1. Chapter 7 - Capital Budgeting Decision Criteria

2. Capital Budgeting: The process of planning for purchases of long-term assets.
For example: Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide?
Will the machine be profitable?
Will our firm earn a high rate of return on the investment?

3. Decision-making Criteria in Capital Budgeting
How do we decide if a capital investment project should be accepted or rejected?

4. 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, and
c) incorporate the required rate of return on the project.

5. Payback Period
How long will it take for the project to generate enough cash to pay for itself?

6. Payback Period
How long will it take for the project to generate enough cash to pay for itself? 1 2 3 4 5 8 6 7
(500)

7. Payback Period
How long will it take for the project to generate enough cash to pay for itself? 1 2 3 4 5 8 6 7
(500)
Payback period = years

8. 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 cut-off of 5 years for projects like ours, what would be our decision?
Accept the project.

9. 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 project’s cash flows.

10. Drawbacks of Payback Period
Does not consider all of the project’s cash flows.
Consider this cash flow stream! 1 2 3 4 5 8 6 7
(500)

11. Drawbacks of Payback Period
Does not consider all of the project’s cash flows.
This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! 1 2 3 4 5 8 6 7
(500)

12. Discounted Payback
Discounts the cash flows at the firm’s 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.

13. Discounted Payback Discounted Year Cash Flow CF (14%) 0 -500 -500.00 11 2 3 4 5
(500)
Discounted
Year Cash Flow CF (14%)

14. Discounted Payback Discounted Year Cash Flow CF (14%) 0 -500 -500.00 11 2 3 4 5
(500)
Discounted
Year Cash Flow CF (14%)
year
280.70

15. Discounted Payback Discounted Year Cash Flow CF (14%) 0 -500 -500.00 11 2 3 4 5
(500)
Discounted
Year Cash Flow CF (14%)
year
280.70

16. Discounted Payback Discounted Year Cash Flow CF (14%) 0 -500 -500.00 11 2 3 4 5
(500)
Discounted
Year Cash Flow CF (14%)
year
280.70
years
88.33

17. Discounted Payback Discounted Year Cash Flow CF (14%) 0 -500 -500.00 11 2 3 4 5
(500)
Discounted
Year Cash Flow CF (14%)
year
280.70
years
88.33

18. Discounted Payback Discounted Year Cash Flow CF (14%) 0 -500 -500.00 11 2 3 4 5
(500)
Discounted
Year Cash Flow CF (14%)
year
280.70
years
88.33
years

19. The Discounted Payback1 2 3 4 5
(500)
Discounted
Year Cash Flow CF (14%)
year
280.70
years
88.33
years
The Discounted Payback
is 2.52 years

20. Other Methods 1) Net Present Value (NPV) 2) Profitability Index (PI)
3) Internal Rate of Return (IRR)
Consider each of these decision-making criteria:
All net cash flows.
The time value of money.
The required rate of return.

21. S NPV = - IO Net Present Value FCFt (1 + k)
NPV = the total PV of the annual net cash flows - the initial outlay.
NPV = IO
FCFt
(1 + k) t n
t=1 S

22. Net Present Value
Decision Rule:
If NPV is positive, accept.
If NPV is negative, reject.

23. NPV Example
Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15%.

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

25. Net Present Value
NPV is just the PV of the annual cash flows minus the initial outflow.
Using TVM:
P/Y = N = I = 15
PMT = 100,000
PV of cash flows = $335,216
- Initial outflow: ($250,000)
= Net PV $85,216

26. NPV with the HP10B: -250,000 CFj 100,000 CFj 5 shift Nj 15 I/YR
shift NPV
You should get NPV = 85,

27. NPV with the HP17BII: Select CFLO mode. FLOW(0)=? -250,000 INPUT
#TIMES(1)= INPUT EXIT
CALC I% NPV
You should get NPV = 85,215.51

28. NPV with the TI BAII Plus:
Select CF mode.

29. NPV with the TI BAII Plus:
Select CF mode.
CFo=? ,000 ENTER

30. NPV with the TI BAII Plus:
Select CF mode.
CFo=? ,000 ENTER
C01=? ,000 ENTER

31. NPV with the TI BAII Plus:
Select CF mode.
CFo=? ,000 ENTER
C01=? ,000 ENTER
F01= ENTER

32. NPV with the TI BAII Plus:
Select CF mode.
CFo=? ,000 ENTER
C01=? ,000 ENTER
F01= ENTER
NPV I= ENTER

33. NPV with the TI BAII Plus:
Select CF mode.
CFo=? ,000 ENTER
C01=? ,000 ENTER
F01= ENTER
NPV I= ENTER CPT

34. NPV with the TI BAII Plus:
Select CF mode.
CFo=? ,000 ENTER
C01=? ,000 ENTER
F01= ENTER
NPV I= ENTER CPT
You should get NPV = 85,215.51

35. Profitability Index

36. Profitability Index
NPV = IO
FCFt
(1 + k) t n
t=1 S

37. S S NPV = - IO FCFt (1 + k) FCFt PI = IO (1 + k) Profitability Index n

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

39. 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

40. Internal Rate of Return (IRR)
IRR: The return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

41. Internal Rate of Return (IRR)

42. Internal Rate of Return (IRR)
NPV = IO
FCFt
(1 + k) t n
t=1 S

43. Internal Rate of Return (IRR)
NPV = IO
FCFt
(1 + k) t n
t=1 S n
t=1 S
IRR: = IO
FCFt
(1 + IRR) t

44. Internal Rate of Return (IRR)S
IRR: = IO
FCFt
(1 + IRR) t
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.

45. 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

46. 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%!

47. 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.

48. 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. ( )

49. 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) (200)

50. 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) (200) 1

51. 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) (200)

52. 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) (200)

53. 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)

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

55. 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.

56. 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 project’s time line. This is called the terminal value (TV).
MIRR: the discount rate that equates the PV of the cash outflows with the PV of the terminal value, ie, that makes:
PVoutflows = PVinflows

57. 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)

58. 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 project’s IRR of 34.37% assumes that cash flows are reinvested at 34.37%.

59. 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 project’s IRR of 34.37% assumes that cash flows are reinvested at 34.37%.
Assuming a reinvestment rate of 15%, the project’s MIRR is 25.81%.