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CAPITAL BUDGETING TECHNIQUES1Capital Budgeting Techniques.

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

12ProjectABInitial Investment$ 42,000.00$ 45,000.00Year1$ 14,000.00$ 28,000.002$ 14,000.00$ 12,000.003$ 14,000.00$ 10,000.004$ 14,000.00$ 10,000.005$ 14,000.00$ 10,000.00Average$ 14,000.00$ 14,000.00 (70 k /5 years)

3At 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)

4NPV calculation for Project AAnnual cash inflows$ 14,000.00PVIFA, 10%, 5 years3.791 (dari tabel)PV of cash inflows$ 53,074.00 (hasil kali an * pv)Initial Investment$ 42,000.00NPV$ 11,074.00 (pv- ini)NPV calculation for Project BYearCash InflowsPVIF, 10%, 5 YearsPV1$ 28,000.000.909 (dari tabel)$ 25,452 (cash inflow x PVIF)2$ 12,000.000.8269,9123$ 10,000.000.7517,5104$ 10,000.000.6836,8305$ 10,000.000.6216,210PV of cash inflows$ 55,914 (total keselu. Pv)Initial Investment$ 45,000NPV$ 10,914 (pv- ini)53. Internal Rate of Return (IRR)

$100,000$130,0006ProjectABInitial Investment$ 42,000.00$ 45,000.00Year1$ 14,000.00$ 28,000.002$ 14,000.00$ 12,000.003$ 14,000.00$ 10,000.004$ 14,000.00$ 10,000.005$ 14,000.00$ 10,000.00Average$ 14,000.00$ 14,000.00In the case of annuityProject Ak1 = 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 inflows43780.3942941868.56996Initial Investment42,00042,000NPV1,780-1317IRR = k1 + (k2 k1)IRR = 18% + (20% 18%)IRR = 19,8%

Project Bk1 = 18%k2 = 22%1$28,000.00 23728.8135622950.819672$12,000.00 8618.2131578062.3488313$10,000.00 6086.3087275507.0688744$10,000.00 5157.8887524513.990885$10,000.00 4371.0921623699.992525PV of cash inflows47962.3163644734.22078Initial Investment45,00045,000NPV2,962-266

8CASE 1A 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 machineAt 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 decisionCalculate the terminal cash inflows associated with the purposed replacement decision9YearDepreciation rate for recovery period3-year5-year7-year10-year15-year20-year133.33%20.00%14.29%10.00%5.00%3.750%244.4532.0024.4918.009.507.219314.8119.2017.4914.408.556.67747.4111.5212.4911.527.706.177511.528.939.226.935.71365.768.927.376.235.28578.936.555.904.88884.466.555.904.52296.565.914.462106.555.904.461113.285.914.462125.904.461135.914.462145.904.461155.914.462162.954.461174.462184.461194.462204.461212.231 Table A-1. 3-, 5-, 7-, 10-, 15-, and 20-Year Property Half-Year Convention

10CASE 2Fitch 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.ProjectMNInitial Investment$ 28,500.00$ 27,000.00Year1$ 10,000.00$ 11,000.002$ 10,000.00$ 10,000.003$ 10,000.00$ 9,000.004$ 10,000.00$ 8,000.00Calculate payback period, NPV and IRR11Comparing NPV and IRR Techniques.

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13Conflicting Rankings.

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Approaches For Dealing With Risk.

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16Sensitivity and Scenario Analysis.

Project AProject BInitial investment$ 10,000$ 10,000Annual Cash InflowsOutcomesPesimisticMost likelyOptimistic$ 1,5002,0002,500$ 02,0004,000Range1,0004,000NPVPesimisticMost likelyOptimistic$ 1,4095,2129,015($10,000)5,21220,424Range7,60630,424

17Risk Adjustment Techniques.

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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 = 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 has annual cash inflows.Payback period = = = 3 years Project B has mixed stream cash inflowsB

$ 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

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 = Initial InvestmentIRR is the discount rate that equates the PV of cash inflows with initial investment associated with a project, thereby causing NPV = 0

0 = Initial Investment OR = Initial Investment

IRR = k1 + (k2 k1)

Example.

Capital expenditure data for Barnet Company.IRR = k1 + (k2 k1)IRR = 18% + (22% 18%)IRR = 21,6%

Discount RateNPV

AB

0%$ 28,000.00$ 25,000.00

10%11,074.0010,914.00

20%01295

22%-1310

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 capitalIRR : the intermediate cash inflows are reinvested at the rate equal to the projects IRR

Project with similar sized investment. Discount RateCASH INFLOW PATTERN

Lower Early Year Cash InflowsHigher Early Year Cash Inflows

LowPreferredNot Preferred

HighNot PreferredPreferred

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 ViewFinancial 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. 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 * (PVIFAk,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 * (PVIFAk,n) Initial Investment > 0 CIF * (PVIFA10%,15) 10,000 > 0 CIF * (7.606) 10,000 > 0

CIF > = $ 1,315

Assume that the analysis results as follows: Probability of CIFA > $1,315100% Probability of CIFB > $1,315 60%

Project A less risky than project B.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.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.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.

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 = Initial Investment

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

Exp.Capital expenditure data for Barnet Company.

Project

AB

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

AB

Year

10,91

20,90,9

30,80,9

40,70,8

50,50,7

RF = 6%.YearProjectCertainty EquivalentCertain CIFACertain CIFBDF 6%PVAPVB

ABAB

1$14,000.00 $28,000.00 0.91.0012600280000.94339611886.7924526415.09434

2$14,000.00 $12,000.00 0.90.912600108000.88999611213.955149611.961552

3$14,000.00 $10,000.00 0.80.91120090000.8396199403.735977556.573547

4$14,000.00 $10,000.00 0.70.8980080000.7920947762.51796336.749306

5$14,000.00 $10,000.00 0.50.7700070000.7472585230.807215230.80721

45497.8086855151.18596

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.

kj = RF + [ bi x {km RF)