Evaluation Techniques

Capital Budgeting / Investment

Appraisal
Net Present Value and Other
Investment Criteria
Chapter Organization
9.1Net Present Value
9.2The Payback Rule
9.3The Average Accounting Return
9.4The Internal Rate of Return
9.5The Profitability Index
9.6The Practice of Capital Budgeting
9.7Summary and Conclusions
M ZAHID KHAN
Financial Management & Policy

T9.1 Evaluation Technique

Introduction / Capital Budgeting

Capital
budgeting
is
a
long-term
economics
decision
making.
Each
potential project's value should be
estimated using a discounted cash flow
(DCF)
valuation,
to
find
its
net present value (NPV). This valuation
requires estimating the size and timing of
all the incremental cash flows from the
project. The NPV is greatly affected by
the discount rate, so selecting the proper
ratesometimes called the hurdle rate
is critical to making the right decision.
M ZAHID KHAN

T9.1 Evaluation Technique

Introduction / Capital Budgeting

The
hurdle
rate
is
the
Minimum acceptable rate of return
on
an
investment. This should reflect the riskiness of
the investment, typically measured by the
volatility of cash flows, and must take into
account the financing mix. Managers may use
models such as the CAPM to estimate a discount
rate appropriate for each particular project, and
use the weighted average cost of capital (WACC)
to reflect the financing mix selected. A common
practice in choosing a discount rate for a project
is to apply a WACC that applies to the entire firm,
but a higher discount rate may be more
appropriate when a project's risk is higher than
the risk of the firm as a whole
M ZAHID KHAN

T9.1 Evaluation Technique

Introduction
The
financial
manager
makes
decisions regarding long-lived assets
in the process referred to as
capital budgeting.
The capital budgeting decisions for a
project requires analysis of:
its future cash flows,
the degree of uncertainty associated
with these future cash flows, and
the value of these future cash flows
considering their uncertainty.
M ZAHID KHAN

T9.1 Evaluation Technique

Concept behind uncertainty

The more uncertain a future cash flow, the less
it is worth today. The degree of uncertainty, or
risk, is reflected in a project's cost of capital.
The cost of capital is what the firm must pay
for the funds to finance its investment. The
cost of capital may be an explicit cost (for
example, the interest paid on debt) or an
implicit cost (for example, the expected price
appreciation of its shares of common stock).
we focus on evaluating the future cash flows.
Given estimates of incremental cash flows for a
project and given a cost of capital that reflects
the project's risk, we look at alternative
techniques that are used to select projects.
M ZAHID KHAN

T9.1 Evaluation Technique

Concept behind uncertainty

For now all we need to understand
about a project's risk is that we can
incorporate risk in either of two ways:
(1) we can discount future cash flows
using a higher discount rate, the
greater the cash flow's risk, or (2) we
can require a higher annual return on
a project, the greater the risk of its
cash flows.

M ZAHID KHAN

T9.1 Evaluation Technique

Evaluation Techniques
We look at six techniques that are
commonly used by firms to evaluating
investments in long-term assets:

Payback period,
Discounted payback period,
Net present value,
Profitability index,
Internal rate of return, and
Modified internal rate of return.

We are interested in how well each

technique discriminates among the different
projects, steering us toward the projects
that maximize owners' wealth.
M ZAHID KHAN

T9.1 Evaluation Technique

An evaluation technique should:

Consider all the future incremental
cash flows from the project;
Consider the time value of money;
Consider the uncertainty associated
with future cash flows, and
Have an objective criteria by which to
select a project.

Projects selected using a technique

that satisfies all three criteria will,
under most general conditions,
maximize owners' wealth.
M ZAHID KHAN

T9.1 Evaluation Technique

Payback Period
The payback period for a project is the
time from the initial cash outflow to invest
in it until the time when its cash inflows
add up to the initial cash outflow. In other
words, how long it takes to get your
money back. The payback period is also
referred to as the payoff period or the
capital recovery period. If you invest
$10,000 today and are promised $5,000
one year from today and $5,000 two years
from today, the payback period is two
years -- it takes two years to get your
$10,000 investment back.
M ZAHID KHAN

T9.4 Payback Rule

Illustrated
Initial outlay -$1,000
Year
Cash flow
1 $200
2 400
3 600
Accumulated
Year
Cash flow
1
2
3

$200
600
1,200

Payback period = 2
years

2/3

T9.1 Evaluation Technique

Payback Period Decision Rule:

A shorter payback period is better
than a longer payback period. Yet
there is no clear-cut rule for how
short is better.
In addition to having no well-defined
decision criteria, payback period
analysis favors investments with
"front-loaded"
cash
flows:
an
investment looks better in terms of
the payback period the sooner its
cash flows are received no matter
M ZAHID KHAN
what its later cash flows look like!

