Title: Chapter 7 - Capital Budgeting Decision Criteria
1Chapter 7 - Capital Budgeting Decision
Criteria
2Capital Budgeting The process of planning for
purchases of long-term assets.
- For example Suppose our firm must decide whether
to purchase a new plastic molding machine for
125,000. How do we decide? - Will the machine be profitable?
- Will our firm earn a high rate of return on the
investment?
3Decision-making Criteria in Capital Budgeting
- How do we decide if a capital investment project
should be accepted or rejected?
4Decision-making Criteria in Capital Budgeting
- The ideal evaluation method should
- a) include all cash flows that occur during the
life of the project, - b) consider the time value of money, and
- c) incorporate the required rate of return on the
project.
5Payback Period
- How long will it take for the project to generate
enough cash to pay for itself?
6Payback Period
- How long will it take for the project to generate
enough cash to pay for itself?
7Payback Period
- How long will it take for the project to generate
enough cash to pay for itself?
Payback period 3.33 years
8Payback Period
- Is a 3.33 year payback period good?
- Is it acceptable?
- Firms that use this method will compare the
payback calculation to some standard set by the
firm. - If our senior management had set a cut-off of 5
years for projects like ours, what would be our
decision? - Accept the project.
9Drawbacks of Payback Period
- Firm cutoffs are subjective.
- Does not consider time value of money.
- Does not consider any required rate of return.
- Does not consider all of the projects cash flows.
10Drawbacks of Payback Period
- Does not consider all of the projects cash
flows. - Consider this cash flow stream!
11Drawbacks of Payback Period
- Does not consider all of the projects cash
flows. - This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
12Discounted Payback
- Discounts the cash flows at the firms required
rate of return. - Payback period is calculated using these
discounted net cash flows. - Problems
- Cutoffs are still subjective.
- Still does not examine all cash flows.
13Discounted Payback
- Discounted
- Year Cash Flow CF (14)
- 0 -500 -500.00
- 1 250 219.30
14Discounted Payback
- Discounted
- Year Cash Flow CF (14)
- 0 -500 -500.00
- 1 250 219.30 1 year
- 280.70
15Discounted Payback
- Discounted
- Year Cash Flow CF (14)
- 0 -500 -500.00
- 1 250 219.30 1 year
- 280.70
- 2 250 192.37
16Discounted Payback
- Discounted
- Year Cash Flow CF (14)
- 0 -500 -500.00
- 1 250 219.30 1 year
- 280.70
- 2 250 192.37 2 years
- 88.33
17Discounted Payback
- Discounted
- Year Cash Flow CF (14)
- 0 -500 -500.00
- 1 250 219.30 1 year
- 280.70
- 2 250 192.37 2 years
- 88.33
- 3 250 168.74
18Discounted Payback
- Discounted
- Year Cash Flow CF (14)
- 0 -500 -500.00
- 1 250 219.30 1 year
- 280.70
- 2 250 192.37 2 years
- 88.33
- 3 250 168.74 .52 years
19Discounted Payback
- Discounted
- Year Cash Flow CF (14)
- 0 -500 -500.00
- 1 250 219.30 1 year
- 280.70
- 2 250 192.37 2 years
- 88.33
- 3 250 168.74 .52 years
20Other Methods
- 1) Net Present Value (NPV)
- 2) Profitability Index (PI)
- 3) Internal Rate of Return (IRR)
- Consider each of these decision-making criteria
- All net cash flows.
- The time value of money.
- The required rate of return.
21Net Present Value
- NPV the total PV of the annual net cash flows -
the initial outlay.
22Net Present Value
- Decision Rule
- If NPV is positive, accept.
- If NPV is negative, reject.
23NPV Example
- Suppose we are considering a capital investment
that costs 250,000 and provides annual net cash
flows of 100,000 for five years. The firms
required rate of return is 15.
24NPV Example
- Suppose we are considering a capital investment
that costs 250,000 and provides annual net cash
flows of 100,000 for five years. The firms
required rate of return is 15.
25Net Present Value
- NPV is just the PV of the annual cash flows minus
the initial outflow. - Using TVM
- P/Y 1 N 5 I 15
- PMT 100,000
- PV of cash flows 335,216
- - Initial outflow (250,000)
- Net PV 85,216
26NPV with the HP10B
- -250,000 CFj
- 100,000 CFj
- 5 shift Nj
- 15 I/YR
- shift NPV
- You should get NPV 85,215.51.
27NPV with the HP17BII
- Select CFLO mode.
- FLOW(0)? -250,000 INPUT
- FLOW(1)? 100,000 INPUT
- TIMES(1)1 5 INPUT EXIT
- CALC 15 I NPV
- You should get NPV 85,215.51
28NPV with the TI BAII Plus
29NPV with the TI BAII Plus
- Select CF mode.
- CFo? -250,000 ENTER
30NPV with the TI BAII Plus
- Select CF mode.
