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CHAPTER 2

LITERATURE REVIEW

Capital budgeting is the process of analyzing investment opportunities and

deciding which ones to accept. (Pearson Education, 2007, 178).

2.1. INTRODUCTION OF CAPITAL BUDGETING

Capital budgeting process consists of three elements:

• Coming up with proposals for investment projects

• Evaluate the project

• Deciding which ones to accept and which to reject

2.1.1. THE NATURE OF PROJECT ANALYSIS

Investment projects starts with an idea for increasing shareholder wealth by

producing a new product or improving the way an existing product is produced.

Investment projects are analyzed as a sequence of decisions and possible events over

time starting with the original concept, gathering information relevant to assessing the

costs and benefits of implementing it, and devising an optimal strategy for

implementing the project overtime.

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Capital budgeting is the process by which the firm renews and reinvents itself

– adapting old projects to the times and finding new ones. It involves comparing cash

inflows that may spread out over many years with cash outflows that generally occur

close to the present.

2.2. IMPORTANCE OF CAPITAL BUDGETING

A number of factors combine to make capital budgeting perhaps the most

important task faced by financial managers. One of the most important factors is

timing. Since the results of capital budgeting decisions continue for many years, the

firm loses some of its flexibility. For example, the purchase of an asset with an

economic life of 10 years “locks in” the firm for a 10-year period. Further, because

asset expansion is based on expected future sales, a decision to buy an asset that is

expected to last 10 years requires a 10-year sales forecast. Finally, a firm’s capital

budgeting decisions define its strategic direction, because moves into new products,

services, or markets must be preceded by capital expenditures.

Effective capital budgeting can improve both timing and the quality of asset

acquisitions. If a firm forecasts its needs for capital assets in advance, it can purchase

and install the assets before they are needed.

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Capital budgeting typically involves substantial expenditures, and before a

firm can spend a large amount of money, it must have the funds lined up. Therefore, a

firm contemplating a major capital expenditure program should plan its financing far

enough in advance to be sure funds are available.

2.2.1. GENERATING IDEAS FOR CAPITAL PROJECTS

A firm’s growth, and even its ability to remain competitive and to survive,

depends on a constant flow of ideas for new products, for ways to make existing

products better, and for ways to operate at a lower cost. Accordingly, a well-managed

firm will go to great lengths to develop good capital budgeting proposals.

If a firm has capable and imaginative executives and amployees, and if its

incentive system is working properly, many ideas for capital investment will be

advanced. Some ideas will be good ones, but others will not. Therefore, procedures

must be established for screening projects.

2.2.2. PROJECT CLASSIFICATIONS

Analyzing capital expenditures proposals is not a costless operation, benefit

can be gained, but analysis does have a cost. For certain types of projects, a relatively

detailed analysis may be warranted; for others, simpler procedures should be used.

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Accoringly, firms generally categorize projects and then analyze those in each

category somewhat differently :

1. Replacement : maintenance of business.

It consists of expenditure to replace worn-out or damaged equipment

used in the production of profitable products. Replacement projects are

necessary if the firm is to continue in business. The only issues here

are (a) should this operation be continued and (b) should we continue

to use the same production processes? The answer are usually yes, so

maintenance decisions are normally made without going through an

elaborate decision process.

2. Replacement : cost reduction.

It includes expenditures to replace servicable but obsolete equipment.

The purpose is to lower the costs of labor, materials, and other inputs

such as electricity.

3. Expansion of existing products or markets.

It includes the expenditures to increase output of existing products, or

to expand retail outlets or distribution facilities in markets. These

decisions are more complex because they require an explicit forecast

of growth in demand. The go/no-go decisions is generally made at a

higher level within the firm.

4. Expansion into new products or markets.

These are investments to produce a new product or to expand into a

geographic area not currently being served. It involve strategic

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decisions that could change the fundamental nature of the business,

and they normally require the expenditure of large sums with delayed

paybacks.

5. Safety and/or environmental projects.

Expenditures necessary to comply with government orders, labor

agreements, or insurance policy terms. These expenditures are called

mandatory investments, and they often involve nonrevenue-producing

projects.

6. Research and development.

For many firms, R&D constitutes the largest and most important type

of capital expenditure. Although it can be analyzed in the same way as

tangible asset investments, the cash flows they produce are often too

uncertain to warrant a standard discounted cash flow (DCF) analysis.

7. Long-term contracts.

Companies are often make long-term contractual agreements to

provide products or services to specific customers. For example,

Company X has signed agreements to handle computer services for

other companies for period of 5 to 10 years.

8. Other.

This catch-all includes office buildings, parking lots, executive

aircraft, and so on. DCF should be used, but how they are actually

handled varies among companies.

