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CAPITAL BUDGETING TECHNIQUES

Capital Budgeting Techniques.

A number of techniques used to analyze the relevant cash flows to asses whether a project is acceptable or to rank projects.

  • 1. Payback period (PP)

Payback period is the exact amount of time required for a firm to recover its initial

investment as calculated from cash inflows.

In the case of annuity, Payback period =

Initial Investment

The Annual Cash Inflows

In the case of mixed Stream, Payback Period must be accumulated until

the Initial Investment is recovered

Example.

Capital expenditure data for Barnet Company.

Project

 

A

B

Initial Investment

 

$ 42,000.00

$ 45,000.00

 

Year

   
 

1

$ 14,000.00

$ 28,000.00

 

2

$ 14,000.00

$ 12,000.00

 

3

$ 14,000.00

$ 10,000.00

 

4

$ 14,000.00

$ 10,000.00

 

5

$ 14,000.00

$ 10,000.00

 

Average

$ 14,000.00

$ 14,000.00 (70 k /5 years)

Project A has annual cash inflows.

 

Payback period =

 

Initial Investment

$ 42.000

The Annual Cash Inflows =

$

14.000 = 3 years

Project B has mixed stream cash inflows

 
B $ 45,000.00 $ 28,000.00 $ 12,000.00 $ 10,000.00 $ 10,000.00 $ 10,000.00 $ 50,000.00 (40

B

$ 45,000.00

$ 28,000.00

$ 12,000.00

$ 10,000.00

$ 10,000.00

$ 10,000.00

$ 50,000.00 (40 + 10)

Accumulated Cash inflows

$ 28,000.00

$ 40,000.00 (28 + 12)

At the end of year 3, $ 50,000.00 will be recovered. Since the amount received by the end of year 3 is greater than the initial investment of $ 45,000.00, the payback period is somewhere between two and three years. It is only $ 5,000.00 must be recovered during year 3. So, it needs 50 percent of $ 10,000.00 to complete the payback of initial investment. Therefore paybeck period for project B is 2.5 years ½ dari 10,000 ditahun ke3 = 5000 untuk mencapai 45,000 kemudian (2 tahun = 40,000 + ½ tahun (0,5) = 5,000 ) years

  • 2. Net Present Value (NPV)

Net Present Value discounts the firm’s cash flows at a specified rate called

discount rate/opportunity rate/cost of capital/.

NPV = Present Value of all Cash Inflows (tahun 1,tahun2 dst) initial Investment

n

NPV =

t 1

CF (1+k) t Initial Investment

t

At the end of year 3, $ 50,000.00 will be recovered. Since the amount received by

NPV calculation for Project A

Annual cash inflows

$ 14,000.00

PVIFA, 10%, 5 years

3.791 (dari tabel)

PV of cash inflows

$ 53,074.00 (hasil kali an * pv)

Initial Investment

$ 42,000.00

NPV

$ 11,074.00 (pv- ini)

 

NPV calculation for Project B

 

Year

Cash Inflows

PVIF, 10%, 5 Years

PV

 
  • 1 $ 28,000.00

0.909 (dari tabel)

$ 25,452 (cash inflow x PVIF)

 
  • 2 $ 12,000.00

  • 0.826 9,912

 
 
  • 3 $ 10,000.00

 
  • 0.751 7,510

 
  • 4 $ 10,000.00

 
  • 0.683 6,830

 
  • 5 $ 10,000.00

 
  • 0.621 6,210

 

PV of cash inflows

$ 55,914 (total keselu.

 

Pv)

 

Initial Investment

$ 45,000

 

NPV

$ 10,914 (pv- ini)

3. Internal Rate of Return (IRR)

IRR

is

the discount

rate that

equates

the

PV

of

cash inflows

with initial

investment associated with a project, thereby causing NPV = 0

n

0 =

t 1

CF

t

(1+IRR) t Initial Investment

OR

n

t 1

CF t

(1+IRR) t

= Initial Investment

IRR = k 1 +

NPV

1

NPV 2 (k 2 k 1 )

NPV 1 -

Example.

$130,000

3. Internal Rate of Return (IRR) IRR is the discount rate that equates the PV of

$100,000

Capital expenditure data for Barnet Company.

