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CAPITAL BUDGETING
Capital Budgeting Decisions ,[object Object],[object Object]
Type of decisions ,[object Object],[object Object]
Capital Budgeting process ,[object Object],[object Object],[object Object]
B. An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get  products across a river. Projects are: mutually exclusive , if the cash flows of one can be adversely impacted by the acceptance of the other. Projects are: independent , if the cash flows of one are unaffected by the acceptance of the other.
Cash Flows v/s Accounting profit ,[object Object],[object Object],[object Object],[object Object]
[object Object],[object Object],[object Object]
Evaluation Techniques ,[object Object],[object Object],[object Object]
What is the payback period? ,[object Object],[object Object],[object Object],[object Object]
Payback for Project L 10 80 60 0 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback 2 + 30/80   =  2.375 years 0 100 2.4
Project S  70 20 50 0 1 2 3 -100 CF t Cumulative -100 -30 20 40 Payback S 1  +  30/50  =  1.6 years 100 0 1.6 =
C.2.  Strengths of Payback: 1. Provides an indication of a project’s  risk  and  liquidity . 2. Easy to calculate  and  understand. C.2.  Weaknesses of Payback: 1. Ignores the  TVM  (time value of money) . 2. Ignores CFs  occurring  after  the payback period.
Where is it useful? ,[object Object],[object Object],[object Object],[object Object]
10 80 60 0 1 2 3 CF t Cumulative -100 -90.91 -41.32 18.79 Discounted payback 2  +  41.32/60.11  =  2.7  yrs Discounted Payback:  Uses discounted rather than raw CFs. PVCF t -100 -100 10% 9.09 49.59 60.11 = Recover invest. + cap. costs in 2.7 yrs.
NPV: Sum of the PVs of inflows and outflows. Cost often is CF 0  and is negative.
What’s Project L’s NPV? 10 80 60 0 1 2 3 10% Project L: -100.00 9.09 49.59 60.11 18.79   = NPV L
Rationale for the NPV Method NPV =  PV inflows - Cost =  Net gain in wealth. Accept project if NPV > 0. Choose between mutually  exclusive projects on basis of higher NPV.  Adds most value.
NPV : An Evaluation ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]
Internal Rate of Return:  IRR 0 1 2 3 CF 0 CF 1 CF 2 CF 3 outflow Inflows IRR is the discount rate that equates the present value of cash inflows and present value of cash outflow.  This is the same as forcing NPV = 0.
NPV:  Enter k, solve for NPV. IRR:  Enter NPV = 0, solve for IRR.
Rationale for the IRR Method If IRR > WACC, then the project’s rate of return is greater than its cost-some return is left over to boost stockholders’ returns. Example : WACC = 10%, IRR = 15%. Profitable.
IRR Acceptance Criteria ,[object Object],[object Object]
If CFs are constant ,[object Object]
For a mixed stream of cash flows ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]
Profitability Index ,[object Object],[object Object],[object Object],[object Object]
[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

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Capital Budgeting

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  • 5. B. An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river. Projects are: mutually exclusive , if the cash flows of one can be adversely impacted by the acceptance of the other. Projects are: independent , if the cash flows of one are unaffected by the acceptance of the other.
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  • 10. Payback for Project L 10 80 60 0 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback 2 + 30/80 = 2.375 years 0 100 2.4
  • 11. Project S 70 20 50 0 1 2 3 -100 CF t Cumulative -100 -30 20 40 Payback S 1 + 30/50 = 1.6 years 100 0 1.6 =
  • 12. C.2. Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity . 2. Easy to calculate and understand. C.2. Weaknesses of Payback: 1. Ignores the TVM (time value of money) . 2. Ignores CFs occurring after the payback period.
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  • 14. 10 80 60 0 1 2 3 CF t Cumulative -100 -90.91 -41.32 18.79 Discounted payback 2 + 41.32/60.11 = 2.7 yrs Discounted Payback: Uses discounted rather than raw CFs. PVCF t -100 -100 10% 9.09 49.59 60.11 = Recover invest. + cap. costs in 2.7 yrs.
  • 15. NPV: Sum of the PVs of inflows and outflows. Cost often is CF 0 and is negative.
  • 16. What’s Project L’s NPV? 10 80 60 0 1 2 3 10% Project L: -100.00 9.09 49.59 60.11 18.79 = NPV L
  • 17. Rationale for the NPV Method NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
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  • 19. Internal Rate of Return: IRR 0 1 2 3 CF 0 CF 1 CF 2 CF 3 outflow Inflows IRR is the discount rate that equates the present value of cash inflows and present value of cash outflow. This is the same as forcing NPV = 0.
  • 20. NPV: Enter k, solve for NPV. IRR: Enter NPV = 0, solve for IRR.
  • 21. Rationale for the IRR Method If IRR > WACC, then the project’s rate of return is greater than its cost-some return is left over to boost stockholders’ returns. Example : WACC = 10%, IRR = 15%. Profitable.
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