Chapter 8 Capital Budgeting Decision Models

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Chapter 8 Capital Budgeting Decision Models

• Learning Objectives
• Differentiate between short term and long term
  capital budgeting models
• Apply the three basic decision models
• Payback
• NPV
• IRR
• Calculate cross-over rates
• Use modified decision models
• Know the strength and weaknesses of each model

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Short-term versus Long-term

• Short-term decisions
• In general, repetitive decisions
• Low cost impacts
• Long-Term decisions
• Capital budgeting decisions
• Impacts over many years
• Difference
• Time
• Cost
• Degree of Information

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Payback Period

• First and easiest model of capital budgeting
• Answers the question, how soon will I get my
  money back?
• Key Features
• Need amount and timing of cash flow
• Not concerned with cash flows after repayment
• Ad hoc cutoff date for repayment

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Payback Period

• Clinko Copiers (example 8.1)
• Initial investment is 5,000
• Positive cash flow each year
• Year 1 -- 1,500
• Year 2 -- 2,500
• Year 3 -- 3,000
• Year 4 -- 4,500
• Year 5 -- 5,500
• Payback in 2 and 1/3rd yearsignore years 4 and 5
  cash flows

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Payback Period

• Strengthens
• Easy to apply
• Initial cash flows most important
• Good for small dollar investments
• Weaknesses
• Ignores cash flow after cutoff period
• Ignores time value of money
• Corrections
• Discount cash flow

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Discounted Payback Period

• Attempt to correct one flaw of Payback
  Periodtime value of money
• Discount cash flow to present and see if the
  discount cash flow are sufficient to cover
  initial cost within cutoff time period
• Careful in consistency
• Discounting means cash flow at end of period
• Appropriate discount rate for cash flow

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Discounted Payback Period

• Discounted Cash Flow of Copiers A B
• Discounted at 6 (APR)
• Both 3 year discounted paybacks with annual cash
  flow
• Copier A 26 months with monthly cash flow
• Copier B 29 months with monthly cash flow
• Potential for poor choice
• Large late positive cash flow
• Longer positive cash flow

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Net Present Value (NPV)

• Correction to discounted cash flow
• Includes all cash flow in decision
• Changes decision (go vs. no-go) to dollars, not
  arbitrary cutoff period
• The Decision Model (a.k.a. Discounted Cash Flow
  Model)
• Need all cash flow
• Need appropriate discount rate

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Net Present Value (NPV)

• Decision
• Accept all positive NPVs
• Reject all negative NPVs
• Copier Example
• Copier A NPV is 5,530.91 Accept
• Copier B NPV is 9,253.09 Accept
• Model good for comparing projects
• Select project with highest NPV
• Can assign different discount rates to projects

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Net Present Value (NPV)

• The Decision Model
• Incorporates risk and return
• Incorporates time value of money
• Incorporates all cash flow

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Internal Rate of Return (IRR)

• Model closely resembles NPV but
• Finding the discount rate (internal rate) that
  implies an NPV of zero
• Internal rate used to accept or reject project
• If IRR gt hurdle rate, accept
• If IRR lt hurdle rate, reject
• Very popular model as managers like the single
  return variable when evaluating projects

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Internal Rate of Return (IRR)

• Process difficult without calculator or
  spreadsheet iterative process
• Need timing and amount of cash flows
• Popcorn Machine (Example 8.4)
• Grannies IRR is 19.86
• Kettle Corn IRR is 20.35
• Packaging Machine IRR is 14.91
• Decision Rule
• Requires hurdle rate for comparison
• Accept all with IRR gt Hurdle Rate

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Internal Rate of Return (IRR)

• Some problems with IRR
• Cross-over Rates flip projects
• Using NPV profiles, project choice changes at
  cross-over rate so need to know both hurdle rate
  and cross-over rate
• Cross-over rate is where two projects have same
  NPV
• Multiple IRRs
• Projects with changing cash flows can have
  multiple IRRs
• Which is the correct IRR? Dont know
• Risk of Project is not included
• IRR calculation void of risk of project
• Risk must be implied with different hurdle rates

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Modified IRR

• Major assumption of IRR is that all cash flow can
  be reinvested at IRR rate
• Alternative (and better) assumption is that all
  cash flow can be reinvested at hurdle rate
• MIRR
• Find future value of all cash inflow at hurdle
  rate
• Find present value of cash outflow
• Find interest rate that equates future values
  with present value
• Adjust comparison projects for differences in the
  time horizon

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Profitability Index (PI)

• Modified version of NPV
• Decision Criteria
• PI gt 1.0, accept project
• PI lt 1.0, reject project

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Profitability Index (PI)

• Close to NPV as we calculate present value of
  future positive cash flows (present value of
  benefits) and initial cash flow (present value of
  costs)
• PI (NPV Initial cost) / Initial Cost
• Answer is modified return
• Choosing between two different projects?
• Higher PI is best choice
• Careful, cannot scale projects up and down

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Profitability Index (PI)

• Example of Large Copier and Mini-Copier (page
  247)
• Large Copier B PI is 2.85 (normal level of risk)
• Mini Copier PI is 2.95
• Pick Mini Copier
• Problem with copier choice
• Original investment in mini-copier only 500
• Original investment in Copier B is 5,000
• Need to buy 10 mini-copiers to match production
  of Copier B

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Problems

• Problem 6 Payback Discounted Period
• Problem 8 Net Present Value
• Problem 12 Internal Rate of Return Modified
  Internal Rate of Return
• Problem 16 Profitability Index
• Problem 20 NPV Profile of Project