Capital Budgeting Chapter 11

273 | P age














Since a firms investments involve large cash outlays
and the amount of time involved is long, a firm has to
find profitable project by using a well- developed
evaluation process.






Learning objectives

After learning this chapter, you should be able to:

1. Define capital budgeting
2. Evaluate proposals according to respective capital budgeting
techniques
3. Select the best proposal





Capital Budgeting


GOAL
Chapter 11 Capital Budgeting

274 | P age

11.0 INTRODUCTION


Capital budgeting is in essence similar to cost-benefit analysis that involves comparison of
expected returns generated and the costs incurred. It involves the whole process of planning
for capital investment or fixed assets, with the expectation of future cash flows beyond one-
year period. Capital investment or capital expenditures may consist of the following
expenditures:

1. Replacement of existing facilities;
2. Expansion of current facilities;
3. Safety and/or environmental projects; and
4. Any other expenditure that affects the firm's cash flow beyond one-year period.

The process of capital budgeting involves measuring the incremental cash flows associated
with the investment proposal and evaluating its attractiveness relative to the costs of the
project. Therefore, it is the process of:

1. Estimating the cash flows after tax generated from the investment;
2. Estimating the level of risk associated with the project; and
3. Employing ways or methods to evaluate the proposed project(s); and
4. Making effective decision to ensure it has a positive contribution to the firm's value.

Proper estimations and evaluations are necessary because it is costly to reverse any capital
decisions made and to ensure the firm's viability. Thus, this chapter will present the process
of estimating the cash flows from capital investment and several capital budgeting
techniques that are commonly used for project's evaluation under: (1) non discounted cash
flows method; and (2) discounted cash flows method. These techniques will enable the
financial managers to identify and choose capital investments that are viable and profitable
for the firm to venture into.


11.1 ESTIMATION OF CASH FLOW


Estimation of cash flows associated with the project over its useful life is the first and utmost
important step in capital budgeting process to evaluate the proposed project. The accuracy
of the estimation is crucial, as it will affect the decisions made by the financial manager. The
Capital Budgeting Chapter 11

275 | P age

focus is on after tax cash flows, whether earnings after taxes (EAT) or cash flows after
tax (CFAT). Cash flow after tax equals to:

CFAT
t
= EAT
t
+ Non cash expenses for the period

In an attempt to estimate cash flows associated with capital investment, explicit
considerations should be given to its amount, timing and appropriate tax treatments. Note
however, the cost of interests or financing costs for the proposed project should be ignored,
as its implications will take in form of discount rate or required rate of return in the capital
budgeting process. Cash flows after taxes consist of three components that are net initial
cash flows, net annual cash flows, and terminal cash flows.

a) Net Initial Cash Flows (NICF)

Net initial cash flows are the initial investment or initial outlay, associated with the
initial cost of implementing the proposed capital project. It represents the net outflows
incurred to implement a proposed capital project at time zero; that is CFAT
0
.

Outflows:

1. Cost of equipment and facilities acquired.
2. All cost related to the acquisitions, transportation, and legal fees, training,
spare parts and installations.
3. Other tangible or intangible assets acquired.
4. Additional requirement for net working capital.
5. Tax liability on disposed assets; sold above the book value.

Inflows:

1. Investments tax credit, if any.
2. Proceeds from disposal of old assets.
3. Tax shield on disposed assets; sold less than the book value.

Not all of the listing above is applicable in all capital budgeting analysis, but any cash
outflows and inflows associated with the initial set up of the capital investment must
be considered, explicitly.

Chapter 11 Capital Budgeting

276 | P age

b) Net Annual Cash Flows (NACF)

Net annual cash flows are the net cash inflows from expanded operations or the net
cash outflows saved from cost reduction projects. NACF also referred as operating
cash flows which occur at time (t) through (n), CFAT
t
; that is from year one through
n years of the project's life.

CFBT
t

: Cash inflows
t
minus Cash outflows
t
; excluding taxes and depreciation
It is also known as Cash Flows before Depreciation and Taxes (CFBDT)
T : Marginal corporate tax rate
Dep
t

: Depreciation expenses for year t
: Refer to incremental change

The NACF requires different treatments when dealing with expansion and
replacement capital investments. The basic determination CFAT is similar, except
that incremental cash flows must be used in determining CFAT
t
of capital
investments that involve replacement. The calculations of CFAT under the tax shield
approach are as follows:

Operating cash flows for expansions project:

CFAT
t

= CFBT
t
(1 T) +Dep
t
(T)

Operating cash flows for replacement project:

CFAT
t

= CFBT
t
(1 T) +Dep
t
(T)

Where represent the incremental or change in cash flows. It is determined
by deducting the present cash flows from the expected cash flows due to the
replacements.

