Capital Budgeting Techniques One of the most important jobs of the Financial Manager is to set up decision rules for choosing capital investments The Rules Payback Period Profitability Index (modified NPV) Internal Rate of Return Net Present Value

Capital Budgeting First and Easiest Decision Model – PAYBACK PERIOD Just determine how long until you get your money back Problem 1 – simple with annuity stream What are the drawbacks to this Ignores Some of the Cash Flows Ignores Time Value of Money Still Used in Industry…Why?

Capital Budgeting Internal Rate of Return, a popular choice The implied yield (or return) on a project that equates the benefits with the costs Decision Rule…if IRR is greater than the hurdle rate project is a go Set up cash flows such that the present value of all inflows and outflows equal zero…solve for r CF0/(1+k)0 + CF1/(1+k)1 + CF2(1+k)2+ ... = 0

Capital Budgeting Example of IRR Some Problems with IRR Problem number #9 Trial and Error for Projects A and D Annuity Streams for projects B and C Using calculator CF functions… Some Problems with IRR standard cash flows mutually exclusive projects, cross-over rate Problem #10 - practice

Capital Budgeting The most important decision rule for choosing capital investments The Rule NET PRESENT VALUE (NPV) Appropriate discounting of all cash flows Discount rate is “given” Compare all projects Fundamentally sound

Capital Budgeting NPV Cash Flows must be estimated Appropriate discount rate used Example, problem # 7 with NPV Rule setting up as a TVM equation with annuities for A using CF function of calculator Mutually exclusive projects? Answer is most money (highest NPV) Problem 5, practice problem

Capital Budgeting Certainty Equivalents Risk Adjusted Discount Rates Just another way to put in a risk factor Now you simple discount at the risk free rate the new cash flows Value = -CE0 +CE1/(1+rf)1+ CE2/(1+rf)2+ CE3/(1+rf)3… Risk Adjusted Discount Rates We should always use the appropriate discount rate for the riskiness of the cash flows so this is redundant!

Capital Budgeting Look back at three potential decision rules Problem #13 (typical exam problem) Project Answers Payback Period three years 3.57 years (assumes steady cash flows) IRR 15.36% and is above hurdle rate NPV $9,080.60, positive so accept

Capital Budgeting Techniques Integration of Chapters 9 and 8 - Problem 18 Step One Determine the Appropriate Cash Flows Investment (Initial Costs) Benefits (future positive cash flows) Step Two Select Appropriate Risk Level Cost of capital (is the company average good?) Step Three Select Decision Rule NPV most appropriate Step Four Make Recommendation