MM5007 FINANCE MANAGEMENTCAPITAL BUDGETING GROUP PRESENTATION

Andri Sumihar Simbolon (29115471)Dicky Wira Senjaya (29115462)Kiki Fitria Rahadian (29115481)Prasetya Eka Winaya (29115455)Ruli Himawan Nugroho (29115515)

HOWWHAT

WHEN WHY

OUR AGENDA

of Capital Budgeting

JUST WHAT IS CAPITAL

BUDGETING?

"The process by which you evaluate the financial potential for each of one or more possible capital

investments"Capital Budgeting for Dummies

DEFINITION(S)

"The process of evaluating and selecting long-term investments that are consistent with the

firm's goal of maximizing owner's wealth"Principles of Managerial Finance, Lawrence J. Gitman & Chad J. Zutter

This? That?

WHEN DOES CAPITAL

BUDGETING COME INTO PLAY?

BUYING LAND,A NEW PLANT,

OR A NEW MACHINERY

OFFERINGA NEW LINE OR A NEW PRODUCT

STARTING A NEW PROJECT

When a corporation is considering

All the above need to be carefully analyzed to determinetheir potential returns and risk before any action taken

WHYIT IS IMPORTANT

The operational and cost efficiencies that the entire corporation

experiences are largely influenced by its capital

budgeting decisions

THE IMPORTANCE OF CAPITAL BUDGETING

HOWWHAT

WHEN WHY

OUR AGENDA

of Capital Budgeting

TECHNIQUES

PAYBACK PERIOD NET PRESENTVALUE (NPV)

INTERNAL RATEOF RETURN (IRR)

"The amount of time required for the firm to

recover its initial investment in a project, as calculated from cash

inflows"

"The NPV method discounts the firm’s

cash flows at the firm’s cost of capital. This rate is the minimum return that must be earned on a project to satisfy the

firm’s investors"

"The discount rate that equates the NPV of an

investment opportunity with $0 (because the present value of cash

inflows equals the initial investment"

Ignore the time-valueof money

Considers the time-valueof money

Commonly used to evaluate proposed

investments Used to evaluate

investment projectsOne of the most widely used capital budgeting

techniques

TECHNIQUES

NPV

IRR

PP

TECHNIQUES

PAYBACK PERIOD NET PRESENTVALUE (NPV)

INTERNAL RATEOF RETURN (IRR)

Decision Criteria

• ACCEPT | If the payback period is less than the maximum acceptable payback period

• REJECT | If the payback period is greater than the maximum acceptable payback period

• ACCEPT | If the NPV is greater than $0 because the firm will earn a return greater than its cost of capital. It would increase the market value of the firmREJECT | If the NPV is less than $0

• ACCEPT | If the IRR is greater than the cost of capital

• REJECT | If the IRR is less than the cost of capital

WHICHTECHNIQUE

ISBETTER?

PAYBACK PERIOD NET PRESENTVALUE (NPV)

INTERNAL RATEOF RETURN (IRR)

PROS & CONS AND OTHER CONSIDERATIONS

• PROS | Large firms sometimes use the payback approach to evaluate small projects, and small firms use it to evaluate most projects. Its popularity results from its computational simplicity and intuitive appeal.

• CONS | Only able to compute the maximum acceptable period of time over which management decides that a project’s cash flows must break even (just equal to the initial investment)

• THEORETICAL VIEW | Given that the financial manager’s objective is to maximize shareholder wealth, the NPV approach has the clearest link to this objective and, therefore, is the “gold standard” for evaluating investment opportunitiesPRACTICAL VIEW | Evidence suggests that in spite of the theoretical superiority of NPV, financial managers use the IRR approach just as often as the NPV method. The appeal of the IRR technique is due to the general disposition of business people to think in terms of rates of return rather than actual dollar returns. Because interest rates, profitability, and so on are most often expressed as annual rates of return, the use of IRR makes sense to financial decision makers

CASE SOLUTIONS

Capital Budgeting:Discounted Cash Flow Analysis

A company invests in a new machine expecting that it would result in cash cost savings for a period of time. Evaluate whether the investment is attractive in economic terms, given the cash flows

A company is considering to replace an old machine with a new more modern one. Evaluate whether the investment economically attractive, and elaborate the available alternatives to maximize the benefit

A CFO is concerned by the long term prospects of a product line. The line have been performing well historically, but the loss of its patent in the future will attract new entrants. Decide whether or not to continue the line

Continuing Case #3, the VP of Marketing proposed a major investment to increase promotion for the line. Decide whether or not the proposal should be approved

#1 #2 #3 #4

CASE #1

A company buys a machine for $500,000 and depreciates it on a straight-line basis over a five-year period for tax purposes. The investment would result in cash cost savings of $200,000 per year, before taxes , for five years. At the end of the five years , it was estimated that the machine would be sold for $75,000. The gain on the sale of the machine would be taxed at a 40% rate.

Is the investment in the machine attractive in economic terms , given all of the cash flows ? Please assume that the cash flows occure at the end of each year, that the tax rate is 40%, and that the appropriate discount rate is 8%. What is net present value ? the internal rate of return ? the payback period ?

CASE PROBLEM

CASE #1IS THE INVESTMENT ATTRACTIVE?

NPV = 165,921, NPV is PositiveIRR ( 9.20%) > I (8%)

YES!The investment in the machine

attractive in economic terms since it has a positive NPV and an IRR that is

higher than discount rate

CASE #2

Schmidt AG is considering the replacement of three hand-loaded block milling machines with an automatic milling machine. The three hand-loaded machines are only three years old and were purchased at a total cost of DM 300,000. The useful life of the machines at the same time of their purchase was estimated to be fifteen years. The salvage value at the end of the fifteen years was estimated to be zero.

Is the investment economically attractive?What are the actual after-tax cash flows for each of the two alternatives?What is the NPV of the actual cash flows for each of the two alternatives?

CASE PROBLEM

CASE #2IS THE INVESTMENT ATTRACTIVE?

The NPV for the two alternatives are as followNPV for Hand-loaded Block 67,989NPV for Automatic Machine 497,348

YES!The investment in automatic milling machine is economically attractive

because NPV of the automatic milling machine is (+)

CASE #3

Richard Pitkin, CFO of Draper Corporation, was concerned by the long-term prospects for the Synectics product line. The product line had performed well historically, but the impending loss of its patent position seemed certain to attract new entrants and result in lower product prices and flat unit sales through the year of 2004.

Management was considering the elimination of the product line as of year-end 1997. Would you recommend that the Synectics product line be discontinued at the beginning of 1998?

CASE PROBLEM

CASE #3SHOULD THE PRODUCT LINE BE

DISCONTINUED?

NO! IT SHOULD CONTINUEIt is better to continue as the PV of cash flows is higher as compared to

discontinuing the product now

CASE #4

The VP of Marketing from Draper Corporation proposed to make a major investment in market share by increasing promotional expenditures by $2,5 million during 1998-2000. Sales were forecast to increase by 250,000 units per year throughout the 1994-2004 period. He also believed that some economies would be realized in the area of selling, general & administrative expenses.

Would you recommend approval of the program?

CASE PROBLEM

CASE #4SHOULD THE PROPOSAL BE

APPROVED?

YES!Approve the initiating investment in market shared by initiating the 2.5 million

special promotion

MM5007 FINANCE MANAGEMENTCAPITAL BUDGETING GROUP PRESENTATION

Andri Sumihar Simbolon (29115471)Dicky Wira Senjaya (29115462)Kiki Fitria Rahadian (29115481)Prasetya Eka Winaya (29115455)Ruli Himawan Nugroho (29115515)