Copy of Capital Budgeting.6

8/2/2019 Copy of Capital Budgeting.6

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Capital budgeting/Investment appraisal

Act Finance

Accruals Cash

Long term decision making

Incremental cash flows

a) NPV (Net present value)

b) Payback Period - calculates how fast the intitial invesment is recovered (time value of money is ig

Discounted payback period

c) IRR (Internal Rate of return)

d) ARR (Accounting rate of return)

Time value of money

a) Inflation

b) Risk / uncertainty

c) Interest rates

Question 1

Is RM 27,778 now different from RM 40,000 in 2 years time, assuming a 20% return on

invetment?

Amount available now 27,778 1

Add: Interest 20% - Year 1 5555.6 (1+r) n

33,334

Add: Interest 20% - Year 2 6666.7 r = Dr

40,000 n = years

Non cash is exluded

sunk costs - e.g. fixed costs

opportunity cost foregone

Year 0 Year 1 Year 2 Year 3 Year 4

RM'000 RM'000 RM'000 RM'000 RM'000

Initial outlay -15

NCF 8 10 5 5

Cash flows -15 8 10 5 5

DF @ 10% 1 0.9091 0.827 0.751 0.683

(15.0) 7.3 8.3 3.8 3.4


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NPV 7.7


RM'000 RM'000 RM'000 RM'000 RM'000

Initial outlay -15

NCF 8 10 5 5

Cash flows -15 8 10 5 5DF @ 20% 1 0.833 0.69 0.578 0.482

(15.0) 6.7 6.9 2.9 2.4

NPV 3.9

Question 1

Company A has extra cash which is available for investment - RM 1,000,000.

The company is considering four projects to choose from. Only one project will be chosen.

The four projects are as follow Alpha Beta Gamma Delta

Initial investment 400,000 380,000 500,000 420,000

Net cash flow Yr 1 0.892 100,000 80,000 150,000 150,000

Yr 2 0.797 100,000 100,000 150,000 150,000

Yr 3 0.711 100,000 140,000 120,000 120,000

Yr 4 0.636 100,000 150,000 160,000 80,000

Yr 5 0.567 100,000 150,000 200,000 40,000

The cost of capital of Co A is 12%.

Calculate the NPV and decide which project to choose.

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

RM'000 RM'000 RM'000 RM'000 RM'000 RM'000

Investment cost -100

Working capital -30 30

Sales revenue 80 120 144 100 64

VC -40 -50 -48 -30 -32

Contribution foregone -15 -15 -15 -15 -15Fixed costs -8 -8 -8 -8 -8

Net cash flow -130 17 47 73 47 39

DF @ 8% 1 0.926 0.857 0.794 0.735 0.681

PV -130 15.742 40.279 57.962 34.545 26.559

NPV 45.087

1 A B IRR

(1 + r) n 10% 10%


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40% 50%

Payback Period (PBP) 0 0

Year 0 -130

Year 1 -113

Year 2 -66

Year 3 7Year 4

2 years

66/73 0.90410959

PBP = 2.9 years

Payback Period Aplha Beta Gamma Delta

Year 0 -400 -380 -500 -420

Year 1 -300 -300 -350 -270

Year 2 -200 -200 -200 -120

Year 3 -100 -60 -80 0

Year 4 0 90 80

Year 5

PBP 4 years 3.4 years 3.5 years 3 years

Decision: Choose Delta


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Alpha


Initial outlay -400

Cash Flow 100 100 100 100 100

DF @ 12% 1 0.892 0.797 0.712 0.636 0.567

PV -400 89.2 79.7 71.2 63.6 56.7

NPV -39.6

Decision: Do not accept Project Alpha


Payback

Year 0 -400

Yr 0 -400 Year 1 -310.8

Yr 1 -300 Year 2 -231.1

Yr 2 -200 Year 3 -159.9

Yr 3 -100 Year 4 -96.3

Yr 4 0 Year 5 -39.6

Yr 5

DPBP > 5 yrs

Payback is 4 years


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BETA Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Flow -380 80 100 140 150 150

DF @ 12% 1 0.892 0.797 0.712 0.636 0.567

PV -380 71.36 79.7 99.68 95.4 85.05

NPV 51.19

Payback

Yr 0 -380

Yr 1 -300

Yr 2 -200

Yr 3 -60

Yr 4 90 60/150 0.4

Yr 5

Payback is 3.4 years

DPBP

Gamma Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Flow -500 150 150 120 160 200

DF @ 12% 1 0.892 0.797 0.712 0.636 0.567

PV -500 133.8 119.55 85.44 101.76 113.4


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NPV 53.95

Payback

Yr 0 -500

Yr 1 -350Yr 2 -200

Yr 3 -80

Yr 4 80 80/160 0.5

Yr 5

Payback is 3.5 years

delta Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Cash Flow -420 150 150 120 80 40

