Capital Budgeting Decision Rules

Slides:



Advertisements
Similar presentations
Chapter Outline 6.1 Why Use Net Present Value?
Advertisements

Net Present Value and Other Investment Rules Chapter 5 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.
McGraw-Hill/Irwin Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.
Chapter 9 - Capital Budgeting Decision Criteria. Capital Budgeting: The process of planning for purchases of long- term assets.  For example: Suppose.
McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 6-0 CHAPTER 6 Some Alternative Investment Rules.
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies,
9-0 Chapter 9: Outline Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability.
Intro to Financial Management Capital Budgeting. Review Homework Cost of bonds –Use net proceeds –Use after-tax cost Cost of common stock –Use net proceeds.
Key Concepts and Skills
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Chapter McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 9 Net Present Value and Other Investment Criteria.
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 9 Net Present Value and Other Investment Criteria.
Chapter McGraw-Hill Ryerson © 2013 McGraw-Hill Ryerson Limited 9 Prepared by Anne Inglis Net Present Value and Other Investment Criteria.
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 0 Chapter 8 Net Present Value and Other Investment Criteria.
B280F Introduction to Financial Management
T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization 9.1Net Present Value 9.2The Payback Rule 9.3The Average.
Drake DRAKE UNIVERSITY Fin 200 NPV IRR and Capital Budgeting.
Ch9. The Basic of Capital Budgeting Goal: To understand the advantage and disadvantage in different investment analyzing tools Tool: - Net Present Value.
CapitalBudgeting Payback Net present value (NPV)
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 9 Net Present Value and Other Investment Criteria.
McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 6-0 CHAPTER 6 Some Alternative Investment Rules.
Net Present Value and Other Investment Criteria
0 Net Present Value and Other Investment Criteria.
Chapter 9 INVESTMENT CRITERIA Pr. Zoubida SAMLAL GF 200.
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. NPV, Internal Rate of Return (IRR), and the Profitability Index.
© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter Nine.
1 Chapter 12 The Basics of Capital Budgeting: Evaluating Cash Flows.
GBUS502 Vicentiu Covrig 1 The basics of capital budgeting (chapter 11) Should we build this plant?
Key Concepts and Skills
© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter 9.
CHAPTER 10 The Basics of Capital Budgeting Omar Al Nasser, Ph.D. FIN
Capital Budgeting Evaluation Technique Pertemuan 7-10 Matakuliah: A0774/Information Technology Capital Budgeting Tahun: 2009.
T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization 9.1Net Present Value 9.2The Payback Rule 9.3The Discounted.
Chapter 9 Net Present Value and Other Investment Criteria
Chapter 9 Net Present Value and Other Investment Criteria
© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter Nine.
Chapter 10: The Basics Of Capital Budgeting. 2 The Basics Of Capital Budgeting :
Good Decision Criteria
9-0 Net Present Value and Other Investment Criteria Chapter 9 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.
1 Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows.
Some Alternative Investment Rules
The Capital Budgeting Decision Chapter 12. Chapter 12 - Outline What is Capital Budgeting? 3 Methods of Evaluating Investment Proposals Payback IRR NPV.
10-1 CHAPTER 11 The Basics of Capital Budgeting Should we build this plant?
Ch10. The Basic of Capital Budgeting Goal: To understand the advantage and disadvantage in different investment analyzing tools Tool: - Net Present Value.
©2012 McGraw-Hill Ryerson Limited 1 of 45 Learning Objectives 1.Define capital budgeting decisions as long-run investment decisions. (LO1) 2.Explain that.
13-1 Agenda for 30 July (Chapter 9) Assessment of various commonly used methods for deciding how capital is to be allocated. Net Present Value (NPV) The.
Net Present Value and Other Investment Criteria By : Else Fernanda, SE.Ak., M.Sc. ICFI.
Basics of Capital Budgeting. An Overview of Capital Budgeting.
0 Corporate Finance Ross  Westerfield  Jaffe Seventh Edition 6 Chapter Six Some Alternative Investment Rules.
Net Present Value and Other Investment Rules Chapter 5.
Other Criteria for Capital Budgeting Text: Chapter 6.
DMH1. 2 The most widely accepted objective of the firm is to maximize the value of the firm. The financial management is largely concerned with investment,
Professor XXXXX Course Name / Number
Key Concepts and Skills
Chapter Outline 6.1 Why Use Net Present Value?
16BA608/FINANCIAL MANAGEMENT
CAPITAL BUDGETING PROCESSES AND TECHNIQUES Dr.Rachanaa Datey
The Basics of Capital Budgeting
TECHNIQUES IN CAPITAL BUDGETING
Net Present Value and Other Investment Rules
Capital Budgeting Techniques FHU3213
The Basics of Capital Budgeting: Evaluating Cash Flows
The Basics of Capital Budgeting
Chapter 11 Investment Decision Criteria
Ch. 8: Net Present Value and Other Investment Criteria
Chapter 7 - Capital Budgeting Decision Criteria
Capital-Budgeting Techniques.
IMPORTANT: In order to view the correct calculator key stroke symbols within this PPT, you will need to follow the font installation directions on this.
Net Present Value (NPV) and Other Investment Rules
Presentation transcript:

Capital Budgeting Decision Rules NPV IRR MIRR Profitability Index Payback Discounted Payback

Net Present Value A. Calculation B. Decision Rule C. Interpretation Forecast the incremental cash flow generated by the project Determine the discount rate; which represents the opportunity cost of capital Calculate the present value of all cash flows Add discounted values and subtract the investments initial costs B. Decision Rule Accept projects with NPV > 0 C. Interpretation The NPV of an investment is the difference between its market value and its cost.

