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Topic Capital

Budgeting

and Cash

Flow

Projection

L

EARNING OUTCOMES

By the end of this topic, you should be able to:

1.

2.

3.

4.

technique; and

5.

Analyse the relationship between cash flow estimation and risk and

also inflation.

INTRODUCTION

assigned to evaluate these projects and submit a report to the board of directors.

How will you evaluate these projects to determine their feasibility? To better

comprehend the technique of project evaluation, it is vital that you, as a financial

manager, understand the meaning of capital budgeting.

In this topic, you will also see how the concept of financial mathematics learnt in

Topic 4 is applied in the evaluation of a financial project.

69

earlier, capital budgeting is a process of planning the asset spending that is the

cash flow expected to be received after a year. Evaluation will be undertaken on

proposals of projects to determine the suitability of those projects to achieve the

firms objective. This can be done by using techniques such as accounting rate

of return, payback period, discounted payback period, net present value and

internal rate of return.

In making a good decision, accurate cash flow is important because it influences

greatly the decision to accept or reject a proposed project. Numerous variables

and many workers will be involved in the process of capital budgeting.

Projections are not made by the finance department only. Other departments

such as the marketing department, production department and human resource

department also make their projections. All data provided by other departments

are compiled by the finance department to make an estimation of cash flow in the

capital budgeting process. Hence, it can be seen how difficult it is to prepare cash

flow estimation. It involves numerous variables, cooperation from many people

and accurate prediction.

A few guidelines on cash flow will be discussed in this topic to help financial

managers to make more accurate cash flow projection.

5.1

CAPITAL BUDGETING

ACTIVITY 5.1

Explain the importance of cash flow in capital budgeting.

Capital budgeting is a process of planning asset spending, which is the receipt of

cash flow expected after a year. In capital budgeting decisions, a company places

funds in various types of projects, such as firm expansion project, production

diversification project, improving cost efficiency project, security project and etc.

Every decision made regarding capital budgeting has significant implications

to both the cash flow expected to be received by the firm and to the cash flow

risk. This is because the decision on capital budgeting involves investment of

assets that is more than one year. For instance, a company wishes to invest in a

project that has life expectancy of five years. Having invested in that project, it is

difficult for a firm to pullout within this five-year period. At this stage, changes

in demand condition, competition and so on may happen. These factors can

influence the cash flow expected to be received and will affect the firms financial

performance. Therefore, it is important for a financial manager to analyse in detail

a long-term investment proposal in order to make the best decision for the firm.

70

its wealth. Capital budgeting process is one of the steps to achieve this objective.

Thus, capital budgeting is part of a strategic management process.

5.1.1

more than a year. If a project has life expectancy of eight years, it means that a

firm will be tied up with that project for eight years. Therefore, it is important

that a firm makes an accurate projection of the expected return. A mistake in

making projection whether in terms of asset requirement or expected return will

have a serious impact on the firms performance. For example, a firm projects

that sales will increase in the future. To fulfil the increase in demand, the firm

must invest in new machines and expand its factory now so that the asset is

available when it is needed. If the projection is correct, the firm will attain profit

because tools and outfit are all ready with the capacity to increase production

and fulfil the increase in demand. But if there are mistakes in the projection, such

as demand does not increase as projected, the firm will experience the problem of

reckless spending due to the excessive capacity. This will incur a loss to the firm

and if the loss is great, this could lead the firm to bankruptcy.

Capital budgeting is part of the process of strategic management. Decision

regarding capital budgeting of the firm shall point to the strategic direction of the

firm. Regardless whether a firm does a replacement project, expansion project or

environmental project, all of these projects need capital budgeting.

The timing of an investment project is important. Effective capital budgeting

must take into consideration the time the project is implemented and the quality

of assets invested. If a project takes place when the economy is in inflation, the

capital cost would be higher due to the high interest rate. This will influence the

discount rate used in the analysis of the projects proposal.

ACTIVITY 5.2

Write three reasons why doing capital budgeting is important.

5.1.2

71

ACTIVITY 5.3

Why is a detailed analysis required for an expansion project compared

to a replacement project?

Assessing capital budgeting proposal involves expenditure. For this reason, a

financial manager may classify projects into various categories to determine the

level of analysis needed replacement project, expansion project, security project,

environmental project etc.

