INVESTMENT

ANALYSIS

BY :
Indra Agus Wibowo (C1K011022)
Arya Baskara (C1K011040)
Naila Kumala P (C1K011043)
Overview of Capital
Budgeting
Capital budgeting is the process of evaluating
and selecting long-term investments that are
consistent with the firms goal of maximizing
owner wealth.
A capital expenditure is an outlay of funds by
the firm that is expected to produce benefits
over a period of time greater than 1 year.
An operating expenditure is an outlay of funds
by the firm resulting in benefits received within
1 year.
2012 Pearson Prentice Hall. All rights
reserved.
10-
2
Capital Budgeting: Steps in the Process and
Independent versus Mutually Exclusive Projects

The capital budgeting process consists
of five steps:
1. Proposal generation. Proposals for
new investment projects are made
at all levels within a business
organization and are reviewed by
finance personnel.
2. Review and analysis. Financial
managers perform formal review
and analysis to assess the merits of
investment proposals
3. Decision making. Firms typically
delegate capital expenditure
decision making on the basis of
dollar limits.
4. Implementation. Following
approval, expenditures are made
and projects implemented.
Expenditures for a large project
often occur in phases.
5. Follow-up. Results are monitored
and actual costs and benefits are
compared with those that were
expected. Action may be required if
actual outcomes differ from
projected ones.
Independent versus Mutually
Exclusive Projects
Independent projects are
projects whose cash flows are
unrelated to (or independent of)
one another; the acceptance of
one does not eliminate the
others from further
consideration.
Mutually exclusive projects
are projects that compete with
one another, so that the
acceptance of one eliminates
from further consideration all
other projects that serve a
similar function
Capital Budgeting

Unlimited Funds versus
Capital Rationing
Unlimited funds is the
financial situation in which
a firm is able to accept all
independent projects that
provide an acceptable
return.
Capital rationing is the
financial situation in which
a firm has only a fixed
number of dollars available
for capital expenditures,
and numerous projects
compete for these dollars.
Accept-Reject versus
Ranking Approaches
An acceptreject
approach is the evaluation
of capital expenditure
proposals to determine
whether they meet the
firms minimum acceptance
criterion.
A ranking approach is the
ranking of capital
expenditure projects on the
basis of some
predetermined measure,
such as the rate of return
Capital Budgeting Techniques
Bennett Company is a medium sized metal
fabricator that is currently contemplating two
projects: Project A requires an initial investment of
$42,000, project B an initial investment of
$45,000. The relevant operating cash flows for the
two projects are presented in Table 10.1 and
depicted on the time lines in Figure 10.1.
Table 10.1 Capital Expenditure
Data for Bennett Company
Figure 10.1 Bennett Companys
Projects A and B
Payback Period
The payback method is the amount of time
required for a firm to recover its initial investment
in a project, as calculated from cash inflows.
Decision criteria:
The length of the maximum acceptable payback
period is determined by management.
If the payback period is less than the maximum
acceptable payback period, accept the project.
If the payback period is greater than the maximum
acceptable payback period, reject the project.
Payback Period (cont.)
We can calculate the payback period for Bennett
Companys projects A and B using the data in Table 10.1.
For project A, which is an annuity, the payback period is 3.0
years ($42,000 initial investment $14,000 annual cash inflow).
Because project B generates a mixed stream of cash inflows, the
calculation of its payback period is not as clear-cut.
In year 1, the firm will recover $28,000 of its $45,000 initial
investment.
By the end of year 2, $40,000 ($28,000 from year 1 + $12,000 from
year 2) will have been recovered.
At the end of year 3, $50,000 will have been recovered.
Only 50% of the year-3 cash inflow of $10,000 is needed to complete
the payback of the initial $45,000.
The payback period for project B is therefore 2.5 years (2 years +
50% of year 3).
Payback Period: Pros and Cons
of Payback Analysis
The payback method is widely used
by large firms to evaluate small
projects and by small firms to
evaluate most projects.
Its popularity results from its
computational simplicity and
intuitive appeal.
By measuring how quickly the firm
recovers its initial investment, the
payback period also gives implicit
consideration to the timing of cash
flows and therefore to the time
value of money.
Because it can be viewed as a
measure of risk exposure, many
firms use the payback period as a
decision criterion or as a
supplement to other decision
techniques.
The major weakness of the payback
period is that the appropriate
payback period is merely a
subjectively determined number.
It cannot be specified in light of the
wealth maximization goal because it is
not based on discounting cash flows to
determine whether they add to the
firms value.
A second weakness is that this
approach fails to take fully into
account the time factor in the value
of money.
A third weakness of payback is its
failure to recognize cash flows that
occur after the payback period.