DF @ 12% 1 0.892 0.797 0.712 0.636 0.567

PV -420 133.8 119.55 85.44 50.88 22.68

NPV -7.65


Payback

Year 0 -420Yr 0 -420 Year 1 -286.2

Yr 1 -270 Year 2 -166.65

Yr 2 -120 Year 3 -81.21

Yr 3 0 Year 4 -30.33

Yr 4 Year 5 -7.65

Yr 5

DPBP > 5 yrs

Payback is 3 years


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DPBP

Alpha Beta Gamma Delta

NPV -39.6 51.19 53.95 -7.65

Payback

Discounted payback

PaybackBenefits

1. Easy to use

2. Widely in use in practice

Limitations

1. Ignore time value of money

2. Ignores cash flows after payback period

Question 10.4


RM mil RM mil RM mil RM mil RM mil RM mil


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Option 1

Property -9 1


Sales revenue 24 30.8 39.6 26.4 10

VC -11.2 -19.6 -25.2 -16.8 -7

FC (exld dep) -0.8 -0.8 -0.8 -0.8 -0.8

Marketing costs -2 -2 -2 -2 -2Opportunity costs -0.1 -0.1 -0.1 -0.1 -0.1

-12 9.9 8.3 11.5 6.7 4.1

DF@ 10% 1 0.909 0.826 0.751 0.683 0.621

PV -12 8.9991 6.8558 8.6365 4.5761 2.5461

NPV 19.6

Workings

Fixed cost 2.4

Depreciation per year = 9 - 1 1.6

5

FC (exld dep) 2.4 - 1.6 = 0.8

Option 2 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5


Royalties 0 4.4 7.7 9.9 6.6 2.8

DF@ 10% 1 0.909 0.826 0.751 0.683 0.621

PV 0 3.9996 6.3602 7.4349 4.5078 1.7388

NPV 24.0



Option 3

Installments 12 12

DF@ 10% 1 0.826

PV 12 9.912

NPV 21.9

Payback

Internal Rate of Return (IRR)




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Option 1

Property -9 1


Sales revenue 24 30.8 39.6 26.4 10

VC -11.2 -19.6 -25.2 -16.8 -7

FC (exld dep) -0.8 -0.8 -0.8 -0.8 -0.8

Marketing costs -2 -2 -2 -2 -2Opportunity costs -0.1 -0.1 -0.1 -0.1 -0.1

-12 9.9 8.3 11.5 6.7 4.1

DF@ 20% 1 0.833 0.694 0.579 0.482 0.402

PV -12 8.2467 5.7602 6.6585 3.2294 1.6482

NPV 13.5




Option 1

Property -9 1


Sales revenue 24 30.8 39.6 26.4 10

VC -11.2 -19.6 -25.2 -16.8 -7

FC (exld dep) -0.8 -0.8 -0.8 -0.8 -0.8

Marketing costs -2 -2 -2 -2 -2

Opportunity costs -0.1 -0.1 -0.1 -0.1 -0.1

-12 9.9 8.3 11.5 6.7 4.1

DF@ 30% 1 0.769 0.592 0.455 0.35 0.269PV -12 7.6131 4.9136 5.2325 2.345 1.1029

NPV 9.2


Year 5


Option 1

Property -9 1


Sales revenue 24 30.8 39.6 26.4 10VC -11.2 -19.6 -25.2 -16.8 -7

FC (exld dep) -0.8 -0.8 -0.8 -0.8 -0.8

Marketing costs -2 -2 -2 -2 -2

Opportunity costs -0.1 -0.1 -0.1 -0.1 -0.1

-12 9.9 8.3 11.5 6.7 4.1

DF@ 40% 1 0.714 0.51 0.364 0.26 0.186

PV -12 7.0686 4.233 4.186 1.742 0.7626

NPV 5.9922


10/27

New example


PPE -600

Cash inflow 500 600 500 700

Cash outflow -200 -400 -400 -500

-600 300 200 100 200DF @ 10% 1 0.909 0.826 0.751 0.683

PV -600 272.7 165.2 75.1 136.6

NPV 49.6


PPE -600

Cash inflow 500 600 500 700

Cash outflow -200 -400 -400 -500

-600 300 200 100 200

DF @ 20% 1 0.833 0.694 0.579 0.482

PV -600 249.9 138.8 57.9 96.4

NPV -57

IRR = A + (B-A) X a

(a - b)

A = + DF 0.1 + (0.2 - 0.1) X 49.6

B = - DF (49.6 + 57a = + NPV

b = - NPV

Accounting rate of return (ARR)

ARR = Average annual profit X 100

Average investment to earn that profit

Average investment = Cost of Investment + Disposal value

2

Question


11/27

Chaotic Industries is considering an investment in a fleet of ten delivery vans to take its

products to customers. The vans cost RM 15,000 each to buy, payable immediately. The

annual running costs are expected to total RM 20,000 for each van (including driver's salary).

