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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
13-3
Project Evaluation:
Alternative Methods
13-4
Proposed Project Data
13-5
Payback Period (PBP)
0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7K
0 1 2 3 (a) 4 5
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?
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
13-10
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)
13-12
NPV Solution
Mr. Dahri determined that the appropriate
discount rate (k) for this project is 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?
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)
13-19
PI Solution
Mr. Dahri determined that the appropriate
discount rate (k) for this project is 13%.
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)
Strengths: Weaknesses:
Same as NPV Same as NPV
Allows Provides only
comparison of relative profitability
different scale
projects
13-23
Internal Rate of Return (IRR)
13-24
IRR Solution
.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?
13-32
Average Accounting
Return
AAR=
Average annual profit
Average investment
13-33
Average Accounting
Return
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