capital budgeting decisions criteria

© 2005, Pearson Prentice Hall
Chapter 9 -Chapter 9 - Capital BudgetingCapital Budgeting
Decision CriteriaDecision Criteria

Capital BudgetingCapital Budgeting:: The processThe process
of planning for purchases of long-of planning for purchases of long-
term assets.term assets.
 For exampleFor example:: Suppose our firm mustSuppose our firm must
decide whether to purchase a new plasticdecide whether to purchase a new plastic
molding machine for $125,000. How domolding machine for $125,000. How do
we decide?we decide?
 Will the machine beWill the machine be profitableprofitable??
 Will our firm earn aWill our firm earn a high rate of returnhigh rate of return
on the investment?on the investment?

Decision-making CriteriaDecision-making Criteria
in Capital Budgetingin Capital Budgeting
How do we decideHow do we decide
if a capitalif a capital
investmentinvestment
project shouldproject should
be accepted orbe accepted or
rejected?rejected?

 The ideal evaluation method should:The ideal evaluation method should:
a) includea) include all cash flowsall cash flows that occurthat occur
during the life of the project,during the life of the project,
b) consider theb) consider the time value of moneytime value of money, and, and
c) incorporate thec) incorporate the required rate ofrequired rate of
returnreturn on the project.on the project.
Decision-making Criteria inDecision-making Criteria in
Capital BudgetingCapital Budgeting

Payback PeriodPayback Period
 How long will it take for the projectHow long will it take for the project
to generate enough cash to pay forto generate enough cash to pay for
itself?itself?

itself?itself?
0 1 2 3 4 5 86 7
(500) 150 150 150 150 150 150 150 150

itself?itself?
Payback period = 3.33 years
0 1 2 3 4 5 86 7
(500) 150 150 150 150 150 150 150 150

 Is aIs a 3.33 year3.33 year payback period good?payback period good?
 Is it acceptable?Is it acceptable?
 Firms that use this method will compareFirms that use this method will compare
the payback calculation to somethe payback calculation to some
standard set by the firm.standard set by the firm.
 If our senior management had set a cut-If our senior management had set a cut-
off ofoff of 5 years5 years for projects like ours,for projects like ours,
what would be our decision?what would be our decision?
 Accept the projectAccept the project..

Drawbacks of Payback PeriodDrawbacks of Payback Period
 Firm cutoffs areFirm cutoffs are subjectivesubjective..
 Does not considerDoes not consider time value oftime value of
moneymoney..
 Does not consider anyDoes not consider any requiredrequired
rate of returnrate of return..
 Does not consider all of theDoes not consider all of the
project’sproject’s cash flowscash flows..

 Does not consider all of theDoes not consider all of the
project’s cash flows.project’s cash flows.
 Consider this cash flow stream!Consider this cash flow stream!
0 1 2 3 4 5 86 7
(500) 150 150 150 150 150 150 150 150

 Does not consider all of the project’sDoes not consider all of the project’s
cash flows.cash flows.
 This project is clearly unprofitable, butThis project is clearly unprofitable, but
we wouldwe would acceptaccept it based on a 4-yearit based on a 4-year
payback criterion!payback criterion!
0 1 2 3 4 5 86 7
(500) 150 150 150 150 150 150 150 150

Discounted PaybackDiscounted Payback
 Discounts the cash flows at the firm’sDiscounts the cash flows at the firm’s
required rate of return.required rate of return.
 Payback period is calculated usingPayback period is calculated using
these discounted net cash flows.these discounted net cash flows.
ProblemsProblems::
 Cutoffs are still subjective.Cutoffs are still subjective.
 Still does not examine all cash flows.Still does not examine all cash flows.

0 1 2 3 4 5
(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 -500-500 -500.00-500.00
11 250250 219.30219.30

0 1 2 3 4 5
(500) 250 250 250 250 250
00 -500-500 -500.00-500.00
11 250250 219.30219.30 1 year1 year
280.70280.70

0 1 2 3 4 5
(500) 250 250 250 250 250
00 -500-500 -500.00-500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.37192.37

00 -500-500 -500.00-500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.37192.37 2 years2 years
88.3388.33
0 1 2 3 4 5
(500) 250 250 250 250 250

0 1 2 3 4 5
(500) 250 250 250 250 250
00 -500-500 -500.00-500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.37192.37 2 years2 years
88.3388.33
33 250250 168.74168.74

0 1 2 3 4 5
(500) 250 250 250 250 250
00 -500-500 -500.00-500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.37192.37 2 years2 years
88.3388.33
33 250250 168.74168.74 .52 years.52 years

0 1 2 3 4 5
(500) 250 250 250 250 250
00 -500-500 -500.00-500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.37192.37 2 years2 years
88.3388.33
33 250250 168.74168.74 .52 years.52 years
The Discounted
Payback
is 2.52 years

Other MethodsOther Methods
1)1) Net Present ValueNet Present Value (NPV)(NPV)
2)2) Profitability IndexProfitability Index (PI)(PI)
3)3) Internal Rate of ReturnInternal Rate of Return (IRR)(IRR)
Consider each of these decision-makingConsider each of these decision-making
criteria:criteria:
 All net cash flows.All net cash flows.
 The time value of money.The time value of money.
 The required rate of return.The required rate of return.

