CHAPTER 6 HTH585

Chapter 6: Capital Budgeting

Introduction to Capital Budgeting

  • Definition: Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm's goal of maximizing owner wealth. It essentially involves planning for a company's long-term capital expenditures.

  • Concept: Derived from two key terms:

    • Capital: Refers to cash or assets required to initiate or expand a business.

    • Budgeting: Involves the projection of future outcomes based on estimates and forecasts relevant for the business decisions.

  • When combined, capital budgeting entails “The projection of future outcomes of investments using current capital.”

  • Purpose: Fundamental for determining the best options for:

    • Acquisition of an asset

    • Acquisition of a new business

    • Pursuing a new business venture

Mutually Exclusive Projects

  • Concept: In capital budgeting, companies often analyze mutually exclusive projects, where selecting one project excludes the possibility of selecting another.

  • Illustrative Example:

    • Example Scenario: Company A has RM10,000 available capital to start a business.

    • Choices include:

      • Burger Stall: Requires RM10,000

      • Hipster Café: Requires RM10,000

    • Due to capital constraints, Company A can only choose one. If Company A chooses one, it must reject the other.

Methods of Capital Budgeting

The company can utilize various methods to analyze investment projects:

Method 1: Capital Recovery (Payback Period)

  • Definition: Known as the payback period method, it calculates how soon the business can recover the invested capital.

  • Formula: Payback period determines how long it takes to earn back the initial investment.

  • Application Example:

    • Given:

    • Capital: RM10,000

    • Cash flows over 4 years:

      • Year 1: RM2,500

      • Year 2: RM2,500

      • Year 3: RM2,500

      • Year 4: RM2,500

    • The accumulated cash flow over these years reaches RM10,000 by the end of Year 4.

    • Final Calculation: Choose the alternative with the shortest payback period.

    • Example Calculation: If a project has a total cash flow of RM9,000 by the end of Year 3, then by year 4:

    • t + rac{Capital - ext{Accumulated Cash Flow at year t}}{ ext{Cash flow at t+1}}

    • t + rac{10000 - 9000}{4000} = 3 + 0.25 = 3.25 ext{ years}

Method 2: Internal Rate of Return (IRR)

  • Definition: The IRR method assesses the profitability of potential investments by calculating the net worth of future cash flows as compared to the value of original capital.

  • Discounted Cash Flow: Requires the use of the discounted cash flow to project values over time.

  • Key Concept: The internal rate of return is described as the “present value interest factor” used for calculating discounted cash flows.

  • Calculation considerations: Requires:

    • Selection of an appropriate rate of return (discount rate).

    • Commonly, rates range from 3%-20%.

  • PVIF Table: Utilized for estimating the present value interest factor based on selected rates over different periods.

    • Example of PVIF outputs:
      | Period | Rate 10% | Rate 11% | Rate 12% | Rate 13% | Rate 14% | Rate 15% | Rate 16% |
      |--------|-----------|----------|-----------|-----------|-----------|-----------|-----------|
      | 1 | 0.909 | 0.901 | 0.893 | 0.885 | 0.877 | 0.870 | 0.862 |
      | 2 | 0.826 | 0.812 | 0.797 | 0.783 | 0.769 | 0.756 | 0.743 |
      | … | … | … | … | … | … | … | … |

Decision Criteria

  1. Capital Recovery: Choose projects with the shortest payback period.

  2. IRR: Select projects yielding a higher internal rate of return compared to the minimum acceptable rate of return.

Present Value Concepts

  • Discounted Cash Flow Philosophy: The future value of cash flows diminishes over time; thus, cash today holds more value than the same cash in the future.

    • Example: RM1 in 2025 holds greater purchasing power than RM1 in 2035 owing to inflation and purchasing power depreciation.

  • Application: Cash flows must be discounted to present value.

    • Given cash flows:

    • Year 1: RM3,000, Year 2: RM3,000, Year 3: RM3,000, Year 4: RM4,000, Year 5: RM5,000

Calculating Present Value Example

  • Future Cash Flows:

    • Using a discount rate of 10%, calculate present value for each cash flow:

    Year

    Cash Flow

    PVIF i=10%

    Present Value

    1

    3000

    0.909

    2727

    2

    3000

    0.826

    2478

    3

    3000

    0.751

    2253

    4

    4000

    0.683

    2732

    5

    5000

    0.621

    3105

    Total Present Value

    13,295

  • Total subtracting initial capital of RM10,000 gives:

    • Net Present Value (NPV) = 13,295 - 10,000 = 3,295

    • Decision: Select the project that generates a positive and higher NPV.

Appendix: Present Value Interest Factors Table

  • An appendix table exhibiting various present value factors at different rates over time periods, critical for valuation studies in capital budgeting decisions.