Capital budgeting -2

Ch. 9:Ch. 9:Capital BudgetingCapital BudgetingDecision CriteriaDecision Criteria

1999, Prentice Hall, Inc.

Capital BudgetingCapital Budgeting:: the process of the process of planning for purchases of long-planning for purchases of long-

term assets.term assets.

exampleexample: :

Suppose our firm must decide Suppose our firm must decide whether to purchase a new plastic whether to purchase a new plastic molding machine for $125,000. How molding machine for $125,000. How do we decide?do we decide?

Will the machine be profitable?Will the machine be profitable? Will our firm earn a high rate of Will our firm earn a high rate of

return on the investment?return on the investment?

Decision-making Criteria in Decision-making Criteria in Capital BudgetingCapital Budgeting

How do we decide How do we decide if a capital if a capital investment investment

project should project should be accepted or be accepted or

rejected?rejected?

The Ideal Evaluation Method should:The Ideal Evaluation Method should:

a) include a) include all cash flowsall cash flows that occur during that occur during the life of the project,the life of the project,

b) consider the b) consider the time value of moneytime value of money,,

c) incorporate the c) incorporate the required rate of returnrequired rate of return on the project. on the project.

Decision-making Criteria in Decision-making Criteria in Capital BudgetingCapital Budgeting

Payback PeriodPayback Period

The number of years needed to The number of years needed to recover the initial cash outlay.recover the initial cash outlay.

How long will it take for the project How long will it take for the project to generate enough cash to pay for to generate enough cash to pay for itself?itself?



00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150 (500) 150 150 150 150 150 150 150 150



00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150 (500) 150 150 150 150 150 150 150 150

Payback period = 3.33 years.Payback period = 3.33 years.

Is a 3.33 year payback period good?Is a 3.33 year payback period good? Is it acceptable?Is it acceptable? Firms that use this method will Firms that use this method will

compare the payback calculation to compare the payback calculation to some standard set by the firm.some standard set by the firm.

If our senior management had set a If our senior management had set a cut-off of 5 years for projects like cut-off of 5 years for projects like ours, what would be our decision?ours, what would be our decision?

Accept the projectAccept the project..

Drawbacks of Payback Period:Drawbacks of Payback Period:

Firm cutoffs are Firm cutoffs are subjectivesubjective.. Does not consider Does not consider time value of moneytime value of money.. Does not consider any Does not consider any required rate of required rate of

returnreturn.. Does not consider all of the project’s Does not consider all of the project’s

cash flowscash flows..


Does not consider all of the project’s Does not consider all of the project’s cash flows.cash flows.

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(500) 150 150 150 150 150 (300) 0 0 (500) 150 150 150 150 150 (300) 0 0

Consider this cash flow stream!


Does not consider all of the project’s Does not consider all of the project’s cash flows.cash flows.

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 (300) 0 0 (500) 150 150 150 150 150 (300) 0 0

This project is clearly unprofitable, but we would accept it based on a 4-year paybackcriterion!

Discounted PaybackDiscounted Payback

Discounts the cash flows at the firm’s Discounts the cash flows at the firm’s required rate of return.required rate of return.

Payback period is calculated using Payback period is calculated using these discounted net cash flows.these discounted net cash flows.

ProblemsProblems:: Cutoffs are still subjective.Cutoffs are still subjective. Still does not examine all cash flows.Still does not examine all cash flows.


00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250

DiscountedDiscounted

YearYear Cash FlowCash Flow CF (14%)CF (14%)

00 -500-500 -500.00-500.00

11 250 250 219.30219.30


00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250



00 -500-500 -500.00-500.00

11 250 250 219.30219.30 1 year1 year

280.70280.70


00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250



00 -500-500 -500.00-500.00

11 250 250 219.30219.30 1 year1 year

280.70280.70

22 250 250 192.38192.38


00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250



00 -500-500 -500.00-500.00

11 250 250 219.30219.30 1 year1 year

280.70280.70

22 250 250 192.38192.38 2 years2 years

88.3288.32


00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250



00 -500-500 -500.00-500.00

11 250 250 219.30219.30 1 year1 year

280.70280.70

22 250 250 192.38192.38 2 years2 years

88.3288.32

33 250 250 168.75 168.75


00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250



00 -500-500 -500.00-500.00

11 250 250 219.30219.30 1 year1 year

280.70280.70

22 250 250 192.38192.38 2 years2 years

88.3288.32

33 250 250 168.75 168.75 .52 years.52 years


00 11 22 33 44 55

(500) 250 250 250 250 250 (500) 250 250 250 250 250



00 -500-500 -500.00-500.00

11 250 250 219.30219.30 1 year1 year

280.70280.70

22 250 250 192.38192.38 2 years2 years

88.3288.32

33 250 250 168.75 168.75 .52 years.52 years

The Discounted The Discounted Payback Payback

is is 2.522.52 years years

Other MethodsOther Methods

1) 1) Net Present ValueNet Present Value (NPV) (NPV)

2) 2) Profitability IndexProfitability Index (PI) (PI)

3) 3) Internal Rate of ReturnInternal Rate of Return (IRR) (IRR)

Each of these decision-making criteria:Each of these decision-making criteria: Examines all net cash flows,Examines all net cash flows, Considers the time value of money, andConsiders the time value of money, and Considers the required rate of return.Considers the required rate of return.

