The document discusses various capital budgeting decision criteria for evaluating investment projects, including payback period, discounted payback period, net present value (NPV), profitability index (PI), and internal rate of return (IRR). It provides examples of how to calculate each metric and the decision rules for accepting or rejecting projects based on the criteria. For a sample problem, it calculates the project's IRR as 34.37%, NPV at a 15% discount rate as $510.52, and PI as 1.57 by taking the NPV and dividing it by the initial investment outlay.

1.  1999, Prentice Hall, Inc. Ch. 9: Capital Budgeting Decision Criteria

2. 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? Capital Budgeting : the process of planning for purchases of long-term assets.

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

4. 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 , c) incorporate the required rate of return on the project. Decision-making Criteria in Capital Budgeting

5. 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? Payback Period

6. How long will it take for the project to generate enough cash to pay for itself? (500) 150 150 150 150 150 150 150 150 Payback Period 0 1 2 3 4 5 8 6 7

7. How long will it take for the project to generate enough cash to pay for itself? Payback period = 3.33 years. Payback Period 0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150

8. 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. 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 . Drawbacks of Payback Period:

10. Does not consider all of the project’s cash flows. (500) 150 150 150 150 150 (300) 0 0 Consider this cash flow stream! Drawbacks of Payback Period: 0 1 2 3 4 5 8 6 7

11. Does not consider all of the project’s cash flows. (500) 150 150 150 150 150 (300) 0 0 This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! Drawbacks of Payback Period: 0 1 2 3 4 5 8 6 7

12. 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. Discounted Payback

13. Discounted Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250

14. Discounted Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250

15. Discounted Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250

16. Discounted Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2 years 88.32 Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250

17. Discounted Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2 years 88.32 3 250 168.75 Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250

18. Discounted Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2 years 88.32 3 250 168.75 .52 years Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250

19. Discounted Year Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2 years 88.32 3 250 168.75 .52 years Discounted Payback 0 1 2 3 4 5 (500) 250 250 250 250 250 The Discounted Payback is 2.52 years

20. 1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Each of these decision-making criteria: Examines all net cash flows, Considers the time value of money, and Considers the required rate of return. Other Methods

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

22. Net Present Value Decision Rule : If NPV is positive, ACCEPT . If NPV is negative, REJECT .

23. Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%. NPV Example

24. Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%. NPV Example 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000

25. -276,400 CFj 83,000 CFj 4 shift Nj 116,000 CFj 15 I/YR shift NPV You should get NPV = 18,235.71 . NPV with the HP10B:

26. Select CFLO mode. FLOW(0)=? -276,400 INPUT FLOW(1)=? 83,000 INPUT #TIMES(1)=1 4 INPUT FLOW(2)=? 116,000 INPUT #TIMES(2)=1 INPUT EXIT CALC 15 I% NPV You should get NPV = 18,235.71 NPV with the HP17BII:

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

28. Select CF mode. CFo=? -276,400 ENTER NPV with the TI BAII Plus:

29. Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER NPV with the TI BAII Plus:

30. Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER NPV with the TI BAII Plus:

31. Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER NPV with the TI BAII Plus:

32. Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER F02= 1 ENTER NPV with the TI BAII Plus:

33. Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER F02= 1 ENTER NPV I= 15 ENTER CPT NPV with the TI BAII Plus:

34. Select CF mode. CFo=? -276,400 ENTER C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER F02= 1 ENTER NPV I= 15 ENTER CPT You should get NPV = 18,235.71 NPV with the TI BAII Plus:

35. Profitability Index NPV = - IO ACF t (1 + k) t n t=1 

36. t Profitability Index NPV = - IO ACF t (1 + k) t n t=1  PI = IO ACF t (1 + k) n t=1 

37. Profitability Index Decision Rule : If PI is greater than or equal to 1, ACCEPT . If PI is less than 1, REJECT .

38. -276,400 CFj 83,000 CFj 4 shift Nj 116,000 CFj 15 I/YR shift NPV You should get NPV = 18,235.71 . Add back IO: + 276,400 Divide by IO: / 276,400 = You should get PI = 1.066 PI with the HP10B:

39. 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. Internal Rate of Return (IRR)

40. Internal Rate of Return (IRR) NPV = - IO ACF t (1 + k) t n t=1 

41. n t=1  Internal Rate of Return (IRR) IRR: = IO ACF t (1 + IRR) t NPV = - IO ACF t (1 + k) t n t=1 

42. 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. Internal Rate of Return (IRR) n t=1  IRR: = IO ACF t (1 + IRR) t

43. 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. Calculating IRR 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000

44. This is what we are actually doing: 83,000 (PVIFA 4, IRR ) + 116,000 (PVIF 5, IRR ) = 276,400 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000

45. This is what we are actually doing: 83,000 (PVIFA 4, IRR ) + 116,000 (PVIF 5, IRR ) = 276,400 This way, we have to solve for IRR by trial and error. 0 1 2 3 4 5 (276,400) 83,000 83,000 83,000 83,000 116,000

46. 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 = 17.63%! IRR with your Calculator

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) 200 100 (200) 400 300 0 1 2 3 4 5

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) 200 100 (200) 400 300 0 1 2 3 4 5

51. Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) We could find 3 different IRRs! (500) 200 100 (200) 400 300 0 1 2 3 4 5 1 2 3

52. 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 . Summary Problem: 0 1 2 3 4 5 (900) 300 400 400 500 600

53. IRR = 34.37%. Using a discount rate of 15%, NPV = $510.52. PI = 1.57. Summary Problem: 0 1 2 3 4 5 (900) 300 400 400 500 600