Both of the above equations assume that the firm is profitable. In the event the firm is
operating at a loss and where there is no tax liability, depreciation tax shield (=CFAT
t

(T)) does not exist.


Capital Budgeting Chapter 11

277 | P age

c) Terminal Cash Flows (TCF)

Terminal cash flows refer to the terminal value associated with the net cash inflows
realized in disposed asset. It represents the end value of a given asset at the end of
its economic life or end of usage due to disposal for replacement. Thus, CFAT
n
of the
project are as follows:

Inflows:

1. Proceeds from the sale of assets.
2. Recovery of net working capital initially required.
3. Tax shields from the sale of assets; sold for less than book value

Outflows:

1. Cost of disposing the assets.
2. Tax liability from the sale of assets; sold above the book value.

The most commonly used term for terminal cash flows is salvage value. However, it
only refers to the expected book value of the assets at the end of its usage (end of
life or for disposal); without consideration of tax effects and other cash flow
associated with its disposal.

In the following sections, a sample of expansion and replacement projects will be
discussed starting from the determination of relevant cash flows and its application in
capital budgeting process. In most cases, the decision to accept or reject a particular
project will be based on the net present value method, since its measure is superior
to others for reasons mentioned earlier.

d) Example for Expansion Decisions

To illustrate, Zaza Products Inc. is considering an investment in a new computerized
machine to expand its production facilities that could increase sales and revenues.
The new machine has a 5-year useful life with a price tag of RM49,000. In addition,
freight and installation costs are RM1,000 and the increase in net working capital of
RM10,000 can be expected. This is due to additional requirements in accounts
receivable and inventory investment.

Chapter 11 Capital Budgeting

278 | P age

The project is expected to generate additional cash flows of RM30,000 per year over
its useful life. The firm will also incurs additional cash outflows of RM5,000 per year
for the first three years, and the cost is expected to increase RM1,000 per year
thereafter as the machine wears out. Currently, the firm's marginal tax rate is 40%
and all assets are depreciated based on the straight-line method (SLM). There is no
salvage value expected at the end of 5 years. The determination of NACF requires
more than one calculation due to changes in cash outflows, and hence cash flows
before tax.

1. Net Initial Investment at year 0 or NICF: CFAT
0


Purchase price 49,000
Plus: Freight and installation 1,000
Increase in net working capital 10,000
NICF or CFAT
0

60,000


2. Operating Cash Flows in Years 1-5 or NACF
1-5
: CFAT
1-5


CFAT
1-3
=CFBT
t
(1 T) +Dep
t
(T)
=(30,000 5,000)(1 0.40) +(50,000 / 5)(0.40)
=RM19,000

Note that CFAT for year 1 through 3 is constant as it has the same CFBT and
Depreciation. However, CFAT for year 4 and 5 must be calculated
individually, as its CFBT are not the same.

CFAT
4

=CFBT
4

(1 T) +Dep
4
(T)
=(30,000 6,000)(1 0.40) +10,000(0.40)
=RM18,400

CFAT
5

=CFBT
5

(1 T) +Dep
5
(T)
=(30,000 7,000)(1 0.40) +10,000(0.40)
=RM17,800


Capital Budgeting Chapter 11

279 | P age

Another method to determine the CFAT is by using the income statement
format or the bottom up approach that uses the basic equation for CFAT, that
is:

CFAT
t
=EAT
t
+Depreciation

It will result in similar answers but with multiple stages of calculations as
shown in Table 11-1.

Table 11-1 Determination of CFAT under Bottom Up Approach

CFAT
1-3
FAT
t

CFAT
5


Sales 30,000 30,000 30,000
Less: Cost of Goods Sold 5,000 6,000 7,000
Gross Profit 25,000 24,000 23,000
Less: Other costs - - -
Depreciation 10,000 10,000 10,000
Operating profit or EBIT 15,000 14,000 13,000
Less: Interest _ .
Taxable Income or EBT 15,000 14,000 13,000
Less: Tax at 40% 6,000 5,600 5,200
Net profit or EAT 9,000 8,400 7,800
Plus: Depreciation 10,000 10,000 10,000
NACF
t
or CFAT
t
19,000 18,400 17,800


3. Terminal cash flows in year 5 of TCF: CFAT
5


Recovery of net working capital RM10,000
Salvage value 0

The TCF value of RM10,000 represents the recovery of working capital
initially invested that is no longer needed after the useful life of the machine.
In addition, the book values or salvage value of zero is based on the
assumption that the assets not sold after its useful life.
Chapter 11 Capital Budgeting

280 | P age

In the event that the assets are sold after its useful life, for example at
RM20,000, the computation for the terminal cash flows will differ as follows:

Selling Price (SP) 20,000
Less: Book Value (BV) 0
Other costs 0.
Profits from sale or recaptured dep. 20,000

Note that there are no capital gains as selling price is less than the cost of
assets.

