WEEK 8: CAPITAL BUDGETING – ISLAMIC PERSPECTIVE

Ronald Rulindo, PhD

Kelas Manajemen Keuangan Islam

Fakultas Ekonomi dan Bisnis – Universitas Indonesia

Background

• Capital budgeting is part of corporate finance
• According to Ross et.al., (2016) corporate finance aims to addresses the following three questions:
• What long-term investments should the firm choose? (capital budgeting topic)
• How should the firm raise funds for the selected investments? (capital structure topic)
• How should short-term assets be managed and financed? (short term asset management topic)

​

Balance sheet of a firm

Source: Ross et.al (2016)

The Capital Budgeting Decision

Source: Ross et.al (2016)

​

Current Assets

​

Fixed Assets

1 Tangible

2 Intangible

​

​

Shareholders’ Equity

​

Current Liabilities

Long-Term Debt

​

What long-term investments should the firm choose?

The Capital Structure Decision

Source: Ross et.al (2016)

How should the firm raise funds for the selected investments?

​

Current Assets

​

Fixed Assets

1 Tangible

2 Intangible

​

​

Shareholders’ Equity

​

Current Liabilities

Long-Term Debt

​

The Short Term Asset Management

Source: Ross et.al (2016)

How should short-term assets be managed and financed?

​

Net Working Capital

​

Shareholders’ Equity

​

Current Liabilities

Long-Term Debt

​

​

Current Assets

​

Fixed Assets

1 Tangible

2 Intangible

​

Method in Capital Budgeting

• Payback Period
• Discounted Payback Period
• Net Present Values
• Internal Rate of Return
• Profitability Index

Adopt the Concept of Time Value of Money!

TVOM in Islamic Perspective (1)

Time Value of Money Vs Economic Value of Time

TVOM in Islamic Perspective (2)

• If TVOM is wrong, and EVOT is right, how to valuate a financial instrument or an investment?
• TVOM or EVOT is just a tool. To ascertain a profit that is prohibited, but giving better return to the lender is permissible as long as based on discretion of the borrower.

​

Rasulullah saw.pernah berutang seekor anak unta. Lalu datang kepada beliau unta sedekah. Kemudian beliau menyuruh untuk membayarkan kepada laki-laki itu anak untanya. Aku berkata, “Tidak aku temukan di dalam unta-unta itu kecuali unta yang lebih baik, unta umur empat tahun.” Lalu Rasul saw. bersabda, “Berikan unta itu kepada dia karena sungguh orang yang paling baik adalah yang paling baik pengembalian-nya.” (HR Abu Dawud dan lainnya).

TVOM in Islamic Perspective (3)

• Formula for TVOM in the case of Future Value: FV = C0×(1 + r)T

​

• Where
• C0 is cash flow at date 0,
• r is the appropriate interest rate, and
• T is the number of periods over which the cash is invested.

​

​

Questions:

How to replace “r” with more sharia compliance indicator?

The Payback Period Method (1)

• How long does it take the project to “pay back” its initial investment?
• Payback Period = number of years to recover initial costs
• Minimum Acceptance Criteria:
• Set by management
• Ranking Criteria:
• Set by management

Source: Ross et.al (2016)

The Payback Period Method (2)

• Disadvantages:
• Ignores the time value of money
• Ignores cash flows after the payback period
• Biased against long-term projects
• Requires an arbitrary acceptance criteria
• A project accepted based on the payback criteria may not have a positive NPV
• Advantages:
• Easy to understand
• Biased toward liquidity
• Perhaps, more sharia compliant

Source: Ross et.al (2016), adjusted

The Discounted Payback Period

• How long does it take the project to “pay back” its initial investment, taking the time value of money into account?
• Decision rule: Accept the project if it pays back on a discounted basis within the specified time.
• By the time you have discounted the cash flows, you might as well calculate the NPV.

​

The Net Present Value (NPV) Rule

• Net Present Value (NPV) =

Total PV of future CF’s + Initial Investment

• Estimating NPV:

1. Estimate future cash flows: how much? and when?

2. Estimate discount rate

3. Estimate initial costs

• Minimum Acceptance Criteria: Accept if NPV > 0
• Ranking Criteria: Choose the highest NPV

Calculating NPV with Spreadsheets

• Spreadsheets are an excellent way to compute NPVs, especially when you have to compute the cash flows as well.
• Using the NPV function:
• The first component is the required return entered as a decimal.
• The second component is the range of cash flows beginning with year 1.
• Add the initial investment after computing the NPV.