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2.3. CAPITAL BUDGETING EVALUATION STEPS

Once a potential capital budgeting project has been identifed, its evaluation

involves the same steps that security analysts use.

Here are the steps in capital budgeting evaluation :

1. The cost of the project must be determined.

2. Management estimates the expected cash flows from the project,

including the salvage value of the asset at the end of its expected life.

3. The risk of the projected cash flowss must be estimated. This requires

information about the probability distribution (risk) of the cash flows.

4. Given the project’s risk, managemenet determines the cost of capital at

which the cash flows should be discounted.

5. The expected cash flows are put on a present value basis to obtain an

estimate of the asset’s value.

6. The present value of the expected cash flows is compared with the

required outlay. If the PV of the cash flows exceeds the cost, the

project should be accepted. Otherwise, it should be rejected.

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2.4. CAPITAL BUDGETING DECISION RULES

There are six keys methods used to rank projects and to decide

whether or not they should be accepted for inclusion in the capital budget :

1. Payback Period

2. Discounted Payback Period

3. Net Present Value (NPV)

4. Internal Rate of Return

5. Modified Internal Rate of Return (MIRR)

6. Profitability Index (PI)

The ranking methods which will be used in this project are :

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

3. Payback Period

2.4.1. NET PRESENT VALUE (NPV)

The net present value (NPV) method relies on discounted cash flow (DCF)

techniques. To implement this approach, we proceed as follows :

1. Find the present value of each cash flow, including both inflows and

outflows, discounted at the project’s cost of capital.

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2. Sum these discounted cas flows; this sum is defined as the project’s

NPV.

3. If the NPV is positve, the project should be accepted, while if the NPV

is negative, it should be rejected. If two projects with positive NPVs

are mutually exclusive, the one with the higher NPV should be chosen.

The equation for the NPV is as follows :

Here CFt is the expected net cash flow at Period t, k is the project’s cost of

capital, and n is its life. Cash outflows (expenditures such as the cost of buying

equipment or buildinf factories) are treated as negative cash flows.

2.4.2. INTERNAL RATE OF RETURN (IRR)

The IRR is defined as the discount rate that equates the present value of a

project’s expected cash inflows to the present value of the project’s costs:

PV (Inflows) = PV (Investment Costs)

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Or, equivalently, the IRR rate that forces the NPV to equal zero :

Notice that the internal rate of return formula is simply the NPV formula,

solved for the particular discount rate that forces the NPV to equal zero. Thus, the

same basic equation is used for both methods, but in the NPV method the discount

rate, k, is specified and the NPV is found, whereas in the IRR method the NPV is

specified equal to zero, and the interest rate that forces this equality (the IRR) is

calculated.

Mathematically, the NPV and IRR methods will always lead to the same

accept/reject decisions for independent projects. This occurs because if NPV is

positive, IRR must exceed k. However, NPV and IRR can give conflicting rankings

for mutually exclusive projects.

2.4.3. PAYBACK PERIOD

The payback period, defined as the expected number of years required to

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recover the original investment, was the first formal method used to evaluate capital

budgeting projects.

For example : Payback Period for Project S and L

Project S : 0 1 2 3 4Net cash flow -1,000 500 400 300 100Cumulative NCF -1,000 -500 -100 200 300Paybacks = 2.33 years

Project L : 0 1 2 3 4Net cash flow -1,000 100 300 400 600Cumulative NCF -1,000 -900 -600 -200 400PaybackL = 3.33 years

The shorter the payback period, the better. Therefore, if the firm required a

payback of three years or less, Project S would be accepted but Project L would be

rejected. If the projects were mutually exclusice, S would be ranked over L because S

has the shorter payback. Mutually exclusive means that if one project is taken on, the

other must be rejected.

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2.4.4. Discounted Payback Period

The discounted payback period is similar to the regular payback period except

the expected cash flows are discounted by the project’s cost of capital. Thus, the

discounted payback period is defined as the number of years required to recover the

investment from discounted net cash flows.

For example : Discounted Payback Period for Project S and L

Project S : 0 1 2 3 4Net cash flow -1,000 500 400 300 100Discounted NCF (at 10%) -1,000 455 331 225 68Cumulative NCF -1,000 -545 -215 11 79Paybacks = 2.95 years

Project L : 0 1 2 3 4Net cash flow -1,000 100 300 400 600Discounted NCF (at 10%) -1,000 91 248 301 410Cumulative NCF -1,000 -909 -661 -361 49PaybackL = 3.88 years

Each cash inflow above is divided by (1 + k)t = (1.10)t, where t is the year in

which the cash flow occurs and k is the project’s cost of capital. After three years,

Project S will have generated $1,011 in discounted cash inflows. Because the cost is

$1,000, the discounted payback is just under three years. Project L’s discounted

payback is 3.88 years :

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Discounted paybackS = 2.0 + $215/$225 = 2.95 years

Discounted paybackL = 3.0 + $361/$410 = 3.88 years

For Project S and L, the rankings are the same regardless of which payback

method is used; that is, Project S is preferred to Project L, and Project S would still be

selected if the firm were to require a discounted payback period of three years or less.

