Chapter 9 Capital Budgeting Techniques

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Chapter 9 Capital Budgeting Techniques
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Capital Budgeting

• The process of decision making with respect to
  investment in fixed assets.
• 0 1 2
  3 4 5 6
• --------------------------------------------
  ---------------------
• I.O. lt--------------------------
  DOCF----------------------gt
• TCF

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Capital-Budgeting Decision Criteria

• Four Criteria for determining acceptability of
  project
• 1. Non-discounted Cash Flow Technique
• Payback Period
• 2. Discounted Cash Flow Technique
• Net Present Value
• Profitability Index (Benefit/Cost Ratio)
• Internal Rate of Return

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Payback Period

• is the number of years needed to recover the
  initial cash outlay.
• how quickly the project will return its original
  investment.
• Accept-Reject Criterion
• compare the calculated payback with the maximum
  desired payback
• Accept when
• Payback cal lt Payback desired

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• Example p.316 If a firms maximum desired
  payback period is three years and an investment
  proposal requires an initial cash outlay of
  10,000 and yields the following set of annual
  cash flows, what is its payback period? Should
  the project be accepted?
• After-tax Cash Flow
• Initial Outlay - 10,000
• Year 1 2,000
• Year 2 4,000
• Year 3 3,000
• Year 4 4,000
• Year 5 1,000

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• 0 1 2 3 4 5
• -10,000 2,000 4,000
  3,000 4,000 1,000
• Cumulative - 8,000 - 4,000 -
  1,000
• Payback cal 3 years 1,000 / 4,000
  3.25 years
• Payback desired 3 years
• Payback from Calculation is longer than maximum
  desired payback
• Therefore, the project should be REJECTED.

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• Table 9-1 Payback Period Example (p. 317)
• Projects A B
• Initial Cash Outlay -10,000 -10,000
• Annual Cash inflows
• Year 1 6,000 5,000
• 2 4,000 5,000
• 3 3,000 0
• 4 2,000 0
• 5 1,000 0

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• Table 9-1 Payback Period Example (p. 317)
• Projects A B
• Initial Cash Outlay -10,000 -10,000
• Annual Cash inflows
• Year 1 6,000 5,000
• 2 4,000 5,000
• 3 3,000 0
• 4 2,000 0
• 5 1,000 0
• Payback of A Payback of B
• As cash flows come faster (6,000 gt 5,000)
• A can generate more cash flows after payback

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• Weak Points of Payback Period Technique
• 1. It ignores cash flow after payback period
• 2. It ignores time value of money
• To consider time value of money, Discounted
  Payback Period is used.
• Discounted Payback Period the number of years
  required to recover the initial cash outlay from
  the discounted net cash flows.

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• 0 1 2 3 4 5
• -10,000 6,000 4,000
  3,000 2,000 1,000
• PVIF i,n PVIF 10,1 PVIF 10,2 PVIF
  10,3 PVIF 10,4 PVIF 10,5
• 1 0.855 0.731 0.624
  0.534 0.456
• -10,000 5,130 2,924
  1,872 1,068 456
• Cumulative - 4,870 -1,946 -
  74
• Payback cal 3 years 74/1068 3.07 years
• Payback required 3 years

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• Good Points of Payback Period
• 1. they deal with cash flows, not accounting
  profits
• 2. they are easy to visualize, quickly
  understood, and easy to calculate
• 3. they are often used as a rough screening
  devices to eliminate projects whose returns do
  not materialize until later years.

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Net Present Value (NPV)

• NPV is equal to the present value of its annual
  after tax net cash flows less the investments
  initial outlay.
• NPV PV (cash inflows) - Initial Outlay
• where PV (cash inflows) will be discounted at
  k
• Accept NPV gt or 0
• Reject NPV lt 0

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• Table 9-3 NPV Illustration of Investment in New
  Machinery
• After-tax Cash Flow
• Initial Outlay - 40,000
• Inflow Year 1 15,000
• Inflow Year 2 14,000
• Inflow Year 3 13,000
• Inflow Year 4 12,000
• Inflow Year 5 11,000

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• Table 9-4 NPV Illustration of Investment in New
  Machinery
• After-tax Cash Flow PVIF at 12
  PV
• Inflow Yr 1 15,000 0.893 13,395
• Inflow Yr 2 14,000 0.797 11,158
• Inflow Yr 3 13,000 0.712 9,256
• Inflow Yr 4 12,000 0.636 7,632
• Inflow Yr 5 11,000 0.567 6,237
• PV (cash inflows) 47,678
• Initial Outlay - 40,000
• Net Present Value 7,678

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• NPV 15,000(PVIF12,1) 14,000(PVIF12,2)
  13,000(PVIF12,3)
• 12,000(PVIF12,4) 11,000(PVIF12,5) -
  40,000
• 47,678 - 40,000
• 7,678
• NPV gt 0
• gt ACCEPT THE PROJECT

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• Good Point of NPV
• 1. It deals with Cash Flow
• 2. It is sensitive to the true timing of
  benefits resulting from project
• 3. It considers time value of money
• 4. Accepting positive NPV increases the value of
  the firm, and is consistent with goal of wealths
  maximization.
• Weak Point of NPV
• It requires long-term forecasts of the
  incremental cash flows

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Profitability Index (Benefit/Cost Ratio)

• a ratio of the present value of the future net
  cash flows to the initial outlay.
• NPV PV of cash inflows - Initial Outlay
• gt Accept when NPV gt or 0
• PI PV of cash inflows / Initial Outlay
• gt Accept when PI gt or 1

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• Example Refer to Table 9-4
• PV of cash inflows 47,678
• Initial Outlay 40,000
• NPV 47,678 - 40,000 7,678
• gt NPV gt 0, ACCEPT
• PI 47,678 / 40,000 1. 19
• gt PI gt 1, ACCEPT

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Internal Rate of Return (IRR)

• is the rate of return a project earns.
• is the discount rate that equates the present
  value of cash inflows with the initial outlay.
• If PV of cash inflows Initial Outlay gt NPV
  0
• NPV PV of cash inflows i k , n -
  Initial Outlay
• 0 PV of cash inflows i IRR , n -
  Initial Outlay
• i lt IRR

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• Accept-Reject Criterion
• Accept IRR gt or k or rr
• Reject IRR lt k
• When NPV is , Accept (NPV PV of cash
  inflows - I.O)
• gt PI will be more than 1 , Accept
• gt IRR will be more than k , Accept
• All discounted techniques will give the same
  accept/reject decision, but may give different
  rankings.

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• Weak Points
• same as weak points of NPV and PI
• being tedious in calculation
• about the implied reinvestment rate assumptions
• gt NPV Method implicitly assumes that cash
  flows over the life of the project can be
  reinvested at the firms required rate of return
  or k.
• gt IRR Method implies that these cash flows
  could be reinvested at IRR rate.

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• The better assumption is that one made by the
  NPV, that cash flows could be reinvested at the
  required rate of return because
• 1. these cash flows will be returned in the form
  of dividends to shareholders who demand the
  required rate of return on their investment
• 2. these cash flows can be reinvested in a new
  investment project