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Chapter 7 - Capital Budgeting Decision Criteria

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Title: Chapter 7 - Capital Budgeting Decision Criteria


1
Chapter 7 - Capital Budgeting Decision
Criteria
2
Capital 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?

3
Decision-making Criteria in Capital Budgeting
  • How do we decide if a capital investment project
    should be accepted or rejected?

4
Decision-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.

5
Payback Period
  • How long will it take for the project to generate
    enough cash to pay for itself?

6
Payback Period
  • How long will it take for the project to generate
    enough cash to pay for itself?

7
Payback Period
  • How long will it take for the project to generate
    enough cash to pay for itself?

Payback period 3.33 years
8
Payback 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.

9
Drawbacks 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.

10
Drawbacks of Payback Period
  • Does not consider all of the projects cash
    flows.
  • Consider this cash flow stream!

11
Drawbacks 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!

12
Discounted 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.

13
Discounted Payback
  • Discounted
  • Year Cash Flow CF (14)
  • 0 -500 -500.00
  • 1 250 219.30

14
Discounted Payback
  • Discounted
  • Year Cash Flow CF (14)
  • 0 -500 -500.00
  • 1 250 219.30 1 year
  • 280.70

15
Discounted Payback
  • Discounted
  • Year Cash Flow CF (14)
  • 0 -500 -500.00
  • 1 250 219.30 1 year
  • 280.70
  • 2 250 192.37

16
Discounted 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

17
Discounted 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

18
Discounted 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

19
Discounted 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

20
Other 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.

21
Net Present Value
  • NPV the total PV of the annual net cash flows -
    the initial outlay.

22
Net Present Value
  • Decision Rule
  • If NPV is positive, accept.
  • If NPV is negative, reject.

23
NPV 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.

24
NPV 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.

25
Net 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

26
NPV with the HP10B
  • -250,000 CFj
  • 100,000 CFj
  • 5 shift Nj
  • 15 I/YR
  • shift NPV
  • You should get NPV 85,215.51.

27
NPV 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

28
NPV with the TI BAII Plus
  • Select CF mode.

29
NPV with the TI BAII Plus
  • Select CF mode.
  • CFo? -250,000 ENTER

30
NPV with the TI BAII Plus
  • Select CF mode.
  • CFo? -250,000 ENTER
  • C01? 100,000 ENTER

31
NPV with the TI BAII Plus
  • Select CF mode.
  • CFo? -250,000 ENTER
  • C01? 100,000 ENTER
  • F01 1 5 ENTER

32
NPV with the TI BAII Plus
  • Select CF mode.
  • CFo? -250,000 ENTER
  • C01? 100,000 ENTER
  • F01 1 5 ENTER
  • NPV I 15 ENTER

33
NPV 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

34
NPV 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

35
Profitability Index
36
Profitability Index
37
Profitability Index
38
Profitability Index
  • Decision Rule
  • If PI is greater than or equal to 1, accept.
  • If PI is less than 1, reject.

39
PI 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

40
Internal 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.

41
Internal Rate of Return (IRR)
42
Internal Rate of Return (IRR)
43
Internal Rate of Return (IRR)
44
Internal 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.

45
Calculating 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.

46
IRR 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!

47
IRR
  • 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.
    (- - )

53
Summary 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.

54
Summary Problem
  • IRR 34.37.
  • Using a discount rate of 15,
  • NPV 510.52.
  • PI 1.57.

55
Modified 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.

56
MIRR 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

57
MIRR
  • 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.

58
MIRR
  • 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.

59
MIRR
  • 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.
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