Capital Budgeting

Decision-making Criteria in Capital Budgeting

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, 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?

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

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

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 cutoff 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 projects cash flows.

Drawbacks of Payback Period

Does not consider all of the projects cash flows.
(500) 150 150 150 150 150 (300) 0 0

Consider this cash flow stream!

Drawbacks of Payback Period

Does not consider all of the projects cash flows.
(500) 150 150 150 150 150 (300) 0 0

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

Discounted Payback
Discounts the cash flows at the firms 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) 0 250 1 250 2 250 3 250 250 4 5

Discounted

Year Cash Flow

0 1 -500 250

CF (14%)
-500.00 219.30

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

Discounted

Year Cash Flow

0 1 -500 250

CF (14%)
-500.00 219.30 280.70 1 year

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

Discounted

Year Cash Flow

0 1 2 -500 250 250

CF (14%)
-500.00 219.30 280.70 192.37 1 year

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

Discounted

Year Cash Flow

0 1 2 -500 250 250

CF (14%)
-500.00 219.30 280.70 192.37 88.33 1 year 2 years

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

Discounted

Year Cash Flow

0 1 2 3 -500 250 250 250

CF (14%)
-500.00 219.30 280.70 192.37 88.33 168.74 1 year 2 years

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

Discounted

Year Cash Flow

0 1 2 3 -500 250 250 250

CF (14%)
-500.00 219.30 280.70 192.37 88.33 168.74 1 year 2 years .52 years

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

Discounted

Year Cash Flow CF (14%) The Discounted

0 1 2 3 -500 -500.00 Payback 250 219.30 is 2.52 years 280.70 250 192.37 88.33 250 168.74 1 year 2 years .52 years

Other Methods
1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR)
Each of these decision-making criteria: Examines all net cash flows, Considers the time value of money, and Considers the required rate of return.

Net Present Value

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

NPV =

S
t=1

FCFt (1 + k) t

- IO

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 Rs.250,000 and provides annual net cash flows of Rs.100,000 for five years. The firms required rate of return is 15%.

NPV Example
Suppose we are considering a capital investment that costs Rs.250,000 and provides annual net cash flows of Rs.100,000 for five years. The firms required rate of return is 15%.
(250,000) 100,000 100,000 100,000 100,000 100,000

Net Present Value (NPV)

NPV is just the PV of the annual cash flows minus the initial outflow.
Using TVM:

P/Y = 1 N = 5 PMT = 100,000

I = 15

PV of cash flows = Rs.335,216 - Initial outflow: (Rs.250,000) = Net PV Rs.85,216

NPV with the HP10B:

-250,000 CFj 100,000 CFj 5 shift Nj 15 I/YR shift NPV You should get NPV = 85,215.51.

NPV with the HP17BII:

Select CFLO mode. FLOW(0)=? -250,000 INPUT FLOW(1)=? 100,000 INPUT #TIMES(1)=1 5 INPUT EXIT CALC 15 I% NPV You should get NPV = 85,215.51

NPV with the TI BAII Plus:

Select CF mode.

NPV with the TI BAII Plus:

Select CF mode. CFo=? -250,000

ENTER

NPV with the TI BAII Plus:

Select CF mode. CFo=? -250,000 C01=? 100,000

ENTER ENTER

NPV with the TI BAII Plus:

Select CF mode. CFo=? -250,000 C01=? 100,000 F01= 1 5

ENTER ENTER ENTER

NPV with the TI BAII Plus:

Select CF mode. CFo=? -250,000 C01=? 100,000 F01= 1 5 NPV I= 15

ENTER ENTER ENTER ENTER

NPV with the TI BAII Plus:

Select CF mode. CFo=? -250,000 C01=? 100,000 F01= 1 5 NPV I= 15

ENTER ENTER ENTER ENTER CPT

NPV with the TI BAII Plus:

Select CF mode. CFo=? -250,000 C01=? 100,000 F01= 1 5 NPV I= 15

ENTER ENTER ENTER ENTER CPT You should get NPV = 85,215.51

Profitability Index

Profitability Index

NPV =

S
t=1

FCFt t (1 + k)

- IO

Profitability Index

NPV =

S
t=1

FCFt t (1 + k)

- IO

PI =

S
t=1

FCFt t (1 + k)

IO

Profitability Index

Decision Rule: If PI is greater than or equal to 1, accept. If PI is less than 1, reject.

PI with the HP10B:

-250,000 CFj 100,000 CFj 5 shift Nj 15 I/YR shift NPV Add back IO: + 250,000 Divide by IO: / 250,000 = You should get PI = 1.34

Internal Rate of Return (IRR)

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

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

NPV =

S
t=1

FCFt (1 + k) t

- IO

Internal Rate of Return (IRR)

NPV =

S
t=1
n

FCFt (1 + k) t

- IO

IRR:

S
t=1

FCFt t (1 + IRR)

= IO

Internal Rate of Return (IRR)

IRR:

S
t=1

FCFt t (1 + IRR)

= IO

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

IRR with your Calculator

IRR is easy to find with your financial calculator. Just enter the cash flows as you did with the NPV problem and solve for IRR. You should get IRR = 28.65%!

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.

 IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)

 IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)

(500)
0

200
1

100
2

(200)
3

400
4

300
5

 IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
1

(500)
0

200
1

100
2

(200)
3

400
4

300
5

 IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
1 2

(500)
0

200
1

100
2

(200)
3

400
4

300
5

 IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
1 2 3

(500)
0

200
1

100
2

(200)
3

400
4

300
5

Summary Problem
Enter the cash flows only once. Find the IRR. Using a discount rate of 15%, find NPV. Add back IO and divide by IO to get PI.

(900)
0

300
1

400
2

400
3

500
4

600
5

Summary Problem
IRR = 34.37%. Using a discount rate of 15%, NPV = Rs.510.52. PI = 1.57. (900)
0

300
1

400
2

400
3

500
4

600
5

Modified Internal Rate of Return (MIRR)

IRR assumes that all cash flows are reinvested at the IRR. MIRR provides a rate of return measure that assumes cash flows are reinvested at the required rate of return.

MIRR Steps:
Calculate the PV of the cash outflows.
Using the required rate of return.

Calculate the FV of the cash inflows at the last year of the projects time line. This is called the terminal value (TV).
Using the required rate of return.

MIRR: the discount rate that equates the PV of the cash outflows with the PV of the terminal value, ie, that makes: PVoutflows = PVinflows

MIRR
Using our time line and a 15% rate: PV outflows = (900) FV inflows (at the end of year 5) = 2,837. MIRR: FV = 2837, PV = (900), N = 5 solve: I = 25.81%.

(900)

300

400

400

500

600

MIRR
Using our time line and a 15% rate: PV outflows = (900) FV inflows (at the end of year 5) = 2,837. MIRR: FV = 2837, PV = (900), N = 5 solve: I = 25.81%. Conclusion: The projects IRR of 34.37%, assumes that cash flows are reinvested at 34.37%.

MIRR

Using our time line and a 15% rate: PV outflows = (900) FV inflows (at the end of year 5) = 2,837. MIRR: FV = 2837, PV = (900), N = 5 solve: I = 25.81%. Conclusion: The projects IRR of 34.37%, assumes that cash flows are reinvested at 34.37%. Assuming a reinvestment rate of 15%, the projects MIRR is 25.81%.