The vans are expected to operate successfully for six years, at the end of which period they

will have to be sold, with disposals proceeds expected to be RM 3000 a van. At present the

business uses a commerical carrier for all of its deliveries. It is expected that this carrier will

charge a total of RM 230,000 each year for the next six years to undertake the deliveries.

What is the ARR of buying the vans?

Cost of van = 15,000 X 10 150,000

Running costs 20,000 X 10 200,000

Cost of hiring carrier 230,000

Annual savings 30,000

Cash outflow and inflow RM'000

Immediately Cost of vans (10 X 15) -150

1 years time Net savings before depreciation 30






6 years time Disposal proceeds from the vans 30

(10 X 3)

Depreciation per year (straight line) 150,000 - 30,000 200006

Thus average annual savings after depreciation = 30,000 - 20,000 = 10,000

Average investment = 150,000 + 30,000 90,000

2

ARR 10,000 X 100 11.10%

90,000

Inflation

Real rate does not incorporate inflation RR

Monetary rate incorporates inflation MR 13.40%

Inflation rate IR 5%


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RR = (1 + MR) 1 + 0.134 -1

(1 + IR) -1 1 + 0.05

MR = (1 + RR) (1 + IR) - 1

A company is condering investing in a project which requires an intital investment of RM 150,000.

The cash flows during years 1 - 3 are expected to be RM 55,000 per year. The company's

monetary cost of capital is 10% and inflation is expected to be 6% during the life of the project.

Calculate the NPV of the project using the MR

Step 1 - Incorporate the Inflation into the cash flows

Year

1 55,000 X 1.06 58300

2 58,300 X 1.06 61798

3 61,798 X 1.06 65506

Yr 0 Yr 1 Yr 2 Yr 3

IO -150000

CF 58300 61798 65506

-150000 58300 61798 65505.88

DF @ 10% 1 0.9091 0.826 0.751

PV -150000 53000.53 51045.148 49194.92NPV 3240.59388

Calculate the NPV of the project using the RR

RR = (1 + 0.1) -1 3.80%

( 1 + 0.06)

Yr 0 Yr 1 Yr 2 Yr 3

IO -150000

CF 55000 55000 55000-150000 55000 55000 55000

DF @ 10% 1 0.963 0.928 0.894

PV -150000 52965 51040 49170

NPV 3175

The effect of taxation


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Tax rate = 25% outflow

Cash outflow current year (50%)

following year (50%)

Tax savings on assets (depreciation)

Net book value = Tax written down value (WDV)

Depreciation = Capital allowance = Writing down allowance (WDA) 25%

Reducing balance

The management of a company are making a decision on whether or not to purchase a new of plant

and machinery which costs RM 100,000. The new machine will generate a net cash flow

of RM 30,000 per year for 4 years. At the end of the 4th year it will be sold for RM 20,000.

The company's cost of capital is 5%. Writing down allowance are 25% reducing balance

and corporate tax rate is 30%.

Calculate NPV

WDV Asset cost 30% tax saved Yr 1 Yr 2 Yr 3

Year 100,000

1 WDA (25%) 25000 7500 3750 3750WDV 75,000

2 WDA (25%) 18750 5625 2812.5 2812.5

56,250 6562.5

3 WDA (25%) 14062.5 4218.75 2109.375

42,188 4921.875

Disposal 20,000

Balancing allowance 22,188 6656.25

Balancing charge

Calculation Yr 1 Yr 2

Year 1 profit 30,000 X 30% 9,000 4500 4500

Year 2 profit 30,000 X 30% 9,000 4500 4500

9000


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Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5

IO -100,000 20,000

Tax saved 3750 6562.5 4921.875 5437.5 3328.125

Profit/CF 30,000 30,000 30,000 30,000

Tax -4500 -9000 -9000 -9000 -4500

-100,000 29,250 27,563 25,922 46,438 -1,172

DF @ 5% 1 0.952 0.907 0.864 0.823 0.784-100000 27846 24999.1875 22396.5 38218.06 -918.75

NPV 12,541


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nored)


16/27


17/27


18/27


19/27


Year 0 -380

Year 1 -308.64

Year 2 -228.94

Year 3 -129.26

Year 4 -33.86

Year 5 51.19

0.40

4.4 yrs


20/27

Year 0 -500

Year 1 -366.2

Year 2 -246.65

Year 3 -161.21Year 4 -59.45

Year 5 53.95

0.5

DPBP 4.5 yrs


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22/27

28.5


23/27


24/27

14.70%


25/27


26/27

8%


27/27

Yr 4 Yr 5

2109.375

3328.125 3328.125

5437.5

Documents

Copy of Capital Budgeting.6