Capital budgeting/Investment appraisal

Act
Accruals

Finance
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 ignored)
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

Add: Interest 20% - Year 1

27,778
5555.6
33,334
6666.7
40,000

Add: Interest 20% - Year 2

1
(1+r) n
r = Dr
n = years

Non cash is exluded

sunk costs - e.g. fixed costs
opportunity cost foregone

Initial outlay
NCF
Cash flows
DF @ 10%

Year 0
RM'000
-15
-15
1
(15.0)

Year 1
RM'000
8
8
0.9091
7.3

Year 2
RM'000

Year 3
RM'000

10
10
0.827
8.3

5
5
0.751
3.8

Year 4
RM'000
5
5
0.683
3.4

NPV

7.7
Year 0
RM'000
-15

Initial outlay
NCF
Cash flows
DF @ 20%

Year 1
RM'000

-15
1
(15.0)
3.9

NPV

Year 2
RM'000

8
8
0.833
6.7

Year 3
RM'000

10
10
0.69

5
5
0.578
2.9

6.9

Year 4
RM'000
5
5
0.482
2.4

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

Initial investment
Net cash flow

Yr 1
Yr 2
Yr 3
Yr 4
Yr 5

0.892
0.797
0.711
0.636
0.567

Beta

Gamma
500,000

Delta

400,000

380,000

420,000

100,000
100,000
100,000
100,000
100,000

80,000
150,000 150,000
100,000 150,000 150,000
140,000 120,000 120,000
150,000 160,000
80,000
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
RM'000
Investment cost
Working capital
Sales revenue
VC
Contribution foregone
Fixed costs
Net cash flow
DF @ 8%
PV
NPV
1
(1 + r) n

Year 1
RM'000

Year 2
RM'000

Year 3
RM'000

Year 4
RM'000

Year 5
RM'000

-100
-30

-130
1
-130
45.087

80
-40
-15
-8
17
0.926
15.742

120
-50
-15
-8
47
0.857
40.279

144
-48
-15
-8
73
0.794
57.962

B
10%

30
64
-32
-15
-8
39
0.681
26.559

100
-30
-15
-8
47
0.735
34.545

IRR
10%

40%
0

Payback Period (PBP)

Year 0
Year 1
Year 2
Year 3
Year 4

66/73

50%
0

-130
-113
-66
7

2 years
0.90410959
PBP =

2.9 years

Payback Period
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5

Aplha
-400
-300
-200
-100
0

Beta

PBP

4 years

3.4 years

Decision: Choose Delta

-380
-300
-200
-60
90

Gamma
-500
-350
-200
-80
80

Delta
-420
-270
-120
0

3.5 years 3 years

Alpha
Year 0
Initial outlay
Cash Flow
DF @ 12%
PV
NPV
Decision:

Year 1

Year 2

Year 3

Year 4

Year 5

-400
1
-400
-39.6

100
0.892
89.2

100
0.797
79.7

100
0.712
71.2

100
0.636
63.6

100
0.567
56.7

Do not accept Project Alpha

Discounted payback period

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

-400
-300
-200
-100
0

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

Payback is 4 years

-400
-310.8
-231.1
-159.9
-96.3
-39.6
> 5 yrs

BETA
Cash Flow
DF @ 12%
PV
NPV

Year 0

Year 1
-380
1
-380
51.19

Year 2

80
0.892
71.36

Year 3
100
0.797
79.7

140
0.712
99.68

Year 4

Year 5

150
0.636
95.4

150
0.567
85.05

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

-380
-300
-200
-60
90

60/150

0.4

Payback is 3.4 years

DPBP
Gamma
Cash Flow
DF @ 12%
PV

Year 0

Year 1
-500
1
-500

150
0.892
133.8

Year 2

Year 3
150
0.797
119.55

120
0.712
85.44

Year 4
160
0.636
101.76

Year 5
200
0.567
113.4

NPV

53.95

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

-500
-350
-200
-80
80

Payback is

3.5 years

delta
Cash Flow
DF @ 12%
PV
NPV

Year 0

80/160

Year 1
-420
1
-420
-7.65

150
0.892
133.8

Year 2

Year 3
150
0.797
119.55

120
0.712
85.44

0.5

Year 4

Year 5

80
0.636
50.88

Discounted payback period

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

-420
-270
-120
0

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

Payback is 3 years

-420
-286.2
-166.65
-81.21
-30.33
-7.65
> 5 yrs

40
0.567
22.68

DPBP
Alpha
NPV
Payback
Discounted payback

Beta
-39.6

Gamma
51.19

Delta
53.95
-7.65

Payback
Benefits
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
Year 0
RM mil

