Chapter 8 – Capital Budgeting Decision Models  Learning Objectives  Differentiate between short term and long term capital budgeting models  Apply the three basic decision models  Payback  NPV  IRR  Calculate cross-over rates  Use modified decision models  Know the strength and weaknesses of each model

Short-term versus Long-term  Short-term decisions  In general, repetitive decisions  Low cost impacts  Long-Term decisions  Capital budgeting decisions  Impacts over many years  Difference  Time  Cost  Degree of Information

Payback Period  First and easiest model of capital budgeting  Answers the question, how soon will I get my money back?  Key Features  Need amount and timing of cash flow  Not concerned with cash flows after repayment  Ad hoc cutoff date for repayment

Payback Period  Clinko Copiers (example 8.1)  Initial investment is $5,000  Positive cash flow each year  Year 1 -- $1,500  Year 2 -- $2,500  Year 3 -- $3,000  Year 4 -- $4,500  Year 5 -- $5,500  Payback in 2 and 1/3 rd years…ignore years 4 and 5 cash flows

Payback Period  Strengthens  Easy to apply  Initial cash flows most important  Good for small dollar investments  Weaknesses  Ignores cash flow after cutoff period  Ignores time value of money  Corrections  Discount cash flow

Discounted Payback Period  Attempt to correct one flaw of Payback Period…time value of money  Discount cash flow to present and see if the discount cash flow are sufficient to cover initial cost within cutoff time period  Careful in consistency  Discounting means cash flow at end of period  Appropriate discount rate for cash flow

Discounted Payback Period  Discounted Cash Flow of Copiers A & B  Discounted at 6% (APR)  Both 3 year discounted paybacks with annual cash flow  Copier A – 26 months with monthly cash flow  Copier B – 29 months with monthly cash flow  Potential for poor choice  Large late positive cash flow  Longer positive cash flow

Net Present Value (NPV)  Correction to discounted cash flow  Includes all cash flow in decision  Changes decision (go vs. no-go) to dollars, not arbitrary cutoff period  The Decision Model (a.k.a. Discounted Cash Flow Model)  Need all cash flow  Need appropriate discount rate

Net Present Value (NPV)  Decision  Accept all positive NPVs  Reject all negative NPVs  Copier Example  Copier A – NPV is $5, – Accept  Copier B – NPV is $9, – Accept  Model good for comparing projects  Select project with highest NPV  Can assign different discount rates to projects

Net Present Value (NPV)  The Decision Model  Incorporates risk and return  Incorporates time value of money  Incorporates all cash flow

Internal Rate of Return (IRR)  Model closely resembles NPV but…  Finding the discount rate (internal rate) that implies an NPV of zero  Internal rate used to accept or reject project  If IRR > hurdle rate, accept  If IRR < hurdle rate, reject  Very popular model as “managers” like the single return variable when evaluating projects

Internal Rate of Return (IRR)  Process difficult without calculator or spreadsheet – iterative process  Need timing and amount of cash flows  Popcorn Machine (Example 8.4)  Grannies IRR is 19.86%  Kettle Corn IRR is 20.35%  Packaging Machine IRR is 14.91%  Decision Rule  Requires hurdle rate for comparison  Accept all with IRR > Hurdle Rate

Internal Rate of Return (IRR)  Some problems with IRR  Cross-over Rates flip projects  Using NPV profiles, project choice changes at cross-over rate so need to know both hurdle rate and cross-over rate  Cross-over rate is where two projects have same NPV  Multiple IRRs  Projects with changing cash flows can have multiple IRRs  Which is the correct IRR? Don’t know  Risk of Project is not included  IRR calculation void of risk of project  Risk must be implied with different hurdle rates

Modified IRR  Major assumption of IRR is that all cash flow can be reinvested at IRR rate…  Alternative (and better) assumption is that all cash flow can be reinvested at hurdle rate  MIRR  Find future value of all cash inflow at hurdle rate  Find present value of cash outflow  Find interest rate that equates future values with present value  Adjust comparison projects for differences in the time horizon

Profitability Index (PI)  Modified version of NPV  Decision Criteria  PI > 1.0, accept project  PI < 1.0, reject project

Profitability Index (PI)  Close to NPV as we calculate present value of future positive cash flows (present value of benefits) and initial cash flow (present value of costs)  PI = (NPV + Initial cost) / Initial Cost  Answer is modified return  Choosing between two different projects?  Higher PI is best choice…  Careful, cannot scale projects up and down

Profitability Index (PI)  Example of Large Copier and Mini-Copier (page 247)  Large Copier B PI is 2.85 (normal level of risk)  Mini Copier PI is 2.95  Pick Mini Copier  Problem with copier choice  Original investment in mini-copier only $500  Original investment in Copier B is $5,000  Need to buy 10 mini-copiers to match production of Copier B…

Problems  Problem 6 – Payback & Discounted Period  Problem 8 – Net Present Value  Problem 12 – Internal Rate of Return & Modified Internal Rate of Return  Problem 16 – Profitability Index  Problem 20 – NPV Profile of Project