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TOPIC 5 CaPITal budgeTIng and Cash flOw PrOjeCTIOn

Topic Capital

Budgeting
and Cash
Flow
Projection

L
EARNING OUTCOMES
By the end of this topic, you should be able to:

1.

Explain the importance of capital budgeting;

2.

Identify steps in evaluating a capital budgeting project;

3.

Evaluate capital budgeting techniques;

4.

Disscuss the advantages and disadvantages of each budgeting

technique; and

5.

Analyse the relationship between cash flow estimation and risk and
also inflation.

INTRODUCTION

Your company wants to do several projects. As a financial manager, you are

assigned to evaluate these projects and submit a report to the board of directors.
How will you evaluate these projects to determine their feasibility? To better
comprehend the technique of project evaluation, it is vital that you, as a financial
manager, understand the meaning of capital budgeting.
In this topic, you will also see how the concept of financial mathematics learnt in
Topic 4 is applied in the evaluation of a financial project.

TOPIC 5 Capital budgeting and cash flow projection

69

Estimation of cash flow is a significant part in capital budgeting. As explained

earlier, capital budgeting is a process of planning the asset spending that is the
cash flow expected to be received after a year. Evaluation will be undertaken on
proposals of projects to determine the suitability of those projects to achieve the
firms objective. This can be done by using techniques such as accounting rate
of return, payback period, discounted payback period, net present value and
internal rate of return.
In making a good decision, accurate cash flow is important because it influences
greatly the decision to accept or reject a proposed project. Numerous variables
and many workers will be involved in the process of capital budgeting.
Projections are not made by the finance department only. Other departments
such as the marketing department, production department and human resource
department also make their projections. All data provided by other departments
are compiled by the finance department to make an estimation of cash flow in the
capital budgeting process. Hence, it can be seen how difficult it is to prepare cash
flow estimation. It involves numerous variables, cooperation from many people
and accurate prediction.
A few guidelines on cash flow will be discussed in this topic to help financial
managers to make more accurate cash flow projection.

5.1

CAPITAL BUDGETING

ACTIVITY 5.1
Explain the importance of cash flow in capital budgeting.
Capital budgeting is a process of planning asset spending, which is the receipt of
cash flow expected after a year. In capital budgeting decisions, a company places
funds in various types of projects, such as firm expansion project, production
diversification project, improving cost efficiency project, security project and etc.
Every decision made regarding capital budgeting has significant implications
to both the cash flow expected to be received by the firm and to the cash flow
risk. This is because the decision on capital budgeting involves investment of
assets that is more than one year. For instance, a company wishes to invest in a
project that has life expectancy of five years. Having invested in that project, it is
difficult for a firm to pullout within this five-year period. At this stage, changes
in demand condition, competition and so on may happen. These factors can
influence the cash flow expected to be received and will affect the firms financial
performance. Therefore, it is important for a financial manager to analyse in detail
a long-term investment proposal in order to make the best decision for the firm.

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TOPIC 5 Capital budgeting and cash flow projection

As mentioned in Topic 1, one of the significant objectives of a firm is to maximise

its wealth. Capital budgeting process is one of the steps to achieve this objective.
Thus, capital budgeting is part of a strategic management process.

5.1.1

The Importance of Capital Budgeting

Capital budgeting involves investment in assets which have life expectancy of

more than a year. If a project has life expectancy of eight years, it means that a
firm will be tied up with that project for eight years. Therefore, it is important
that a firm makes an accurate projection of the expected return. A mistake in
making projection whether in terms of asset requirement or expected return will
have a serious impact on the firms performance. For example, a firm projects
that sales will increase in the future. To fulfil the increase in demand, the firm
must invest in new machines and expand its factory now so that the asset is
available when it is needed. If the projection is correct, the firm will attain profit
because tools and outfit are all ready with the capacity to increase production
and fulfil the increase in demand. But if there are mistakes in the projection, such
as demand does not increase as projected, the firm will experience the problem of
reckless spending due to the excessive capacity. This will incur a loss to the firm
and if the loss is great, this could lead the firm to bankruptcy.
Capital budgeting is part of the process of strategic management. Decision
regarding capital budgeting of the firm shall point to the strategic direction of the
firm. Regardless whether a firm does a replacement project, expansion project or
environmental project, all of these projects need capital budgeting.
The timing of an investment project is important. Effective capital budgeting
must take into consideration the time the project is implemented and the quality
of assets invested. If a project takes place when the economy is in inflation, the
capital cost would be higher due to the high interest rate. This will influence the
discount rate used in the analysis of the projects proposal.