The Internal Rate of Return (IRR) A. Calculation IRR is the discount rate which makes NPV = 0. Is calculated by iterations or computer. B. Decision Rule Accept projects with IRR greater than the opportunity cost of capital. C. Interpretation The IRR is the discount rate that makes the estimated NPV of an investment equal to zero. Why might people prefer to think about the capital budgeting decision in terms of an interest rate rather than a present value?

NPV Illustrated (Calculation) 1 2 Initial outlay ($1,100) Revenues $1,000 Expenses 500 Cash flow $500 Revenues $2,000 Expenses 1,000 Cash flow $1,000 – $1,100.00 +454.54 +826.45 +$180.99 1 $500 x 1.10 1 $1,000 x 1.10 2 NPV

Internal Rate of Return Illustrated Initial outlay = -$1100 Year Cash flow 1 500 2 1000 Find the IRR such that NPV = 0 500 1000 0 = -1100 + + (1+IRR)1 (1+IRR)2 500 1000 1100 = + (1+IRR)1 (1+IRR)2

NPV Illustrated (concluded) 1 2 Initial outlay ($1,100) Revenues $1,000 Expenses 500 Cash flow $500 Revenues $2,000 Expenses 1,000 Cash flow $1,000 – $1,100.00 +414.10 +658.90 $0.00 1 $500 x 1.207448 1 $1,000 x 1.2074482 NPV

NPV using a Financial Calculator CF 2nd CLR Work CF0 = -1100 ENTER C01 = 500 ENTER F01 = 1 ENTER C02 = 1000 ENTER F02 = 1 ENTER NPV I = 10 ENTER CPT $180.99 The cash flow registers have the same information as the NPV analysis. IRR CPT 20.74 %

Excel Calculations (double click on Excel Sheet)

Modified Internal Rate of Return (MIRR) MIRR is the discount rate which causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at cost of capital. Thus, MIRR assumes cash inflows are reinvested at cost of capital.

MIRR Illustrated (I require to earn at least 10 percent on my investment, do the cash flows provide at least this much in return?) 1 2 Initial outlay ($1,100) Revenues $1,000 Expenses 500 Cash flow $500 Revenues $2,000 Expenses 1,000 Cash flow $1,000 Terminal Value: Positive Cash Flows $500 x 1.10 1 550 1550 PV outflows TV inflows TV PV = (1 + MIRR) 2 1550 1100 = (1 + MIRR) 2

Excel Calculations (double click on Excel Sheet)

It measures the “bang for the buck.” Profitability Index The profitability index (PI) is the present value of future cash flows divided by the initial cost. It measures the “bang for the buck.” PV future CF PI = Initial Cost

PI Illustrated (Calculation) 1 2 Initial outlay ($1,100) Revenues $1,000 Expenses 500 Cash flow $500 Revenues $2,000 Expenses 1,000 Cash flow $1,000 Initial Cost +454.54 +826.45 +$1280.99 1 $500 x 1.10 1 $1,000 x 1.10 2 PV of future CF 1,280.99 PV future CF PI = = = 1.1645 Initial Cost 1,100.00

Payback Rule A. Calculation: The number of years for the project to return its investment. B. Decision rule Accept projects with payback less than some specified period C. Interpretation The payback period is the length of time until the sum of an investment’s cash flows equals its cost. (This does not imply that additional flows are profit.) D. Advantages Simple to calculate E. Disadvantages Does not allow for time value of money Ignores cash flows after cutoff date Does not consider the risk of the project

Payback Rule Illustrated 1 year and 600/1000 of the second years CFs 1. 6 years payback period. If this is less than the cut-off period, the project is acceptable.

Discounted Payback Rule Illustrated 1 year and 645.46/826.45 of the second years CFs 1. 78 years discounted payback period. If this is less than the cut-off period, the project is acceptable.

Excel Calculations (double click on Excel Sheet)

Net Present Value (NPV) and Internal Rate of Return (IRR) Advantages of NPV Correctly accounts for time value of money Incorporates the risk-adjusted discount rate Always gives the correct accept/reject decision Disadvantages of NPV None - (Unless if a preference by individuals toward another method is considered a disadvantage) Advantages of IRR Easy to understand and compare with other projects. Gives the same accept/reject decisions as NPV for projects that are (1) independent and (2) have conventional cash flows. Disadvantages of IRR Assumes reinvestment of cash flows at IRR Sometimes no IRR exists Does not differentiate between borrowing and lending Can have more than one IRR. Can give the wrong decision when comparing mutually exclusive problems. Can incorrectly rank projects Cannot consider changing interest rate expectations

Sometimes no IRR exists.

IRR does not differentiate between borrowing and lending (Example 1).

IRR does not differentiate between borrowing and lending (Example 2)

Can have more than one IRR

Problems in Ranking Mutually Exclusive Projects Problems in Ranking Mutually Exclusive Projects. Mutually exclusive means that either A or B may be taken, but not both.