1. 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

2. 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?

3. 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) = 0

4. 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

5. 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

6. 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

7. 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!

8. 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

9. 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