T9.1 Evaluation Technique

Payback Period Decision Rule

Payback should only be used as a
coarse initial screen of investment
projects. But it can be a useful
indicator of some things. Since a
dollar of cash flow in the early years
is worth more than a dollar of cash
flow in later years, the payback
period method provides a simple, yet
crude measure of the value of the
investment.
M ZAHID KHAN

T9.1 Evaluation Technique

Payback Period Decision Rule

The payback period also offers some indication
on the risk of the investment. In industries
where
equipment
becomes
obsolete
rapidly
or
where
there
are
very
competitive conditions, investments with
earlier payback are more valuable. That's
because cash flows farther into the future are
more uncertain and therefore have lower
present value. In the personal computer
industry, for example, the fierce competition
and rapidly changing technology requires
investment in projects that have a payback of
less than one year since there is no expectation
of project benefits beyond one year.
M ZAHID KHAN

T9.1 Evaluation Technique

Payback Period Decision Rule

Further, the payback period gives us
a rough measure of the liquidity of
the investment -- how soon we get
cash flows from our investment.
However, because the payback
method doesn't tell us the particular
payback period that maximizes
wealth, we cannot use it as the
primary
screening
device
for
investment in long-lived assets
M ZAHID KHAN

T9.1 Evaluation Technique

Discounted Payback Period

The discounted payback period is the time
needed to pay back the original investment in
terms of discounted future cash flows.
Each cash flow is discounted back to the
beginning of the investment at a rate that
reflects both the time value of money and the
uncertainty of the future cash flows. This rate
is the cost of capital -- the return required by
the suppliers of capital (creditors and owners)
to compensate them for time value of money
and the risk associated with the investment.
The more uncertain the future cash flows, the
greater the cost of capital.
M ZAHID KHAN

T9.1 Evaluation Technique

The Cost of Capital, The Required Rate of

Return, and the Discount Rate:
We discount an uncertain future cash flow to
the present at some rate that reflects the
degree of uncertainty associated with this
future cash flow. The more uncertain, the less
the cash flow is worth today -- this means that
a higher discount rate is used to translate it
into a value today.
This discount rate is a rate that reflects the
opportunity cost of funds. In the case of a
corporation, we consider the opportunity cost
of funds for the suppliers of capital (the
creditors and owners). We refer to this
opportunity cost as the cost of capital.
M ZAHID KHAN

T9.1 Evaluation Technique

The Cost of Capital, The Required Rate

of Return, and the Discount Rate:
The cost of capital comprises the
required rate of return (RRR) (that is,
the return suppliers of capital demand on
their investment) and the cost of raising
new capital if the firm cannot generate the
needed capital internally (that is, from
retaining earnings). The cost of capital and
the required rate of return are the same
concept but from different perspective.
Therefore, we will use the terms
interchangeably in our study of capital
budgeting.
M ZAHID KHAN

T9.5 Discounted Payback

Illustrated
Initial outlay -$1,000
R = 10%
Year
1
2
3
4
Year
1
2
3
4

Cash flow

PV of
Cash flow

$ 200 $ 182
400 331
700 526
300 205
Accumulated
discounted cash flow
$ 182
513
1,039
1,244

Discounted payback period is just under 3 years

T9.6 Ordinary and Discounted

Payback (Table 9.3)
Cash Flow
Cash Flow
Year
Undiscounted
Discounted
1
2
3
4
5

$100
100 79
100 70
100 62
100 55

$89 $100
200 168
300 238
400 300
500 355

Discounted
$89

Accumulated
Undiscounted

T9.1 Evaluation Technique

Discounted Payback Decision Rule:

It appears that the shorter the
payback period, the better, whether
using discounted or non-discounted
cash flows. But how short is better?
We don't know. All we know is that an
investment "breaks-even" in terms of
discounted
cash
flows
at
the
discounted payback period -- the
point in time when the accumulated
discounted cash flows equal the
M ZAHID KHAN
amount of the investment.

T9.1 Evaluation Technique

Net Present Value

The net present value (NPV) is the
present value of all expected cash flows.
Net present value = Present value of all
expected cash flows.
The word "net" in this term indicates that
all cash flows -- both positive and negative
-- are considered. Often the change in
operating cash flows are inflows and the
investment cash flows are outflows.
Therefore we tend to refer to the net
present value as the difference between
the present value of the cash inflows and
the present value of the cash outflows.
M ZAHID KHAN

T9.1 Evaluation Technique

Net Present Value

We can represent the net present
value using summation notation,
where t indicates any particular
period, CFt represents the cash flow
at the end of period t, i represents
the cost of capital, and N the number
of periods comprising the economic
life of the investment:
NPV = CF / (1+r)^t
M ZAHID KHAN

NPV (

The Present Value of an Investment Project net Cash Flows minus the Project initial Cash Flows

).