   

Project

A

B

Initial Investment

$ 42,000.00

$ 45,000.00

Year

   

1

$ 14,000.00

$ 28,000.00

2

$ 14,000.00

$ 12,000.00

3

$ 14,000.00

$ 10,000.00

4

$ 14,000.00

$ 10,000.00

5

$ 14,000.00

$ 10,000.00

Average

$ 14,000.00

$ 14,000.00

In the case of annuity

 

Project A

k1 = 18%

k2 = 20%

 
  • 1 $14,000.00

11864.40678

$11,666.67

 
  • 2 $14,000.00

10054.58202

$9,722.22

 
  • 3 $14,000.00

8520.832218

$8,101.85

 
  • 4 $14,000.00

7221.044252

$6,751.54

 
  • 5 $14,000.00

6119.529027

$5,626.29

 

PV of cash inflows

43780.39429

41868.56996

 

Initial Investment

42,000

42,000

 

NPV

1,780

-131

IRR = k 1 + (k 2 k 1 )

IRR = 18% + (20% 18%)

IRR = 19,8%

 

Project B

k1 = 18%

k2 = 22%

 
  • 1 $28,000.00

23728.81356

22950.81967

 
  • 2 $12,000.00

8618.213157

8062.348831

 
  • 3 $10,000.00

6086.308727

5507.068874

 
  • 4 $10,000.00

5157.888752

4513.99088

 
  • 5 $10,000.00

4371.092162

3699.992525

 

PV of cash inflows

47962.31636

44734.22078

 

Initial Investment

45,000

45,000

 

NPV

2,962

-266

IRR = k 1 +

NPV

1

NPV 1 -

NPV 2 (k 2 k 1 )

IRR = 18% +

IRR = 21,6%

  • 2.962 (-266) (22% 18%)

2.962 -

CASE 1

A machine currently in use was originally purchased two years ago for $ 40,000. The machine is being depreciated under ACRSusing 5 recovery period. It has three years of usable life remaining. The current machine can be sold today to net $ 42,000. A new machine using 3 year ACRS recovery period can be purchased at a price of $ 140,000. It will require $ 10,000 to install and has 3 years

useble life. If the new machine is acquired, the investment in account receivables is expected to rise by $ 10,000, the inventory investment will increase by $ 25,000 and account payable will increase by $ 15,000. EBIT is expected to be $ 70,000 for each of next three years with the old

machine and $ 120,000 in the first year and $ 130,000 in the second year and third year with the

new machine

At the end of three years, the market value of the old machine would equal zero, but the new machine could be sold to net $ 35,000 befor taxes. Both ordinary corporate income and capital gains are subject to a 40% tax. Determine initial investment associated with the purposed replacement decision. Calculate the incremental operating cash inflows for years 1 to 4 associated with the purposed replacement decision Calculate the terminal cash inflows associated with the purposed replacement decision

Table A-1. Convention

3-, 5-, 7-, 10-, 15-, and 20-Year Property Half-Year

Year

 

Depreciation rate for recovery period

 

3-year

5-year

7-year

10-year

15-year

20-year

1

33.33%

20.00%

14.29%

10.00%

5.00%

3.750%

2

44.45

  • 32.00 24.49

18.00

9.50

7.219

3

14.81

  • 19.20 17.49

14.40

8.55

6.677

4

7.41

  • 11.52 12.49

11.52

7.70

6.177

5

  • 11.52 8.93

9.22

6.93

5.713

6

 

5.76

8.92

7.37

6.23

5.285

7

8.93

6.55

5.90

4.888

8

4.46

6.55

5.90

4.522

9

6.56

5.91

4.462

10

6.55

5.90

4.461

11

     

3.28

5.91

4.462

12

5.90

4.461

13

5.91

4.462

14

5.90

4.461

15

5.91

4.462

16

       

2.95

4.461

17

4.462

18

4.461

19

4.462

20

4.461

21

         

2.231

CASE 2

Fitch industry is in the process of choosing the better of two equal risk, mutually

exclusive project- M and N. Information for each project as follows.

   

Project

M

N

Initial Investment

$ 28,500.00

$ 27,000.00

Year

   

1

$ 10,000.00

$ 11,000.00

2

$ 10,000.00

$ 10,000.00

3

$ 10,000.00

$ 9,000.00

4

$ 10,000.00

$ 8,000.00

Calculate payback period, NPV and IRR

Comparing NPV and IRR Techniques.