• NPV = the total PV of the annual net
cash flows - the initial outlay.
NPVNPV = - IO= - IO
FCFFCFtt
(1 + k)(1 + k) tt
nn
t=1t=1
ΣΣ
Net Present ValueNet Present Value

Decision RuleDecision Rule::
•If NPV is positive,If NPV is positive, acceptaccept..
•If NPV is negative,If NPV is negative, rejectreject..

NPV ExampleNPV Example
 Suppose we are considering a capitalSuppose we are considering a capital
investment that costsinvestment that costs $250,000$250,000 andand
provides annual net cash flows ofprovides annual net cash flows of
$100,000$100,000 for five years. The firm’sfor five years. The firm’s
required rate of return isrequired rate of return is 15%15%..

NPV ExampleNPV Example
0 1 2 3 4 5
(250,000) 100,000 100,000 100,000 100,000 100,000
 Suppose we are considering a capitalSuppose we are considering a capital
investment that costsinvestment that costs $250,000$250,000 andand
provides annual net cash flows ofprovides annual net cash flows of
$100,000$100,000 for five years. The firm’sfor five years. The firm’s
required rate of return isrequired rate of return is 15%15%..

NPV is just the PV of the annual cashNPV is just the PV of the annual cash
flows minus the initial outflow.flows minus the initial outflow.
Using TVM:Using TVM:
P/Y = 1 N = 5 I = 15P/Y = 1 N = 5 I = 15
PMT = 100,000PMT = 100,000
PV of cash flows =PV of cash flows = $335,216$335,216
- Initial outflow:- Initial outflow: ($250,000)($250,000)
= Net PV= Net PV $85,216$85,216

NPV with the HP10B:NPV with the HP10B:
 -250,000-250,000 CFjCFj
 100,000100,000 CFjCFj
 55 shift Njshift Nj
 1515 I/YRI/YR
 shift NPVshift NPV
 You should get NPV =You should get NPV = 85,215.5185,215.51..

NPV with the HP17BII:NPV with the HP17BII:
 SelectSelect CFLOCFLO mode.mode.
 FLOW(0)=?FLOW(0)=? -250,000 INPUT-250,000 INPUT
 FLOW(1)=?FLOW(1)=? 100,000 INPUT100,000 INPUT
 #TIMES(1)=1#TIMES(1)=1 5 INPUT5 INPUT
EXITEXIT
 CALC 15 I% NPVCALC 15 I% NPV
 You should get NPV =You should get NPV = 85,215.5185,215.51

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

 CFo=?CFo=? -250,000-250,000 ENTERENTER

 C01=?C01=? 100,000100,000 ENTERENTER

 C01=?C01=? 100,000100,000 ENTERENTER
 F01= 1F01= 1 55 ENTERENTER

 C01=?C01=? 100,000100,000 ENTERENTER
 NPVNPV I=I= 1515 ENTERENTER

 C01=?C01=? 100,000100,000 ENTERENTER
CPTCPT

 C01=?C01=? 100,000100,000 ENTERENTER
CPTCPT
 You should getYou should get NPV = 85,215.51NPV = 85,215.51

Profitability Index
NPV = - IO
FCFt
(1 + k) t
n
t=1
Σ

Profitability Index
PI = IO
FCFt
(1 + k)
n
t=1
Σ t
NPV = - IO
FCFt
(1 + k) t
n
t=1
Σ

•Decision Rule:
•If PI is greater than or equal
to 1, accept.
•If PI is less than 1, reject.
Profitability Index

PI with the HP10B:PI with the HP10B:
 -250,000-250,000 CFjCFj
 100,000100,000 CFjCFj
 55 shift Njshift Nj
 1515 I/YRI/YR
 shift NPVshift NPV
 Add back IO:Add back IO: + 250,000+ 250,000
 Divide by IO:Divide by IO: / 250,000 =/ 250,000 =
 You should getYou should get PI = 1.34PI = 1.34

Internal Rate of Return (IRR)Internal Rate of Return (IRR)
 IRRIRR:: The return on the firm’sThe return on the firm’s
invested capital. IRR is simply theinvested capital. IRR is simply the
rate of returnrate of return that the firm earns onthat the firm earns on
its capital budgeting projects.its capital budgeting projects.

