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FINANCIAL
MANAGEMENT
For Engineers
Capital Investment Appraisal
Ismail Ab.Wahab
Edit by Bulan Abdullah (28 May 2017)
Summary of finance
formula
F = P (1 + i ) n (1 i ) n 1
P A for i 0
n
i (1 i )
i (1 i ) n
A P
(1 i ) n
1
F = P(1 + i ) n P = F[1 / (1 + i ) n]
F = P (1 + i )n
Legend
F= FUTURE, P= PRESENT
i= interest, n = no of years
Example: Finding Future Value
A person deposits $5000 into an account which pays interest at a rate of
8% per year. The amount in the account after 10 years is closest to:
Solution:
The cash flow diagram is:
F = P (1 + i )n
F = 5000 (1 + 0.1 )8
= $10,794.50
The present worth of $400 in year 1 and amounts increasing by $30 per year
through year 5 at an interest rate of 12% per year is closest to:
(A) $1532 (B) $1,634 (C) $1,744 (D) $1,829
1 400 357.14
40
0 430
460 2 430 342.79
490
G = $30 520 3 460 327.42
5 520 295.06
F = P (1 + i )n
1,633.82
Uniform Series Involving P/A and A/P
The uniform series factors that involve P and A are derived as follows:
A = Given A=?
0 1 2 3 4 5 0 1 2 3 4 5
P=? P = Given
(1 i ) n 1 i (1 i ) n
P A n
for i 0 A P
i (1 i ) 2012 by McGraw-Hill, New York, N.Y All Rights Reserved (1 i ) n
1
Example: Uniform Series Involving P/A
A chemical engineer believes that by modifying the structure of a certain water treatment
polymer, his company would earn an extra $5000 per year. At an interest rate of 10% per year,
how much could the company afford to spend now to just break even over a 5 year project period?
(A) $11,170 (B) 13,640 (C) $15,300 (D) $18,950
Solution:
(1 i ) n 1
P A n
for i 0
i (1 i )
The cash flow diagram is as follows:
A = $5000
0 1 2 3 4 5
i =10%
P=?
= $18,954
Solution:
LCM = 6 years; repurchase A after 3 years
Option 1
Solution Using Formula
DETERMINING THE NET PRESENT VALUE DETERMINING THE NET PRESENT VALUE
Firm's cost of capital 12% Firm's cost of capital 10%
machine A Year-End Cash Flow MACHINE B Year-End Cash Flow
interest 0.12 interest 0.1
Year Project A using Formula Year Project A using Formula
0 (20,000) (20,000.00) first year cost 0 (30,000) (30,000.00)
operation
c1 3 (9,000) (22,381.67) cost 6 (7,000) (30,486.82)
3 4,000 3,005.26 salvarege 6 6,000 3,386.84
present value (39,376.41)
present
3 (20,000) (15,026.30) value (57,099.98)
6 (9,000) (39,197.35)
6 4,000 2,257.90
c2 present value (51,965.75)
3 6
Solution: LCM = 6 years; repurchase A after 3 years
PWA = -20,000 9000(P/A,10%,6) 16,000(P/F,10%,3) + 4000(P/F,10%,6)
20,000 4,000
= $-68,961 in year 3
PWB = -30,000 7000(P/A,10%,6) + 6000(P/F,10%,6)
= $-57,100
Select alternative B
Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR)
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
Capital Investment Appraisal Techniques
Option 1- using calculation 3. Internal Rate of Return (IRR) (cont.)
Example:
An investment of $20,000 in new equipment will generate income of $7000 per
year for 3 years, at which time the machine can be sold for an estimated $8000.
If the companys MARR is 15% per year, should it buy the machine?
generate income of
$7000 per year for 3 years 3 7,000 15,982.58 14,745.37 15,219.91
machine can be sold for
an estimated $8000 3 8,000 5,260.13 4,629.63 4,869.05
NPW present value 1,242.71 -625.00 88.96
Since i* > MARR = 15%, the company should buy the machine
Since i* > MARR = 15%, the company should buy the machine
16
CAPITAL INVESTMENT
APPRAISAL
Ismail Ab.Wahab
17
Capital Investment Appraisal Techniques
1. Payback Period
2. Net Present Value (NPV)
3. Internal Rate of Return (IRR)
Capital Investment Appraisal Techniques
Case 1
Table 1
Capital Expenditure Data for Bennett Sdn Bhd
Capital Investment Appraisal Techniques
The cash flow diagram is as follows:
Figure 1
Capital Expenditure Data for Bennett Sdn Bhd
Capital Investment Appraisal Techniques
1. Payback Period
DETERMINING THE NET PRESENT VALUE
Decision Criteria
If NPV > 0, accept the project
If NPV < 0, reject the project
If NPV = 0, technically indifferent
Capital Investment Appraisal Techniques
2. Net Present Value (NPV) (Cont.)
Using
excel
CALUCATE EACH VALUE USING
FORMULA
USING FORMULA
DETERMINING THE NET PRESENT VALUE
Decision Criteria
If IRR > k, accept the project
If IRR < k, reject the project
If IRR = k, technically indifferent
Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)
Figure 3
Calculation of IRRs for Bennett Sdn Bhds
Capital Expenditure Alternatives
Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)
Using MS EXCEL
Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)
Using formula DETERMINING THE NET PRESENT VALUE
Firm's cost of capital
Year-End Cash Flow
interest =i 0.1 0.1
Year =n Project A using Formula Project B using Formula
0 (42,000) (42,000.00) (45,000) (45,000)
1 14,000 12,727.27 28,000 25,454.55
2 14,000 11,570.25 12,000 9,917.36
3 14,000 10,518.41 10,000 7,513.15
4 14,000 9,562.19 10,000 6,830.13
5 14,000 8,692.90 10,000 6,209.21
Project A Project B
interest NPV
10 11071.01 10,924
X 0 0
25 -4350.08 10924.397
38
Case 2: Exercise
The objective of this exercise is to examine an
investment and measure its performance using the
following techniques:
Payback Period
NPV
IRR
Yr. RM RM RM
1 12,000 18,000 24,000
2 21,000 12,000 27,000
3 27,000 21,000 15,000
4 15,000 21,000 15,000
5 21,000 19,500 9,000
96,000 91,500 90,000
Which Approach is Better?