ACTIVITY 5.2
Write three reasons why doing capital budgeting is important.

TOPIC 5 Capital budgeting and cash flow projection

5.1.2

Evaluation of Capital Budgeting Project

71

ACTIVITY 5.3
Why is a detailed analysis required for an expansion project compared
to a replacement project?
Assessing capital budgeting proposal involves expenditure. For this reason, a
financial manager may classify projects into various categories to determine the
level of analysis needed replacement project, expansion project, security project,
environmental project etc.
Normally, a more detailed analysis is required for expansion project compared to
an analysis for a replacement project. A large-scale project which requires huge
budget will be evaluated more thoroughly than a small-scale project.

5.1.3

Steps in Evaluating Capital Budgeting Project

Evaluation of capital budgeting project involves a number of steps as shown in

Figure 5.1.

Determining
Cost of Project

Cash Flow
Forecasting

Determining
Risk

Comparing of
Cash

Present Value
Acquisition

Choosing
a Suitable
Capital Cost

Figure 5.1: Steps in evaluating capital budgeting project

The chart in Figure 5.1 can be further explained as:

(a) Determining cost of project

Cost of project is the average rate of payment for the use of capital fund for
the operation of that particular capital budgeting project. Cost of project can
be influenced by factors such as financing policy and types of investment.
Whether a capital budgeting project is accepted or rejected depends mostly
on the discount rate used and this discount rate can be regarded as capital
cost. Capital cost will be discussed in detail in Topic 6.

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(b) Cash Flow Forecasting

Estimation of cash flow is an important step in analysing a capital budgeting
project. To make a correct decision, accurate estimation of cash flow is
crucial. Estimation of cash flow is a complicated and difficult step to make
due to the existence of various factors which can influence a projects cash
flow.

This step requires a financial manager to refer to a number of guidelines on

cash flow estimation in ensuring that only relevant additional cash flow are
taken into account before making a capital budgeting decision. Guidelines
regarding the estimation of cash flow shall be discussed in depth in this
topic.

(c) Determining Risk

Risk plays a vital role in capital budgeting. Ignoring risk in the analysis of
proposed projects may lead to wrong decision in capital budgeting; and
hence will erode the firms financial standing.

(d) Choosing a Suitable Capital Cost

Based on cash flow risk, a suitable capital cost will be adopted for the
discounting of cash flow expected to be received.

(e) Present Value Acquisition

Cash flow is discounted at present value to get an expected value of the
asset to the firm.
(f) Comparing of Cash

The proposed project shall be accepted if present value of cash inflow
is more than cash outflow. On the contrary, the proposed project will be
rejected if present value of cash inflow is less than cash outflow.

5.1.4

Methods in Evaluating Project

There are a number of evaluation techniques which can be used to determine

whether a project can be accepted or rejected. The evaluation techniques are as
follows:

(a) Accounting Rate of Return

Accounting rate of return is a traditional method to evaluate a proposed
project in capital budgeting. The equation for accounting rate of return
(ARR) is as follows:

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73

Equation 1

ARR(%) =

Or

Equation 2

Net Average Income

X 100

Average Investment Book Value

ARR(%) =

Net Average Income

Sum of Average Investment Value

X 100

Net average income refers to income after depreciation and tax expenditure.

Now look at Example 5.1 that shows how to calculate accounting rate of
return and use the figures to determine choice of project.

Example 5.1
The table shows information regarding two projects, A and B. Book value for
both projects are RM30,000.