Normally, a more detailed analysis is required for expansion project compared to

an analysis for a replacement project. A large-scale project which requires huge

budget will be evaluated more thoroughly than a small-scale project.

5.1.3

Figure 5.1.

Determining

Cost of Project

Cash Flow

Forecasting

Determining

Risk

Comparing of

Cash

Present Value

Acquisition

Choosing

a Suitable

Capital Cost

(a) Determining cost of project

Cost of project is the average rate of payment for the use of capital fund for

the operation of that particular capital budgeting project. Cost of project can

be influenced by factors such as financing policy and types of investment.

Whether a capital budgeting project is accepted or rejected depends mostly

on the discount rate used and this discount rate can be regarded as capital

cost. Capital cost will be discussed in detail in Topic 6.

72

Estimation of cash flow is an important step in analysing a capital budgeting

project. To make a correct decision, accurate estimation of cash flow is

crucial. Estimation of cash flow is a complicated and difficult step to make

due to the existence of various factors which can influence a projects cash

flow.

cash flow estimation in ensuring that only relevant additional cash flow are

taken into account before making a capital budgeting decision. Guidelines

regarding the estimation of cash flow shall be discussed in depth in this

topic.

(c) Determining Risk

Risk plays a vital role in capital budgeting. Ignoring risk in the analysis of

proposed projects may lead to wrong decision in capital budgeting; and

hence will erode the firms financial standing.

(d) Choosing a Suitable Capital Cost

Based on cash flow risk, a suitable capital cost will be adopted for the

discounting of cash flow expected to be received.

(e) Present Value Acquisition

Cash flow is discounted at present value to get an expected value of the

asset to the firm.

(f) Comparing of Cash

The proposed project shall be accepted if present value of cash inflow

is more than cash outflow. On the contrary, the proposed project will be

rejected if present value of cash inflow is less than cash outflow.

5.1.4

whether a project can be accepted or rejected. The evaluation techniques are as

follows:

(a) Accounting Rate of Return

Accounting rate of return is a traditional method to evaluate a proposed

project in capital budgeting. The equation for accounting rate of return

(ARR) is as follows:

73

Equation 1

ARR(%) =

Or

Equation 2

X 100

ARR(%) =

Sum of Average Investment Value

X 100

Net average income refers to income after depreciation and tax expenditure.

Now look at Example 5.1 that shows how to calculate accounting rate of

return and use the figures to determine choice of project.

Example 5.1

The table shows information regarding two projects, A and B. Book value for

both projects are RM30,000.

Year 1

Year 2

Year 3

Average

(RM)

(RM)

(RM)

(RM)

8,000

12,000

16,000

12,000

16,000

12,000

8,000

12,000

30,000

20,000

10,000

20,000

10,000

25,000

15,000

5,000

15,000

Net income of Project B

(after depreciation and tax)

Book value

Average

1st January

31st December

74

By using Equation 1, accounting rate of return (ARR) for each project is:

Project A

Project B

ARR% =

=

12,000

15,000

X 100

80%

12,000

15,000

X 100

80%

By using Equation 2, accounting rate of return (ARR) for each project is:

Project A

Project A

ARR% =

=

ARR% =

12,000

30,000

40%

X 100

ARR% =

=

12,000

30,000

X 100

40%

accounting rate of return with minimum rate of return required:

(i) Accept a project if ARR is higher than minimum rate of return required;

and

(ii) Reject a project if ARR is lower than minimum rate of return required.

If projects compete with one another or overlap each other, we will choose a

project that will give the highest rate of return as long as the project gives a

higher accounting return rate than the required minimum rate of return.

In Example 5.1, both projects A and B are attractive because their accounting

rate of return are 80% (by using Equation 1) and 40% (by using Equation

2). Both projects A and B will be accepted if the required minimum rate of

return is less than 40%.

to project A which gives a higher return in year 3. If we take into calculation

the present value of money, project B will become more attractive as

compared to project A even though both projects give the same accounting

rate of return.

easy to understand and to be used. The concept of income, book value and

rate of return is a simple concept to understand by managers.

