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- 1. Capital Budgeting Techniques and Practice
- 2. Capital Budgeting : the process of planning for purchases of long-term assets. <ul><li>example : </li></ul><ul><li>Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? </li></ul><ul><li>Will the machine be profitable ? </li></ul><ul><li>Will our firm earn a high rate of return on the investment? </li></ul>
- 3. <ul><li>The Ideal Evaluation Method should: </li></ul><ul><li>a) include all cash flows that occur during the life of the project, </li></ul><ul><li>b) consider the time value of money , </li></ul><ul><li>c) incorporate the required rate of return on the project. </li></ul>Decision-making Criteria in Capital Budgeting
- 4. Payback Period <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul>Payback period = 3.33 years . 0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
- 5. <ul><li>Is a 3.33 year payback period good? </li></ul><ul><li>Is it acceptable? </li></ul><ul><li>Firms that use this method will compare the payback calculation to some standard set by the firm. </li></ul><ul><li>If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? </li></ul><ul><li>Accept the project . </li></ul>Payback Period
- 6. Other Methods <ul><li>1) Net Present Value (NPV) </li></ul><ul><li>2) Profitability Index (PI) </li></ul><ul><li>3) Internal Rate of Return (IRR) </li></ul><ul><li>Each of these decision-making criteria: </li></ul><ul><li>Examines all net cash flows, </li></ul><ul><li>Considers the time value of money, and </li></ul><ul><li>Considers the required rate of return. </li></ul>
- 7. Net Present Value <ul><li>NPV = the total PV of the annual net cash flows - the initial outlay. </li></ul>NPV = - IO ACF t (1 + k) t n t=1
- 8. Net Present Value <ul><li>Decision Rule : </li></ul><ul><li>If NPV is positive, accept . </li></ul><ul><li>If NPV is negative, reject . </li></ul>
- 9. <ul><li>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% . </li></ul>NPV Example 0 1 2 3 4 5 250,000 100,000 100,000 100,000 100,000 100,000
- 10. Net Present Value (NPV) <ul><li>NPV is just the PV of the annual cash flows minus the initial outflow. </li></ul><ul><li>Using TVM: </li></ul><ul><li>P/Y = 1 N = 5 I = 15 </li></ul><ul><li>PMT = 100,000 </li></ul><ul><li>PV of cash flows = $335,216 </li></ul><ul><li>- Initial outflow: ($250,000) </li></ul><ul><li>= Net PV $85,216 </li></ul>
- 11. Profitability Index PI = IO ACF t (1 + k) n t=1 t NPV = - IO ACF t (1 + k) t n t=1
- 12. <ul><li>Decision Rule : </li></ul><ul><li>If PI is greater than or equal to 1, accept . </li></ul><ul><li>If PI is less than 1, reject . </li></ul>Profitability Index
- 13. Internal Rate of Return (IRR) <ul><li>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. </li></ul>
- 14. Internal Rate of Return (IRR) NPV = - IO ACF t (1 + k) t n t=1 n t=1 IRR: = IO ACF t (1 + IRR) t
- 15. Internal Rate of Return (IRR) <ul><li>IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay . </li></ul><ul><li>This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond. </li></ul>n t=1 IRR: = IO ACF t (1 + IRR) t
- 16. Calculating IRR <ul><li>Looking again at our problem: </li></ul><ul><li>The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay. </li></ul>0 1 2 3 4 5 250,000 100,000 100,000 100,000 100,000 100,000
- 17. IRR <ul><li>Decision Rule : </li></ul><ul><li>If IRR is greater than or equal to the required rate of return, accept . </li></ul><ul><li>If IRR is less than the required rate of return, reject . </li></ul>

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