Net income of Project A

Year 1

Year 2

Year 3

Average

(RM)

(RM)

(RM)

(RM)

8,000

12,000

16,000

12,000

16,000

12,000

8,000

12,000

30,000

20,000

10,000

20,000

10,000

25,000

15,000

5,000

15,000

(after depreciation and tax)

Net income of Project B
(after depreciation and tax)
Book value

Average

1st January
31st December

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TOPIC 5 Capital budgeting and cash flow projection

By using Equation 1, accounting rate of return (ARR) for each project is:
Project A

Project B

ARR% =
=

12,000
15,000

X 100

80%

12,000
15,000

X 100

80%

By using Equation 2, accounting rate of return (ARR) for each project is:
Project A

Project A

ARR% =
=

ARR% =

12,000
30,000
40%

X 100

ARR% =
=

12,000
30,000

X 100

40%

To determine whether to accept or reject a proposed project, compare the

accounting rate of return with minimum rate of return required:
(i) Accept a project if ARR is higher than minimum rate of return required;
and
(ii) Reject a project if ARR is lower than minimum rate of return required.

If projects compete with one another or overlap each other, we will choose a
project that will give the highest rate of return as long as the project gives a
higher accounting return rate than the required minimum rate of return.

In Example 5.1, both projects A and B are attractive because their accounting
rate of return are 80% (by using Equation 1) and 40% (by using Equation
2). Both projects A and B will be accepted if the required minimum rate of
return is less than 40%.

Based on Example 5.1, project B gives a higher return in year 1 as compared

to project A which gives a higher return in year 3. If we take into calculation
the present value of money, project B will become more attractive as
compared to project A even though both projects give the same accounting
rate of return.

One of the advantages of using Accounting Rate of Return (ARR) is, it is

easy to understand and to be used. The concept of income, book value and
rate of return is a simple concept to understand by managers.

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75

The following are the disadvantages of using accounting rate of return

(ARR):
(i) It does not take into account the present value of money as seen in
Example 5.1;
(ii) It uses accounting measurement and not cash flow; and
(iii) Different methods of calculation may cause different decisions made.
By using equation 1, the project may be accepted but by using equation
2 it may be rejected.

(b) Payback Period

This is a very simple technique whereby we only have to determine the
period required in order to get back the sum of money invested in the
project. The firms management will decide on a payback period; whether
the project is to be accepted or rejected depends on whether the payback
period is longer or shorter than the period set by the management. The
principles for payback period are as follows:
(i) Accept the project if the payback period is less than or the same as the
period decided by the management; and
(ii) Reject the project if the payback period is more than the period decided
by the management.

Now, look at Example 5.2 which shows the method of choosing a project
based on payback period.

Example 5.2
Hebat Company is evaluating whether to accept Project A. The investment
required is RM12,000. The total cash flow expected for Project A is as
follows:

Year

Cash Inflow
(RM)

3,000

3,000

5,000

5,000

5,000

If Hebat Company sets the payback period to three years, Project A will be
rejected because the investment payback period exceeds the period set by

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TOPIC 5 Capital budgeting and cash flow projection

the management. After three years, this project will only give a return of
RM3,000 + RM3,000 + RM5,000 = RM11,000 whereas the cost of investment
is RM12,000.

If Hebat Company sets a payback period of four years, will this project be
accepted? Project A will be accepted because the payback period is less than
the period set. After three years, the firm will receive a return of RM11,000.
Therefore, it still needs RM1,000 to tally the cost of investment of RM12,000.
Assuming that cash flow is constant, Hebat Company will take a time of
(1,000 5,000) 0.2 years to get back the balance of RM1,000. Therefore, the
payback period is 3.2 years compared to the set period of four years.

self-check 5.1

Pasti Jaya Company has a project proposal that requires an

investment of RM100,000. The schedule of cash inflow is as follows:
(a) Calculate the payback period for this project.
Year

Cash Inflow (RM)

30,000

30,000

30,000

30,000

(b) If the management of the Pasti Jaya Company has decided on a
payback period of three years, will this project be accepted?

Now look at Example 5.3.

Example 5.3
Hebat Company has two investment projects proposals: Project A and
Project B. The information on these projects is in the following table:

Assume that Hebat Company sets the payback period to be in three years
time. Based on the technique of payback period, Hebat Company will accept
project B and reject project A. But is this a good decision?

