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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
0 1 2 3 4 5 6 7 8
Payback Period
0 1 2 3 4 5 6 7 8
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
S
FCFt
NPV = - IO
(1 + k) t
t=1
Net Present Value
Decision Rule:
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
S
FCFt
NPV = t - IO
(1 + k)
t=1
S
FCFt
PI = t IO
(1 + k)
t=1
Profitability Index
Decision Rule:
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
0 1 2 3 4 5
Problem 1