Often, however, the regular and the discounted paybacks produce conflicting

rankings.

2.5. ESTIMATING CASH FLOW

The most important, but also the most difficult, step in capital budgeting is

estimating project’s cash flows. Cash flows here involve the the investment outlays

and the annual net cash inflows after a project goes into operation. Many variables

are involved, and many individuals and departments participate in the process. For

example, the forecasts of unit sales and sales prices are normally made by the

marketing group, based on their knowledge of price elasticity, advertising effects, the

state of the economy, competitors’ reactions, and trends in consumers’ tastes.

Similarly, the capital outlays associated with a new product are generally obtained

from the engineering and product development staffs, while operating costs are

estimated by cost accountants, production experts, personnel specialists, purchasing

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agents, and so forth.

The financial staff’s role in the forecasting process includes :

1. Obtaining information from various departments such as engineering

and marketing,

2. Ensuring that everyone involved with the forecast uses a consistent set

of economic assumptions, and

3. Making sure that no biases are inherent in the forecasts.

2.6. IDENTIFYING THE RELEVANT CASH FLOW

The first step in capital budgeting is to identify the relevant cash flows,

defined as the specific set of cash flows that should be considered in the decision at

hand. Analysts often make errors in estimating cash flows, but two cardinal rules can

be implemented to minimize mistakes :

1. Capital budgeting decisions must be based on cash flows, not

accounting income.

2. Only incremental cash flows are relevant.

2.6.1 PROJECT CASH FLOW VERSUS ACCOUNTING INCOME

The firm receives and is able to reinvest cash flows, whereas accounting

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profits are shown when they are earned rather than when the money is actually in

hand. Unfortunately, a firm’s accounting profits and cash flows may not be timed to

occur together. For example, capital expenses, such as vehicles, plant and equipment,

are depreciated over several years, with their annual depreciation substracted from

profit. Cash flows correctly reflect the timing of benefits and costs, that is, when the

money is received, when it can be reinvested, and when it must be paid out.

In capital budgeting analysis, we use the yearly cash flows, not the accounting

income. Recall that free cash flow is calculated as follows :

FCF = NOPAT + Depreciation – Gross Capital Expenditures – Change in

Working Capital

= EBIT(1 – T) + Depreciation – Gross Capital Expenditures –

(Δ Current Operating Assets – Δ Current Operating Liabilities)

2.6.2. INCREMENTAL CASH FLOW

In evaluating a project, we focus on those cash flows that occur if and only if

we accept the project. These cash flows, called incremental cash flows, represent the

change in the firm’s total cash flow that occurs as a direct result of accepting the

project. Three special problems in determining incremental cash flows are :

1. Sunk Costs. A sunk cost is an outlay that has already occured, hence

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is not affected by the decision under consideration. Since sunk costs

are not incremental costs, they should not be included in the analysis.

2. Opportunity Costs. A second potential problem relates to opportunity

costs, which are cash flows that could be generated from an asset the

firm already owns provided.

3. Effects on Other Parts of the Firm : Externalities. This problem

involves the effects of a project on other parts of the firm.

2.7. CHANGES IN NET OPERATING WORKING CAPITAL

Normally, additional inventories are required to support a new operation, and

expanded sales tie up additional funds in accounts receivable. However, payables and

accruals increase as a result of the expansion, and this reduces the cash needed to

finance inventories and receivables. The difference between the required increase in

current operating assets and the increase in current operating liabilites is the change in

net operating working capital. If this change is positive, as it generally is for

expansion projects, then additional financing, over and above the cost of the fixed

assets, will be needed.

Toward the end of a project’s life, inventories will be used but not replaced,

and receivables will be collected without corresponding replacements. As these

changes occur, the firm will receive cash inflows, and as a result, the investment in

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net operating working capital will be returned by the end if the project’s life.

2.8. EVALUATING CAPITAL BUDGETING PROJECTS

Cash flow analysis affect capital budgeting decisions. Conceptually, capital

budgeting is straightforward. A potential project creates value for the firm’s

shareholders if and only if the net present value of the incremental cash flows from

the project is positive. Incremental cash flows are affected by whether the project is

an expansion project or replacement project.

2.8.1. NEW EXPANSION PROJECT ANALYSIS

A new expansion project analysis is defined as an activity to analyze where

the firm invests in new assets to increase sales.