TOPIC 5 Capital budgeting and cash flow projection

Project A

Project B

RM12,000

RM12,000

RM3,000

RM3,000

RM3,000

RM4,000

RM5,000

RM5,000

RM5,000

RM5,000

Investment

77

Cash inflow
Year

In the payback period technique, Hebat Company does not take into
account the cash inflow after the set payback period. Although Project B is
able to yield return on the investment in year 3, it will not be able to give
any returns after that. On the contrary, Project A may take a longer period
to yield returns on the investment but it will still produce a cash inflow of
RM5,000 in year 4 and year 5:

Following are the advantages of using the payback period technique:

(i) This is a very easy technique in the project evaluation method. The
calculation is simple and time needed for making evaluation is short.
Thus, the cost of using this technique is low.
(ii) Since this technique is simple and involves low cost, the management
can use this technique to screen several project proposals and to reject
projects which are unattractive in terms of payback period return.
After that, a detailed evaluation can be undertaken) on the existing
project proposal. With this, the management can save time and cost of
evaluating proposed project.

There are difficulties in projecting cash flow in the long term because
of the elements of uncertainty. Hence, payback period technique is a
useful risk evaluation method.

Based on Examples 5.2 and 5.3, the disadvantages of the payback period
technique are as follows:
(i) This technique emphasises on cash inflow in the early years. What
happens if the payback period is ignored?

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TOPIC 5 Capital budgeting and cash flow projection

(ii) This technique fails to consider the present value of money because it
does not do discount cash flow received to present value. Normally,
investment involves cash outflow at present and the revenue acquired
in the future. As explained in Topic 4, one ringgit received now is of
higher value than one ringgit received in the future. If cash inflow
is not discounted to the present value, the decision made may be
incorrect.

To overcome these disadvantages, the discounted payback period

technique can be used. This technique will still determine the period
needed to get back the sum of money invested but the cash inflow is
discounted to present value before the decision to accept or reject the
project is made.

(c) Discounted Payback Period

To overcome the disadvantages of the payback period technique, discounted
payback period can be used. This technique still determines the period
needed to get back the sum of money invested but the cash inflow is
discounted to the present value before the decision to accept or reject the
project is made.

Example 5.4 shows how the technique of discounted payback period is used.
Example 5.4
Referring to Example 5.2 and assuming that the discount rate is 10%, a
discounted payback period schedule can be constructed:
Year

Cash Inflow

PVIF i=10%

Discounted Cash
Inflow

RM3,000

0.9091

2727.3

RM3,000

0.8264

2479.2

RM5,000

0.7513

3756.5

RM5,000

0.6830

3415.5

RM5,000

0.6209

3104.5

Referring to the last column in the table, it shows that the total cash flow
collected for the first three years is RM8,963 (RM2,727.20 + RM2,479.20 +
RM3,756.50). For the first four years, total cash flow collected is RM12,378
(RM8,963 + RM3,415). Since the project investment cost is RM12,000,
discounted payback period is three to four years. Therefore, we still need
RM3,037 from year 4. Thus, the discounted payback period is:

TOPIC 5 Capital budgeting and cash flow projection

79

Discounted payback period years = 3.89 years

Even though this technique takes into consideration the time value of
money, it still does not take into account the cash flow after the payback
period.

(d) Net Present Value

Net present value of a project is the difference of the present value of all cash
inflow minus the present value of all cash outflow.

To obtain net present value: 3 +

3037

year

3415

Discount all cash flow to the present value

Compare present value of the sum of cash inflow with cash outflow

Accept the project if net present value is positive and reject

it if present value is negative

Based on the information in Example 5.2 for Hebat Company, please look at
Example 5.5.

Example 5.5
Year

Cash Inflow (RM)

Present Value of Cash Inflow (RM)

3,000

0.9093 x 3000 = 2727.90

3,000

0.8264 x 3000 = 2479.20

5,000

0.7514 x 5000 = 3756.50

5,000

0.6830 x 5000 = 3415

5,000

0.6209 x 5000 = 3104.50

Total

15483.10

Investment required = RM12,000

No discounting is required on the cost of investment because this sum of

money is presently withdrawn.

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TOPIC 5 Capital budgeting and cash flow projection

Discount rate used =

Net Present Value =


=

=

10%
The sum of present value of cash inflow
investment cost.
RM15,483.10 RM12,000
RM3,483.10

Accept this project because net present value (NPV) is positive.

