Investment Criteria

Timothy R. Mayes, Ph.D.

FIN 3300: Chapter 9

What is Capital Budgeting?

Capital budgeting refers to the process of

deciding how to allocate the firms scarce
capital resources (land, labor, and capital) to
its various investment alternatives

Overview

All of these techniques attempt to

compare the costs and benefits of a
project
The over-riding rule of capital budgeting
is to accept all projects for which the
cost is less than, or equal to, the
benefit:
Accept if:
Reject if:

Cost Benefit
Cost > Benefit

The Six Criteria

There are six criteria that we will use:

The payback period

The discounted payback period
Internal rate of return (IRR)
Modified internal rate of return (MIRR)
Net present value (NPV)
Profitability index (PI)

The Example

We will use the following example to

demonstrate the techniques of capital budgeting
Assume that your company is investigating a
new labor-saving machine that will cost $10,000.
The machine is expected to provide cost savings
each year as shown in the following timeline:
-10,000 2000
0

2500

3000

3500

4000

If your required return is 12%, should this

machine be purchased?

The Payback Period

The payback period measures the time that it

takes to recoup the cost of the investment.
If the cash flows are an annuity, then we can
simply divide the cost by the annual cash flow to
determine the payback period
Otherwise, as in the example, we subtract the cash
flows from the cost until the remainder is zero
The shorter the payback period, the better
Generally, firms will have some maximum
allowable payback period against which all
investments are compared
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The Payback Period: An

Example

For our example project, we will subtract the

cash flows from the initial outlay until the entire
cost is recovered:

Since it will take 0.7143 years (= 2500/3500)

to recover the last 2,500, the payback period
must be 3.7143 years
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Problems with the Payback

Period

The payback period suffers from two primary

problems that limit its usefulness in evaluating
investments:
It ignores the time value of money
It ignores all cash flows beyond the payback period

Still, it has a couple of redeeming qualities

It is quick and easy to calculate
It gives a measure of the liquidity of the project

The Discounted Payback

Period

The discounted payback period is exactly the same

as the regular payback period, except that we use
the present values of the cash flows in the calculation
Since our required return (WACC) is 12%, the timeline
with the PVs looks like this:
-10,0001785.711992.982135.342224.312269.71
0

The discounted payback period is 4.82 years

Note that the discounted payback period is
always longer than the regular payback period
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Problems with Discounted

Payback

The discounted payback period solves the time

value problem, but it still ignores the cash
flows beyond the payback period
Therefore, you may reject projects that have
large cash flows in the outlying years that
make it very profitable
In other words, any measure of payback can
lead to a focus on short-run profits at the
expense of larger long-term profits

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The Internal Rate of Return

The internal rate of return (IRR) is the discount

rate that equates the present value of the cash
flows and the cost of the investment
Usually, we cannot calculate the IRR directly,
instead we must use a trial and error process
For our example, the IRR is found by solving
the following:

In this case, the solution is 13.45%

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Problems with the IRR

The IRR is a popular technique primarily

because it is a percentage which is easily
compared to the WACC
However, it suffers from a couple of flaws:
The calculation of the IRR implicitly assumes that the
cash flows are reinvested at the IRR. This may not
always be realistic.
Percentages can be misleading (would you rather
earn 100% on a $100 investment, or 10% on a
$10,000 investment?)

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The Modified Internal Rate of

Return

The modified IRR (MIRR) is the average annual

rate of return that will be earned on an
investment if the cash flows are reinvested at
the specified rate of return (usually, the WACC)
To calculate the MIRR, first find the total future
value of the cash flows at the reinvestment
rate, and then apply the formula:

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The MIRR: An Example

To calculate the MIRR for our example, first find

the FV of the cash flows at 12% (the WACC):

This is the amount that you will have

accumulated by the end of the life of the
investment
Now, find the average annual rate of return:
Since the MIRR is greater than the WACC, this
project is acceptable
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The Net Present Value

The net present value (NPV) is the difference

between the present value of the cash flows (the
benefit) and the cost of the investment (IO):

In other words, this is the increase in wealth

that the shareholders will receive if the project
is accepted
All projects with NPV greater than or equal to
zero should be accepted
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The NPV: An Example

NPV is calculated by subtracting the initial outlay

(cost) from the present value of the cash flows
Note that the discount rate is the WACC (12% in
this example)

Since the NPV is positive, the project is

acceptable
Note that a positive NPV also means that the
IRR is greater than the WACC

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The Profitability Index

The profitability index is the same as the NPV, except

that we divide the PVCF by the initial outlay:

Accept all projects with PI greater than or

equal to 1.00
For the example, the PI is:

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