Tax liability from sale =20,000(0.40) 8,000

Net proceeds from sale =20,000 8,000 12,000

Therefore, terminal cash flows for the disposed asset:
Recovery of net working capital 10,000
Plus: Net proceeds from sale 12,000
Terminal cash flows 22,000

The above calculation can be simplified in the following equation.

TCF
n
=Recovery of net working capital +SP (SP BV)(T)
=10,000 +20,000 (20,000 0)(0.4)
=22,000

Note that he above equation is not applicable if the selling price is above the
cost of assets as capital gains require different tax treatments.

4. Time Line and Decision. To have a better view of its flows, a time line can
be developed as follows before the evaluation process:

Year 0 1 2 3 4 5

CFAT
t
TCF
60,000 19,000 19,000 19,000 18,400 17,800
10,000

It is advisable to develop the time line as it provides better view of the cash
flows involved in the particular project and ease of determining its present
value for capital budgeting decisions.
Capital Budgeting Chapter 11

281 | P age

Example for Replacement Decisions

Determining CFATs for replacement project is more complicated than the
expansion project as it involves incremental cost-benefit analysis. Other
procedures will remain the same.

For example, Iza Company is considering replacing an existing machine that
was purchased 2 years ago for RM50,000 with a computerized system that
could improve the company's operations. The old machine is being
depreciated under straight-line method over its useful life of 5 years with no
salvage value. Its current market value is RM40,000.

The new machine has a purchase price of RM60,000 and an estimated
salvage value of RM6,000 at the end of its useful life of 3 years. If the new
machine is purchased, the cash inflows are expected to increase by 10%
from the current level of RM30,000 per year. In addition, the cash outflows of
RM15,000 associated with the old machine are expected to decrease to
RM8,000 per year. Assume that the firm's cost of capital is 10%, marginal tax
rate is 40%, and capital gains rate is 28%.

1. Net Initial Investment at year or NICF: CFAT
0


Purchase price of new machine 60,000
Less: Net proceeds from sale of old machine 40,000
Plus: Tax liability from sale of old machines 4,000
a

NICF or CFAT
0

24,000

a
Computation of tax liability from the sale of old machine:

Book value =COA Accumulated depreciation
=50,000 (50,000 / 5) 2
=RM30,000

Profit/Loss =SP BV Other costs
=40,000 30,000 0
=RM10,000
Chapter 11 Capital Budgeting

282 | P age

Since the company realized a profit of RM10,000 from the sale, it creates tax
liability:
Tax Liability =Profit/Loss (T)
=10,000 (0.40)
=RM4,000

2. Operating cash flows in years 1-3 or NACF
1-3
: CFAT
1-3

CFBT
1-3
=Increase in cash inflows
t
+Decrease in cash outflows
t

=(30,000)(0.10) +(15,000 8,000)
=RM10,000

Dep
1-3

=(New Dep.
t
Old Dep.
t
)
=((60,000 6,000) / 3) (50,000 / 5)
=RM18,000 RM10,000
=RM8,000

CFAT
1-3

=CFBT
t
(1 T) +Dep.
t
(T)
=10,000 (1 0.40) +8,000 (0.40)
=RM9,200

3. Terminal cash flows in year 3; or TCF: CFAT
3


Salvage value of the new machine RM6,000

4. Time Line and Decision. A proper time line can be developed to
show the cash flows associated with the above project after which it
can be evaluated for its attractiveness:

Year 0 1 2 3

CFAT
t
TCF
24,000 9,200 9,200 9,200
6,000

In the incremental cash flow analysis, the focus is on the cash flows that
would change due to the acceptance of the proposed capital investment. Any
Capital Budgeting Chapter 11

283 | P age

existing cash flow that is irrelevant and does not change due to the proposed
project should be ignored in capital budgeting process. The net present value
method is the most common approach to evaluate the acceptability of the
proposed projects. This is due the fact that NPV is best method of evaluation
under normal circumstances.

11.2 CAPITAL BUDGETING TECHNIQUES

The last part of capital budgeting is to develop proper evaluations and decisions making to
ensure the capital investment employed will contribute to the firm's value. Proper and
appropriate techniques must be employed in determining the worth of the projects before
accept-reject decisions is applied.

