MBA fin mgt Lecture 5 inv appraisal.pptx

Capital Budgeting Decision
Models

Learning Objectives
1. Explain capital budgeting and differentiate between short-term and long-term budgeting decisions.
2. Explain the payback model and its two significant weaknesses and how the discounted payback period
model addresses one of the problems.
3. Understand the net present value (NPV) decision model and appreciate why it is the preferred criterion
for evaluating proposed investments.
4. Calculate the most popular capital budgeting alternative to the NPV, the internal rate of return (IRR).
5. Understand the profitability index (PI) as a modification of the NPV model.
6. Compare and contrast the strengths and weaknesses of each decision model in a holistic way.

Capital budgeting techniques are grouped in two:
• a) Non-discounted cash flow techniques (traditional methods)
• Pay back period method(PBP)
• Accounting rate of return method(ARR)
• b) Discounted cash flow techniques (modern methods)
• Net present value method(NPV)
• Discounted payback period (DPBP)
• Internal rate of return method(IRR)
• Profitability index method(PI)

NON-DISCOUNTED CASH FLOW TECHNIQUES
Payback period
• Pay back period refers to the number of periods/ years that a
project will take to recoup its initial cash outlay. This technique
applies cash flows and not accounting profits.If the project
generates constant annual cash inflows, the Pay back period
will be given by,
• PBP=Initial Investment/ Annual cash flow

Payback
• Payback measures the time it will take to payback the initial cost of
the investment.
• This includes calculating the year and month in which it will be paid
back.
• Payback is the most commonly used by businesses due to its
simplicity. However, rarely used on its own.

Payback
• Very important to a business with cash flow problems
• Also if the business is investing in equipment that may become out-
of-date quickly.
• May be important if the business is run on external sources of
finance.

Payback example
• A company plans to buy a new
machine costing ¢500,000
• It will bring in new revenues of
¢100,000 the following year and
then ¢150,000 for each of the
following four years.
• There will maintenance costs of
• Year 3: ¢20,000
• Year 4: ¢30,000
• Year 5: ¢50,000
• How long will it take to repay the
initial investment?
Year Cash out Cash in Net Cash
Flow
0
1
2
3
4
5

Payback example
• A company plans to buy a new
machine costing ¢500,000
• It will bring in new revenues of
¢100,000 the following year and
then ¢150,000 for each of the next
four years.
• There will maintenance costs of
• Year 3: ¢20,000
• Year 4: ¢30,000
• Year 5: ¢50,000
• How long will it take to repay the
initial investment?
Flow
0 ¢500,000 0 (¢500,000)
1 ¢0 ¢100,000 ¢100,000
2 ¢0 ¢150,000 ¢150,000
3 ¢20,000 ¢150,000 ¢130,000
4 ¢30,000 ¢150,000 ¢120,000
5 ¢50,000 ¢150,000 ¢100,000

Payback example
Flow
0 ¢500,000 0 (¢500,000)
1 ¢0 ¢100,000 ¢100,000
2 ¢0 ¢150,000 ¢150,000
3 ¢20,000 ¢150,000 ¢130,000
4 ¢30,000 ¢150,000 ¢120,000
5 ¢50,000 ¢150,000 ¢110,000
Investment of ¢500,000 is paid back
in year 4
YEAR 1 + YEAR 2
¢100,000 + ¢150,000 = ¢250,000
YEAR 1
¢100,000
YEAR 1 + YEAR 2 + YEAR 3
¢100,000 + ¢150,000 = ¢130,000 = ¢380,000
YEAR 1 + YEAR 2 + YEAR 3 + YEAR 4
¢100,000 + ¢150,000 + ¢130,000 + ¢120,000 = ¢500,000
We determine the payback period by
calculating the cumulative next cash flow
until the initial outlay is paid off.

It’s never that easy!
• Most payback problems require you to calculate the specific month
of payback as well as the year.
• How do we do this?