75

(ARR):

(i) It does not take into account the present value of money as seen in

Example 5.1;

(ii) It uses accounting measurement and not cash flow; and

(iii) Different methods of calculation may cause different decisions made.

By using equation 1, the project may be accepted but by using equation

2 it may be rejected.

(b) Payback Period

This is a very simple technique whereby we only have to determine the

period required in order to get back the sum of money invested in the

project. The firms management will decide on a payback period; whether

the project is to be accepted or rejected depends on whether the payback

period is longer or shorter than the period set by the management. The

principles for payback period are as follows:

(i) Accept the project if the payback period is less than or the same as the

period decided by the management; and

(ii) Reject the project if the payback period is more than the period decided

by the management.

Now, look at Example 5.2 which shows the method of choosing a project

based on payback period.

Example 5.2

Hebat Company is evaluating whether to accept Project A. The investment

required is RM12,000. The total cash flow expected for Project A is as

follows:

Year

Cash Inflow

(RM)

3,000

3,000

5,000

5,000

5,000

If Hebat Company sets the payback period to three years, Project A will be

rejected because the investment payback period exceeds the period set by

76

the management. After three years, this project will only give a return of

RM3,000 + RM3,000 + RM5,000 = RM11,000 whereas the cost of investment

is RM12,000.

If Hebat Company sets a payback period of four years, will this project be

accepted? Project A will be accepted because the payback period is less than

the period set. After three years, the firm will receive a return of RM11,000.

Therefore, it still needs RM1,000 to tally the cost of investment of RM12,000.

Assuming that cash flow is constant, Hebat Company will take a time of

(1,000 5,000) 0.2 years to get back the balance of RM1,000. Therefore, the

payback period is 3.2 years compared to the set period of four years.

self-check 5.1

investment of RM100,000. The schedule of cash inflow is as follows:

(a) Calculate the payback period for this project.

Year

30,000

30,000

30,000

30,000

(b) If the management of the Pasti Jaya Company has decided on a

payback period of three years, will this project be accepted?

Example 5.3

Hebat Company has two investment projects proposals: Project A and

Project B. The information on these projects is in the following table:

Assume that Hebat Company sets the payback period to be in three years

time. Based on the technique of payback period, Hebat Company will accept

project B and reject project A. But is this a good decision?

Project A

Project B

RM12,000

RM12,000

RM3,000

RM3,000

RM3,000

RM4,000

RM5,000

RM5,000

RM5,000

RM5,000

Investment

77

Cash inflow

Year

In the payback period technique, Hebat Company does not take into

account the cash inflow after the set payback period. Although Project B is

able to yield return on the investment in year 3, it will not be able to give

any returns after that. On the contrary, Project A may take a longer period

to yield returns on the investment but it will still produce a cash inflow of

RM5,000 in year 4 and year 5:

(i) This is a very easy technique in the project evaluation method. The

calculation is simple and time needed for making evaluation is short.

Thus, the cost of using this technique is low.

(ii) Since this technique is simple and involves low cost, the management

can use this technique to screen several project proposals and to reject

projects which are unattractive in terms of payback period return.

After that, a detailed evaluation can be undertaken) on the existing

project proposal. With this, the management can save time and cost of

evaluating proposed project.

There are difficulties in projecting cash flow in the long term because

of the elements of uncertainty. Hence, payback period technique is a

useful risk evaluation method.

Based on Examples 5.2 and 5.3, the disadvantages of the payback period

technique are as follows:

(i) This technique emphasises on cash inflow in the early years. What

happens if the payback period is ignored?

78

(ii) This technique fails to consider the present value of money because it

does not do discount cash flow received to present value. Normally,

investment involves cash outflow at present and the revenue acquired

in the future. As explained in Topic 4, one ringgit received now is of

higher value than one ringgit received in the future. If cash inflow

is not discounted to the present value, the decision made may be

incorrect.

technique can be used. This technique will still determine the period

needed to get back the sum of money invested but the cash inflow is

discounted to present value before the decision to accept or reject the

project is made.

(c) Discounted Payback Period

To overcome the disadvantages of the payback period technique, discounted

payback period can be used. This technique still determines the period

needed to get back the sum of money invested but the cash inflow is

discounted to the present value before the decision to accept or reject the

project is made.

Example 5.4 shows how the technique of discounted payback period is used.