To illustrate the techniques involved, consider the alternative projects that Kurnia
Corporation is planning to evaluate for investment in 1995, as presented in Table 11-2. It
shows that both projects have the same initial investment or initial outlay of RM6,000 with
depreciation expenses of RM1,500 (=6,000 / 4) based on straight-line method with no
salvage value.

Table 11-2 Cash Flows of Investment Alternatives for Kurnia

Year Project A EAT CFAT Project B EAT CFAT
1
2
3
4
RM900
900
900
900
RM2,400
2,400
2,400
2,400
RM500
700
900
1,200
RM2,000
2,200
2,400
2,700
Total cash inflows RM3,600 RM9,600 RM3,300 RM9,300
Average inflows RM 900 RM2,400 RM 825 RM2,325
Salvage value RM - RM -
Initial outlay RM6,000 RM6,000

Where EAT : Earnings after tax or net income
CFAT : Cash flows after tax =EAT +Depreciation







Chapter 11 Capital Budgeting

284 | P age

11.2.1 Non-Discounted Cash Flow Method

Non discounted cash flow methods do not consider the time value of money
in the their analysis of capital investment. Two methods are average rate of
return and payback period.

Average Rate of Return (ARR)

The average rate of return or accounting rate of return measures
the profitability of a proposed capital investment as the ratio of
average earnings after taxes (EAT) to average investment. For Kurnia:

ARR =AEAT / AI

n
Where AEAT = (EAT
t

) / n
t=1

AI =(IO +SV) / 2

Where AEAT : Average earnings after taxes
AI : Average investment
SV : Estimated salvage value of the project
IO : Initial outlay or Initial investment

ARR
A

=((900 +900 +900 +900) / 4) / ((6,000 +0)/ 2)
=900 / 3,000
=30.00%

ARR
B

=((500 +700 +900 +1,200) / 4) / ((6,000 +0) / 2)
=825 / 3,000
=27.50%

As an investment criterion, high average rate of return is better as it
represents greater accounting rate of return on the average.

1. Independent projects. The firm should accept all projects that
provide returns above the minimum required rate of return.
Capital Budgeting Chapter 11

285 | P age

2. Mutually exclusive projects. Kurnia should adopt project 'A' as
it gives higher return as only one project will be accepted.

Average rate of return method is simple to calculate but has some
drawbacks. It fails to account for the time value of money and uses
earnings after taxes in the analysis. In actual sense, the use of cash
flows after taxes (CFAT) is more appropriate as net cash flows is more
important in determining the firm's success in the long run than net
profit (EAT).

Payback Period (PB)

The payback period measures the length of time in years for the firm
to recover back its initial investment; that is the amount of time for an
investment to pay for or liquidate itself. Thus, payback occurs when
the sums of cash inflows or CFAT equal the initial cash investment:

?
PB =(IO CFAT
t
) =0
t=1
PB = (Yr. 1) + [(IO Cumulative cash inflows before Yr.) / Cash
inflows in Yr.]

Where IO : Initial outlay or cash investment; CFAT
0

Yr. : Years to recovery of initial outlay; where total CFAT
t

exceeds the IO
PB : Payback period

Using the relevant financial data in Table 12-2,

PB
A
=(3 1) +[(6,000 4,800) / 2,400]
=2.5 years




Chapter 11 Capital Budgeting

286 | P age

Year CFAT for A Cumulative CFAT
1
2
3
4
RM2,400
2,400
2,400
2,400
RM2,400
4,800
7,200

If the cash flows are an annuity, such as in project A a simplified
formula can be used to determine the payback as follows:

PB
A
=IO / Annuity cash flow
=6,000 / 2,400
=2.5 years

The above equation is not applicable for uneven cash flows such as in
project B.

PB
B

=(3 1) +[(6,000 4,200) / 2,400]
=2.75 years

Year CFAT for B Cumulative CFAT
1
2
3
4
RM2,000
2,200
2,400
2,700
RM2,000
4,200
6,600

The above calculations show that both projects give the same
recovery period. Other things being equal, short recovery time indicate
the liquidity of the project that could provide rapid cash return and
securing the certainty of cash inflows from the project in relatively
short time. As a decision criterion, projects with shorter payback or
payback period smaller than the maximum payback established are
acceptable.

1. Independent projects. The firm should accept all projects that
provide payback less than maximum payback period as stated
by the firm.
Exceeds initial outlay of
RM6,000.
Therefore yr. =3
Exceeds initial outlay of
RM6,000.
Therefore yr. =3
Capital Budgeting Chapter 11

287 | P age

2. Mutually exclusive projects. Kurnia should adopt project 'A' as
it can recover the initial costs faster than B and thus reduces
risks and increases liquidity.

