PRESENT VALUE


Firm's cost of capital 12%
PT = ? Year-End Cash Flow
i = 12% Year Project A using Formula
0 1 2 3 4 5 Year 0 - -

1 400 357.14
40
0 430
460 2 430 342.79
490
G = $30 520 3 460 327.42

Using formula 4 490 311.40

5 520 295.06
F = P (1 + i )n
1,633.82
Uniform Series Involving P/A and A/P
The uniform series factors that involve P and A are derived as follows:

(1) Cash flow occurs in consecutive interest periods


(2) Cash flow amount is same in each interest period
Note: P is one period
The cash flow diagrams are: Ahead of first A value

A = Given A=?

0 1 2 3 4 5 0 1 2 3 4 5

P=? P = Given

P = A(P/A,i,n) Standard Factor A = P(A/P,i,n)


Notation

(1 i ) n 1 i (1 i ) n
P A n
for i 0 A P
i (1 i ) 2012 by McGraw-Hill, New York, N.Y All Rights Reserved (1 i ) n
1
Example: Uniform Series Involving P/A
A chemical engineer believes that by modifying the structure of a certain water treatment
polymer, his company would earn an extra $5000 per year. At an interest rate of 10% per year,
how much could the company afford to spend now to just break even over a 5 year project period?
(A) $11,170 (B) 13,640 (C) $15,300 (D) $18,950
Solution:
(1 i ) n 1
P A n
for i 0
i (1 i )
The cash flow diagram is as follows:

A = $5000

0 1 2 3 4 5
i =10%
P=?
= $18,954

2012 by McGraw-Hill, New York, N.Y All Rights Reserved


Answer is (D)
Example: Different-Life Alternatives
Compare the machines below using present worth analysis at i = 10% per year
Machine A Machine B
First cost, $ 20,000 30,000
Annual cost, $/year 9000 7000
Salvage value, $ 4000 6000
Life, years 6
3

Solution:
LCM = 6 years; repurchase A after 3 years
Option 1
Solution Using Formula

DETERMINING THE NET PRESENT VALUE


Firm's cost of capital 10% DETERMINING THE NET PRESENT VALUE
Firm's cost
machine A Year-End Cash Flow
of capital 10%
interest 0.1
Year-End Cash Flow
Year Project A using Formula
machine B interest 0.1
0 (20,000) (20,000.00)
Year Project A using Formula
1 (9,000) (8,181.82)
0 (30,000) (30,000.00)
2 (9,000) (7,438.02)
1 (7,000) (6,363.64)
3 (9,000) (6,761.83)
2 (7,000) (5,785.12)
3 4,000 3,005.26
3 (7,000) (5,259.20)
3 (20,000) (15,026.30)
4 (7,000) (4,781.09)
4 (9,000) (6,147.12)
5 (7,000) (4,346.45)
5 (9,000) (5,588.29)
6 (7,000) (3,951.32)
6 (9,000) (5,080.27)
6 6,000 3,386.84
6 4,000 2,257.90
present value (57,099.98)
present value (68,960.49)
NPV (65,000) (87,099.98)
NPV (86,000) (88,960.49) Choice of
Choice of project #REF! project #REF!

LCM = 6 years; repurchase A after


3 years
Select alternative
11 B
Option 2
Solution Using Formula

DETERMINING THE NET PRESENT VALUE DETERMINING THE NET PRESENT VALUE
Firm's cost of capital 12% Firm's cost of capital 10%
machine A Year-End Cash Flow MACHINE B Year-End Cash Flow
interest 0.12 interest 0.1
Year Project A using Formula Year Project A using Formula
0 (20,000) (20,000.00) first year cost 0 (30,000) (30,000.00)
operation
c1 3 (9,000) (22,381.67) cost 6 (7,000) (30,486.82)
3 4,000 3,005.26 salvarege 6 6,000 3,386.84
present value (39,376.41)
present
3 (20,000) (15,026.30) value (57,099.98)
6 (9,000) (39,197.35)
6 4,000 2,257.90
c2 present value (51,965.75)

Total in 6 year (91,342.16) (68,960.49) C2-C1


(274,026.47)
NPV (50,000) (294,026.47)
Choice of project
LCM = 6 years; repurchase A after
3 years
Select alternative
12 B
Option 3
Solution Using table

3 6
Solution: LCM = 6 years; repurchase A after 3 years
PWA = -20,000 9000(P/A,10%,6) 16,000(P/F,10%,3) + 4000(P/F,10%,6)
20,000 4,000
= $-68,961 in year 3
PWB = -30,000 7000(P/A,10%,6) + 6000(P/F,10%,6)
= $-57,100
Select alternative B
Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount


rate that will equate the present value of the
outflows with the present value of the inflows.
The IRR is the projects intrinsic rate of return.

Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
Capital Investment Appraisal Techniques
Option 1- using calculation 3. Internal Rate of Return (IRR) (cont.)
Example:
An investment of $20,000 in new equipment will generate income of $7000 per
year for 3 years, at which time the machine can be sold for an estimated $8000.
If the companys MARR is 15% per year, should it buy the machine?

DETERMINING THE NET PRESENT VALUE


Firm's cost of capital 15%

machine A Year-End Cash Flow


interest =i 0.15 0.2 0.18
Year= n Project A using Formula using Formula using Formula
investment of $20,000 0 -20,000 -20,000.00 -20,000.00 -20,000.00

generate income of
$7000 per year for 3 years 3 7,000 15,982.58 14,745.37 15,219.91
machine can be sold for
an estimated $8000 3 8,000 5,260.13 4,629.63 4,869.05
NPW present value 1,242.71 -625.00 88.96

Solve using interpolation technique. i* = 18.2% per year

Since i* > MARR = 15%, the company should buy the machine

2012 by McGraw-Hill All Rights Reserved


Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)

Solve using interpolation technique.

Solve using interpolation technique.

Since i* > MARR = 15%, the company should buy the machine
16
CAPITAL INVESTMENT
APPRAISAL
Ismail Ab.Wahab

17
Capital Investment Appraisal Techniques

Capital investment appraisal (or capital budgeting) is the


planning process used to determine whether an
organization's long term investments such as new
machinery, replacement of machinery, new plants, new
products, and research development projects are worth
the funding of cash through the firm's capitalisation
structure (debt, equity or retained earnings).
It is the process of allocating resources for major capital, or
investment, expenditures.
One of the primary goals of capital budgeting investments
is to increase the value of the firm to the shareholders.
Capital Investment Appraisal Techniques

1. Payback Period
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
Capital Investment Appraisal Techniques

Case 1

Bennett Sdn Bhd is a medium sized metal fabricator


that is currently contemplating two projects: Project A
requires an initial investment of RM42,,000, project B
an initial investment of RM45,,000. The relevant
operating cash flows for the two projects are presented
in Table 1 and depicted on the time lines in Figure 1.
Capital Investment Appraisal Techniques

Table 1
Capital Expenditure Data for Bennett Sdn Bhd
Capital Investment Appraisal Techniques
The cash flow diagram is as follows:
Figure 1
Capital Expenditure Data for Bennett Sdn Bhd
Capital Investment Appraisal Techniques
1. Payback Period
DETERMINING THE NET PRESENT VALUE

Firm's cost of capital 10%


Year-End Cash Flow
Year Project A Project B
0 (42,000) accumulation (45,000) accumulation
1 14,000 14,000 28,000 28,000
2 14,000 28,000 12,000 40,000
3 14,000 42,000 10,000 50,000
4 14,000 56,000 10,000 60,000
5 14,000 70,000 10,000 70,000

Project A= 3 years. Project B= less than 3 years


Capital Investment Appraisal Techniques
1. Payback Period
The payback method simply measures how long
(in years and/or months) it takes to recover the
initial investment.
The maximum acceptable payback period is
determined by management.
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.
Capital Investment Appraisal Techniques
1. Payback Period
Pros and Cons
The payback method is widely used by large firms
to evaluate small projects and by small firms to
evaluate most projects.
It is simple, intuitive, and considers cash flows
rather than accounting profits.
It also gives implicit consideration to the timing of
cash flows and is widely used as a supplement to
other methods such as Net Present Value and
Internal Rate of Return.
Capital Investment Appraisal Techniques
1. Payback Period
Pros and Cons (cont.)
One major weakness of the payback method is
that the appropriate payback period is a
subjectively determined number.
It also fails to consider the principle of wealth
maximization because it is not based on
discounted cash flows and thus provides no
indication as to whether a project adds to firm
value.
Thus, payback fails to fully consider the time
value of money.
Capital Investment Appraisal Techniques
2. Net Present Value (NPV)
Net Present Value (NPV): Net Present Value is found
by subtracting the present value of the after-tax
outflows from the present value of the after-tax
inflows.

Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
Capital Investment Appraisal Techniques
2. Net Present Value (NPV) (Cont.)