Example 5.4

Referring to Example 5.2 and assuming that the discount rate is 10%, a

discounted payback period schedule can be constructed:

Year

Cash Inflow

PVIF i=10%

Discounted Cash

Inflow

RM3,000

0.9091

2727.3

RM3,000

0.8264

2479.2

RM5,000

0.7513

3756.5

RM5,000

0.6830

3415.5

RM5,000

0.6209

3104.5

Referring to the last column in the table, it shows that the total cash flow

collected for the first three years is RM8,963 (RM2,727.20 + RM2,479.20 +

RM3,756.50). For the first four years, total cash flow collected is RM12,378

(RM8,963 + RM3,415). Since the project investment cost is RM12,000,

discounted payback period is three to four years. Therefore, we still need

RM3,037 from year 4. Thus, the discounted payback period is:

79

Even though this technique takes into consideration the time value of

money, it still does not take into account the cash flow after the payback

period.

Net present value of a project is the difference of the present value of all cash

inflow minus the present value of all cash outflow.

3037

year

3415

Compare present value of the sum of cash inflow with cash outflow

it if present value is negative

Based on the information in Example 5.2 for Hebat Company, please look at

Example 5.5.

Example 5.5

Year

3,000

3,000

5,000

5,000

5,000

Total

15483.10

money is presently withdrawn.

80

Discount rate used =

Net Present Value =

=

=

10%

The sum of present value of cash inflow

investment cost.

RM15,483.10 RM12,000

RM3,483.10

(i) NPV technique takes into consideration present value of money

because it discounts cash flow to present value; and

(ii) This technique takes into consideration all money flow for the life

expectancy of the project.

(i) In the determination of a suitable discount rate, different discount rates

are used. These will affect present value of returns and as such, will

influence the managements decision on a particular project. This can

be seen in Topic 4, that is, if a higher discount rate is used, the present

value of a sum of money will become smaller. Therefore, choosing a

suitable discount rate is quite important for this type of evaluation.

(ii) Since this technique takes into consideration all cash flow of the life

expectancy of the project, projection of cash flow must be accurate. If

the projection is not accurate, this can cause a project to be accepted

even though it ought to be rejected.

If the discount rate given is 10%, use the technique of net present value

to evaluate the proposed project in Self Check 5.1 (Pasti Jaya Company).

Would you accept or reject the project? Give reasons.

(e) Internal Rate of Return

In the internal rate of return technique, we try to find the interest rate that

equals the present value of the total cash flow with investment cost. The

management will decide on a required rate of return from a particular

project. Accepting or rejecting a project depends on the internal rate of

return (IRR). Therefore, it is necessary to determine whether IRR is higher

or lower than the rate of return which has been set by the management.

We will accept a project if the internal rate of return (IRR) is higher or the

same as the rate of return set by the management. We will reject a project

if the internal rate of return (IRR) is lower than the rate of return set by

management.

81

Now, look at Example 5.6 which shows how the internal rate of return

technique is used.

Example 5.6

Megah Company is evaluating whether to accept or reject project X.

The investment needed is RM18,000. X project is expected to have a life

expectancy of three years and is expected to give a cash inflow of RM8,000 per

year for three years. The management has set a desired 10% rate of returns.

Based on the information, try to find an interest rate which equals the

investment cost with the present value on all cash flow for project X.

18,000

8,000

(1 + i)1

8,000

(1 + i)2

8,000

(1 + i)3

Since cash flow for every year is the same for three years, we can use the

annuity concept to solve this problem. (Refer to Topic 4 on the explanation

of the annuity concept).

18,000

= 8,000 (PVIFA i = ?, n = 3 )

18,000 / 8000 = PVIFA i = ?, n = 3

2.25

= ? PVIFA i = ?, n = 3

Referring to the PVIFA table for the period of three years, it shows that:

PVIFA at an interest rate = 15% is 2.2832

PVIFA at an interest rate = 16% is 2.2459

Therefore, internal rate of return acquired can be said as between 15% to

16%.

Compare the internal rate of return acquired (15% - 16%) with the interest

rate set by the management (12%). Accept the project because the internal

rate of return received is more than the interest rate set by the management.