Payback example: Machine A
Flow
0 ¢750,000 0 (¢750,000)
1 ¢7,500 ¢150,000 ¢142,500
2 ¢7,500 ¢200,000 ¢192,500
3 ¢7,500 ¢260,000 ¢252,500
4 ¢7,500 ¢260,000 ¢252,500
5 ¢7,500 ¢300,000 ¢292,000
Since the investment of ¢750,000 is
more than the cumulative net cash flow
in year 3 but less than in year 4, we
know that the investment is paid back
sometime in Year 4. On to step 2…
Step 1: Find the year of payback
Add up net cash flows year by year
until the cumulative net cash flow
exceeds the initial investment
YEAR 1
¢142,500
YEAR 1 + YEAR 2 + YEAR 3 + YEAR 4
¢142,500 + ¢192,500 + ¢252,500 + ¢252,500 = ¢840,000
YEAR 1 + YEAR 2 + YEAR 3
¢142,500 + ¢192,500 + ¢252,500 = ¢587,500
YEAR 1 + YEAR 2
¢142,500 + ¢192,500 = ¢335,000

Payback example: Machine A
Flow
0 ¢750,000 0 (¢750,000)
1 ¢7,500 ¢150,000 ¢142,500
2 ¢7,500 ¢200,000 ¢192,500
3 ¢7,500 ¢260,000 ¢252,500
4 ¢7,500 ¢260,000 ¢252,500
5 ¢7,500 ¢300,000 ¢292,000
Step 2: Find the month of payback
which the investment is paid back
a) Calculate remaining cash required
¢750,000 - ¢587,500 = ¢162,500
b) Divide remaining cash required
by net cash flow for that year
and multiply by 12
¢162,500
¢252,500
= 0.644 x 12 = 7.728
months
Payback period is 3 years and 8 months
c) Round up to next month
d) Add back the number of years
At end of year 3

Payback
• The shorter the payback period the less risk there is
involved in the project and the quicker the business
start to generate profit from the investment.

Disadvantages of payback
• Doesn’t take into account the business’ profitability.
• Doesn’t take into account additional cash inflow after the payback period
• Assumes steady inflows throughout the year.
Exam Help:
Try and think of payback in relation to the business, such as expected lifespan of
the project, seasonality and cash flow situation.

Activity
• Calculate payback period for Machine B
• Which is the best investment?

Average Rate of Return (ARR)
• Assesses the value of an investment by calculating the average annual
profit as a percentage of the initial investment cost.
• Therefore the formula is…

ARR formula
x 100
Average annual profit
Initial investment
Average
annual
profit
=
Number of years*
Total net cash flow
* The “life” of the asset

ARR example: Machine A
Flow
0 ¢750,000 0 (¢750,000)
1 ¢7,500 ¢150,000 ¢142,500
2 ¢7,500 ¢200,000 ¢192,500
3 ¢7,500 ¢260,000 ¢252,500
4 ¢7,500 ¢260,000 ¢252,500
5 ¢7,500 ¢300,000 ¢292,500
Step 1: Calculate average annual net
profit
Total net
cash flow
Life of the
asset
¢382,500
¢382,500
5
= = ¢76,500
Step 2: Divide average annual profit by
the initial investment and multiply by 100
¢76,500
¢750,000
X 100 = 10.2%

ARR for Machine B
Flow
0 £310,000 0 (£310,000)
1 £15,000 £125,000 £110,000
2 £15,000 £127,000 £112,000
3 £15,000 £140,000 £125,000
4 £15,000 £140,000 £125,000
5 £15,000 £130,000 £115,000
Step 1: Calculate average annual net
profit
Total net
cash flow
Life of the
asset
£277,000
5
= = £55,400
Step 2: Divide average annual profit by
the initial investment and multiply by 100
£55,400
£310,000
X 100 = 17.9%

ARR
• The higher the ARR the potentially profitable the investment.
• Allows easy comparison to other forms of investment like bank
interest rates.
• It can be easily compared to the current or target ROCE.

Disadvantage of ARR
• Doesn’t take timing of the cash flow into account

Activity
• Calculate ARR period for Machine B
• Which is the best investment?

