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## CAPITAL BUDGETING TECHNIQUES

• ### 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.

### \$ 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 + 10)

Accumulated Cash inflows

\$ 28,000.00

\$ 40,000.00 (28 + 12)

• ### 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

NPV =

### t  1

CF (1+k) t Initial Investment

t ### \$ 14,000.00

PVIFA, 10%, 5 years

### Cash Inflows

PVIF, 10%, 5 Years

### 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

0 =

### t  1

CF

t

(1+IRR) t Initial Investment

OR

# 

### 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 ## \$100,000

Capital expenditure data for Barnet Company.

### -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 -

## 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% ### 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

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 project’s 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.

## 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.

Two

major

risk

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.

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 \$ 10,000.00 \$ 14,000.00 \$ 10,000.00 \$ 14,000.00 \$ 10,000.00 \$ 14,000.00 \$ 14,000.00 Project Initial Investment
Year
4
5
3
2
1
Average 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
• 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 0.9 0.9 \$14,000.00 \$10,000.00 0.8 0.9
• 10800 0.889996

12600

12600  9403.73597
7556.573547 11213.95514
9611.961552 28000
0.943396
11886.79245
26415.09434 Certain
CIF A
Certain
CIF B
DF 6%
PVA
PVB        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 Acceptance
IRR > k, NPV>0
rejection
IRR < k, NPV<0

Project Risk (β)