Capital Budgeting Decisionmaking Criteria

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Capital Budgeting Decision-making Criteria

• Capital Budgeting
• Payback Period
• Discounted Payback
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Modified Internal Rate of Return (MIRR)

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Capital Budgeting the process of planning for
purchases of long-term assets

• 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?

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Decision-making Criteria in Capital Budgeting

• The Ideal Evaluation Method should
• Include all cash flows that occur during the life
  of the project
• Consider the time value of money
• Incorporate the required rate of return on the
  project

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Payback Period

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

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Payback Period (PB)
Cumulative
Years
Cash Flow
Cash Flow
0
-500
1
150
150
2
150
300
3
150
450
4
150
600
5
150
750
6
150
900
7
150
1050
8
150
1200

• It takes more than 3, but less than 4 years

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Payback Period (Continued)

• To find the fraction of the 4th year, we first
  assume that cash flows are evenly distributed
  throughout the year
• Payback Number of Full Years (Initial
  Investment Cumulative Cash Flow at the end of
  Last Full Year) / The Next Years Cash Flow
• Payback 3 (500 450) / 150 3.33 years

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Payback Period (Continued)

• 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 cut-off of 5
  years for projects like ours, what would be our
  decision?
• Accept the project

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Drawbacks of Payback Period

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

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Drawbacks of Payback Period (Continued)

• Does not consider all of the projects cash
  flows.
• This project is clearly unprofitable, but we
  would accept it based on a 4-year payback
  criterion!

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Discounted Payback (DPB)

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

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Discounted Payback Example

• Cumulative
• Year Cash Flow PVCIF (14) PVCIF
• 0 -500 -500.00 0.00
• 1 250 219.30 219.30
• 2 250 192.37 411.67
• 3 250 168.74 580.41
• Payback 2 (500 411.67) / 168.74 2.52
  years

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Other Methods

• Net Present Value (NPV)
• Profitability Index (PI)
• Internal Rate of Return (IRR)
• Each of these decision-making criteria
• Examines all net cash flows
• Considers the time value of money
• Considers the required rate of return

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Net Present Value (NPV)

• NPV the total PV of the annual net cash flows
  the initial outlay.
• Where, FCF is the Free Cash Flow
• k is the required return
• t is the time subscript
• Decision Rule
• If NPV is positive, accept
• If NPV is negative, reject

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Profitability Index (PI)

• Decision Rule
• If PI is greater than or equal to 1, accept
• If PI is less than 1, reject

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Internal Rate of Return (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
• IRR is the rate of return that makes the PV of
  the cash flows equal to the initial outlay or NPV
  0
• This looks very similar to our Yield to Maturity
  formula for bonds. In fact, YTM is the IRR of a
  bond

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Internal Rate of Return (IRR) (Continued)

• Decision 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

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Internal Rate of Return (IRR) (Continued)

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

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Internal Rate of Return (IRR) (Continued)

• We know that the IRR is the discount rate that
  makes the PV of the projected cash flows equal to
  the initial outlay or NPV 0
• Above table shows a trial and error procedure is
  applied to determine the IRR. Using different
  discount rates we check if NPV 0

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Internal Rate of Return (IRR) (Continued)
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Modified Internal Rate of Return (MIRR)

• IRR assumes that all cash flows are reinvested at
  the IRR
• MIRR provides a rate of return measure that
  assumes cash flows are reinvested at the required
  rate of return

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Modified Internal Rate of Return (MIRR)

• Calculate the PV of the cash outflows (PVCOF)
  using the required rate of return this is
  usually the investment amount
• Calculate the FV of the cash inflows (FVCIF) at
  the last year of the projects time line. This
  is also called the terminal value (TV)
• Using the required rate of return
• MIRR is the growth rate of money from initial
  investment to terminal value over the life of the
  investment

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Modified Internal Rate of Return (MIRR)
(Continued)

• Finding FV of Uneven Cash Flows
• Cumulate CF one year at a time taking FV into
  account
• Find FV of each CF at the end of project life and
  then sum FVs
• Use of NPV function (faster) First, find the
  PVCIF (NPV) (exclude initial investment) using
  required return. Second, change the sign of NPV
  and store it in PV (now a single cash flow as PV
  of all cash inflows) to find FV at the end of
  project life