OBJECTIVE

•AT THE END OF THE LESSON, STUDENT WILL BE ABLE TO:

• CALCULATE BY USING CAPITAL BUDGETING TECHNIQUES (PAYBACK
PERIOD, DISCOUNTED PAYBACK PERIOD AND NET PRESENT VALUE) IN
ORDER TO EVALUATE PERFORMANCE OF THE PROJECT WILL BE
SELECTED.
OVERVIEW CAPITAL BUDGETING
TECHNIQUES
•PROCESS OF IDENTIFYING, ANALYSING AND SELECTING
INVESTMENT PROJECT.
•DETERMINE THE ACCEPTABILITY OF THE INVESTMENT PROJECTS.
•TO ENABLE THE BEST PROJECT TO BE IDENTIFIED AND CHOSEN
TYPES OF CAPITAL BUDGETING
TECHNIQUES
• PAYBACK PERIOD
NON DISCOUNTED
CASH FLOW METHOD

• DISCOUNTED PAYBACK PERIOD

DISCOUNTED CASH • NET PRESENT VALUE
FLOW METHODS • PROFITABILITY INDEX
• INTERNAL RATE OF RETURN (IRR)
1. PAYBACK PERIOD (PP)
• THE AMOUNT OF TIME REQUIRED FOR THE FIRM TO RECOVER ITS INITIAL
INVESTMENT
• ACCEPT THE PROJECT – PP IS LESS THAN THE MAXIMUM ACCEPTABLE PP
• REJECT THE PROJECT – PP IS GREATER THAN THE MAXIMUM ACCEPTABLE
PP
PAYBACK PERIOD
Payback Period =
Year before
recover + (Uncover
CF/CF Next year)
PAYBACK PERIOD (PP)- EXAMPLE
Maximum payback period is 3 years
Year Cash Flow (RM) Cumulative Cash Flows (RM)
0 (20,000) – IO (20,000)
1 15,000 -20,000 + 15,000 = (5,000)
2 15,000 -5,000 + 15,000 = 10,000
3 13,000 10,000 + 13,000 = 23,000
4 3,000 23,000 + 3,000 = 26,000
Payback Period = 1 + (5,000 /15,000)
= 1.33 years ( 1 year and 4 months)
Accept the project because the Payback Period is less than maximum
payback period
PAYBACK PERIOD (PP)
•ADVANTAGES:
•EASY TO CALCULATE
•EASY TO UNDERSTAND
•DISADVANTAGES:
• NOT CONSIDER TIME VALUE OF MONEY CONCEPT
2. DISCOUNTED PAYBACK PERIOD (DPP)
• SAME AS THE REGULAR PAYBACK PERIOD, EXCEPT THAT WE USE THE PRESENT VALUES OF THE
CASH FLOWS IN THE CALCULATION
• APPLY DISCOUNT RATE TO CASH FLOWS DURING PAYBACK PERIOD (TIME VALUE OF MONEY)
• DPP IS ALWAYS LONGER THAN REGULAR PAYBACK PERIOD
• ACCEPT THE PROJECT – WHEN DPP IS LESS THAN THE MAXIMUM ACCEPTABLE PP
• REJECT THE PROJECT – WHEN DPP IS GREATER THAN THE MAXIMUM ACCEPTABLE PP
DISCOUNTED PAYBACK PERIOD (DPP)
Discounted Payback
Period = Year before
recover + (Uncover
CF/CF Next year)
DISCOUNTED PAYBACK PERIOD (DPP)-
EXAMPLE (COST OF CAPITAL IS 10%)
Maximum payback period is 3 years
Year Cash Flow PV @ 10% PV of CF Cumulative CF
0 (20,000) 1.000 (20,000) (20,000)
1 15,000 0.9091 13,636.50 -20,000 + 13,636.50 = (6,363.50)
2 15,000 0.8264 12,396.00 -6,363.50 + 12,396.00 = 6,032.50
3 13,000 0.7513 9,766.90 6,032.50 + 9,766.90 = 15,799.40

Discounted Payback Period = 1 + (6,363.50 /12,396.00)

= 1.51 years
Accept the project because the Discounted Payback Period is less than
maximum payback period
DISCOUNTED PAYBACK PERIOD (PP)
• ADVANTAGES:
• CONSIDER THE RISKINESS OF THE PROJECT’S CASH FLOWS (THROUGH THE
COST OF CAPITAL)
• CONSIDER THE TIME VALUE OF MONEY
• DISADVANTAGES:
• REQUIRED AN ESTIMATE OF THE COST OF CAPITAL IN ORDER TO DO THE
COMPUTATION.
NET PRESENT VALUE (NPV)

