Chapter 9 Capital Budgeting Decision Models

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Chapter 9Capital Budgeting Decision Models

• Short-term versus Long-term Decisions
• Payback Period
• Discounted Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)

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Short-term versus Long-term Decisions

• Short-term decisions
• Working capital decisions (Chapter 13)
• In general, repetitive decisions
• Long-Term decisions
• Capital budgeting decisions (Chapter 9)
• 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 flows
• Not concerned with cash flows after repayment
• Ad hoc cutoff date for repayment

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Payback Period

• Clinko Copiers (example 9.1)
• 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 flows after cutoff period
• Ignores time value of money
• Corrections
• Discount cash flows

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Discounted Payback Period

• Attempt to correct one flaw of Payback
  Periodtime value of money
• Discount cash flows to present and see if the
  discount cash flows 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 flows

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Discounted Payback Period

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

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Net Present Value (NPV)

• Correction to discounted cash flows
• Includes all cash flows 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 flows
• 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 flows

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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
• Examples
• Copier A IRR is 41
• High returnaccept project
• Assumes can borrow funds for project for less
  than 41

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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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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
• 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 1 Payback Period
• Problem 3 Discounted Payback Period
• Problem 7 Net Present Value
• Problem 11 Internal Rate of Return
• Problem 15 Profitability Index
• Problem 19 NPV Profile of Project