Ch.

9: Capital Budgeting Decision Criteria

1999, Prentice Hall, Inc.

Capital Budgeting: Budgeting: the process of planning for purchases of longlongterm assets.
 example example: :

Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide?  Will the machine be profitable?  Will our firm earn a high rate of return on the investment?

Decision-making Criteria in DecisionCapital Budgeting

How do we decide if a capital investment project should be accepted or rejected?

Decision-making Criteria in DecisionCapital Budgeting

 The

Ideal Evaluation Method should:

a) include all cash flows that occur during the life of the project, b) consider the time value of money, money, c) incorporate the required rate of return on the project.

Payback Period
 The

number of years needed to recover the initial cash outlay.  How long will it take for the project to generate enough cash to pay for itself?

Payback Period
 How

long will it take for the project to generate enough cash to pay for itself?
150

(500) 150 150 150 150 150 150 150

Payback Period
 How

long will it take for the project to generate enough cash to pay for itself?
150

(500) 150 150 150 150 150 150 150

Payback period = 3.33 years.

 Is

a 3.33 year payback period good?  Is it acceptable?  Firms that use this method will compare the payback calculation to some standard set by the firm.  If our senior management had set a cutcut -off of 5 years for projects like ours, what would be our decision?  Accept the project. project.

Drawbacks of Payback Period:

 Firm

subjective. . cutoffs are subjective money.  Does not consider time value of money.  Does not consider any required rate of return. return .  Does not consider all of the projects cash flows. flows.

Drawbacks of Payback Period:

 Does

not consider all of the projects cash flows.

0

(500) 150 150 150 150 150 (300) 0

Consider this cash flow stream!

Drawbacks of Payback Period:

 Does

not consider all of the projects cash flows.

0

(500) 150 150 150 150 150 (300) 0

This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!

Discounted Payback
the cash flows at the firms required rate of return.  Payback period is calculated using these discounted net cash flows.  Problems Problems: :  Cutoffs are still subjective.  Still does not examine all cash flows.
 Discounts

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 -500 250

CF (14%)
-500.00 219.30

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 -500 250

CF (14%)
-500.00 219.30 280.70 1 year

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 -500 250 250

CF (14%)
-500.00 219.30 280.70 192.38 1 year

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 -500 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 1 year 2 years

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 3 -500 250 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 3 -500 250 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years .52 years

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 3

The Discounted -500 -500.00 Payback 250 219.30 is 2.52 years

250 250 280.70 192.38 88.32 168.75

CF (14%)
1 year 2 years .52 years

Other Methods
1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Each of these decisiondecision-making criteria:  Examines all net cash flows,  Considers the time value of money, and  Considers the required rate of return.

Net Present Value

y NPV = the total PV of the annual net cash flows - the initial outlay. n

NPV =

7
t=1

ACFt (1 + k) t

- IO

Net Present Value

Decision Rule: Rule:

If NPV is positive, ACCEPT. y If NPV is negative, REJECT.

y

NPV Example


Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firms required rate of return is 15%.

NPV Example


Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firms required rate of return is 15%.

83,000 83,000 83,000 83,000 116,000 (276,400)

NPV with the HP10B:

 -276,400  83,000 4  116,000  15  shift

CFj CFj shift Nj CFj I/YR

NPV 18,235.71. .  You should get NPV = 18,235.71

NPV with the HP17BII:

CFLO mode. -276,400 INPUT  FLOW(0)=?  FLOW(1)=? 83,000 INPUT  #TIMES(1)=1 4 INPUT  FLOW(2)=? 116,000 INPUT  #TIMES(2)=1 INPUT EXIT  CALC 15 I% NPV  You should get NPV = 18,235.71
 Select

NPV with the TI BAII Plus:

 Select

CF mode.

NPV with the TI BAII Plus:

 Select

CF mode. -276,400  CFo=?