For conventional projects, NPV and IRR will always generate the same accept- reject decision. The differences in their assumptions cause them to rank projects differently.

1. NPV Profiles

Projects can be compared graphically by constructing NPV profiles.

Example.

 

A

B

$ 28,000.00

$ 25,000.00

11,074.00

10,914.00

0

1295

-131

0

NPV

Discount Rate

0% 10% 20% 22%
0%
10%
20%
22%
12

Conflicting Rankings.

Conflicting rankings dengan menggunakan NPV dan IRR karena:

The magnitude of cash flows

Timing of cas flows

Asumsi implicit: reinvestment of intermediate ash inflows (cash inflows received

prior of intermediate cash inflows).

NPV: the intermediate cash inflows are reinvested at the cost of capital

IRR : the intermediate cash inflows are reinvested

projects IRR

at

the

rate

equal to

the

Project with similar sized investment.

 

Lower Early Year Cash

Higher Early Year Cash

Inflows

Inflows

Preferred

Not Preferred

Not Preferred

Preferred

CASH INFLOW PATTERN

Discount Rate

Low High
Low
High

Which One Is Better?

Theoritical View.

 

NPV

is

better

approach to capital

budgeting. NPV assumes that the

intermediate cash inflows are reinvested at the cost of capital (reasonable

estimate) than IRR at the rate equal to the projects IRR.

Practical View

 

Financial managers prefer to use IRR. The business manager prefers to use

rate of return rather than actual dollar returns. Interest rate and profitability

expressed as annual return.

Approaches For Dealing With Risk.

Risk refers to the chance that the project will prove unacceptable (NPV < 0 and IRR < CoC).

Risk in capital budgeting stems from CASH INFLOWS (uncertainty), while initial investment is known with relative certainty. All components in cash inflows (sales, CGS, operating expenses) are uncertain.

Analyst has to evaluate the probability that the cash inflows will be large enough

to provide for project acceptance.

14

Exp.

Tyre company has 2

mutually exclusive projects (A and B). Each requires $

10,000 initial investment (II) and provides equal annual CIF over 15 years lives.

NPV = CIF * (PVIFA k,n ) Initial Investment > 0

k =10%, n = 15 years, II = $ 10,000, the breakeven cash inflows (minimum

level of cash inflows) necessary for projects to be acceptable:

NPV = CIF * (PVIFA k,n ) Initial Investment > 0

CIF * (PVIFA 10%,15 ) 10,000 > 0

CIF * (7.606) 10,000 > 0

CIF >

  • 10.000 = $ 1,315

7.606

Assume that the analysis results as follows:

Probability

of CIF A > $1,315

100%

Probability

of CIF B > $1,315

60%

Project A less risky than project B.

Sensitivity and Scenario Analysis.

Sensitivity analysis: an approach that uses a number of possible values for a given variable such as CIF in order to asses its impact on a firms return such as

 

NPV.

Project A

Project B

 

Initial investment

$ 10,000

$ 10,000

 

Annual Cash Inflows

Outcomes

   

Pesimistic

$ 1,500

$ 0

Most likely

2,000

2,000

Optimistic

2,500

4,000

Range

1,000

4,000

NPV

   

Pesimistic

$ 1,409

($10,000)

Most likely

5,212

5,212

Optimistic

9,015

20,424

Range

7,606

30,424

k =10%

Scenario anaylsis is an approach that evaluates the impact on return of simultaneous changes in a number of variables such as CIF, COF, CoC.

Example, firm could evaluate the impact of both high inflation (scenario 1) and low inflation (scenario 2) on NPV. Each scenario will affect the firm s CIF, COF and CoC.

Risk Adjustment Techniques.

Two

major

risk

adjustment

techniques

using

NPV

decision

method.

Intial

investment is known with certainty, a projects risk is embodied in the PV of CIF.

CF t

(1+k) t

Two opportunities to adjust the PV of CIF fo r risk:

CIF using Certainty Equivalents

Discount rate using Risk Adjusted Discount Rate.

Certainty Equivalents is risk adjustment factors that represent the percentage

of estimated CIF that investors would be satisfied to receive for certain rather

than the CIF that are possible for each year.

n

NPV =

t 1

α t x CF t

(1+R F ) t

Initial Investment

α

R F

: Certainty equivalent factor in year t (0 α t t)

: Risk free rate of return such as US Tresurry Bill

Exp.