Net Present Value:

If offered an investment that costs $5,000
today and promises to pay you $7,000 two
years from today and if your opportunity cost
for projects of similar risk is 10%, would you
make this investment? To determine whether
or not this is a good investment you need to
compare your $5,000 investment with the
$7,000 cash flow you expect in two years.
Since you feels that a discount rate of 10%
reflects the degree of uncertainty associated
with the $7,000 expected in two years, today it
is worth:
Present value of $7,000 to be received in 2
years = $7,000/(1 + 0.10)2 = $5,785.12.
M ZAHID KHAN

T9.1 Evaluation Technique

Net Present Value

By investing $5,000, today you are getting in
return, a promise of a cash flow in the future
that is worth $5,785.12 today. You increase
your wealth by $785.12 when you make this
investment.
Another way of stating this is that the present
value of the $7,000 cash inflow is $5,785.12,
which is more than the $5,000, today's cash
outflow to make the investment. When we
subtract today's cash outflow to make an
investment from the present value of the cash
inflow from the investment, the difference is
the increase or decrease in our wealth
referred to as the net present value.
M ZAHID KHAN

T9.2 NPV Illustrated

Assume you have the following information

on Project X:
Initial outlay -$1,100
Required return =
10%
Annual cash revenues and expenses are as
follows:
Year
Revenues
Expenses
1
$1,000
$500
2
2,000
1,000
Draw
a X.
time line and compute the NPV of
project

T9.1 Evaluation Technique

Net Present Value Decision Rule:

If
this means that
and you...
NPV > 0 - the investment is expected to
increase shareholder wealth - should
accept the project.
NPV < 0 - the investment is expected to
decrease shareholder wealth - should
reject the project.
NPV = 0 - the investment is expected
not to change shareholder wealth should be indifferent between accepting
or rejecting the project
M ZAHID KHAN

T9.1 Evaluation Technique

Net Present Value Decision Rule:

Suppose , Investment A increases the
value of the firm by $516,315 and B
increases it by $552,620. If these are
independent
investments,
both
should be taken on because both
increase the value of the firm. If A
and B are mutually exclusive, such
that the only choice is either A or B,
then B is preferred since it has the
greater NPV. Projects are said to be
mutually exclusive if accepting one
preclude the acceptance of the Mother.
ZAHID KHAN

T9.1 Evaluation Technique

Net Present Value Decision Rule:

NPV and Further Considerations:
The net present value technique
considers:
all expected future cash flows,
the time value of money, and
the risk of the future cash flows.

One, NPV calculations result in a dollar

amount, say $500 or $23,413, which is
the incremental value to owners' wealth.
However, investors and managers tend
to think in terms of percentage returns,
"Does this project return 10%? 15%?"
M ZAHID KHAN

T9.1 Evaluation Technique

Net Present Value Decision Rule:

And two, to calculate NPV we need a cost of
capital. This is not so easy. The concept
behind the cost of capital is simple: It is
compensation to the suppliers of capital for
(a) the time value of money and (b) the risk
they accept that the cash flows they expect to
receive may not materialize as promised.
Getting
an
estimate
of
how
much
compensation is needed is not so simple.
That's because to estimate a cost of capital
we have to make a judgment on the risk of a
project and how much return is needed to
compensate for that risk -M ZAHID KHAN

Irwin/McGraw-Hill

copyright

2002 McGraw-Hill Ryerson, Ltd.

T9.1 Evaluation Technique

Internal Rate of Return

An
investment's
internal rate of return (IRR) is the
discount rate that makes the present
value of all expected future cash
flows equal to zero.

M ZAHID KHAN

T9.1 Evaluation Technique

Internal Rate of Return Decision

Rule:
The decision rule for the internal rate of return is to invest
in a project if it provides a return greater than the cost of
capital. The cost of capital, in the context of the IRR, is a
hurdle rate -- the minimum acceptable rate of return. For
independent projects and situations in which there is no
capital rationing, then

Ifthis means thatand you...