Advantages of using the net present value (NPV) technique:

(i) NPV technique takes into consideration present value of money
because it discounts cash flow to present value; and
(ii) This technique takes into consideration all money flow for the life
expectancy of the project.

Disadvantages of using the net present value (NPV) technique:

(i) In the determination of a suitable discount rate, different discount rates
are used. These will affect present value of returns and as such, will
influence the managements decision on a particular project. This can
be seen in Topic 4, that is, if a higher discount rate is used, the present
value of a sum of money will become smaller. Therefore, choosing a
suitable discount rate is quite important for this type of evaluation.
(ii) Since this technique takes into consideration all cash flow of the life
expectancy of the project, projection of cash flow must be accurate. If
the projection is not accurate, this can cause a project to be accepted
even though it ought to be rejected.

If the discount rate given is 10%, use the technique of net present value
to evaluate the proposed project in Self Check 5.1 (Pasti Jaya Company).
Would you accept or reject the project? Give reasons.

(e) Internal Rate of Return

In the internal rate of return technique, we try to find the interest rate that
equals the present value of the total cash flow with investment cost. The
management will decide on a required rate of return from a particular
project. Accepting or rejecting a project depends on the internal rate of
return (IRR). Therefore, it is necessary to determine whether IRR is higher
or lower than the rate of return which has been set by the management.

We will accept a project if the internal rate of return (IRR) is higher or the
same as the rate of return set by the management. We will reject a project
if the internal rate of return (IRR) is lower than the rate of return set by
management.

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81

Now, look at Example 5.6 which shows how the internal rate of return
technique is used.

Example 5.6
Megah Company is evaluating whether to accept or reject project X.
The investment needed is RM18,000. X project is expected to have a life
expectancy of three years and is expected to give a cash inflow of RM8,000 per
year for three years. The management has set a desired 10% rate of returns.

Based on the information, try to find an interest rate which equals the
investment cost with the present value on all cash flow for project X.
18,000

8,000
(1 + i)1

8,000
(1 + i)2

8,000
(1 + i)3

Since cash flow for every year is the same for three years, we can use the
annuity concept to solve this problem. (Refer to Topic 4 on the explanation
of the annuity concept).
18,000
= 8,000 (PVIFA i = ?, n = 3 )
18,000 / 8000 = PVIFA i = ?, n = 3
2.25
= ? PVIFA i = ?, n = 3

Referring to the PVIFA table for the period of three years, it shows that:
PVIFA at an interest rate = 15% is 2.2832
PVIFA at an interest rate = 16% is 2.2459
Therefore, internal rate of return acquired can be said as between 15% to
16%.

Compare the internal rate of return acquired (15% - 16%) with the interest
rate set by the management (12%). Accept the project because the internal
rate of return received is more than the interest rate set by the management.

Example 5.7
Syarikat Boleh Jaya (SBJ) is evaluating whether to accept or reject project S.

Investment required is RM800,000. Project S is expected to have a life

expectancy of four years and will give cash inflow as follows:
Year
1
2
3
4

Cash Flow (RM)

350,000
300,000
250,000
150,000

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TOPIC 5 Capital budgeting and cash flow projection

The management requires 12% minimum rate of return for this type of
project. Based on the above information, calculate the rate of return for
project S.

Answer:
For varying cash flow, we have to use the trial and error technique. This
means that we will use one discount rate to determine the net present value
of the project. If the net present value is not equivalent to zero, we will try a
new discount rate to determine the net present value.

For a start, we can use the discount rate (i) = 12% (same as capital cost). With
this rate, net present value of the project can be determined as follows:
Year

(1)
Cash Flow (RM)

(2)
PVIF i=12%, n=4

(3) = (1) x (2)

Present Value

350,000

0.8929

312,515

300,000

0.7972

239,160

3
4

250,000
150,000

0.7118
0.6355

177,950
95,325
824,950

Net Present Value = RM824,950 RM800,000

= RM24,950

Due to the net present value being positive, the discount rate must be
increased. Now, we try with i = 14%.
(1)

(2)

Cash Flow (RM)

PVIF i=14%, n=4

350,000

0.8772

307,020

300,000

0.7695

230,850

3
4

250,000
150,000

0.6750
0.5921

168,750
88,815
795,435

Year

(3) = (1) x (2)

Present Value

Due to the net present value being negative, the discount rate must be
reduced. Now, we try with i = 13%.

