Capital Budgeting Decision Criteria

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Chapter 9

• Capital Budgeting Decision Criteria

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Introduction

• This chapter looks at capital budgeting decision
  models.
• It discusses and illustrates their relative
  strengths and weaknesses.
• It examines project review and post-audit
  procedures, and traces a sample project through
  the capital budgeting process.

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Capital Budgeting Criteria

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

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Net Present Value (NPV)

• PV of the stream of future CFs from a project
  minus the projects net investment

K firms cost of capital
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NPV Decision Rule

• General Rule Accept a project if NPV gt 0
• Mutually Exclusive Projects Accept the one
  having the largest NPV gt 0

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NPV Example 1
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NPV Example 2
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NPV Example 2

• NCFs represent a 6-year annuity
• Calculate the PV of the annuity
• PMT 10,000
• n 6
• I/Y 14
• CPT PV
• PV 38,887 PVNCF
• Now determine the NPV
• NPV PVNCF - NINV
• 38,887 - 30,000 8,887

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What Does the NPV mean?

• Projects addition to the firms value
• Firm value without the project
• Projects NPV
• Firm value with the project
• Wealth increase or decrease resulting from the
  project
• Positive NPVs increase owners wealth
• Negative NPVs decrease owners wealth

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Internal Rate of Return (IRR)

• Discount rate that equates the PV of net cash
  flows of a project with the PV of the NINV.

r IRR

• IRR is the discount rate at which the NPV equals
  zero.
• PVNCF-NINV 0
• PVNCF NINV

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IRR Decision Rule

• Accept a project if its IRR is greater than the
  firms cost of capital
• Accept if r gt k
• When a projects IRR is greater than cost of
  capital, the net present value of the project is
  greater than 0.
• r gt k, the NPV gt 0
• When a projects IRR is less than cost of
  capital, the net present value of the project is
  less than 0.
• r lt k, the NPV lt 0

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IRR Example

• A project requires a net initial investment of
  30,000. It is expected to generate an annual net
  cash flow of 10,000 for each of the next 6
  years. Determine the IRR of the project.
• Using the calculator
• NCF is the PMT 10,000
• NINV is the PV -30,000
• n 6
• FV 0
• Need to calculate IRR which is the I/Y
• CPT I/Y
• I/Y 24.29. Therefore, r 24.29

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IRR Example

• Is the project acceptable?
• Need to compare r (IRR) with k (cost of capital).
• Suppose the firms cost of capital (k) is 18.
• Accept since r gt k
• 24.29 gt 18

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Some Important Facts of IRR

• Multiple IRR Problem
• Non-normal CF patterns ( CFs having more than one
  sign change) can result in more than one IRR.
• If the decisions using the NPV IRR criteria
  disagree,then NPV is preferred

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Profitability Index (PI)

• Ratio of the PV of future net cash flows over the
  life of the project to the NINV

• PI PVNCF / NINV
• PI gives the return per dollar invested.

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PI Decision Rules

• Independent Projects
• Accept if PI gt 1
• When PI gt 1, then the NPV gt 0
• When PI lt 1, then the NPV lt 0

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PI Example Independent Projects

• Which ones would you accept if they are
  independent?
• Projects A, B, C because their PI gt 1
• (and NPV)

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PI Decision Rules

• Mutually Exclusive Projects
• When projects are of equal size (same NINV), NPV
  and PI will give the same decision.
• Accept if PI gt 1 (Highest PI project)
• When projects are of unequal size (unequal NINV),
  NPV and PI could result in conflicting
  decisions.
• Use NPV instead of PI
• Accept if NPV gt 0 (Largest NPV project)

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PI Example Mutually Exclusive Projects

• Which one would you accept if they are mutually
  exclusive?
• Project A, because all projects have the same
  NINV, and A gives the highest PI and NPV

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PI Example Mutually Exclusive Projects

• Which one would you accept if they are mutually
  exclusive?
• Project B, because projects have unequal NINV
  and B gives the largest NPV

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Payback Period (PB)

• Number of years it takes for the cumulative net
  cash flows from a project to equal the initial
  cash outlay
• If NCFs are equal each year, then
• PB NINV/NCF
• If NCFs are not equal each year, then find the
  number of years it takes for cumulative NCFs to
  equal the NINV.

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PB Example
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PB Example

• Project A Equal annual NCFs
• PB 50,000 / 12,500 4 years
• Project B Unequal annual NCFs
• Cumulative NCFs at year 4
• 5,000 10,000 15,000 15,000 45,000
• Need 5,000 more from year 5 NCF of 25,000
• 5,000/25,000 0.20
• PB 4.20 years.
• Measure of risk longer the time, greater the
  risk

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PB Main Features

• Simple
• Provides a measure of project liquidity
• Measure of risk longer the time, greater the
  risk
• Not a true measure of profitability
• Ignores CFs after the payback period
• Ignores the time value of money (the variability
  of CFs)

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Capital Rationing (Independent Projects)

• Firm has a capital constraint ( limited capital
  budget)
• Objective must be to maximize the returns per
  dollars invested.
• Calculate the PI for projects
• Order the projects from the highest to the lowest
  PI
• Accept the projects with the highest PI until the
  entire capital budget is spent

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Capital Rationing Example 1

• Which ones would you accept if the firms capital
  budget is limited to 20,000?
• Projects A B. They provide the highest
  return per dollar of investment and fully utilize
  the budget.

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What Happens When the Next Acceptable Project is
too Large?

• Search for another combination of projects that
  increase the NPV
• Attempt to relax the funds constraint
• Excess funds
• Invest in short-term securities
• Reduce outstanding debt
• Pay dividends

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Capital Rationing Example 2

• Which ones would you accept if the firms capital
  budget is limited to 17,000?
• Projects A C.

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Summary of Capital Budgeting Methods

• See Table 9-4 in the Text