- CFo? -250,000 ENTER
- C01? 100,000 ENTER
31NPV with the TI BAII Plus
- Select CF mode.
- CFo? -250,000 ENTER
- C01? 100,000 ENTER
- F01 1 5 ENTER
32NPV with the TI BAII Plus
- Select CF mode.
- CFo? -250,000 ENTER
- C01? 100,000 ENTER
- F01 1 5 ENTER
- NPV I 15 ENTER
33NPV with the TI BAII Plus
- Select CF mode.
- CFo? -250,000 ENTER
- C01? 100,000 ENTER
- F01 1 5 ENTER
- NPV I 15 ENTER CPT
34NPV with the TI BAII Plus
- Select CF mode.
- CFo? -250,000 ENTER
- C01? 100,000 ENTER
- F01 1 5 ENTER
- NPV I 15 ENTER CPT
- You should get NPV 85,215.51
35Profitability Index
36Profitability Index
37Profitability Index
38Profitability Index
- Decision Rule
- If PI is greater than or equal to 1, accept.
- If PI is less than 1, reject.
39PI with the HP10B
- -250,000 CFj
- 100,000 CFj
- 5 shift Nj
- 15 I/YR
- shift NPV
- Add back IO 250,000
- Divide by IO / 250,000
- You should get PI 1.34
40Internal Rate of Return (IRR)
- IRR The return on the firms invested capital.
IRR is simply the rate of return that the firm
earns on its capital budgeting projects.
41Internal Rate of Return (IRR)
42Internal Rate of Return (IRR)
43Internal Rate of Return (IRR)
44Internal Rate of Return (IRR)
- IRR is the rate of return that makes the PV of
the cash flows equal to the initial outlay. - This looks very similar to our Yield to Maturity
formula for bonds. In fact, YTM is the IRR of a
bond.
45Calculating IRR
- Looking again at our problem
- The IRR is the discount rate that makes the PV of
the projected cash flows equal to the initial
outlay.
46IRR with your Calculator
- IRR is easy to find with your financial
calculator. - Just enter the cash flows as you did with the NPV
problem and solve for IRR. - You should get IRR 28.65!
47IRR
- Decision Rule
- If IRR is greater than or equal to the required
rate of return, accept. - If IRR is less than the required rate of return,
reject.
48- IRR is a good decision-making tool as long as
cash flows are conventional. (- ) - Problem If there are multiple sign changes in
the cash flow stream, we could get multiple IRRs.
(- - )
49- IRR is a good decision-making tool as long as
cash flows are conventional. (- ) - Problem If there are multiple sign changes in
the cash flow stream, we could get multiple IRRs.
(- - )
50- IRR is a good decision-making tool as long as
cash flows are conventional. (- ) - Problem If there are multiple sign changes in
the cash flow stream, we could get multiple IRRs.
(- - )
1
51- IRR is a good decision-making tool as long as
cash flows are conventional. (- ) - Problem If there are multiple sign changes in
the cash flow stream, we could get multiple IRRs.
(- - )
52- IRR is a good decision-making tool as long as
cash flows are conventional. (- ) - Problem If there are multiple sign changes in
the cash flow stream, we could get multiple IRRs.
(- - )
53Summary Problem
- Enter the cash flows only once.
- Find the IRR.
- Using a discount rate of 15, find NPV.
- Add back IO and divide by IO to get PI.
54Summary Problem
- IRR 34.37.
- Using a discount rate of 15,
- NPV 510.52.
- PI 1.57.
55Modified Internal Rate of Return(MIRR)
- IRR assumes that all cash flows are reinvested at
the IRR. - MIRR provides a rate of return measure that
assumes cash flows are reinvested at the required
rate of return.
56MIRR Steps
- Calculate the PV of the cash outflows.
- Using the required rate of return.
- Calculate the FV of the cash inflows at the last
year of the projects time line. This is called
the terminal value (TV). - Using the required rate of return.
- MIRR the discount rate that equates the PV of
the cash outflows with the PV of the terminal
value, ie, that makes - PVoutflows PVinflows
57MIRR
- Using our time line and a 15 rate
- PV outflows (900).
- FV inflows (at the end of year 5) 2,837.
- MIRR FV 2837, PV (900), N 5.
- Solve I 25.81.
58MIRR
- Using our time line and a 15 rate
- PV outflows (900).
- FV inflows (at the end of year 5) 2,837.
- MIRR FV 2837, PV (900), N 5.
- Solve I 25.81.
- Conclusion The projects IRR of 34.37 assumes
that cash flows are reinvested at 34.37.
59MIRR
- Using our time line and a 15 rate
- PV outflows (900).
- FV inflows (at the end of year 5) 2,837.
- MIRR FV 2837, PV (900), N 5.
- Solve I 25.81.
- Conclusion The projects IRR of 34.37 assumes
that cash flows are reinvested at 34.37. - Assuming a reinvestment rate of 15, the
projects MIRR is 25.81.