The payback method is very useful to evaluate; (1) risky projects; (2)
estimations of cash flow associate with the projects are difficult; and
(3) if the company itself is facing liquidity problems. In such cases, it is
to the best interest of the firm to recover the initial cash investment as
soon as possible. The payback method is simple to calculate, and is a
better measure than average rate of return, since it considers cash
flows after tax (CFAT) rather than accounting profit (EAT).

The major drawbacks are the failure: (1) to consider time value of
money that plays an important part of all investment decisions; and (2)
to recognize cash flows that occurs after the payback period. Thus,
payback method is a bad profitability indicator of the proposed capital
investment.

11.2.2 Discounted Cash Flows Method

Unlike non-discounted cash flows method discussed above, discounted
method explicitly considers the time value of money and employs the
discounted cash flow framework in the analysis. These methods of capital
budgeting support the wealth maximization goal of the firm, as it considers
time value of money and marginal cost of capital as the minimum required
rate of return from the investment. The three common discounted cash flow
techniques are net present value, internal rate of return and profitability index.

Net Present Value (NPV)

One of the widely used capital budgeting techniques is the net present
value. It explicitly considers time value of money and defined as: (1)
the net of cumulative present value of cash flows; plus (2) the present
value of terminal value of the project; minus (3) the initial cash
investment:


Chapter 11 Capital Budgeting

288 | P age

NPV =Present value of cash flows Initial investment

n
NPV = (CFAT
t
/ (1 +k)
t
) IO
t=1

n
Alternatively NPV = (CFAT
t
x PVIF
k,n
) IO
t=1

If marginal cost of capital for Kurnia Corporation is 10%, the net
present value for project 'A' and 'B' are as follows:

NPV
A

=2,400 (PVIFA
10%,4
) 6,000
=2,400 (3.1699) 6,000
=7,607.76 6,000
=RM1,607.76

NPV
B

=2,000 (PVIF
10%,1
) +2,200 (PVIF
10%,2
) +2,400 (PVIF
10%,3
) +
2,700 (PVIF
10%,4
) 6,000
=2,000 (0.9091) +2,200 (0.8264) +2,400 (0.7513) +2,700
(0.6830) 6,000
=7,283.66 6,000
=RM1,283.66

As investment criterion, the basic rule for NPV is to accept projects
with NPV greater than zero. At this level, it indicates that the firm will
earn a return greater than or equal to the required rate of return.

1. Independent projects. The firm should accept both projects A
and B as both projects give a positive net present value.

2. Mutually exclusive projects. Kurnia should accept project 'A' as
its NPV is higher than of B and will better increase the firms
value.

The accuracy of NPV method will significantly depend on the accuracy
of the cash flow estimates and the estimates of k, the required rate
of return. This leads to a major drawback in NPV in some cases as
Capital Budgeting Chapter 11

289 | P age

difficulty may arise in (1) estimation of the relevant cash flows with
accuracy, especially when involve with longer time period, and (2)
estimation of the risk level or the discount rate to use due to the
uncertainty of the business environment.

Despite the difficulties, it is accepted as "the method" to use in capital
budgeting as its assumptions are more sound and logical theoretically;
that is all cash inflows generated from the capital project can be
invested at the cost of capital or the required rate of return.

Profitability Index (PI)

The concept behind this method is quite similar to that of net present
values. Profitability index is a relative measure that shows the present
value of cash flows earned per Ringgit of initial cash invested;
whereas NPV gives the difference between the present value of cash
flows and the initial cash investment. The profitability index equals
(data form NPV calculations):

PI =Present value of cash flows / Initial investment
n
= (CFAT
t
/ (1 +k)
t
) / IO
t=1

n
Alternatively PI = CFAT
t
x PVIF
k,n
/ IO
t=1

PI
A

=7,615.44 / 6,000
=1.269

PI
B

=7,292.41 / 6,000
=1.215

The decision criterion with PI is to accept any project that gives PI
greater than 1.0. The above computations indicate that project A and
B returns RM1.269 and RM1.219 Ringgits, respectively for each
Ringgit initially invested.

Chapter 11 Capital Budgeting

290 | P age

1. Independent projects. The firm should accept both projects A
and B as the PIs for both project is greater than 1.

2. Mutually exclusive projects. Kurnia should accept project 'A' as
its PI is greater than of B.

Due to their similarity is equation base, PI will give similar ranking as
NPV.