2.8.2. REPLACEMENT PROJECT ANALYSIS

A replacement project occurs when the firm replaces the existing asset with a

new one. In a replacement project analysis, the company is comparing its value if it

takes on the new project to its value if it continues to use the esixting asset.

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2.9. PROJECT RISK ANALYSIS

The project risk analysis is important for all financial decisions, especially for

the capital budgeting decisions. Although it is intuitively clear that riskier projects

have a higher cost of capital, it is difficult to estimate project risk.

There are three separate and distinct types of risk that can be identified:

1. Stand-alone risk is the project’s risk regarding the fact that it is but

one asset within the firm’s portfolio of assets and that the firm is but

one stock ina typical investor’s portfolio of stocks. It is measured by

the variability of the project’s expected returns.

2. Corporate, or within-firm, risk is the project’s risk to the

corporation, giving consideration to the fact that the project represents

only one of the firm’s portfolio of assets, hence that some of its risk

effects will be diversified away. It is measured by the project’s effect

on uncertainty about the firm’s future earnings.

3. Market, or beta, risk is the riskiness of the project as seen by a well-

diversified stockholder who recognizes that the project is only one of

the firm’s assets and that the firm’s stock is but one part of his or her

total portfolio. It is measured by the project’s effect on the firm’s beta

coefficient.

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2.10. FINANCIAL RISKS IN FOREIGN EXCHANGE

The investment of this project will be in United States Dollar (USD) as

writer already mentioned above, there are some financial risks for company

could be facing such as the revenue will be in Indonesian Rupiah (IDR). The

financial risk that could happen to the foreign exchange exposure because of

the different currencies, and it will cause a foreign gain or loss for the

company.

Also to reduce the foreign exchange risk, the company should execute

the hedging method. The hedging techniques generally involve the

derivatives, which are options and futures. With hedging, the company can

enter into a futures contract which allows the company to make a transaction

at a specific price at a set date in the future. Thus the company can create any

budget without worrying the fluctuating commodity.

2.11. TECHNIQUES FOR MEASRUING MEASURING STAND-

ALONE RISK

The starting point for analyzing a project’s stand-alone risk involves

determining the uncertainty inherent in its cash flows.

The nature of individual cash flow distributions, and their correlations with

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one antoher, determine the nature of the NPV probability distribution and, thus, the

project’s stand-alone risk. There are four techniques for assessing a project’s stand-

alone risk :

1. Sensitivity Analysis

Sensitivity analysis is a technique that indicates how much NPV will

change in response to a given change in an input variable, other things

held constant.

2. Scenario Analysis

Scenario analysis brings in the probabilities of changes in the key

variables, and it allows us to change more than one variable at a time.

3. Monte Carlo Simulation

Monte Carlo Simulation analyze projects on gambling stratigies.

Taken from the famous European casino, because it attempt into model

of real-world uncertainty.

4. Real Options

When valuing capital projects, net present value (NPV) analysis is the

best approache. Somehow practioners and scholars have pointed out

that there is a problem with NPV. Therefore there are real options to

adjust the best suited for projects for being accepted, such as: Option

to expand, option to abondon, and option in timely.

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2.12 INTRODUCTION TO REAL OPTIONS

As writers mentioned above, Real Options is the most suited for managers

who are looking for alternative decision making tool than NPV. The indicator of NPV

is negative, then the project should be rejected. However, in traditional capital

budgeting theory indicate that actions can be taken after the project has been accepted

and placed in operation that might cause the cash flows to increase. Implicate that this

theory is a like a manager who like to gamble into a project until it see what is next

what is coming.

There are several options such as:

• Managerial options

It gives manager an opportunity to change on circum

conditions which can influence the result of the project.

• Strategic options

Usually managers are often associated with large, strategic

projects rather than routine maintenance projects.

• Real options

Managers are involve with real case or situation rather than

financial or assets. There are several options that manager

should try to create options within projects.

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2.12.1 INVESTMENT TIMING OPTIONS

Other than NPV analysis being positive or negative, companies is looking for

third choice which is delay the decision until later when more information is

available. This investment timing option can implicate the profit and risk project

could be affected.

2.12.2 GROWTH OPTIONS

Growth option is when a company has a plan to increase its capacity when the

market conditions are better than expected. There are several growth options which

are:

• Increase the capacity of an existing product line

• Expand into new geographic markets

• Add new products

2.12.3 ABANDONMENT OPTIONS

Abandonment option is when evaluating a potential project, standard DCF

analysis assumes that assets will be used over a specified economic life. While other

projects must be operated over their full economic life, even though market

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conditions might deteriorate and cause lower than expected cash flows, others can be

abandoned.

2.12.4 FLEXIBILITY OPTIONS

Flexibility options that permit the permit the company to alter operations

depending on how conditions change during the life of the project. Typically, either

inputs or outputs (or both) can be changed.