ENTER

NPV with the TI BAII Plus:

 Select

CF mode. -276,400  CFo=?  C01=? 83,000

ENTER ENTER

NPV with the TI BAII Plus:

 Select

CF mode. -276,400  CFo=?  C01=? 83,000  F01= 1 4

ENTER ENTER ENTER

NPV with the TI BAII Plus:

 Select

CF mode. -276,400  CFo=?  C01=? 83,000  F01= 1 4  C02=? 116,000

ENTER ENTER ENTER ENTER

NPV with the TI BAII Plus:

 Select

CF mode. -276,400  CFo=?  C01=? 83,000  F01= 1 4  C02=? 116,000  F02= 1

ENTER ENTER ENTER ENTER ENTER

NPV with the TI BAII Plus:

 Select

CF mode. -276,400  CFo=?  C01=? 83,000  F01= 1 4  C02=? 116,000  F02= 1  NPV I= 15

ENTER ENTER ENTER ENTER ENTER ENTER

CPT

NPV with the TI BAII Plus:

 Select

CF mode. -276,400 ENTER  CFo=?  C01=? 83,000 ENTER  F01= 1 4 ENTER  C02=? 116,000 ENTER  F02= 1 ENTER  NPV I= 15 ENTER  You should get NPV = 18,235.71

CPT

Profitability Index
n

NPV =

7
t=1

ACFt t (1 + k)

- IO

Profitability Index
n

NPV =

7
t=1 n

ACFt t (1 + k)

- IO

PI =

7
t=1

ACFt t (1 + k)

IO

Profitability Index
y

Decision Rule: Rule:

If PI is greater than or equal to 1, ACCEPT. y If PI is less than 1, REJECT.

y

 -276,400  83,000 4  116,000  15  shift

CFj CFj shift Nj CFj I/YR

PI with the HP10B:

NPV 18,235.71. .  You should get NPV = 18,235.71  Add back IO: + 276,400  Divide by IO: / 276,400 =  You should get PI = 1.066

Internal Rate of Return (IRR)

IRR: :  IRR the return on the firms invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

Internal Rate of Return (IRR)

n

NPV =

7
t=1

ACFt (1 + k) t

- IO

Internal Rate of Return (IRR)

n

NPV =

7
t=1 n

ACFt (1 + k) t

- IO

IRR:

7
t=1

ACFt t (1 + IRR)

= IO

Internal Rate of Return (IRR)

n

IRR:
 IRR

7
t=1

ACFt t (1 + IRR)

= IO

is the rate of return that makes the PV of the cash flows equal to the initial outlay.  This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.

Calculating IRR
 Looking again

at our problem:  The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.
83,000 83,000 83,000 83,000 116,000 (276,400)

83,000 83,000 83,000 83,000 116,000 (276,400)

0 1 2 3 4  This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400

83,000 83,000 83,000 83,000 116,000 (276,400)

0
 This

is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400

 This

way, we have to solve for IRR by trial and error.

IRR with your Calculator

is easy to find with your financial calculator.  Just enter the cash flows as you did with the NPV problem and solve for IRR.  You should get IRR = 17.63%!
 IRR

IRR
y y

Decision Rule: Rule: If IRR is greater than or equal to the required rate of return, ACCEPT. If IRR is less than the required rate of return, REJECT.

 IRR

is a good decisiondecision-making tool as long as cash flows are . (- + + + + +) conventional. conventional  Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)

 IRR

is a good decisiondecision-making tool as long as cash flows are . (- + + + + +) conventional. conventional  Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
(500) 200 0 1 100 2 (200) 3 400 4 300 5

 IRR

is a good decisiondecision-making tool as long as cash flows are . (- + + + + +) conventional. conventional  Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
(500) 200 0 1 100 2 (200) 3 400 4 300 5

 Problem:

If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)  We could find 3 different IRRs!
1 (500) 200 0 1 100 2 2 (200) 3 3 400 4 300 5

Summary Problem:
the cash flows only once. IRR. .  Find the IRR V. .  Using a discount rate of 15%, find NPV I.  Add back IO and divide by IO to get PI. (900) 300 0 1 400 2 400 3 500 4 600 5
 Enter

Summary Problem:
= 34.37%.  Using a discount rate of 15%, NPV = $510.52.  PI = 1.57.
 IRR

(900) 300 0 1

400 2

400 3

500 4

600 5