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CHAPTER COVERAGE
At the end of this topic, you should be able to:
Explain capital investment;
Apply various capital investment appraisal techniques;
Examine the effects of inflation and taxation in capital investment
appraisal;
Identify risks and uncertainty, sensitivity analysis and capital rationing;
and nalyse ethical issues and other qualitative factors in long-term
decision making.
11. INTRODUCTION
Managers often make decisions involving an investment today with the hope
to get returns in the future. All of investments require significant initial capital
or fund outlay with the hope of getting a return of extra cash flows in the
future.
These significant investment decisions in projects that have long-term
implications and benefits are known as capital budgeting or capital
investment decisions. There could be many potential projects but the
availability of funds is a major constraint. Therefore, managers must
thoroughly evaluate and choose projects with the highest future returns.
(d) Payback;
(e) Net present value;
(f) Profitability index.
11.1.2 Payback
The payback method is very popular, widely used, and can be considered as the
easiest and most straightforward method. Payback period refers to the time
required for a firm to recover its original investment.
Consider the following two capital investments A and B. Both projects require
the same amount of initial investment of RM300,000 and have a 4-year life. The
expected cash flows for A and B are as follows.
Investment
Year 1
Year 2
Year 3
RM150,000
RM100,000
Year 4
RM100,000
RM50,000 RM100,000
Calculate the Payback period for two projects, suggest the best option and
discuss the pros and cons.
NPV
measures the profitability of an investment by looking at the difference
in the present value of the cash inflows and outflows associated with the
capital investment.
NPV = (PV of cash inflows PV of cash outflows) Investment Outlay
NPV = PV of net cash flows - Investment Outlay
- I0
(100,000)
Year 1
22,727
Year 2
20,660
Year 3
18,783
Year 4
27,320
Year 5
31,045
Year 6
28,225
Year 7
25,660
Projec Investme
ts
nt
PV of Cash inflows
150,000
245,000
100,000
190,000
90,000
150,000
EFFECT OF TAXATION
RM1,500,000
RM 600,000
RM1,000,000
RM 550,000
RM 200,000
RM 500,000
Assume the company ceases after 10 years, and thus the business will be
closed that year. The equipment would then be sold at its salvage value. The
companys after tax cost of capital is 12% and its tax rate is 25%. The
company uses the straight line method, assuming no salvage value for
computing tax-shield purposes.
CAPM
Consider the following example to calculate the expected return on these
investments
Sensitivity Analysis:
These variables include estimated cost of capital (the i), estimated life of the
project (the n), estimated initial outlay (the I), and estimated stream of cash
flows that can be broken up into selling price, sales volume, and operating
costs.
SUMMARY