NPV = - IO
FCFt
(1 + k) t
n
t=1
Σ

NPV = - IO
FCFt
(1 + k) t
n
t=1
Σ
n
t=1
ΣIRR: = IO
FCFt
(1 + IRR)t

 IRR is theIRR is the rate of returnrate of return that makes thethat makes the
PV of the cash flowsPV of the cash flows equalequal to theto the initialinitial
outlayoutlay..
 This looks very similar to our Yield toThis looks very similar to our Yield to
Maturity formula for bonds. In fact, YTMMaturity formula for bonds. In fact, YTM
n
t=1
ΣIRR: = IO
FCFt
(1 + IRR)t

Calculating IRRCalculating IRR
 Looking again at our problem:Looking again at our problem:
 The IRR is the discount rate thatThe IRR is the discount rate that
makes the PV of the projected cashmakes the PV of the projected cash
flowsflows equalequal to the initial outlay.to the initial outlay.
0 1 2 3 4 5
(250,000) 100,000 100,000 100,000 100,000 100,000

IRR with your CalculatorIRR with your Calculator
 IRR is easy to find with your financialIRR is easy to find with your financial
calculator.calculator.
 Just enter the cash flows as you didJust enter the cash flows as you did
with the NPV problem and solve forwith the NPV problem and solve for
IRR.IRR.
 You should getYou should get IRR = 28.65%!IRR = 28.65%!

IRRIRR
Decision RuleDecision Rule::
• If IRR is greater than or equal toIf IRR is greater than or equal to
the required rate of return,the required rate of return,
acceptaccept..
• If IRR is less than the requiredIf IRR is less than the required
rate of return,rate of return, rejectreject..

 IRR is a good decision-making tool asIRR is a good decision-making tool as
long as cash flows arelong as cash flows are conventionalconventional..
(- + + + + +)(- + + + + +)
 Problem:Problem: If there are multiple signIf there are multiple sign
changes in the cash flow stream, wechanges in the cash flow stream, we
could get multiple IRRs.could get multiple IRRs. (- + + - + +)(- + + - + +)

(- + + + + +)(- + + + + +)
0 1 2 3 4 5
(500) 200 100 (200) 400 300

(- + + + + +)(- + + + + +)
0 1 2 3 4 5
(500) 200 100 (200) 400 300
11

(- + + + + +)(- + + + + +)
0 1 2 3 4 5
(500) 200 100 (200) 400 300
1 2

(- + + + + +)(- + + + + +)
0 1 2 3 4 5
(500) 200 100 (200) 400 300
1 2 3

Summary ProblemSummary Problem
 Enter the cash flows only once.Enter the cash flows only once.
 Find theFind the IRRIRR..
 Using a discount rate ofUsing a discount rate of 15%,15%, findfind NPVNPV..
 Add back IO and divide by IO to getAdd back IO and divide by IO to get PIPI..
0 1 2 3 4 5
(900) 300 400 400 500 600

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

Modified Internal Rate of ReturnModified Internal Rate of Return
(MIRR)(MIRR)
 IRRIRR assumes that all cash flows areassumes that all cash flows are
reinvested at thereinvested at the IRRIRR..
 MIRRMIRR provides a rate of returnprovides a rate of return
measure that assumes cash flows aremeasure that assumes cash flows are
reinvested at thereinvested at the required rate ofrequired rate of
returnreturn..

MIRR Steps:MIRR Steps:
 Calculate the PV of the cash outflows.Calculate the PV of the cash outflows.
 Using the required rate of return.Using the required rate of return.
 Calculate the FV of the cash inflows atCalculate the FV of the cash inflows at
the last year of the project’s time line.the last year of the project’s time line.
This is called the terminal value (TV).This is called the terminal value (TV).
 Using the required rate of return.Using the required rate of return.
 MIRR: the discount rate that equatesMIRR: the discount rate that equates
the PV of the cash outflows with the PVthe PV of the cash outflows with the PV
of the terminal value, ie, that makes:of the terminal value, ie, that makes:
 PVPVoutflowsoutflows = PV= PVinflowsinflows

MIRRMIRR
Using our time line and a 15% rate:Using our time line and a 15% rate:
 PV outflows =PV outflows = (900).(900).
 FV inflows (at the end of year 5) =FV inflows (at the end of year 5) = 2,837.2,837.
 MIRR: FV = 2837, PV = (900), N = 5.MIRR: FV = 2837, PV = (900), N = 5.
 Solve: I =Solve: I = 25.81%.25.81%.
0 1 2 3 4 5
(900) 300 400 400 500 600

 Solve: I =Solve: I = 25.81%.25.81%.
ConclusionConclusion:: The project’s IRR ofThe project’s IRR of 34.37%34.37%
assumes that cash flows are reinvested atassumes that cash flows are reinvested at
34.37%.34.37%.
MIRRMIRR

 Solve: I =Solve: I = 25.81%.25.81%.
ConclusionConclusion:: The project’s IRR ofThe project’s IRR of 34.37%34.37%
assumes that cash flows are reinvested atassumes that cash flows are reinvested at
34.37%.34.37%.
 Assuming a reinvestment rate ofAssuming a reinvestment rate of 15%,15%,
the project’s MIRR isthe project’s MIRR is 25.81%.25.81%.
MIRRMIRR

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