Published by: ALJOHN SEBUC 102716

2. Capital budgeting – is the process of planning
for purchases of long – term assets.
Capital Budgeting
Decision Criteria
 The Payback Period
 Net Present Value
 Profitability Index
 Internal Rate of Return

4.  The number of years needed to recover the
initial cash outlay.
 How long will it take for the project to
generate enough cash to pay for itself?
 RULE:
If payback is ≤ maximum acceptable payback period, ACCEPT
If payback is > maximum acceptable payback period, REJECT
= Initial InvestmentPayback Period
Average Annual Cash Inflow
It is calculated as:

5. Alaskan Lumber is considering the
purchase of a band saw that costs
$50,000 and which will generate
$10,000 per year of net cash flow.
Alaskan is also considering the
purchase of a conveyor system for
$36,000, which will reduce saw mill
transport costs by $12,000 per year. If
Alaskan only has sufficient funds to
invest in one of these projects, and if it
were only using the payback method as
the basis for its investment decision, it
would buy the conveyor system, since it
has a shorter payback period.
EXAMPLE 1:
= Initial InvestmentPayback Period
Average Annual Cash Inflow
(for band saw)
A
= $50,000/$10,000
= 5.0 years, payback
period for this
capital investment.
(for conveyor system)
B
= $36,000/$12,000
= 3.0 years, , payback
period for this capital
investment.

6. Year Cash Flow
0 -1000
1 500
2 400
3 200
4 200
5 100
The calculation of
the Payback Period
is best illustrated
with an example.
Consider Capital
Budgeting project
A which yields the
following cash
flows over its five
year life.
EXAMPLE 2:

7. Year Cash Flow Net Cash Flow
0 -1000 -1000
1 500 -500
2 400 -100
3 200 100
4 200 300
5 100 400
To begin the calculation of the Payback
Period for project A let's add an additional column
to the above table which represents the Net Cash
Flow (NCF) for the project in each year.

8. Notice that after two years the Net Cash
Flow is negative (-1000 + 500 + 400 = -100)
while after three years the Net Cash Flow is
positive (-1000 + 500 + 400 + 200 = 100). Thus
the Payback Period, or breakeven point,
occurs sometime during the third year. If we
assume that the cash flows occur regularly
over the course of the year, the Payback
Period can be computed using the following
equation:
Payback Period = 2 + (100)/(200) = 2.5 yearsrs

9. ADVANTAGES
Uses Free Cash Flows
Is Easy To Calculate And Understand
May Be Use As Rough Screening Device
DISADVANTAGES
Ignores The Time Value Of Money
Ignores Free Cash Flows Occurring After The
Payback Period
Selection Of The Maximum Acceptable Payback
Period Is Arbitrary

11. It determines how long it takes an
investment to recover its costs.
It’s similar to a simple payback, but a
discounted payback period accounts for
money’s time value.
It’s more precise estimate of when
investors will recover their total
investment.

13.  Table 10-2 shows the difference
between traditional payback and
discounted payback methods.
 With undiscounted free cash flows,
the payback period is only 2 years
while with discounted free cash flows
(at 17%), the discounted payback
period is 3.07 years.
Discounted Payback
Period Example

14. Uses Free Cash Flows
Is Easy To Calculate And Understand
Considers time value of money
DISADVANTAGES
Ignores free cash flows occurring after the
discounted payback period
Selection Of The Maximum Acceptable
Payback Period Is Arbitrary
ADVANTAGES

16. DECISION RULE:
 If NPV is positive, ACCEPT
 If NPV is negative, REJECT
where
• CFt = the cash flow at time t
and
• r = the cost of capital.

17. The example below illustrates the
calculation of Net Present Value. Consider
Capital Budgeting projects A and B which
yield the following cash flows over their five
year lives. The cost of capital for the project is
10%.
Year Cash Flow Net Cash Flow
0 -1000 -1000
1 500 100
2 400 200
3 200 200
4 200 400
5 100 700

19. Uses Free Cash Flows
Recognizes the time value of money
Is consistent with the firm’s goal of
shareholder wealth maximization
DISADVANTAGES
Requires detailed long-term forecasts of a
project’s free cash flows
Sensitivity to the choice of the discount rate
ADVANTAGES

21. Profitability Index, divides the projected capital
inflow by the projected capital outflow to
determine the profitability of a project.
DECISION RULE:
 If PI is greater or equal to 1, ACCEPT
 If PI is less than 1, REJECT
PI = PV of FCF/Initial outlay

22.  A firm with a 10% required rate of
return is considering investing in a
new machine with an expected life
of six years. The initial cash outlay
is $50,000.
EXAMPLE:

23. FCF PVF @ 10% PV
Initial Outlay –$50,000 1.000 –$50,000
Year 1 15,000 0.909 13,636
Year 2 8,000 0.826 6,612
Year 3 10,000 0.751 7,513
Year 4 12,000 0.683 8,196
Year 5 14,000 0.621 8,693
Year 6 16,000 0.564 9,032

24. PI = ($13,636 + $6,612+$7,513 + $8,196
+ $8,693+ $9,032) / $50,000
= $53,682/$50,000
= 1.0736
Project’s PI is greater than 1. Therefore,
accept.

