CAPITAL BUDGETING TECHNIQUES

1
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.
2
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
The Annual Cash Inflows
=
$ 42.000
$ 14.000
= 3 years
Project B has mixed stream cash inflows
B
$ 45,000.00
Accumulated Cash inflows
$ 28,000.00 $ 28,000.00
$ 12,000.00 $ 40,000.00 (28 + 12)
$ 10,000.00 $ 50,000.00 (40 + 10)
$ 10,000.00
$ 10,000.00

3
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 dari 10,000 ditahun ke3 = 5000 untuk mencapai
45,000 kemudian (2 tahun = 40,000 + tahun (0,5) = 5,000 ) years

2. Net Present Value (NPV)
Net Present Value discounts the firms 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 =

n
t 1
CF
t
(1+k)
t
Initial Investment
4
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)
5
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 =

n
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
1
- NPV
2
(k
2
k
1
)

Example.

Capital expenditure data for Barnet Company.
$100,000
$130,000
6
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
7
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% +
2.962
2.962 - (-266)
(22% 18%)
IRR = 21,6%

8
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
9
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
Table A-1. 3-, 5-, 7-, 10-, 15-, and 20-Year Property Half-Year
Convention

10
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
11
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.
Discount Rate NPV
A B
0% $ 28,000.00 $ 25,000.00
10% 11,074.00 10,914.00
20% 0
1295
22%
-131
0

12
13
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 at the rate equal to the
projects IRR

Project with similar sized investment.

Discount Rate
CASH INFLOW PATTERN
Lower Early Year Cash
Inflows
Higher Early Year Cash
Inflows
Low Preferred Not Preferred
High Not Preferred Preferred

14
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.
15
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
7.606
= $ 1,315

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.
16
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
Most likely
Optimistic
$ 1,500
2,000
2,500
$ 0
2,000
4,000
Range 1,000 4,000
NPV
Pesimistic
Most likely
Optimistic
$ 1,409
5,212
9,015
($10,000)
5,212
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 firms CIF, COF
and CoC.
17
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 for 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 =

n
t 1

t
x CF
t
(1+R
F
)
t
Initial Investment

: Certainty equivalent factor in year t (0
t
t)
R
F
: Risk free rate of return such as US Tresurry Bill

18
Exp.
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

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

Certainty Equivalent
A B
Year
1 0,9 1
2 0,9 0,9
3 0,8 0,9
4 0,7 0,8
5 0,5 0,7

R
F
= 6%.
19
Ye
ar
Project Certainty
Equivalent
Certain
CIFA
Certain
CIFB
DF 6%
PVA PVB A B A B
1 $14,000.00 $28,000.00 0.9 1.00
12600 28000 0.943396 11886.79245
26415.09434
2 $14,000.00 $12,000.00 0.9 0.9
12600 10800 0.889996 11213.95514
9611.961552
3 $14,000.00 $10,000.00 0.8 0.9
11200 9000 0.839619 9403.73597
7556.573547
4 $14,000.00 $10,000.00 0.7 0.8
9800 8000 0.792094 7762.5179
6336.749306
5 $14,000.00 $10,000.00 0.5 0.7
7000 7000 0.747258 5230.80721
5230.80721

45497.80868 55151.18596
Initial Investment
$42,000.00 $45,000.00
NPV $3,497.81 $10,151.19


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
)
20








SML
Required rate of return
Project Risk ()
Acceptance
IRR > k, NPV>0
rejection
IRR < k, NPV<0