• THE SUM OF PRESENT VALUE OF A PROJECT’S CASH INFLOW AND OUTFLOW

• NPV IS A DIFFERENCE BETWEEN THE PV OF THE PROJECT’S CASH FLOWS AND ITS INITIAL INVESTMENT
• ACCEPT – IF NPV MORE OR EQUAL TO “0”
• REJECT – IF NPV LESS “0”
NET PRESENT VALUE (NPV)
Net present value
(npv)= Total PV of
cash inflow –
Initial Outlay
 NET PRESENT VALUE (NPV)
INITIAL OUTLAY = RM 20,000
Year Cash Flow PV @ 10% PV of CF
1 15,000 0.9091 13,636.50
2 15,000 0.8264 12,396.00
3 13,000 0.7513 9,766.90
4 3,000 0.6830 2,049.00
TOTAL 37,848.40
Net present value (npv)= RM 37,848,40 – RM 20,000
= RM 17,848.40

ACCEPT THE PROJECT BECAUSE THE NPV FOR THE CASH FLOW IS POSITIVE
NET PRESENT VALUE (NPV)-
• ADVANTAGES
• IT IS DIRECT MEASURE OF THE RM CONTRIBUTION TO STOCKHOLDERS
• CONSIDER ALL THE CASH FLOW (INFLOW CF AND OUTFLOW CF)
• DISADVANTAGES
• REQUIRE AN ESTIMATE OF THE COST OF CAPITAL
• EXPRESS IN TERMS OF RM, NOT IN THE PERCENTAGES
PROFITABILITY INDEX (PI)
• ALSO KNOWN AS PROFIT INVESTMENT RATIO (PIR) AND VALUE INVESTMENT RATIO
(VIR).
• IT IS A RATIO OF PAYOFF TO INVESTMENT OF A PROPOSED PROJECT
• TO IDENTIFY THE RELATIONSHIP BETWEEN THE COST AND BENEFITS OF A PROPOSED
PROJECT.
• ACCEPT – IF PI MORE OR EQUAL TO “1”
• REJECT – IF NPV LESS “1”
PROFITABILITY INDEX (PI)
Profitability index (pi)
=
Total PV of cash inflow
Initial Outlay
 PROFITABILITY INDEX (PI)
INITIAL OUTLAY = RM 20,000
Year Cash Flow PV @ 10% PV of CF
1 15,000 0.9091 13,636.50
2 15,000 0.8264 12,396.00
3 13,000 0.7513 9,766.90
4 3,000 0.6830 2,049.00
TOTAL 37,848.40
Profitability index (pi) = RM 37,848,40 / RM 20,000
= 1.89

ACCEPT THE PROJECT BECAUSE THE PI FOR THE CASH FLOW IS MORE THAN 1
PROFITABILITY INDEX (PI)
• ADVANTAGES:
• ASSIST IN CHOOSING PROJECT THAT FIT WITHIN THE BUDGET
• CONSIDER TIME VALUE OF MONEY

• DISADVANTAGES:
• DIFFICULTIES IN DETERMINE THE REQUIRED RATE OF RETURN
• IGNORE ALL THE SUNK COST
THANK YOU
Question 1 (OctDec2017)
El Zara Berhad is planning to replace one of its processing machine with a newer and more
efficient one. The cost of capital for this firm is 14% and the maximum required payback period is 2
years. The expected of Cash Flow for the project is given below:

Year Cash Flow (RM)

0 (1,246,000)
1 712,000
2 712,000
3 712,000
4 712,000
5 712,000 + 350,000
1.Determine the project’s:
- Payback Period (PP)
- Discounted Payback Period (DPP)
- Net Present value (NPV)
PAYBACK PERIOD
Year Cash Flow (RM) Cum CF (RM)
Payback Period
0 (1,246,000) (1,246,000)
= 1 + (534,000 /
1
2
712,000
712,000
(534,000)
178,000
712,000)
3 712,000 890,000 = 1.75 Years
4 712,000 1,602,000
5 1,062,000 2,664,000
DISCOUNTED PAYBACK PERIOD
Year Cash Flow PV @ PV of CF Cum CF
Discounted
(RM) 14% (RM) (RM)
Payback Period
0 (1,246,000) 1.0000 (1,246,000) (1,246,000) = 2 + (73,549.60 /
1 712,000 0.8772 624,566.4 (621,433.60)
480,600)
2 712,000 0.7695 547,884 (73,549.60) = 2.15 Years
3 712,000 0.6750 480,600 407,050.40
4 712,000 0.5921 421,575.2 828,625.60
5 1,062,000 0.5194 551,602.80 1,380,228.4
NET PRESENT VALUE
Year Cash Flow PV @ PV of CF
(RM) 14% (RM) Net Present Value
1 712,000 0.8772 624,566.4

2 712,000 0.7695 547,884 =RM 2,626,228.4 –

3 712,000 0.6750 480,600
4 712,000 0.5921 421,575.2 RM 1,246,000
5 1,062,000 0.5194 551,602.80 = RM 1,380,228.40
total 2,626,228.4