Internal Rate of Return (IRR)

The internal rate of return of the capital investment is the discount rate
that causes the NPV to equal zero. In other words, the discount rate
that equates total present value of cash inflows to initial cash
investment to zero. Therefore, IRR is whereby NPV equals to zero:

n
IRR = (CFAT
t
/ (1 +IRR)
t
) IO =0
t=1

n
Alternatively IRR = (CFAT
t
)(PVIF
IRR,n
) IO =0
t=1

As investment criterion, the firm should accept projects with IRR
higher than or equal to the required rate of return or the marginal cost
of capital. Unlike other methods, calculating the IRR is more complex
at times especially when the cash flows involved are uneven and of
longer periods. Single lump sum or an annuity payment is easier to
calculate and others may involve determination of IRR by trial an
error:

1. Lump Sums. To illustrate, consider a project with initial
investment of RM4,000, which give single cash inflow at the
end of year 3 of RM5,720.



Capital Budgeting Chapter 11

291 | P age

a. Divide the initial investment by the lump sum cash
inflow to determine the PVIF
k,3
factor:

PV
0

=FV
3
(PVIF
k,3
)
PVIF
k, 3

=PV
0
/ FV
3

=4,000 / 5,720
=0.6993

b. Refer to PVIF table for 0.699 in row 3: 0.6993 is
between 12% (0.7118) and 14% (0.6750). Therefore,
interpolation is necessary to estimates the IRR with
relative accuracy. By interpolation, IRR is:





IRR

=12% +(0.0125 / 0.0368)(14 12)
=12.68%

2. Annuities. To illustrate, consider project A for Kurnia, with
initial investment of RM6,000, which give cash flows of
RM2,400 annually for 4 years.

a. Divide the Initial cash investment by annuity cash flow
to determine a PVIFA
k,4
factor:

PV
0

=Annuity (PVIFA
k,4
)
PVIFA
k,4

=PV
0
/ Annuity
=6,000 / 2,400
=2.5




Percent PVIF
k,n

12% 0.7118
K 0.6993 0.0125
14% 0.6750 0.0368
Chapter 11 Capital Budgeting

292 | P age

b. Refer to PVIFA table for 2.5 in row 4; 2.5 are between
20% (2.5887) and 24% (2.4044). Thus by interpolation
IRR equals to:






IRR
A

=20% +(0.0887 / 0.1843) 4
=21.93%

The above project is acceptable as long as the IRR is
greater than the firm's marginal cost of capital or the
required rate of return. For example if the required rate
of 10%, the project is acceptable.

3. Uneven Stream of Cash Flows. Calculating IRR under these
circumstances is more complexes and a tedious process. One
way to simplify the trial and error process is to use a 'simulated
annuity' as a starting point. To illustrate, consider project 'B' of
Kurnia Corporation. It involves:

a. Determine the simulated annuity; that is average CFAT
for the project:

Avg. CFAT
B

=(2,000+2,200 +2,400 +2,700) / 4
=RM2,325.00

b. Determine the approximate or simulated IRR (SIRR);
that is by dividing the initial cash investment by the
simulated annuity.

6,000 =2,325 (PVIFA
k,4
)
PVIFA
k,4
=6,000 / 2,325
=2.5806
Percent PVIFA
k,n

20% 2.5887
K 2.5000 0.0887
24% 2.4044 0.1843
Capital Budgeting Chapter 11

293 | P age

By looking at PVIFA table in row 4; 2.5806 lies between
18% (2.6901) and 20% (2.5887). Thus, the
approximate or simulated IRR for B is between 18%
and 20%.

c. Adjustment of approximates IRR. It is necessary to
adjust the rough estimate of IRR accordingly in relation
to the cash flows pattern of the project. In the event of
higher cash inflows in the early years compared to
later years, adjust the estimated IRR upward a few
percentage points, and vice versa. In our case, the
adjustment is downwards since the cash inflows for the
project is higher in later years. Therefore, 20% is the
focal point of adjustment. Since the differences in cash
flows are not significant, the trial and error can begins
at 20% as a starting point.

d. Trial and error. By using the adjusted approximate IRR
of 20% as the initial discount rate, calculations for IRR
by using NPV concept are as follows:

At 20% NPV
B

=2,000(PVIF
20%,1
) +2,200(PVIF
20%,2
) +
2,400(PVIF
20%,3
) +2,700(PVIF
20%,4
)
6,000

= 2,000(0.8333) + 2,200(0.6944) +
2,400(0.5789) +2,700(0.4823)
6,000

= RM114.15




Chapter 11 Capital Budgeting

294 | P age

NPV at 20% is negative; therefore, the true IRR should
be below 20%. Let discount rate equals to 18%,
calculate the second trial and error:

