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Chapter 06

Capital Budgeting
Techniques
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
13-1
Capital Budgeting
Techniques
 Capital Budgeting involves evaluation of
(decision about) projects. Which projects should
be accepted?
 The Capital Budgeting is based on forecasting.
 Evaluate project based on the evaluation method.
 Classification of Projects
 Mutually Exclusive - accept ONE project only
 Independent - accept ALL profitable projects.

13-2
Project Evaluation:
Alternative Methods

 Payback Period (PBP)


 Internal Rate of Return (IRR)
 Net Present Value (NPV)
 Profitability Index (PI)

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Project Evaluation:
Alternative Methods

 Payback Period (PBP)

13-4
Proposed Project Data

Ms. Dahri is evaluating a new project


for her firm, He determined that the
after-tax cash flows for the project
will be $10,000; $12,000; $15,000;
$10,000; and $7,000, respectively, for
each of the Years 1 through 5. The
initial cash outlay will be $40,000.

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Payback Period (PBP)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K

PBP is the period of time


required for the cumulative
expected cash flows from an
investment project to equal
the initial cash outflow.
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Payback Solution (#1)

0 1 2 3 (a) 4 5

-40 K (-b) 10 K 12 K 15 K 10 K(d) 7K


10 K 22 K 37 K(c) 47 K 54 K

Cumulative
Inflows PBP =a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
13-7
Payback Solution (#2)

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows
Note: Take absolute value of last
negative cumulative cash flow
13-8 value.
PBP Acceptance Criterion
The management of Dahri firm has
set a maximum PBP of 3.5 years for
projects of this type.
Should this project be accepted?

Yes! The firm will receive back the


initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]

13-9
PBP Strengths
and Weaknesses
Strengths: Weaknesses:
 Easy to use and  Does not account
understand for TVM
 Can be used as a  Does not consider
measure of cash flows beyond
liquidity the PBP
 Easier to forecast
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ST than LT flows
PBP
Mr. Mukesh, Present a proposal of ice
Factory,
Initial invest is 75000
Cash inflows are
5000, 13000, 12000, 6000, 3000, 5000,
13000, 17000, 32000 yearwise
Mr Mukesh set Maximum limit of PBP
8Year max.
13-11
Net Present Value (NPV)

NPV is the present value of an


investment project’s net cash
flows minus the project’s initial
cash outflow.

CF1 CF2 CFn


NPV = + +...+ - ICO
(1+k)1 (1+k)2 (1+k) n

13-12
NPV Solution
Mr. Dahri determined that the appropriate
discount rate (k) for this project is 13%.

NPV = $10,000 +$12,000 +$15,000 +


(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)

13-13
NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801
= - $1,428
13-14
NPV Acceptance Criterion
The management of Dahri firm
determined that the required rate is
13% for projects of this type.
Should this project be accepted?

No! The NPV is negative. This means


that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
13-15
NPV
Mr. Mukesh, Present a proposal of ice
Factory,
Initial invest is 75000
Cash inflows are
5000, 13000, 12000, 6000, 3000, 5000,
13000, 17000, 32000 yearwise
Mr Mukesh set limit of required retun
Minium 8%
13-16
NPV
 NET CASH FLOWS (IN $ 1,000)

NET CASH FLOWS (IN $ 1,000)

YEAR 0 1 2 3 4 5 6
PROJECT A -60 20 20 20 20 20 20
PROJECT B -72 45 22 20 13 13 13

1. Calculate pay payback period maximum period for both 2.5 year
1. Calculate the NPVs for each project, assuming 10% cost of capital

13-17
NPV Strengths
and Weaknesses
Strengths: Weaknesses:
 Cash flows  May not include
assumed to be managerial
reinvested at the options embedded
hurdle rate. in the project. See
Chapter 14.
 Accounts for TVM.
 Considers all
13-18
cash flows.
Profitability Index (PI)

PI is the ratio of the present value of


a project’s future net cash flows to
the project’s initial cash outflow.
CF1 CF2 CFn
PI = + +...+ ICO
(1+k)1 (1+k) 2 (1+k)n

13-19
PI Solution
Mr. Dahri determined that the appropriate
discount rate (k) for this project is 13%.

NPV = $10,000 +$12,000 +$15,000 +


(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 +
(1.13) (1.13)5

13-20
PI Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) - $40,000
NPV = $10,000(.885) + $12,000(.783) +
$15,000(.693) + $10,000(.613) +
$ 7,000(.543) - $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801
= 38572
13-21
PI Acceptance Criterion
PI = $38,572 / $40,000
= .9643 (Method #1, 13-34)

Should this project be accepted?

No! The PI is less than 1.00. This


means that the project is not profitable.
[Reject as PI < 1.00 ]
13-22
PI Strengths
and Weaknesses

Strengths: Weaknesses:
 Same as NPV  Same as NPV
 Allows  Provides only
comparison of relative profitability
different scale
projects

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Internal Rate of Return (IRR)

IRR is the discount rate that equates the


present value of the future net cash
flows from an investment project with
the project’s initial cash outflow.

CF1 CF2 CFn


ICO = + +...+
(1+IRR)1 (1+IRR)2 (1+IRR)n

13-24
IRR Solution

$40,000 = $10,000 $12,000


+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ +
(1+IRR)3 (1+IRR)4 (1+IRR)5

Find the interest rate (IRR) that causes the


discounted cash flows to equal $40,000.
13-25
IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +


$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
13-26
IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +


$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
13-27
IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X $1,444
.05 = $4,603

13-28
IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X $1,444
.05 = $4,603

13-29
IRR Solution (Interpolate)

.10 $41,444
X $1,444
.05 IRR $40,000 $4,603
.15 $36,841

X = ($1,444)(0.05) X = .0157
$4,603
IRR = .10 + .0157 = .1157 or 11.57%
13-30
IRR Acceptance Criterion
The management of firm determined
that the hurdle rate is 13% for
projects of this type.
Should this project be accepted?

No! The firm will receive 11.57% for


each dollar invested in this project at
a cost of 13%. [ IRR < Hurdle Rate ]
13-31
IRR Strengths
and Weaknesses
Strengths: Weaknesses:
 Accounts for  Assumes all cash
TVM flows reinvested at
 Considers all the IRR
cash flows  Difficulties with
 Less project rankings and
subjectivity Multiple IRRs

13-32
Average Accounting
Return

AAR=
Average annual profit
Average investment

13-33
Average Accounting
Return
 NET CASH FLOWS (IN $ 1,000)

NET CASH FLOWS (IN $ 1,000)

YEAR 0 1 2 3 4 5 6
PROJECT A -60 20 20 20 20 20 20
PROJECT B -72 45 22 20 13 13 13

Calculate AAR ?

13-34
Evaluation Summary

Basket Wonders Independent Project


Method Project Comparison Decision
PBP 3.3 3.5 Accept
IRR 11.47% 13% Reject
NPV -$1,424 $0 Reject
PI .96 1.00 Reject
13-35
Other Project
Relationships
 Dependent -- A project whose
acceptance depends on the
acceptance of one or more other
projects.
 Mutually Exclusive -- A project
whose acceptance precludes the
acceptance of one or more
alternative projects.
13-36

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