Example 5.7

Syarikat Boleh Jaya (SBJ) is evaluating whether to accept or reject project S.

expectancy of four years and will give cash inflow as follows:

Year

1

2

3

4

350,000

300,000

250,000

150,000

82

The management requires 12% minimum rate of return for this type of

project. Based on the above information, calculate the rate of return for

project S.

Answer:

For varying cash flow, we have to use the trial and error technique. This

means that we will use one discount rate to determine the net present value

of the project. If the net present value is not equivalent to zero, we will try a

new discount rate to determine the net present value.

For a start, we can use the discount rate (i) = 12% (same as capital cost). With

this rate, net present value of the project can be determined as follows:

Year

(1)

Cash Flow (RM)

(2)

PVIF i=12%, n=4

Present Value

350,000

0.8929

312,515

300,000

0.7972

239,160

3

4

250,000

150,000

0.7118

0.6355

177,950

95,325

824,950

Net Present Value = RM824,950 RM800,000

= RM24,950

Due to the net present value being positive, the discount rate must be

increased. Now, we try with i = 14%.

(1)

(2)

350,000

0.8772

307,020

300,000

0.7695

230,850

3

4

250,000

150,000

0.6750

0.5921

168,750

88,815

795,435

Year

Present Value

Due to the net present value being negative, the discount rate must be

reduced. Now, we try with i = 13%.

(1)

(2)

350,000

0.8850

309,750

300,000

0.7831

234,930

3

4

250,000

150,000

0.6931

0.6133

173,275

91,995

809,950

Year

Net Present Value = RM809,950 RM800,000

= RM9,950

Summary

12%

13%

IRR = ?

14%

83

Present Value

RM24,950

RM9,950

RM0

RM4,565

This means that zero net present value must be between the discount rates

of 13% and 14%. The projects internal rate of return is the same as 13% +

but less than 14%.

It must be reminded that, students must repeat the trial and error calculation

(i.e. try a number of different discount rates) until arriving at 2 ranges of

net present value (one positive and another negative). This ensures that

net present value equals to zero can be determined. IRR is the discount rate

which makes the net present value becomes zero:

(i) This technique measures rate of return on investment. Rate of return

concept is easily understood by the management; and

(ii) This technique takes into account present value of money as net present

value technique.

(i) With regard to certain cash flow, there probably is more than one

internal rate of return. This will confuse the management in making

decisions; and

(ii) For competing projects, it is a situation whereby management is

required to choose only one project, for instance, in a power station

project, management has a choice between hydro electric, nuclear or

84

coal. The internal rate of return technique may give priority to the

wrong project.

(iii) The calculation of this technique is quite difficult if there are different

returns during the life of the project.

5.2

ESTIMATION

ACTIVITY 5.4

Based on the project evaluation methods mentioned before, what is the

best method you will employ if you are a project manager? What are the

characteristics you will consider?

self-check 5.2

1.

Company), calculate the internal rate of return for that project.

2.

Will you accept or reject the project if the management sets the

required rate of return at 15%? Give your reasons.

As a financial manager, what is the guideline that you will use for the estimation

of cash flow in your organisation?

A financial manager has to consider several important guidelines for a more

accurate cash flow projection in getting better accuracy for capital budget

decisions. We will discuss these guidelines in the next subtopic.

5.2.1

Profit

Profit is based on accrued concept. For instance, this years sale is considered

done and this years profit can take into consideration those sales. But, even if

sales happen this year, collection does not necessarily happen in this year too.

Therefore, we cannot take into calculation those sales as a cash inflow. Without

this cash inflow, the firms project may be impeded due to financial difficulties.

This applies to any payment made by the company. Sometimes, the firm needs

to make a certain payment to another party next year and in the calculation of

85

accounting profit, this payment is this years cost because service has been given

or merchandise has been supplied by the party concerned. But since payment

need not be paid this year, cash outflow does not happen and with that, this cash

flow will not be shown this year.

5.2.2

Considered

Additional cash flow is net cash flow that is related to the investment project.

This cash flow will happen if only we accept the project. In determining

additional cash flow, a few doubts may arise, for instance, sunk cost, opportunity

cost and externality. Are these items included as a part of additional cash flow?