At 18% NPV
B

=2,000(PVIF
18%,1
) +2,200(PVIF
18%,2
) +
2,400(PVIF
18%,3
) +2,700(PVIF
18%,4
)
6,000

= 2,000(0.8475) + 2,200(0.7182) +
2,400(0.6086) +2,700(0.5158)
6,000

= RM128.34

Since the NPV at 18% is positive RM128.34 and at
20% is negative RM114.15, the true IRR for project B is
at NPV of zero between 18% and 20%. In order to
estimate the true IRR, interpolation is required.
Therefore IRR:

Percent NPV(RM)
8% 128.34
K 0.00 128.34
20% 114.15 242.79

IRR
B

=18% +(128.34 / 242.79) 2
=19.06%

As investment criterion, accept all independent projects
with IRR greater than the required rate of return.

1. Independent projects. The firm should accept
both projects A and B as the IRRs for both
project are greater than the required rate of
return of 10%.

Capital Budgeting Chapter 11

295 | P age

2. Mutually exclusive projects. Kurnia should
accept project 'A' with higher IRR of 21.93%
compared to B at 19.06%.

Theoretically, IRR is inferior to either NPV or the PI.
This is because the most of the time the firm cannot
achieve return from the reinvestments of cash flows
from the investment at IRR rate. On the other hand,
NPV and the PI use the cost of capital to discount all of
the cash flows and it is sounder to say that the firm can
manage to earn at that going rate from the
reinvestment made.

11.3 PROJECTS WITH UNEQUAL LIFE


In the previous example, the replacement decision was simplified by assuming that the
useful life of the new machine matches equally to the remaining life of the old machine. In
practice, the probability of this to occur is low. For example, consider the following projects :

Year CFAT for
X
CFAT for Y
1
2
3
4
5
6
RM5,000
5,000
5,000
RM4,000
4,000
4,000
4,000
4,000
4,000
Initial Outlay
NPV at 10%
Project's life
RM12,000
435
3 years
RM16,000
1,420
6 years


A choice can be made if these projects are evaluated independently; under NPV criteria
project Y is better. But, it could be an incorrect decision. This issue can be resolved by
comparing the projects based on NPV's of both projects for the same number of years.
Thus, a proper method to evaluate projects with unequal lives must be developed. There are
three methods that are commonly used for evaluations are least common life, equivalent
annual cost, and annualized net present value. For our purpose, the latter method will be
used.


Chapter 11 Capital Budgeting

296 | P age

Annualized Net Present Value (ANPV)

One of the methods for making unequal lived projects comparable is by
finding the net present value of each project assuming continuous
replacement chains to infinity. This is called annualized net present value
approach. Though it seems complex, but it only involves three basic steps:

1. Determine the original NPV for each project individually.
2. Divide the original NPV of each project from step 1, by the annuity
factor for the project life to obtain the equivalent annuity amount.
3. Choose the project with the highest NPV of the infinite annuity.

In all cases, the ANPV method leads to the same decision as the simple
chain method, or the least common life. In addition, ANPV is easier to
calculate but its concept sometimes is not easy to comprehend as it involves
an infinite time horizon. Under ANPV:

ANPV
i

=NPV
i
/ PVIFA
k,n


ANPV
X

=435 / PVIFA
10%,3

=435 / 2.4868
=RM174.92

ANPV
Y

=1,420 / PVIFA
10%,6

=1,420 / 4.3585
=RM325.80

Based on ANPV method, project Y should be accepted as its ANPV is greater
than ANPV of X. As a general rule, the replacement chain issue only arise in
a mutually exclusive projects with different lives are evaluated.









Capital Budgeting Chapter 11

297 | P age

11.4 COMPARISONS OF CAPITAL BUDGETING TECHNIQUES


Most of the time NPV, IRR and PI will give consistent decisions particularly if evaluations
involve only a single project or the multiple independent projects. In mutually exclusive
projects, not all of the discounted cash flows methods give consistent ranking. To illustrate,
let assume that the initial investment for Kurnia in the previous example equals to RM4,000,
instead of RM8,000 previously; with no salvage value. Table 11-3 presents all relevant data
and capital budgeting results associate with the old and new initial investment for Kurnia.

Table 11-3 Mutually Exclusive Projects Ranking at Different Initial Outlay








Note: All data are from discussions presented

Different ranking problems will be dealt with exclusively in advance finance courses. Under
normal circumstances, discounted cash flows method will give similar rankings. However,
conflicting rankings may result due to:

1. Size disparity. It refers to the differences in the initial cash investment of the projects
involved that is one project may have substantially higher initial cash investment
compared to the other.