Using the Bennett Sdn Bhd data from Table 1,


assume the firm has a 10% cost of capital. Based
on the given cash flows and cost of capital (required
return), the NPV can be calculated as shown below:
Capital Investment Appraisal Techniques
2. Net Present Value (NPV) (Cont.)
Figure 2
Calculation of NPVs for Bennett Sdn Bhds
Capital Expenditure Alternatives
Capital Investment Appraisal Techniques
2. Net Present Value (NPV) (Cont.)
Using MS EXCEL

Using
excel
CALUCATE EACH VALUE USING
FORMULA
USING FORMULA
DETERMINING THE NET PRESENT VALUE

Firm's cost of capital 10%


Year-End Cash Flow
GIVEN CALCULATE GIVEN CALCULATE
Year Project A using Formula Project B using Formula
0 (42,000) (42,000.00) (45,000) (45,000)
1 14,000 12,727.27 28,000 25,454.55
2 14,000 11,570.25 12,000 9,917.36
3 14,000 10,518.41 10,000 7,513.15
4 14,000 9,562.19 10,000 6,830.13
5 14,000 8,692.90 10,000 6,209.21

NPV 11,071 11,071.01 10,924 10,924.40


Choice of project Project A

NPV= SUM FROM YEAR 0 TO 5


Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount


rate that will equate the present value of the
outflows with the present value of the inflows.
The IRR is the projects intrinsic rate of return.

Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)
Figure 3
Calculation of IRRs for Bennett Sdn Bhds
Capital Expenditure Alternatives
Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)
Using MS EXCEL
Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)
Using formula DETERMINING THE NET PRESENT VALUE
Firm's cost of capital
Year-End Cash Flow
interest =i 0.1 0.1
Year =n Project A using Formula Project B using Formula
0 (42,000) (42,000.00) (45,000) (45,000)
1 14,000 12,727.27 28,000 25,454.55
2 14,000 11,570.25 12,000 9,917.36
3 14,000 10,518.41 10,000 7,513.15
4 14,000 9,562.19 10,000 6,830.13
5 14,000 8,692.90 10,000 6,209.21

NPV 11,071 11,071.01 10,924 10,924.40


IRR 19.9% 21.7%
Choice of project Project A

Let say interest rate 10%= NPV +ve


Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)
DETERMINING THE NET PRESENT VALUE
Firm's cost of capital
Year-End Cash Flow
interest =i 0.25 0.25
Year =n Project A using Formula Project B using Formula
0 (42,000) (42,000.00) (45,000) (45,000)
1 14,000 11,200.00 28,000 22,400.00
2 14,000 8,960.00 12,000 7,680.00
3 14,000 7,168.00 10,000 5,120.00
4 14,000 5,734.40 10,000 4,096.00
5 14,000 4,587.52 10,000 3,276.80

NPV 11,071 (4,350.08) 10,924 (2,427.20)


IRR 19.9% 21.7%
Choice of project Project A

Let say interest rate 25%= NPV -ve


Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)

Solve using interpolation technique.

Project A Project B
interest NPV
10 11071.01 10,924
X 0 0
25 -4350.08 10924.397

using interpolation we find:


IRR 19.9% 21.7%

38
Case 2: Exercise
The objective of this exercise is to examine an
investment and measure its performance using the
following techniques:
Payback Period
NPV
IRR

A firm is considering an investment programme. It has a


choice of three projects each of which cost RM60,,000,
but capital is limited to RM60,,000.

The firms existing return on capital is 15% and in this


case this is assumed to be their cost of capital for
appraisal purposes.
Case 2 (Cont.)

Project A Project B Project C


Hydraulic Ramps Modification to metal Special Delivery
Workshop cutting machine vehicle

Forecasted Net Cash Flows:

Yr. RM RM RM
1 12,000 18,000 24,000
2 21,000 12,000 27,000
3 27,000 21,000 15,000
4 15,000 21,000 15,000
5 21,000 19,500 9,000
96,000 91,500 90,000
Which Approach is Better?

On a purely theoretical basis, NPV is the better


approach because:
NPV assumes that intermediate cash flows are reinvested at
the cost of capital whereas IRR assumes they are reinvested
at the IRR,
Certain mathematical properties may cause a project with
non-conventional cash flows to have zero or more than one
real IRR.
Despite its theoretical superiority, however, financial
managers prefer to use the IRR because of the
preference for rates of return.
Table 8
Summary of Key Formulas/Definitions and Decision Criteria
for Capital Budgeting Techniques
THANK YOU