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Chapter 11

The Basics of Capital Budgeting

 2005, Pearson Prentice Hall


Capital Budgeting: The process
of planning for purchases of
long-term assets.

How do we decide
if a capital
investment
project should
be accepted or
rejected?
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.
Payback Period

 How long will it take for the project


to generate enough cash to pay for
itself?

(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8
Payback Period

 How long will it take for the project


to generate enough cash to pay for
itself?

(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

Payback period = 3.33 years


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.
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
project’s cash flows.
Discounted Payback

 Discounts the cash flows at the


firm’s 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.
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.37
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
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
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
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
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
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
Discounted Payback
(500) 250 250 250 250 250

0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
The Discounted
0 -500Payback
-500.00
1 250 219.30 1 year
is 2.52 years
280.70
2 250 192.37 2 years
88.33
3 250 168.74 .52 years
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.
Net Present Value
 NPV = the total PV of the annual net
cash flows - the initial outlay.

S
FCFt
NPV = - IO
(1 + k) t
t=1
Net Present Value

Decision Rule:

 If NPV is positive, accept.


 If NPV is negative, reject.
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 firm’s
required rate of return is 15%.

(250,000) 100,000 100,000 100,000 100,000 100,000

0 1 2 3 4 5
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 IO = 250,000

PV of cash flows = $335,200


- Initial outflow: ($250,000)
= Net PV $85,200
Profitability Index
n

S
FCFt
NPV = t - IO
(1 + k)
t=1

S
FCFt
PI = t IO
(1 + k)
t=1
Profitability Index

 Decision Rule:

 If PI is greater than or equal


to 1, accept.
 If PI is less than 1, reject.
Profitability Index
PI is just the PV of the annual cash
flows divided by the initial outflow.
Using TVM:
P/Y = 1 N = 5 I = 15%
PMT = 100,000

PV of cash flows = $335,200


 Initial outflow: $250,000
= PI 1.34
Internal Rate of Return (IRR)

 IRR: The return on the firm’s


invested capital. IRR is simply the
rate of return that the firm earns on
its capital budgeting projects.
Internal Rate of Return (IRR)
n

S
FCFt
NPV = - IO
(1 + k) t
t=1

S
FCFt
IRR: t = IO
(1 + IRR)
t=1
Internal Rate of Return (IRR)
n

S
FCFt
IRR: t = IO
(1 + IRR)
t=1
 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.
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.

(250,000) 100,000 100,000 100,000 100,000 100,000

0 1 2 3 4 5
Problem 1

Year Cash Flow PVIFA PVIFA PVIFA2 PVIFA


15%,t 25%,t 28%,t 29%,t
1-5 100,000 3.352 2.689 2.532 2.483
PV of CF 335,200 268,900 253,200 248,300
- IO 250,000 250,000 250,000 250,000
NPV 85,200 18,900 3,200 -1,700
IRR = 29% (NPV closest to zero)
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.

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