Capital Budgeting Decision Rules

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Capital Budgeting Decision Rules

• Chpt. 6 problems 2, 9, 10, 15, 19, 23, 30

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Capital Budgeting Questions

1. Given the cash flow and risk of an individual
   project, do you accept or reject the project?
   (independent project)
2. If you have to choose between 2 or more projects,
   which one should you accept? (mutually exclusive
   projects). How do you adjust for differences in
   lifetime, scale?

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I. Accounting based rules Example - Average
accounting return (AAR)

• A project is acceptable if its average accounting
  return exceeds a target return.
• Assume the initial investment required is 240.
• Average net income (105 30 0)/3 45
• Average book value (240 160 80 0)/4
  120
• AAR Ave NI/Ave BV 45/120 37.5

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II. Payback Rules

• Payback period the length of time until
  accumulated cash flows generated by the project
  cover the initial investment.
• An investment is acceptable if its calculated
  payback is less than some prespecified number of
  years.
• Discounted payback period the length of time
  until accumulated discounted cash flows equal or
  exceed the initial investment.

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Example payback rules
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III. Net Present Value

• Difference between the market value of an
  investment and its costs.
• The NPV amount determines the additional value
  created by the firm undertaking the investment.
• If NPV gt 0, accept investment
• If NPV lt 0, reject investment
• NPV does not account for the scale of the
  project.
• NPV(ABC) NPV(A) NPV(B) NPV(C)
• If interest rates are expected to change
• NPV CF1/(1r1) CF2/(1r1)(1r2)

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IV. Internal rate of return (IRR)

• IRR the rate that makes the present value of
  future cash flows equal to the initial cost of
  the investment. In other words, the discount
  rate that gives a project a 0 NPV. An
  investment is acceptable if the required return
  is less than the IRR.
• Example of IRR
• Initial outlay -200
• Year FCF
• 1 50
• 2 100
• 3 150
• Find the IRR such that NPV 0.
• 0 -200 50/(1IRR)1 100/(1IRR)2
  150/(1IRR)3

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Rule conflicts for mutually exclusive projects

• Conflicts between IRR and NPV may be due to
  differences in size or timing of the projects
  cash flows.

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V. Profitability index

• The NPV of a project is stated in dollar terms
  and does not factor in the scale of the project.
  An adjustment to NPV can be made by using the
  profitability index
• Profitability index PV of cash flows/initial
  investment in the project
• The IRR is a percentage of return, which is
  standardized for the scale of the project.

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