25. Uses Free Cash Flows
Recognizes the time value of money
Is consistent with the firm’s goal of
shareholder wealth maximization
DISADVANTAGES
Requires detailed long-term forecasts of a
project’s free cash flows
ADVANTAGES

27. The return on the firm’s
invested capital. IRR is simply the
rate of return that the firm earns
on its capital budgeting projects.
DECISION RULE:
 If IRR is greater or equal to the
required rate of return, ACCEPT
 If IRR is less than the required rate
of return, REJECT
 IRR is the discount rate that equates the
present value of a project’s future net cash
flows with the project’s initial cash outlay.

29. Uses Free Cash Flows
Recognizes the time value of money
Is in general consistent with the firm’s goal of
shareholder wealth maximization.
DISADVANTAGES
Requires detailed long-term forecasts of a
project’s free cash flows
Possibility of multiple IRRs
Assumes cash flows over the life of the project
are reinvested at the IRR
ADVANTAGES

30.  Initial Outlay: $3,817
 Cash flows: Yr.1=$1,000, Yr. 2=$2,000,
Yr. 3=$3,000
Discount rate NPV
15% $4,356
20% $3,958
22% $3,817
 IRR is 22% because the NPV equals the
initial cash outlay at that rate.
EXAMPLE:

31. FCF PVF @ 15% PV
Initial Outlay –$3,817
Year 1 $1,000 .870 $ 870
Year 2 2,000 .756 1,512
Year 3 3,000 .658 1,974
Present value of
inflows
$4,356
Initial outlay -$3,817

32. FCF PVF @ 20% PV
Initial Outlay –$3,817
Year 1 $1,000 .833 $ 833
Year 2 2,000 .694 1,388
Year 3 3,000 .579 1,737
Present value of
inflows
$3,958
Initial outlay -$3,817

33. FCF PVF @ 22% PV
Initial Outlay –$3,817
Year 1 $1,000 .820 $ 820
Year 2 2,000 .672 1,344
Year 3 3,000 .551 1,653
Present value of
inflows
$3,817
Initial outlay -$3,817

34. The discount rate that equates the present value of the
project’s cash outflows with the present value of the
project’s terminal value.
ADVANTAGES
• Use free cash flows
• Recognizes the time value of money
• In general, is consistent with the goal of maximization of
shareholder wealth
DISADVANTAGES
• Requires detailed long- term forecasts of a project’s free cash
flows

35. Modified IRR allows the decision maker to
directly specify the appropriate reinvestment rate.
DECISION RULE:
 If MIRR is ≥ to the required rate of return, ACCEPT
 If MIRR is < to the required rate of return, REJECT

36. FCF
Initial Outlay –$6,000
Year 1 $2,000
Year 2 3,000
Year 3 4,000
 Project having a 3 year life and a
required rate of return of 10% with the
following cash flows:
EXAMPLE:

37.  Step 3: Determine the discount rate that
equates to the PV of the terminal value
and the PV of the project’s cash outflows.
MIRR = 17.446%. It is greater than required
rate of return so Accept.
 Step 1: Determine the PV of the project’s
cash outflows. $6,000 is already at present.
 Step 2: Determine the terminal value of the
project’s free cash flows. To do this use the
project’s required rate of return to calculate
the FV of the project’s three cash flows of the
project’s cash outflows. They turn out to be
$2,420 + $3,300 + $4,000 = $9,720 for the
terminal value.

39. Calculation:
6000 =
$2,000 1+.10 2+$3,000 1+.10 1+$4,000 1+.10 ^0
(1+𝑀𝐼𝑅𝑅)^3
6000 =
$2,420+$3,300+$4,000
(1+𝑀𝐼𝑅𝑅)^3
6000 =
$9,720
(1+𝑀𝐼𝑅𝑅)^3
MIRR = 17.446%

41.  Ethics play a role in capital budgeting
 Any actions that violate ethical
standards can have a negative impact
on the image of the firm and
consequently, future cash flows.
Ethics in Capital Budgeting