TOPIC 5 Capital budgeting and cash flow projection

(1)

(2)

Cash Flow (RM)

PVIF i=13%, n=4

350,000

0.8850

309,750

300,000

0.7831

234,930

3
4

250,000
150,000

0.6931
0.6133

173,275
91,995
809,950

Year

Net Present Value = RM809,950 RM800,000

= RM9,950

Summary

Discount rate (i)

12%
13%
IRR = ?
14%

83

(3) = (1) x (2)

Present Value

Net Present Value

RM24,950
RM9,950
RM0
RM4,565

This means that zero net present value must be between the discount rates
of 13% and 14%. The projects internal rate of return is the same as 13% +
but less than 14%.

It must be reminded that, students must repeat the trial and error calculation
(i.e. try a number of different discount rates) until arriving at 2 ranges of
net present value (one positive and another negative). This ensures that
net present value equals to zero can be determined. IRR is the discount rate
which makes the net present value becomes zero:

Advantages of using the internal rate of return technique:

(i) This technique measures rate of return on investment. Rate of return
concept is easily understood by the management; and
(ii) This technique takes into account present value of money as net present
value technique.

Disadvantages of using the internal rate of return technique:

(i) With regard to certain cash flow, there probably is more than one
internal rate of return. This will confuse the management in making
decisions; and
(ii) For competing projects, it is a situation whereby management is
required to choose only one project, for instance, in a power station
project, management has a choice between hydro electric, nuclear or

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TOPIC 5 Capital budgeting and cash flow projection

coal. The internal rate of return technique may give priority to the
wrong project.
(iii) The calculation of this technique is quite difficult if there are different
returns during the life of the project.

5.2

GUIDELINES ON CASH FLOW

ESTIMATION

ACTIVITY 5.4
Based on the project evaluation methods mentioned before, what is the
best method you will employ if you are a project manager? What are the
characteristics you will consider?

self-check 5.2
1.

Based on the information available in Self-Check 5.1 (Pasti Jaya

Company), calculate the internal rate of return for that project.

2.

Will you accept or reject the project if the management sets the
required rate of return at 15%? Give your reasons.

As a financial manager, what is the guideline that you will use for the estimation
of cash flow in your organisation?
A financial manager has to consider several important guidelines for a more
accurate cash flow projection in getting better accuracy for capital budget
decisions. We will discuss these guidelines in the next subtopic.

5.2.1

Based on Cash Flow and Not on Accounting

Profit

Profit is based on accrued concept. For instance, this years sale is considered
done and this years profit can take into consideration those sales. But, even if
sales happen this year, collection does not necessarily happen in this year too.
Therefore, we cannot take into calculation those sales as a cash inflow. Without
this cash inflow, the firms project may be impeded due to financial difficulties.
This applies to any payment made by the company. Sometimes, the firm needs
to make a certain payment to another party next year and in the calculation of

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85

accounting profit, this payment is this years cost because service has been given
or merchandise has been supplied by the party concerned. But since payment
need not be paid this year, cash outflow does not happen and with that, this cash
flow will not be shown this year.

5.2.2

Only Relevant Additional Cash Flow is

Considered

Additional cash flow is net cash flow that is related to the investment project.
This cash flow will happen if only we accept the project. In determining
additional cash flow, a few doubts may arise, for instance, sunk cost, opportunity
cost and externality. Are these items included as a part of additional cash flow?
(a) Sunk Cost

Sunk cost refers to the total cost spent and is not collectable whether a
project is accepted or not. Therefore, a sunk cost cannot be included in the
analysis. For instance, the fee paid to a consultant for conducting a market
research. Consultant fees cannot be included in a project analysis because
this cost has been spent, regardless of whether the project is accepted and
the cost cannot be collected back.