Net Present Value (NPV)
• Takes into account the total return from an investment in today’s
terms.
• This is done using the
DISCOUNT FACTOR
The rate by which future cash flows are reduced to reflect the current
interest rates.

• An another advantage of NPV is that is takes into
account the
• This is the recognition of the fact that £1 today is
worth more than £1 in the future.
NPV
time value of money

Time value of money
• Suppose I have £10 today and I put that money in the bank for two
years at an interest rate 10%. How much will I end up with in 2012?
• £10 x 10% x 10% = £12.10
• Or more accurately,
• £10 x 1.1 x 1.1 = £12.10
• This is compound interest.
• A shorter formula for compound interest is (1+0.1)2

Discount factor
• How would I find out how much £12.10 in two years’
time is worth today?
• In effect, it is the reciprocal of the compound interest
formula
• And is known as the discount factor:
• = £12.10 x 1÷ (1+0.1)2 = £10.00
• = £12.10 x 0.826446 = £10.00

NPV Example: Machine A
Year Cash out Cash in Net Cash Flow Discount
factor
NPV
0 750,000 (750,000) 1.00 (750,000)
1 7,500 150,000 142,500 0.91 129,675
2 7,500 200,000 192,500 0.83 159,775
3 7,500 260,000 252,500 0.75 189,375
4 7,500 260,000 252,500 0.68 171,700
5 7,500 300,000 292,500 0.62 181,350
81,875
Net present value

NPV Example: Machine B
Year Cash out Cash in Net Cash Flow Discount
factor
NPV
0 310,000 (310,000) 1.00 (310,000)
1 15,000 125,000 110,000 0.91 100,100
2 15,000 127,000 112,000 0.83 92,960
3 15,000 140,000 125,000 0.75 93,750
4 15,000 140,000 125,000 0.68 85,000
5 15,000 130,000 115,000 0.62 71,300
133,110

Mutually Exclusive versus Independent Projects
NPV approach useful for independent as well as mutually exclusive projects.
A choice between mutually exclusive projects arises when:
1. There is a need for only one project, and both projects can fulfill that need.
2. There is a scarce resource that both projects need, and by using it in one project, it is not available
for the second.
NPV rule considers whether or not discounted cash inflows outweigh the cash outflows
emanating from a project. Higher positive NPVs are preferred to lower or negative NPVs.
Decision is clear-cut.

Mutually Exclusive versus Independent Projects
(continued)
Example 4: Calculate NPV for choosing between Mutually Exclusive Projects
Problem
The owner of Perfect Images Salon has a dilemma. She wants to start offering tanning services and has to
decide between purchasing a tanning bed or a tanning booth. In either case, she figures that the cost of
capital will be 10%. The relevant annual cash flows with each option are as follows:
Year Tanning Bed Tanning Booth
0 -10,000 -12,500
1 4,000 4,400
2 4,500 4,800
3 10,000 11,000
4 8,000 9,500
Can you help her make the right decision?

9.3 (A) Mutually Exclusive versus Independent
Projects (continued)
Example 4: Calculate NPV for Choosing between Mutually Exclusive Projects
Solution
Since these are mutually exclusive options, the one with the higher NPV would be the best choice.
NPV bed = -$10,000 + $4,000/(1.10)+ $4,500/(1.10)2 +
$10,000/(1.10)3+$8,000/(1.10)4
=-$10,000 +$3636.36+$3719.01+$7513.15+$5464.11
=$10,332.62
NPV booth = -$12,500 + $4,400/(1.10)+ $4,800/(1.10)2 +
$11,000/(1.10)3+$9,500/(1.10)4
=-$12,500 +$4,000+$3,966.94+$8,264.46+$6,488.63
=$10,220.03
Thus, the less expensive tanning bed with the higher NPV
(10,332.62>10,220.03) is the better option.