Net Present Value (NPV)
Net present value (NPV) is a sophisticated capital
budgeting technique; found by subtracting a
projects initial investment from the present value
of its cash inflows discounted at a rate equal to the
firms cost of capital.
NPV = Present value of cash inflows Initial
investment

Net Present Value (NPV)
(cont.)
Decision criteria:
If the NPV is greater than $0, accept the project.
If the NPV is less than $0, reject the project.

If the NPV is greater than $0, the firm will earn a
return greater than its cost of capital. Such action
should increase the market value of the firm, and
therefore the wealth of its owners by an amount
equal to the NPV.


Net Present Value (NPV):
NPV and the Profitability Index
For a project that has an initial cash outflow
followed by cash inflows, the profitability index
(PI) is simply equal to the present value of cash
inflows divided by the initial cash outflow:



When companies evaluate investment
opportunities using the PI, the decision rule they
follow is to invest in the project when the index is
greater than 1.0.
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is a
sophisticated capital budgeting technique; the
discount rate that equates the NPV of an
investment opportunity with $0 (because the
present value of cash inflows equals the initial
investment); it is the rate of return that the firm
will earn if it invests in the project and receives the
given cash inflows.
Internal Rate of Return (IRR)
Decision criteria:
If the IRR is greater than the cost of capital, accept
the project.
If the IRR is less than the cost of capital, reject the
project.

These criteria guarantee that the firm will earn at
least its required return. Such an outcome should
increase the market value of the firm and,
therefore, the wealth of its owners.
6.4 Average Accounting
Return
Another attractive, but fatally flawed,
approach
Ranking Criteria and Minimum
Acceptance Criteria set by management
Investment of Value Book Average
Income Net Average
AAR
Example
Projects need funding 280,000,000,
age 3 years, residual value
40,000,000. Profit after tax 3 years in
a row. Year-to-1 40,000,000,
50,000,000 in year 2 and year 3
30,000,000

((40.000.000+ 50.000.000 +
30.000.000 ) : 3)/( 280.000.000 +
40.000.000 ) / 2 ) x 100%
= 40.000.000/160.000.000
= 0,25 = 25%

Average Accounting Return
Advantages:
The accounting
information is
usually available
Easy to calculate

Disadvantages:
Ignores the time
value of money
Uses an arbitrary
benchmark cutoff
rate
Based on book
values, not cash
flows and market
values

Summary Discounted Cash
Flow
Net present value
Difference between market value and cost
Accept the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually
exclusive projects
Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing
Summary Payback Criteria
Payback period
Length of time until initial investment is recovered
Take the project if it pays back in some specified
period
Does not account for time value of money, and there is
an arbitrary cutoff period
Discounted payback period
Length of time until initial investment is recovered on a
discounted basis
Take the project if it pays back in some specified
period
There is an arbitrary cutoff period
Summary Accounting Criterion
Average Accounting Return
Measure of accounting profit relative to
book value
Similar to return on assets measure
Take the investment if the AAR exceeds
some specified return level
Serious problems and should not be used
JOURNAL
REVIEW
Capital Budgeting Practices: A
survey in the Firms in Cyprus
The purpose of this paper is to isvestigate :
The methods used by the Cyprus companies to
evaluate investments
The approach adopted to handle important
estimation problem inherent the use of these
method, such as the definition and estimation of
the cost of capital and the incorporation of risk
analysis in the evaluation methods used
Research study was by 32 numbered
qustions in questionaire promoted by the
students of the Department of Accounting
and Finance at the University of Macedonia
in March 2001 to 100 selected enterprises
from all over the republic of Cyprus

Result
Investment Evaluation Techniques Used

Techniques Percentage
NPV 11.39
IRR 8.86
PI 2.59
Anual Equivalent Amount 3.80
PP 36.71
ROI 17.72
None 18.99
Total 100.00
Contd
Factors Determining The Cost of Capital
for Investment Financing

Factors Percentage
Cost of Borrowing 30.95
Past Experience 26.19
Cost of equity capital 20.24
The average cost of all capital the
business uses
5.95
The yield of an asset without danger
plus a percentage relating to the
investments danger
3.57
Other 13.10
Total 100.00
Contd
Risk Analysis Methods Used

Methods Percentage
Total statistical risk analysis 31.67
Risk analysis with application of
scenarios
30.00
Sensitivity analysis 28.33
Risk analysis with decision trees 10.00
Contd
Reason that Most Firms Do Not
Incorporate Risk Analysis into Their
Investment Decision
Reason Percentage
They arent familiar with risk analysis 28.57
Lack of staff, time, and experience 28.57
There are not available sercices
according to the enterprises volume
of business
19.05
Overview and Conclusions
Small and medium size enterprises in
Cyprus, for the most part, do not
follow scientific evaluation techniques
for their investment projects prabably
due to lack of familiarity with such
method. These findings indicate the
need for training and educating the
managers of the firm in the capital
budgeting area of financial
management.