Unit III

Capital Budgeting
Decision Criteria

Dr. NCR.
 Leaning Objective

 Why Decision?
 Planning for future investments
 What Decision?
 Mutually Exclusive, Accept Reject,
Independent or Capital Rationing
 How - Process
 Capital Budgeting: the process of
planning for purchases of long-
term assets.
 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?
Decision-making Criteria in
Capital Budgeting

How do we decide
if a capital
investment
project should
be accepted or
rejected?
 The Process

 Idea Generation
 Market Research
 Identification of the Project Alternatives
 Selection of the Project
 Implementation
 Feedback
 Decision-making Criteria in
Capital Budgeting
 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.
 Payback Period
 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
 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

0 1 2 3 4 5 6 7 8
 Payback Period
 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

0 1 2 3 4 5 6 7 8

Payback period = 3.33 years.

 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.
 Drawbacks of Payback Period:

 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:

 Does not consider all of the project’s

cash flows.
(500) 150 150 150 150 150 (300) 0 0

0 1 2 3 4 5 6 7 8

Consider this cash flow stream!

 Drawbacks of Payback Period:

 Does not consider all of the project’s

cash flows.
(500) 150 150 150 150 150 (300) 0 0

0 1 2 3 4 5 6 7 8
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
 Discounted Payback

 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
(500) 250 250 250 250 250

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

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

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

0 1 2 3 4 5
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
(500) 250 250 250 250 250

0 1 2 3 4 5
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
(500) 250 250 250 250 250

0 1 2 3 4 5
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
(500) 250 250 250 250 250

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

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.
 Net Present Value

 NPV = the total PV of the annual net

cash flows - the initial outlay.


ACFt
NPV = - IO
(1 + k) t
t=1
 Net Present Value

 Decision Rule:

 If NPV is positive, ACCEPT.

 If NPV is negative, REJECT.
 NPV Example
 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
 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%.

83,000 83,000 83,000 83,000 116,000

(276,400)

0 1 2 3 4 5
 NPV with the HP10B:
 -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 HP17BII:
 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 TI BAII Plus:
 Select CF mode.
 NPV with the TI BAII Plus:
 Select CF mode.
 CFo=? -276,400 ENTER
 NPV with the TI BAII Plus:
 Select CF mode.
 CFo=? -276,400 ENTER
 C01=? 83,000 ENTER
 NPV with the TI BAII Plus:
 Select CF mode.
 CFo=? -276,400 ENTER
 C01=? 83,000 ENTER
 F01= 1 4 ENTER
 NPV with the TI BAII Plus:
 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:
 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:
 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:
 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
 Profitability Index


ACFt
NPV = t - IO
(1 + k)
t=1
 Profitability Index


ACFt
NPV = t - IO
(1 + k)
t=1


ACFt
PI = IO
(1 + k) t
t=1
 Profitability Index

 Decision Rule:

 If PI is greater than or equal

to 1, ACCEPT.
 If PI is less than 1, REJECT.
 -276,400 CFj PI with
 83,000 CFj the
4 shift Nj HP10B:
 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
Internal Rate of Return (IRR)

 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)


ACFt
NPV = - IO
(1 + k) t
t=1
 Internal Rate of Return (IRR)


ACFt
NPV = - IO
(1 + k) t
t=1

n
ACFt
IRR:

t=1
(1 + IRR) t = IO
 Internal Rate of Return (IRR)
n
ACFt
IRR:
t=1
(1 + IRR) t = IO

 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.
 Calculating IRR
 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.

83,000 83,000 83,000 83,000 116,000

(276,400)

0 1 2 3 4 5
 83,000 83,000 83,000 83,000 116,000
(276,400)

0 1 2 3 4 5
 This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR)

= 276,400
 83,000 83,000 83,000 83,000 116,000
(276,400)

0 1 2 3 4 5
 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.
 IRR with your Calculator

 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
 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.
 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. (- + + - + +)
  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
  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
  Problem: If there are multiple
sign changes in the cash flow
stream, we could get multiple
IRRs. (- + + - + +)
 We could find 3 different IRRs!

1 2 3
(500) 200 100 (200) 400 300

0 1 2 3 4 5
 Summary Problem:
 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.

(900) 300 400 400 500 600

0 1 2 3 4 5
 Summary Problem:

 IRR = 34.37%.
 Using a discount rate of 15%,

NPV = $510.52.
 PI = 1.57.

(900) 300 400 400 500 600

0 1 2 3 4 5