(a) Sunk Cost

Sunk cost refers to the total cost spent and is not collectable whether a

project is accepted or not. Therefore, a sunk cost cannot be included in the

analysis. For instance, the fee paid to a consultant for conducting a market

research. Consultant fees cannot be included in a project analysis because

this cost has been spent, regardless of whether the project is accepted and

the cost cannot be collected back.

(b) Opportunity Cost

Opportunity cost refers to the return which can be acquired from an asset

if the asset is utilised for other usage. For instance, ABC Company has an

office that can be used as a new branch office or that office can be rented to

other people for RM36,000 per year. If ABC Company opens a branch, it will

lose the opportunity of having a years rent of RM36,000. This opportunity

cost must be included in the analysis.

(c) Externality

Externality refers to the impact of the project on other departments in the

firm or to the firms existing production. For instance, if the firm introduces

a new product, this may affect an existing product sale. A financial manager

should take into account external impacts when estimating an investment

projects cash flow.

ACTIVITY 5.5

86

ACTIVITY 5.5

Provide one example to describe each of the following items:

1.

Sunk cost

2.

Opportunity cost

3.

Externality

5.3

PROJECT AND REPLACEMENT PROJECT

analysis as compared to replacement project? In capital budgeting, two types

of decisions are usually made, which are decisions concerning the following

analyses:

(a) Replacement project analysis; and

(b) Expansion project analysis.

Usually, analysis of expansion project is more difficult and complex compared

to analysis of replacement project. Analysis of expansion project involves

investment in new assets for the purpose of increasing sales and expansion

of firms market share. Replacement project involves investment to replace

equipments or old assets.

For expansion project, all cash outflow or cost and all cash inflow or revenue

need to be considered. A financial manager must consider the degree of risk as

well as the inflation rate relating to the project when evaluating this particular

project. Evaluating technique such as payback period, net present value and rate

of return discussed in this topic can be used to analyse the project.

For replacement project, additional cash flow such as cash received from sale of

old assets or used assets must be calculated. Besides this, the impact of saving on

taxes also needs to be considered.

5.4

87

What is the relationship between cash flow estimation and risk? Risk measures

variance between real outcome and expected outcome. In capital budgeting,

every period is a random variable and cash flow projection may not be accurate.

The bigger the variance or the difference between projection of cash flow and real

cash flow, the higher the risk will be. In order to make a more accurate analysis, a

financial manager needs to include the degree of risk into capital analysis.

5.5

INFLATION

What is the relationship between cash flow projection and inflation? Inflation

refers to increase in the general prices of goods and services. When inflation

rate increases, the value of money decreases. If expected inflation rate is not

calculated into the analysis of cash flow projection, the value received is

deflected and inaccurate. As a result, the capital budgeting decision made will

not be accurate and may affect the firms financial standing. Due to this, capital

budgeting analysis must consider the effects of inflation on cash flow projection

to get a more accurate decision.

The inflation rate expected must be included in the analysis of net present value

to ensure that capital cost takes into consideration the inflation rate. If inflation

rate is found to be higher, the discount rate used should be raised. If the inflation

rate is low, the discounted rate must be lowered. Please refer to Topic 4 on

Financial Mathematics to revise on discount rate and present value. You should

be able to understand the relationship between cash flow estimation and inflation

more clearly after having revised Topic 4.

self-check 5.3

Fill in the blanks.

1.

The _________ the difference between cash flow projection with true

cash flow, the more _____________ its risk.

2.

___________, the discount rate used must be increased. When

inflation rate is ____________, the discount rate used must be

lowered.

88

SUMMARY

In this topic, you have learned that capital budgeting involves planning

and evaluation of a long-term project as well as the importance of capital

budgeting for a firm.

Several methods of evaluating projects such as accounting rate of return,

payback period, discounted payback, net present value and internal rate of

return have been explained and examples of calculation for each technique

have been shown. Besides this, advantages and disadvantages of each

technique have also been discussed.

Cash flow projection is important in the analysis of a proposed investment

project. A number of guidelines on cash flow projection have been discussed

to help you in making decisions on whether to include the cost.

Degree of risk of the project and inflation rate are need to be considered when

evaluating a project.

Budgeting technique

Cash floor

Capital budgeting

Inflation

Opportunity cost

Sunk cost

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