Chapter 4: Capital Budgeting Decision Methods

The purpose of this chapter is to evaluate and decide whether to purchase new equipment, the acquisition of property or acquisition of another company. Therefore the best project can give a maximum return from the companys investment.

4.1 The Capital Budgeting Process

The process of capital budgeting involved four steps which is as follow :
1. Estimates the cash flows after tax from

investment. 2. Consider the risk involved associated to the investment.

Cont.
3. Choose the best methods to evaluate the

project ; non-discounted method and discounted method. 4. Make a best decision to ensure those investments provides a positive return to the companys value. The decision is based on mutual exclusive investment and/or independent investment.

Capital Budgeting Decision Methods

2 cash flow methods : Non-discounted cash flow Discounted cash flow method

Non-discounted cash flow

This method does not consider the time value of money in calculating and analyze the capital investment. Under this method, there are two techniques that commonly used by Financial Manager to calculate and evaluate the best investment i.e. Average Rate of Return and Payback Period.

The Accounting Rate of Return (ARR)

This method is to measures the average on profitability of proposed capital investment as the ratio of average net income after tax to the average investment. ARR = Average Net Income After Tax Average Investment

The Payback Period

The payback period method focuses on the time value of money and uses cash flow after tax, instead of net profit in evaluating an investment. This method use to measure the length of time that the company needs to consider to recover back the cost of investment. Thus, payback occurs when the total of cash inflows equal to the initial investment :
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Payback period (When the cash flows are an annuity) = IO / Average CF

Payback period (When the cash flows are mixed stream) = (Yr 1) + [ (IO Cum. inflow before Yr.) ] Cash inflow in Yr.
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Example

Shasha Farzana is the Financial Manager for RIDZ Sdn Bhd. She needs to considering the potential investment for company i.e. Project A and Project B which can maximize the companys return.

Cont.

The below table shows the detail of each projects :

Year 1 2 3 Total Inflow Initial Outlay

Project A RM2,500 RM2,500 RM2,500 RM7,500 RM5,000

Project B RM2,500 RM700 RM3,300 RM6,500 RM5,000

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Discounted cash flow method

Discounted cash flow method considers the time value of money in the analysis. This method support the goal of the firm i.e. to maximize the shareholders wealth. There are three common techniques in discounted cash flow ; net present value, internal rate of return and profitability index.

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Net Present Value (NPV)

This technique among the common techniques and is widely used in analyzing the best investment for company. NPV is the present value of an investments annual cash flows less the initial outlay. It can be expressed as follows :

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Cont.
NPV (mixed stream cash flows) = = [ PV1 + PV2 + + PVn ] - IO (1 + i)1 (1 + i)1 (1 + i)n

NPV (an annuity) = PV [ 1 1 ] (1 + i)n i

- IO

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Profitability Index (PI)

Profitability index measures the ratio of present value of cash flow to the cost of investment. This index can be expressed as follows : PI = [ PV1 + PV2 + + PVn ] (1 + i)1 (1 + i)1 (1 + i)n ----------------------------------------Initial Outlay

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Internal Rate of Return (IRR)

IRR is the discount rates that cause the NPV to equal zero. Therefore, IRR is when NPV is equates to zero :
[ CFATt / (1 + IRR)t ] IO

IRR =

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Capital Rationing

Capital rationing is referring to placing a limit on the dollar size of the capital budget. There are three basic principles for imposing a capital-rationing constraint.

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Example

Company ABC has a budget constraint of RM4 million and there are four projects available. The table below is the information for each of proposed projects :
Project AA BB CC DD Initial Outlay (RM) 2.0 million 1.0 million 1.2 million 1.8 million NPV (RM) 0.8 million 0.4 million 0.6 million 0.9 million
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Chapter 5 : Capital Structure Basics

Capital structure is the mix or combination of firms permanent long term financing including firms debt, preferred stock and common stock.

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Different companies may imply different optimal structure. The objectives of capital structure are as follows :
Investment decision Financing decision Dividend policy decision

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Breakeven Analysis and Leverage

Breakeven analysis is focus on the relationship between sales volume and profitability, which has a direct relationship to the firms total cost structure.

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Break Even Point

Also known as a cost-volume analysis which is finding the level of sales where operating profit or net income before interest and tax equals to zero that is the total revenues equal to total cost. EBIT is; EBIT = Q (P V) FC
: : : : Sales quantity (in unit) Price per unit Variable cost per unit Fixed cost

Where ; Q P V FC

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Sales Break Even

It involves the same formula except the sales break even uses contribution margin (CM). The sales break even can be calculated as follows :
CM = = 1 Variable cost ratio 1 (V / P)

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Cash Break Even (CBE)

It concern with the sales level in order to meet operating cash requirement. This is because cash receipts and expenditure do not correspond directly with the sales and expenses as per income statement. In CBE, non-cash expenses such as depreciation are not included as it will overstate the CBE. The CBE can be computed as follows;

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Cont.

CBE (in unit) = (FC depreciation) (P V) CBE (in RM) = (FC depreciation) [ 1 - (V / P)

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Break Even Margin

This technique is used to calculate the margin of safety when the level of sales is known. This relates to the firms current sales level to break even point and thus it will measures the risk on how much the sales can be decline before meet the break even point which result in negative operating earnings.

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Cont.

Break even margin (BEM) can be computed using the following formula : BEM = S0 BE (in RM) / S0

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Leverage

Leverage implies the usage of fixed costs in a business to firms earnings. The leverage is included the operating leverage and financial leverage.
Operating leverage is the fixed operating costs which is appear in the firms income statement.

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Cont.

Financial leverage relates to the financial sources which carry fixed financing charges that the company willing to bear in order to maximize their returns on shareholders wealth. The combination between operating leverage and financial leverage known as the total leverage.

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Degree of Operating Leverage (DOL)

DOL is the percentage change in a firms operating profit due to the change in sales volume. The formula to calculate DOL is as follows: DOL = Percentage chg. in operating profit Percentage change in sales

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Degree of Financial Leverage (DFL)

DFL is defined as the percentage of change in EPS as the result from percentage change in EBIT. The level of financial leverage can be determined by applying the following formula :

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Cont.

DFL = % change in EPS____ % change in operating profit DFL= ________EBIT_______ EBIT 1 Preferred divd. / (1 Tax)

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Example
Company
Sales (RM) Operating cost : Fixed cost (RM) Variable cost (RM) Operating profit Fixed cost

Syarikat Mama 5,500

1,000

Syarikat Mimi 9,750

7,000

Syarikat Mumu 5,000

3,500

3,500 1,000 0.22

1,500 1,250 0.82

1,000 500 0.78

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Cont.

The above illustration, it shows that Syarikat Mimi has the highest percentage of fixed cost of 0.82. This is requires a large amount of sales in this company as compared to Syarikat Mama and Mumu in recovering the total costs and thus able to make a highest profit.

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