Net Present Value (NPV)
• If POSITIVE value then the project is profitable and is
therefore WORTHWHILE
• If NEGATIVE value then the project is considered
unprofitable and will be REJECTED

Advantages of NPV
• Takes account of whole life of the investment
• Takes into account net cash flows for whole period
• Takes account of the time value of money
• Takes account of the opportunity cost of the project

Disadvantages of NPV
• Quite complex and technical – not easily understood by non-financial
managers
• Often inaccurate discount factor over time

9.2 (A) Discounted Payback Period
• Calculates the time it takes to recover the initial investment in current or
discounted dollars.
• Incorporates time value of money by adding up the discounted cash inflows
at time 0, using the appropriate hurdle or discount rate, and then
measuring the payback period.
• It is still flawed in that cash flows after the payback are ignored.

9.2 (A) Discounted Payback Period (continued)
Example 2: Discounted Payback Period
Problem
Calculate the discounted payback period of the tanning bed, stated in Example 1,
by using a discount rate of 10%.

9.2 (A) Discounted Payback Period (continued)
Year
Cash
flow
Discounted
CF
Yet to be
recovered
Percent of Year
Recovered/Inflow
0 (10,000) (10,000) (10,000)
1 4,000 3,636 (6,364)
2 4,500 3,719 (2,645)
3 10,000 7,513 4,869 35%
4 8,000 5,464
Not used
in
decision
Discounted
Payback =
2.35 years

Profitability Index
• If faced with a constrained budget, we should choose projects that give us the best “bang for our
buck.”
• The Profitability Index can be used to calculate the ratio of the PV of benefits (inflows) to the PV
of the cost of a project as follows:
• In essence, it tells us how many dollars we are getting per dollar invested.

9.5 Profitability Index
• If faced with a constrained budget, we should choose projects that give us the best “bang for our
buck.”
• The Profitability Index can be used to calculate the ratio of the PV of benefits (inflows) to the PV
of the cost of a project as follows:
• In essence, it tells us how many dollars we are getting per dollar invested.

9.5 Profitability Index (continued)
Example 10: PI Calculation
Problem
Using the cash flows and NPVs listed in Example 8 and a discount rate of 10%, calculate the PI of each
project. Which one should be accepted, if they are mutually exclusive? Why?
Solution
PIA= (NPV + Cost)/Cost = ($17,092.41/$10,000) = $1.71
PIB = (NPV + Cost)/Cost = ($13,816.68/$7,000) = $1.97
PROJECT B, HIGHER PI
Year A B
0 -10,000 -7,000
1 5,000 9000
2 7000 5000
3 9000 2000
NPV@10% $7,092.41 $6,816.68

9.6 Overview of Six Decision Models
1. Payback period
• simple and fast, but economically unsound
• ignores all cash flow after the cutoff date
• ignores the time value of money
2. Discounted payback period
• incorporates the time value of money
• still ignores cash flow after the cutoff date.
3. Net present value (NPV)
• economically sound
• properly ranks projects across various sizes, time horizons, and
levels of risk, without exception for all independent projects.

9.6 Overview of Six Decision Models (continued)
4. Internal rate of return (IRR)
• provides a single measure (return)
• has the potential for errors in ranking projects
• can also lead to an incorrect selection when there are two mutually exclusive projects or incorrect
acceptance or rejection of a project with more than a single IRR
5. Modified internal rate of return (MIRR)
• corrects for most of, but not all, the problems of IRR and gives the solution in terms of a return
• the reinvestment rate may or may not be appropriate for the future cash flows, however
6. Profitability index (PI)
• incorporates risk and return
• but the benefits-to-cost ratio is actually just another way of expressing the NPV

Table 9.4 Summary of Six Decision Models

Risks of investment decisions
• Sum to invest
• Source of funds
• Impact on rest of business
• Ability to reverse decision
• Impact of investment of future plans

Uncertainties of investment decisions
• Market stability – extent of change
• Competitor reactions
• Economic environment
• Accuracy of cash flow projections
• Projected life of investment decision

Qualitative factors
• Aims and objectives of the business
• Image- effect on reputation and brand
• Personnel: work habits, morale, culture etc.
• Consumer perceptions
• Effect on communities
• Production issues
• Cultural issues

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