Net Present ValueNet Present Value

NPV = the total PV of the annual net NPV = the total PV of the annual net cash flows - the initial outlay.cash flows - the initial outlay.

NPVNPV = - IO = - IO ACFACFtt

(1 + k)(1 + k) tt

nn

t=1t=1

Net Present ValueNet Present Value

Decision RuleDecision Rule::

If NPV is positive, If NPV is positive, ACCEPTACCEPT.. If NPV is negative, If NPV is negative, REJECTREJECT..

NPV ExampleNPV Example

Suppose we are considering a capital investment that Suppose we are considering a capital investment that costs costs $276,400$276,400 and provides annual net cash flows of and provides annual net cash flows of $83,000$83,000 for four years and for four years and $116,000$116,000 at the end of the at the end of the fifth year. The firm’s required rate of return is fifth year. The firm’s required rate of return is 15%.15%.

NPV ExampleNPV Example

0 1 2 3 4 5

(276,400)83,000 83,000 83,000 83,000 116,000

Suppose we are considering a capital investment that Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%.fifth year. The firm’s required rate of return is 15%.

NPV with the HP10B:NPV with the HP10B:

-276,400 -276,400 CFjCFj 83,000 83,000 CFjCFj 4 4 shift Njshift Nj 116,000 116,000 CFjCFj 15 15 I/YRI/YR shift NPVshift NPV You should get NPV = You should get NPV = 18,235.7118,235.71..

NPV with the HP17BII:NPV with the HP17BII:

Select CFLO mode.Select CFLO mode. FLOW(0)=? FLOW(0)=? -276,400 INPUT-276,400 INPUT FLOW(1)=? FLOW(1)=? 83,000 INPUT83,000 INPUT #TIMES(1)=1 #TIMES(1)=1 4 INPUT4 INPUT FLOW(2)=? FLOW(2)=? 116,000 INPUT116,000 INPUT #TIMES(2)=1 #TIMES(2)=1 INPUT EXITINPUT EXIT CALC CALC 15 I%15 I% NPVNPV You should get NPV = You should get NPV = 18,235.7118,235.71

NPV with the TI BAII Plus:NPV with the TI BAII Plus:

Select CF mode.Select CF mode.


Select CF mode.Select CF mode. CFo=? CFo=? -276,400 -276,400 ENTERENTER


Select CF mode.Select CF mode. CFo=? CFo=? -276,400 -276,400 ENTERENTER C01=? C01=? 83,000 83,000 ENTERENTER


Select CF mode.Select CF mode. CFo=? CFo=? -276,400 -276,400 ENTERENTER C01=? C01=? 83,000 83,000 ENTERENTER F01= 1 F01= 1 4 4 ENTERENTER


Select CF mode.Select CF mode. CFo=? CFo=? -276,400 -276,400 ENTERENTER C01=? C01=? 83,000 83,000 ENTERENTER F01= 1 F01= 1 4 4 ENTERENTER C02=? C02=? 116,000 116,000 ENTERENTER


Select CF mode.Select CF mode. CFo=? CFo=? -276,400 -276,400 ENTERENTER C01=? C01=? 83,000 83,000 ENTERENTER F01= 1 F01= 1 4 4 ENTERENTER C02=? C02=? 116,000 116,000 ENTERENTER F02= 1 F02= 1 ENTERENTER


Select CF mode.Select CF mode. CFo=? CFo=? -276,400 -276,400 ENTERENTER C01=? C01=? 83,000 83,000 ENTERENTER F01= 1 F01= 1 4 4 ENTERENTER C02=? C02=? 116,000 116,000 ENTERENTER F02= 1 F02= 1 ENTERENTER NPV NPV I= 15 I= 15 ENTERENTER

CPTCPT


Select CF mode.Select CF mode. CFo=? CFo=? -276,400 -276,400 ENTERENTER C01=? C01=? 83,000 83,000 ENTERENTER F01= 1 F01= 1 4 4 ENTERENTER C02=? C02=? 116,000 116,000 ENTERENTER F02= 1 F02= 1 ENTERENTER NPV NPV I= 15 I= 15 ENTERENTER CPTCPT You should get NPV = You should get NPV = 18,235.7118,235.71

Profitability IndexProfitability Index


(1 + k)(1 + k) tt

nn

t=1t=1


t


(1 + k)(1 + k) tt

nn

t=1t=1

PI = IO ACFt

(1 + k)

n

t=1



If PI is greater than or equal If PI is greater than or equal to 1, to 1, ACCEPTACCEPT..