Internal Rate of Return (IRR)

• Disadvantages:
• Does not distinguish between investing and borrowing
• IRR may not exist, or there may be multiple IRRs
• Problems with mutually exclusive investments

​

• Advantages:
• Easy to understand and communicate

​

IRR: Example

Consider the following project:

The internal rate of return for this project is 19.44%

NPV Payoff Profile

If we graph NPV versus the discount rate, we can see the IRR as the x-axis intercept.

Calculating IRR with Spreadsheets

• You start with the same cash flows as you did for the NPV.
• You use the IRR function:
• You first enter your range of cash flows, beginning with the initial cash flow.
• You can enter a guess, but it is not necessary.
• The default format is a whole percent – you will normally want to increase the decimal places to at least two.

The Profitability Index (PI)

• Minimum Acceptance Criteria:
• Accept if PI > 1

​

• Ranking Criteria:
• Select alternative with highest PI

The Profitability Index

• Disadvantages:
• Problems with mutually exclusive investments
• Advantages:
• May be useful when available investment funds are limited
• Easy to understand and communicate
• Correct decision when evaluating independent projects

​

Watch this video for more technical explanation

https://www.youtube.com/watch?v=CO8LDV2sO6M

Should we rely on quantitative techniques?

• Three types of Urgency based on Maqasid Sharia:

Dharuriyyah

Hajiyyah

Tahsiniyyah

Fokus pada menghindari yang Haram

Membawa maslahah: memastikan yang wajib tersedia, mengerjakan yang sunnah, dan menghindari yang makruh

Bertujuan memberikan dampak yang lebih besar: Rahmatan lil Alamin

Sharia Screening

Maslahah Screening

Maqasid Sharia Screening

Penjelasan

Metode

Sharia Screening for Daftar Efek Syariah

Proposed Maslahah Screening

Proposed Maqasid Sharia Screening

Which projects that you choose? (1)

• Supposed you have Rp.500.000.000 and you are offered the following set of projects:
• Peternakan Ayam

Petani memerlukan tambahan modal Rp. 250 juta untuk membangun kendang ayam baru, membeli bibit ayam, serta makanan ayam. Tenor project 3 tahun dengan perkiraan cash flow Rp. 125 juta setiap tahun.

• Skin Care

Pengusaha skincare ingin mengajak kerja sama untuk launching produk baru. Modal yang diperlukan berkisar Rp. 250 juta. Tenor Kerjasama project adalah 5 tahun. Estimasi cashflow pada tahun 1: Rp. 75 juta; tahun 2: Rp. 75 juta; tahun 3: Rp. 100 juta: Tahun 4: 150 juta; Tahun 5: 150 juta.

• Bakso Outlet

Abang tukang Bakso mengajak berbisnis membuka outlet bakso baru. Biaya yang dibutuhkan untuk sewa tempat selama 3 tahun, membeli peralatan, dan bahan-bahan keperluan lainnya adalah Rp.200 juta. Estimasi cashflow pada tahun 1 adalah Rp. 75 juta, sedangkan untuk tahun ke 2 dan 3 adalah 100 juta setiap tahunnya.

• Outsourcing Jasa Kebersihan

PT Bergaya mengajak Kerjasama untuk menyediakan tenaga kebersihan suatu Gedung, yang memerlukan 20 tenaga kebersihian setiap bulannya. Jumlah estimasi modal yang dibutuhkan untuk kerja sama ini adalah sekitar Rp. 200 juta selama 5 tahun, dengan estimasi cashflow setiap tahunnya adalah Rp. 75 juta.

• Music Caffee

Bisnis tempat nongkrong saat ini sedang menjamur. Teman anda yang memiliki rumah dilokasi strategis mengajak anda untuk membuka kafe yang bertamakan music dan karaouke. Dibutuhkan dana untuk renovasi dan hal lainnya sebesar Rp. 200 juta. Estimasi Cashflow setiap tahunnya berkisar 250 juta setiap tahun untuk tiga tahun kedepan.

​

​

​

​

Which projects that you choose? (2)

Continued:

• Calculate PP, Discounted PP, NPV, IRR, and PI for each project if interest rate in the market is 5%;
• Please choose which project that you want to invest in (you can choose more than one project) based on the results of your calculation above.
• By considering Sharia Screening, Maslahah Screening, or Maqasid Sharia Screening, will you change your investment decision? If yes, in which project that you will invest your money in?

​

​

​

​

​

​