Capital expenditure data for Barnet Company.

A B $ 42,000.00 $ 45,000.00 $ 14,000.00 $ 28,000.00 $ 14,000.00 $ 12,000.00 $ 14,000.00

A

B

$ 42,000.00

$ 45,000.00

   

$ 14,000.00

$ 28,000.00

$ 14,000.00

$ 12,000.00

$ 14,000.00

$ 10,000.00

$ 14,000.00

$ 10,000.00

$ 14,000.00

$ 10,000.00

$ 14,000.00

$ 14,000.00

Project
Project
Initial Investment Year 4 5 3 2 1 Average
Initial Investment
Year
4
5
3
2
1
Average
A B $ 42,000.00 $ 45,000.00 $ 14,000.00 $ 28,000.00 $ 14,000.00 $ 12,000.00 $ 14,000.00

Manager estimates the certainty equivalens each year for both project as follows.

 

A

B

0,9

1

0,9

0,9

0,9

0,7

0,8

0,5

0,7

0,8

Certainty Equivalent

   

Year

 

1

 

2

 

3

 

4

 

5

 

R F = 6%.

18

  • 7762.5179 6336.749306

$3,497.81

$42,000.00

45497.80868

5230.80721

5230.80721 $45,000.00 $10,151.19 55151.18596
5230.80721
$45,000.00
$10,151.19
55151.18596
  • 4 $14,000.00

$10,000.00

0.7

  • 0.8
    9800

    • 8000 0.792094

NPV

Initial Investment

  • 5 $14,000.00

0.747258

  • 7000 7000

0.7

0.5

$10,000.00

9000 0.839619 11200 Project Certainty Equivalent A B A B $14,000.00 $28,000.00 0.9 1.00 $14,000.00 $12,000.00
  • 9000 0.839619

11200

 

Project

Certainty

 

Equivalent

A

B

A

B

$14,000.00

$28,000.00

0.9

1.00

$14,000.00

$12,000.00

0.9

0.9

$14,000.00

$10,000.00

0.8

0.9

  • 10800 0.889996

12600

12600

9000 0.839619 11200 Project Certainty Equivalent A B A B $14,000.00 $28,000.00 0.9 1.00 $14,000.00 $12,000.00
9403.73597 7556.573547
9403.73597
7556.573547
11213.95514 9611.961552
11213.95514
9611.961552
28000 0.943396 11886.79245 26415.09434
28000
0.943396
11886.79245
26415.09434
Certain CIF A Certain CIF B DF 6% PVA PVB
Certain
CIF A
Certain
CIF B
DF 6%
PVA
PVB
9000 0.839619 11200 Project Certainty Equivalent A B A B $14,000.00 $28,000.00 0.9 1.00 $14,000.00 $12,000.00
9000 0.839619 11200 Project Certainty Equivalent A B A B $14,000.00 $28,000.00 0.9 1.00 $14,000.00 $12,000.00
9000 0.839619 11200 Project Certainty Equivalent A B A B $14,000.00 $28,000.00 0.9 1.00 $14,000.00 $12,000.00
9000 0.839619 11200 Project Certainty Equivalent A B A B $14,000.00 $28,000.00 0.9 1.00 $14,000.00 $12,000.00
9000 0.839619 11200 Project Certainty Equivalent A B A B $14,000.00 $28,000.00 0.9 1.00 $14,000.00 $12,000.00
9000 0.839619 11200 Project Certainty Equivalent A B A B $14,000.00 $28,000.00 0.9 1.00 $14,000.00 $12,000.00
9000 0.839619 11200 Project Certainty Equivalent A B A B $14,000.00 $28,000.00 0.9 1.00 $14,000.00 $12,000.00
7762.5179 6336.749306 $3,497.81 $42,000.00 45497.80868 5230.80721 5230.80721 $45,000.00 $10,151.19 55151.18596 4 $14,000.00 $10,000.00 0.7 0.8 9800

The risk adjustment discount rate is the rate of return that must be earned on a

given project in order to compensate the firms owners adequately, thereby

resulting in the maintenance of share price.

k j = R F + [ b i x {k m R F )

Required rate of return

SML
SML
Acceptance IRR > k, NPV>0 rejection IRR < k, NPV<0
Acceptance
IRR > k, NPV>0
rejection
IRR < k, NPV<0

Project Risk (β)