Capital Budgeting: Decision Criteria and Real Option Consideration

1
Chapter 9

• Capital Budgeting Decision Criteria and Real
  Option Consideration

2
Evaluation Models

• Net present value (NPV)
• Profitability Index (PI)
• Internal rate of return (IRR)
• Payback (PB) period

3
NPV

• NPV PVNCF - NINV
• where
• For independent projects, all projects with NPV ?
  0 is acceptable. For mutually exclusive
  projects, choose the one with the highest NPV.
• Advantage consistent with SWM
• Disadvantage absolute value, not relative

4
NPV -- example

• Example 1 from Chapter 8.
• NINV 62K
• NCF15 14.4, 19.5, 27.55, 22.54, 34.46 K
• Cost of capital 8

CF0 - 62, CF114.4, CF219.5, CF327.55,
CF422.54, CF534.46, I/YR8 gt NPV
29.94 CF0 0, CF114.4, CF219.5, CF327.55,
CF422.54, CF534.46, I/YR8 gt PVNCF 91.94
gtNPV91.94-6229.94
5
Profitability Index

• PI PVNCF / NINV
• For independent projects, all projects with PI ?
  1 is acceptable. Should yield identical
  decisions as NPV method.
• For mutually exclusive projects, decision may be
  different from NPV method. Should consider other
  factors.

6
PI NPV -- example

• Project A
• PVNCF 92K
• NINV 62K
• NPV92-6230
• PI92/621.48

• Project C
• PVNCF 20K
• NINV 10K
• NPV20-1010
• PI20/102

• Project B
• PVNCF 27K
• NINV 30K
• NPV27-30-3
• PI27/300.9

• If A, B, and C independent, choose both A and
  C
• If A, B, and C mutually exclusive, choose A
  (use NPV) when there is no capital rationing,
  choose C (use PI) when facing capital rationing.

7
Internal rate of return (1)
NPV PVNCF - NINV, where
IRR the rate of return that will make the
project break even (have a NPV0)

• Example 1 from Chapter 8.
• NINV 62K
• NCF15 14.4, 19.5, 27.55, 22.54, 34.46 K

CF0 - 62, CF114.4, CF219.5, CF327.55,
CF422.54, CF534.46, gt IRR 22.66
8
IRR (2)

• Decision rules
• Independent projects all projects with
  r ? cost of capital
• Mutually exclusive projects project with the
  highest r (r ? cost of capital)
• Advantage takes account both the magnitude and
  the timing of cash flows
• Disadvantage possible existence of multiple
  internal rate of returns

9
IRR NPV (1)

• Identical decisions for independent projects
• May have contradictory decisions for mutually
  exclusive projects.
• NPV assumes cash flows are reinvested
  (compounded) at the firms cost of capital --
  more realistic
• IRR assumes cash flows are reinvested
  (compounded) at IRR

10
IRR NPV (2)

• Cost of capital 8
• Project X
• NINV 62K
• NCF15 14.4, 19.5, 27.55, 22.54, 34.46
• Project Y
• NINV 62K
• NCF15 0, 0, 10, 20, 120

• Project X
• NPVx29.25
• IRRx22.66
• Project Y
• NPVy42.31
• CF05 -62, 0, 0, 10, 20, 120
• I/YR 8
• IRRy 20.68
• CF05 -62, 0, 0, 10, 20, 120

• If X and Y independent, choose both X and Y
• If X and Y mutually exclusive, choose X (use
  NPV)

11
Payback (PB) period

• Undiscounted PB period
• Discounted PB period
• Special case undiscounted PB period of equal
  annual net cash flows
• Example project X and Y

12
Homework

• page 365-366, question 2, 3, 4, 5
• page 367-371, problem 4, 9, 16, 18