(b) Opportunity Cost

Opportunity cost refers to the return which can be acquired from an asset
if the asset is utilised for other usage. For instance, ABC Company has an
office that can be used as a new branch office or that office can be rented to
other people for RM36,000 per year. If ABC Company opens a branch, it will
lose the opportunity of having a years rent of RM36,000. This opportunity
cost must be included in the analysis.
(c) Externality

Externality refers to the impact of the project on other departments in the
firm or to the firms existing production. For instance, if the firm introduces
a new product, this may affect an existing product sale. A financial manager
should take into account external impacts when estimating an investment
projects cash flow.

ACTIVITY 5.5

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TOPIC 5 Capital budgeting and cash flow projection

ACTIVITY 5.5
Provide one example to describe each of the following items:
1.

Sunk cost

2.

Opportunity cost

3.

Externality

5.3

MAKING DECISIONS ON EXPANSION

PROJECT AND REPLACEMENT PROJECT

Why is an expansion project more complicated and needs a more detailed

analysis as compared to replacement project? In capital budgeting, two types
of decisions are usually made, which are decisions concerning the following
analyses:
(a) Replacement project analysis; and
(b) Expansion project analysis.
Usually, analysis of expansion project is more difficult and complex compared
to analysis of replacement project. Analysis of expansion project involves
investment in new assets for the purpose of increasing sales and expansion
of firms market share. Replacement project involves investment to replace
equipments or old assets.
For expansion project, all cash outflow or cost and all cash inflow or revenue
need to be considered. A financial manager must consider the degree of risk as
well as the inflation rate relating to the project when evaluating this particular
project. Evaluating technique such as payback period, net present value and rate
of return discussed in this topic can be used to analyse the project.
For replacement project, additional cash flow such as cash received from sale of
old assets or used assets must be calculated. Besides this, the impact of saving on
taxes also needs to be considered.

TOPIC 5 Capital budgeting and cash flow projection

5.4

87

CASH FLOW ESTIMATION AND RISK

What is the relationship between cash flow estimation and risk? Risk measures
variance between real outcome and expected outcome. In capital budgeting,
every period is a random variable and cash flow projection may not be accurate.
The bigger the variance or the difference between projection of cash flow and real
cash flow, the higher the risk will be. In order to make a more accurate analysis, a
financial manager needs to include the degree of risk into capital analysis.

5.5

CASH FLOW ESTIMATION AND

INFLATION

What is the relationship between cash flow projection and inflation? Inflation
refers to increase in the general prices of goods and services. When inflation
rate increases, the value of money decreases. If expected inflation rate is not
calculated into the analysis of cash flow projection, the value received is
deflected and inaccurate. As a result, the capital budgeting decision made will
not be accurate and may affect the firms financial standing. Due to this, capital
budgeting analysis must consider the effects of inflation on cash flow projection
to get a more accurate decision.
The inflation rate expected must be included in the analysis of net present value
to ensure that capital cost takes into consideration the inflation rate. If inflation
rate is found to be higher, the discount rate used should be raised. If the inflation
rate is low, the discounted rate must be lowered. Please refer to Topic 4 on
Financial Mathematics to revise on discount rate and present value. You should
be able to understand the relationship between cash flow estimation and inflation
more clearly after having revised Topic 4.

self-check 5.3
Fill in the blanks.
1.

The _________ the difference between cash flow projection with true
cash flow, the more _____________ its risk.

2.

In cash flow projection analysis, when the inflation rate is

___________, the discount rate used must be increased. When
inflation rate is ____________, the discount rate used must be
lowered.

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TOPIC 5 Capital budgeting and cash flow projection

SUMMARY
In this topic, you have learned that capital budgeting involves planning
and evaluation of a long-term project as well as the importance of capital
budgeting for a firm.
Several methods of evaluating projects such as accounting rate of return,
payback period, discounted payback, net present value and internal rate of
return have been explained and examples of calculation for each technique
have been shown. Besides this, advantages and disadvantages of each
technique have also been discussed.
Cash flow projection is important in the analysis of a proposed investment
project. A number of guidelines on cash flow projection have been discussed
to help you in making decisions on whether to include the cost.
Degree of risk of the project and inflation rate are need to be considered when
evaluating a project.

Budgeting technique
Cash floor
Capital budgeting

Inflation
Opportunity cost
Sunk cost