Year 1
RM mil

Year 2
RM mil

Year 3
RM mil

Year 4
RM mil

Year 5
RM mil

Option 1
Property
Working capital
Sales revenue
VC
FC (exld dep)
Marketing costs
Opportunity costs

-9
-3

DF@ 10%
PV
NPV

-12
1
-12
19.6

Workings
Fixed cost

2.4

Depreciation per year =

24
-11.2
-0.8
-2
-0.1
9.9
0.909
8.9991

30.8
-19.6
-0.8
-2
-0.1
8.3
0.826
6.8558

39.6
-25.2
-0.8
-2
-0.1
11.5
0.751
8.6365

9-1
5

FC (exld dep)

2.4 - 1.6 =

Option 2

Year 0
RM mil

Royalties
DF@ 10%
PV
NPV
Year 0
RM mil
Option 3
Installments
DF@ 10%
PV
NPV

1.6

0.8

Year 1
RM mil
0
1
0
24.0

26.4
-16.8
-0.8
-2
-0.1
6.7
0.683
4.5761

1
3
10
-7
-0.8
-2
-0.1
4.1
0.621
2.5461

Year 2
RM mil

4.4
0.909
3.9996

Year 1
RM mil

Year 3
RM mil
7.7
0.826
6.3602

Year 2
RM mil

12
1
12
21.9

9.9
0.751
7.4349

Year 4
RM mil
6.6
0.683
4.5078

Year 5
RM mil
2.8
0.621
1.7388

Year 3
RM mil

Year 4
RM mil

Year 5
RM mil

Year 3
RM mil

Year 4
RM mil

Year 5
RM mil

12
0.826
9.912

Payback

Internal Rate of Return (IRR)

Year 0
RM mil

Year 1
RM mil

Year 2
RM mil

Option 1
Property
Working capital
Sales revenue
VC
FC (exld dep)
Marketing costs
Opportunity costs

-9
-3

-12
1
-12
13.5

DF@ 20%
PV
NPV

24
-11.2
-0.8
-2
-0.1
9.9
0.833
8.2467

30.8
-19.6
-0.8
-2
-0.1
8.3
0.694
5.7602

39.6
-25.2
-0.8
-2
-0.1
11.5
0.579
6.6585

26.4
-16.8
-0.8
-2
-0.1
6.7
0.482
3.2294

1
3
10
-7
-0.8
-2
-0.1
4.1
0.402
1.6482

Internal Rate of Return (IRR)

Year 0
RM mil
Option 1
Property
Working capital
Sales revenue
VC
FC (exld dep)
Marketing costs
Opportunity costs

Year 1
RM mil

Year 2
RM mil

Year 3
RM mil

Year 4
RM mil

-9
-3

-12
1
-12
9.2

DF@ 30%
PV
NPV

24
-11.2
-0.8
-2
-0.1
9.9
0.769
7.6131

30.8
-19.6
-0.8
-2
-0.1
8.3
0.592
4.9136

39.6
-25.2
-0.8
-2
-0.1
11.5
0.455
5.2325

26.4
-16.8
-0.8
-2
-0.1
6.7
0.35
2.345

Year 5
RM mil
1
3
10
-7
-0.8
-2
-0.1
4.1
0.269
1.1029

Internal Rate of Return (IRR)

RM mil
Option 1
Property
Working capital
Sales revenue
VC
FC (exld dep)
Marketing costs
Opportunity costs
DF@ 40%
PV
NPV