If PI is less than 1, If PI is less than 1, REJECTREJECT..

PI with PI with the the

HP10B:HP10B:

-276,400-276,400 CFjCFj 83,000 83,000 CFjCFj 4 4 shift Njshift Nj 116,000 116,000 CFjCFj 15 15 I/YRI/YR shift NPVshift NPV You should get NPV = You should get NPV = 18,235.7118,235.71.. Add back IO:Add back IO: + 276,400+ 276,400 Divide by IO:Divide by IO: / 276,400/ 276,400 = = You should get You should get PI = 1.066PI = 1.066

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRRIRR: : the return on the firm’s the return on the firm’s invested capital. invested capital. IRR is simply IRR is simply the rate of return that the firm the rate of return that the firm earns on its capital budgeting earns on its capital budgeting projects.projects.



(1 + k)(1 + k) tt

nn

t=1t=1


n

t=1IRR: = IO

ACFt

(1 + IRR) t


(1 + k)(1 + k) tt

nn

t=1t=1


IRR is the rate of return that makes the PV IRR is the rate of return that makes the PV of the cash flows of the cash flows equalequal to the initial outlay. to the initial outlay.

This looks very similar to our Yield to This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM Maturity formula for bonds. In fact, YTM isis the IRR of a bond. the IRR of a bond.

n

t=1IRR: = IO

ACFt

(1 + IRR) t

Calculating IRRCalculating IRR

Looking again at our problem:Looking again at our problem: The IRR is the discount rate that The IRR is the discount rate that

makes the PV of the projected cash makes the PV of the projected cash flows flows equalequal to the initial outlay. to the initial outlay.

0 1 2 3 4 5

(276,400)83,000 83,000 83,000 83,000 116,000

This is what we are actually doing:This is what we are actually doing:

83,000 (PVIFA 83,000 (PVIFA 4, IRR4, IRR) + 116,000 (PVIF ) + 116,000 (PVIF 5, IRR5, IRR))

= 276,400= 276,400

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(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000

This is what we are actually doing:This is what we are actually doing:

83,000 (PVIFA 83,000 (PVIFA 4, 4, IRRIRR) + 116,000 (PVIF ) + 116,000 (PVIF 5, 5, IRRIRR))

= 276,400= 276,400

This way, we have to solve for IRR by trial This way, we have to solve for IRR by trial and error.and error.

00 11 22 33 44 55

(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000

IRR with your CalculatorIRR with your Calculator

IRR is easy to find with your IRR is easy to find with your financial calculator.financial calculator.

Just enter the cash flows as you did Just enter the cash flows as you did with the NPV problem and solve for with the NPV problem and solve for IRR.IRR.

You should get You should get IRR = 17.63%!IRR = 17.63%!

IRRIRR


If IRR is greater than or equal If IRR is greater than or equal to the required rate of return, to the required rate of return, ACCEPTACCEPT..

If IRR is less than the required If IRR is less than the required rate of return, rate of return, REJECTREJECT..

IRR is a good decision-making IRR is a good decision-making tool as long as cash flows are tool as long as cash flows are conventionalconventional. . (- + + + + +)(- + + + + +)

Problem: If there are multiple Problem: If there are multiple sign changes in the cash flow sign changes in the cash flow stream, we could get multiple stream, we could get multiple IRRs. IRRs. (- + + - + +)(- + + - + +)

IRR is a good decision-making IRR is a good decision-making tool as long as cash flows are tool as long as cash flows are conventionalconventional. . (- + + + + +)(- + + + + +)


0 1 2 3 4 5

(500) 200 100 (200) 400 300


We could find 3 different IRRs!We could find 3 different IRRs!

0 1 2 3 4 5

(500) 200 100 (200) 400 300

1 2 31 2 3

Summary Problem:Summary Problem:

Enter the cash flows only once.Enter the cash flows only once. Find the Find the IRRIRR.. Using a discount rate of 15%, find Using a discount rate of 15%, find NPVNPV.. Add back IO and divide by IO to get Add back IO and divide by IO to get PIPI..

0 1 2 3 4 5

(900) 300 400 400 500 600

Summary Problem:Summary Problem:

IRR = IRR = 34.37%.34.37%. Using a discount rate of 15%, Using a discount rate of 15%,

NPV = NPV = $510.52.$510.52. PI = PI = 1.57.1.57.

0 1 2 3 4 5

(900) 300 400 400 500 600

Capital budgeting -2

Economy & Finance

Transcript of Capital budgeting -2