2. Time disparity. Refer to the differences in timing of cash flows of the project. That is
one project may have higher CFAT in the early years, while the other has higher
CFAT in later years.

NPV and PI generally will give the same ranking due to similarity in information used.
However conflicting rankings may occur if the initial investments of the projects are different
in size; size disparity. The use of PI to evaluate mutually projects, is therefore requires
cautions when the initial investments of the projects are not the same.

Initial investment RM6,000 Project A Project B Decision
Average rate of return 30.00% 27.50% A
Payback period 2.50 years 2.75 years A
Net present value RM1,615.44 RM1,292.41 A
Profitability index 1.269 1.215 A
Internal rate of return 21.93% 19.06% A
Chapter 11 Capital Budgeting

298 | P age

In the case of NPV and IRR, it may give different rankings in case of the presence of size
and/or time disparity. In case of conflicts, decision under NPV criterion should have the
priority due to its more realistic assumption of reinvestment rate compared to IRR. The NPV
method assumes that the cash flows generated from the project can be invested at the cost
of capital or the required rate of return. On the other hand, IRR assumes that the
reinvestment is at the project's IRR that is not that reasonable, especially when the project
has high IRR.















Capital Budgeting Chapter 11

299 | P age



QUESTION 1

Putra Sdn Bhd is in the process of evaluating capital investment proposals. This
company has to consider two (2) investment projects, A and B:

A B
Initial Outlay RM10,000 RM10,000
Annual Net Cash Flow:

Year 1
2
3
4


RM6,000
4,000
3,000
2,000


RM4,000
4,000
4,000
4,000

As a friend to EN Putra the owner of Putra Sdn Bhd you are asked to advise in
determining which project to choose. Cost of capital is 10% and you are required to
evaluate according to these techniques:

a) Payback Period
b) Net Present Value (NPV)
c) Internal Rate of Return (IRR)
(20 marks)










Chapter 11 Capital Budgeting

300 | P age

QUESTION 2

a) Setron Berhad is considering two mutually projects with widely differing lives.
The companys cost of capital is 10%. The project cash flows are summarized
as follows:

Project A (RM) Project B (RM)

Initial Investment 25,000 23,000

Year 1 9,742 4,641
Year 2 9,742 4,641
Year 3 9,742 4,641
Year 4 - 4,641
Year 5 - 4,641
Year 6 - 4,641
Year 7 - 4,641
Year 8 - 4,641
Year 9 - 4,641



You are required to choose the project that Setron should tahe by using:

i) Payback Period technique
ii) Net Present Value (NPV) technique
iii) Internal Rate of Return (IRR) technique
(3+5+9=17 marks)

b) Briefly explain the meaning of mutually exclusive projects.
(3 marks)

(Total : 20 marks)



Capital Budgeting Chapter 11

301 | P age

QUESTION 3

a) Inamoto Inc. is considering two mutually exclusive pieces of machinery that
perform the same task. The two alternative machineries provide the following
set of after-tax net cash flow :
Equipment Y Equipment X

Initial outlay RM50,000 RM50,000
Inflow year 1 RM15,625 0
Inflow year 2 RM15,625 0
Inflow year 3 RM15,625 0
Inflow year 4 RM15,625 0
Inflow year 5 RM15,625 RM100,000

Calculate each projects :

i) Payback Period
ii) Net Present Value (NPV)
iii) Internal Rate of Return (Approximate)
(15 marks)

b) Batis Tuta & Son Oil Company is considering two drilling proposals. Proposal
A lasts for three years, costs RM20 million to start, pays back quickly, and
has an NPV of RM15 million.

Proposal B also costs about RM20 million, but has an expected life of seven
years, takes much longer to pay-back, and has an NPV of RM17 million.

Mr. Batis, the companys founder, favors proposal A because of the quick
investment recovery. His son Gabriel, however, has taken a Finance course
at college and insists that the only way to judge projects is by its NPV. He
therefore favors proposal B.

What is your advice to them? Explain.
(5 marks)

(Total : 20 marks)
Chapter 11 Capital Budgeting

302 | P age

QUESTION 4

Triple AAA Company is considering investment in one of the three mutually exclusive
projects listed below.

Year Project Intelek
(RM)
Project Integresi
(RM)
Project Bistari
(RM)
0 -12,000 -10,000 -17,000
1 5,000 6,000 5,000
2 5,000 3,000 8,000
3 5,000 3,000 10,000


The firms average cost of capital is 12%.

a) Calculate:

i) Payback period for each project.
ii) Net Present Value for each project.
iii) Internal rate of return for Project Intelek (estimated).
(18 marks)

b) Based on the answer a) (i) and a) (ii), which project is preferred?
(2 marks)