RM mil

RM mil

RM mil

RM mil

-9
-3

-12
1
-12
5.9922

24
-11.2
-0.8
-2
-0.1
9.9
0.714
7.0686

30.8
-19.6
-0.8
-2
-0.1
8.3
0.51
4.233

39.6
-25.2
-0.8
-2
-0.1
11.5
0.364
4.186

26.4
-16.8
-0.8
-2
-0.1
6.7
0.26
1.742

Year 5
RM mil
1
3
10
-7
-0.8
-2
-0.1
4.1
0.186
0.7626

New example
Year 0
PPE
Cash inflow
Cash outflow

Year 1

-600
1
-600
49.6

Year 0
PPE
Cash inflow
Cash outflow

500
-200
300
0.909
272.7

Year 1

Year 4

600
-400
200
0.826
165.2

Year 2

500
-400
100
0.751
75.1

Year 3

700
-500
200
0.683
136.6

Year 4

-600

-600
1
-600
-57

DF @ 20%
PV
NPV

A + (B-A) X

Year 3

-600

DF @ 10%
PV
NPV

IRR =

Year 2

500
-200
300
0.833
249.9

600
-400
200
0.694
138.8

500
-400
100
0.579
57.9

700
-500
200
0.482
96.4

a
(a - b)

A=
B=
a=
b=

+ DF
- DF
+ NPV
- NPV

0.1 + (0.2 - 0.1) X

49.6
(49.6 + 57

Accounting rate of return (ARR)

ARR =

Average investment =

Question

Average annual profit

Average investment to earn that profit
Cost of Investment + Disposal value
2

X 100

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
Cost of hiring carrier
Annual savings

20,000 X 10

200,000
230,000
30,000

Cash outflow and inflow

Immediately
1 years time
2 years time
3 years time
4 years time
5 years time
6 years time
6 years time

Cost of vans (10 X 15)

Net savings before depreciation
Net savings before depreciation
Net savings before depreciation
Net savings before depreciation
Net savings before depreciation
Net savings before depreciation
Disposal proceeds from the vans
(10 X 3)

Depreciation per year (straight line)

150,000 - 30,000
6

Thus average annual savings after depreciation =

Average investment =

ARR

RM'000
-150
30
30
30
30
30
30
30

20000

30,000 - 20,000 =

150,000 + 30,000
2
10,000 X 100
90,000

10,000

90,000

11.10%

Inflation
Real rate
Monetary rate
Inflation rate

does not incorporate inflation

incorporates inflation

RR
MR
IR

13.40%
5%

RR =

(1 + MR)
(1 + IR)

MR =

1 + 0.134
1 + 0.05

-1

-1

(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
2
3

55,000 X 1.06
58,300 X 1.06
61,798 X 1.06
Yr 0

IO
CF

58300
61798
65506
Yr 1

Yr 2

Yr 3

-150000
58300
-150000
58300
1
0.9091
-150000 53000.53
3240.59388

DF @ 10%
PV
NPV

61798
65506
61798 65505.88
0.826
0.751
51045.148 49194.92

Calculate the NPV of the project using the RR

RR =

(1 + 0.1)
( 1 + 0.06)

Yr 0
IO
CF
DF @ 10%
PV
NPV

The effect of taxation

-1

Yr 1

3.80%

Yr 2

Yr 3

-150000
-150000
1
-150000
3175

55000
55000
0.963
52965

55000
55000
0.928
51040

55000
55000
0.894
49170

Tax rate =
Cash outflow

25%

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
Year

Asset cost
100,000

30% tax saved Yr 1

1 WDA (25%)
WDV

25000
75,000

7500

2 WDA (25%)

18750
56,250

5625

3 WDA (25%)

14062.5
42,188

4218.75

Disposal
Balancing allowance
Balancing charge

Calculation
Year 1 profit
Year 2 profit

20,000
22,188

Yr 2

3750

3750

2812.5
6562.5

2812.5

2109.375
4921.875

6656.25

Yr 1
30,000 X 30%
30,000 X 30%

Yr 3

9,000
9,000

Yr 2
4500

4500
4500
9000

4500

Yr 0
IO
Tax saved
Profit/CF
Tax
DF @ 5%
NPV

Yr 1

Yr 2

Yr 3

-100,000

-100,000
1
-100000
12,541

3750
30,000
-4500
29,250
0.952
27846

6562.5 4921.875
30,000
30,000
-9000
-9000
27,563
25,922
0.907
0.864
24999.1875 22396.5

Yr 4
Yr 5
20,000
5437.5 3328.125
30,000
-9000
-4500
46,438
-1,172
0.823
0.784
38218.06
-918.75

money is ignored)

Discounted payback period

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

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

-500
-366.2
-246.65
-161.21
-59.45
53.95
0.5

DPBP

4.5 yrs

28.5

14.70%

8%

ew of plant

Yr 4

Yr 5

2109.375

3328.125 3328.125
5437.5