Capital Budgeting

1. CAPITAL BUDGETING
DECISION RULES
MICHAEL A. ALONZO
MBA 518 Managerial Economics
Southern Luzon State University

2. DECISION RULES
An economically sound capital budgeting decision rule
must consistently lead to the acceptance of projects that
will increase the value of the firm.
When Net Present Value (NPV) is used to make accept–
reject decisions, the decision criteria are as follows:
• If the NPV is greater than 0, accept the project.
• If the NPV is less than 0, reject the project.
If the NPV is greater than 0, the firm will earn a return
greater than its cost of capital.

3. COST OF CAPITAL
Cost of capital represents the firm’s cost of
financing and is the minimum rate of return that
a project must earn to increase firm value.

4. NET PRESENT VALUE
FORMULA
CF0 - project’s initial investment (outflows)
CFt - cash inflows
r - discount rate equal to the firm’s cost of capital.

5. ILLUSTRATION:
We can illustrate the net present value (NPV)
approach by using the Bennett Company data
presented in Table 10.1. If the firm has a 10%
cost of capital, the net present values for
projects A (an annuity) and B (a mixed stream)
can be…

7. DECISION?
Calculated as shown on the time lines. These
calculations result in net present values for
projects A and B of $11,071 and $10,924,
respectively. Both projects are acceptable,
because the net present value of each is greater
than $0. If the projects were being
ranked, however, project A would be
considered superior to B, because it has a
higher net present value than that of B ($11,071
versus $10,924).

8. Manual?
Nope! We can always use
the technology!

9. SAMPLE PROBLEM: Find the
NPV.

10. PFIV
Present-Value Interest Factor
PFIV = 1
(1+r)n
r = cost of capital; discount rate
n= no. of years

11. Profitability Index or
Benefit/Cost Ratio Analysis (PI)
The PI shows the relative profitability of any project, or
the present value of benefits per dollar of cost.

12. DECISION MAKING
• PI > 1 implies desirable investment
• IF NPV > 0 then PI > 1
• A project with PI > 1 - accept
• a project with PI < 1 - reject

13. PI = (NPV/PV of outflows) + 1
This means that the capital investment project
returns $1.38 in cash inflows for each dollar
of cash outflow, when both figures are
expressed in present-value terms.

14. INTERNAL RATE OF RETURN
• The IRR is the discount rate that equates the
NPV of an investment opportunity with
$0 (because the present value of cash inflows
equals the initial investment).
• Because the net present-value equation is
complex, it is difficult to solve for the actual
internal rate of return on an investment without
a computer or sophisticated calculator.

15. DECISION CRITERIA
• If the IRR is greater than the cost of capital (r),
accept the project.
• If the IRR is less than the cost of capital(r),
reject the project.

16. ILLUSTRATION:

17. Payback Period Analysis
Payback Period = Number of Years to Recover Investment
DECISION CRITERIA
When the payback period is used to make accept–reject
decisions, the following decision criteria apply:
• If the payback period is less than the maximum
acceptable payback period, accept the project.
• If the payback period is greater than the maximum
acceptable payback period, reject the project.
The length of the maximum acceptable payback period is
determined by management.

18. • PAYBACK PERIOD = INITIAL INVESTMENT/ANNUAL CASH INFLOW(for annuity)

19. THE END
MICHAEL A. ALONZO
MBA 518 Managerial Economics
Southern Luzon State University