IRR > cost of capital ----the investment is expected to increase

shareholder wealth----should accept the project.
IRR < cost of capital-----the investment is expected to decrease
shareholder wealth---should reject the project.
IRR = cost of capital----the investment is expected not to change
shareholder wealth---should be indifferent between accepting or
rejecting the project

M ZAHID KHAN

T9.8 Internal Rate of Return

Illustrated
Initial
outlay = -$200
Year

Cash

flow
1
2
3

$ 50
100
150

Find the IRR such that NPV = 0

50
100
150
0 = -200 +
+
+
(1+IRR)1
(1+IRR)2
(1+IRR)3

T9.8 Internal Rate of Return

Illustrated (concluded)
Trial and Error
Discount rates
0%$100
5%68
10% 41
15% 18
20% -2

NPV

IRR is just under 20% -- about

19.44%

T9.9 Net Present Value

Profile
Net present value
120
100
80

Year

Cash flow

0
1
2
3
4

$275
100
100
100
100

60
40
20
0
20
Discount rate

40
2%

6%

10%

14%

18%
IRR

22%

T9.12 Profitability Index: The Present Value

of an investment future cash flows divided
by its initial cost. Also, benefit cost ratio.

Now lets go back to the initial example - we

assumed the following information on Project
X:
Initial outlay -$1,100 Required return = 10%
Annual cash benefits:
Year Cash flows
1
$ 500
2
1,000
Whats the Profitability Index (PI)?

T9.12 Profitability Index Illustrated

(concluded)
Previously we found that the NPV of Project X is equal to:

($454.55 + 826.45) - 1,100 = $1,281.00 - 1,100 = $181.00.

The PI = PV inflows/PV outlay = $1,281.00/1,100 = 1.1645.
This is a good project according to the PI rule. Can you
explain why?
Its a good project because the present value of the inflows
exceeds the outlay.

Profitability Index Illustrated

(concluded)
The PI is obviously very similar to the NPV.However ,
Consider the project that cost 5$ has a 10$ present
value and an investment that cost 100$ with a 150$
present value. The First of these investment has an NPV
of 5$ and a PI of 2. The second has the NPV of 50$ and a
PI of 1.50. If these project are Mutually Exclusive than
the second one is preferred, even though is has lower PI.
The ranking problem is very similar to the IRR ranking
problem as we are more interested in the Profitability
bottom line rather than the Ratio PI or Percent IRR.

Profitability Index (Advantage &

Disadvantage )
Advantages :
Closely related to the NPV, generally leading to the identical
decision.
Easy to understand and communicate.
May be useful when available funds are limited.
Drawback
May lead to incorrect decision making in comparison of
Mutually exclusive Investment.

T9.13 Summary of Investment

Criteria
I. Discounted cash flow criteria
A. Net present value (NPV). The NPV of an investment is the
difference between its market value and its cost. The NPV
rule is to take a project if its NPV is positive. NPV has no
serious flaws; it is the preferred decision criterion.
B. Internal rate of return (IRR). The IRR is the discount rate that
makes the estimated NPV of an investment equal to zero.
The IRR rule is to take a project when its IRR exceeds the
required return. When project cash flows are not conventional,
there may be no IRR or there may be more than one.
C. Profitability index (PI). The PI, also called the benefit-cost
ratio, is the ratio of present value to cost. The profitability index
rule is to take an investment if the index exceeds 1.0. The PI
measures the present value per dollar invested.

T9.13 Summary of Investment

Criteria (concluded)
II. Payback criteria
A. Payback period. The payback period is the length of time until the sum
of an investments cash flows equals its cost. The payback period rule is to
take a project if its payback period is less than some prespecified cutoff.
B. Discounted payback period. The discounted payback period is the length
of time until the sum of an investments discounted cash flows equals its
cost. The discounted payback period rule is to take an investment if the
discounted payback is less than some prespecified cutoff.

III. Accounting criterion

A. Average accounting return (AAR). The AAR is a measure of accounting
profit relative to book value. The AAR rule is to take an investment if its
AAR exceeds a benchmark.

T9.15 Chapter 9 Quick Quiz

1. Which of the capital budgeting techniques do account for both
the time value of money and risk?
2. The change in firm value associated with investment in a
project is measured by the projects _____________ .
a. Payback period
b. Discounted payback period
c. Net present value
d. Internal rate of return
3. Why might one use several evaluation techniques to assess a
given project?

T9.15 Chapter 9 Quick Quiz

1. Which of the capital budgeting techniques do account for both
the time value of money and risk?
Discounted payback period, NPV, IRR, and PI
2. The change in firm value associated with investment in a
project is measured by the projects Net present value.
3. Why might one use several evaluation techniques to assess a
given project?
To measure different aspects of the project; e.g., the payback
period measures liquidity, the NPV measures the change in
firm value, and the IRR measures the rate of return on the
initial outlay.

T9.16 Solution to Problem

9.3
Offshore Drilling Products, Inc. imposes a payback
cutoff of 3 years for its international investment
projects. If the company has the following two
projects available, should they accept either of them?
Year Cash Flows A
Cash Flows B
0 -$30,000 -$45,000
1

15,000

5,000

10,000

10,000

10,000

5,000

20,000
250,000

T9.16 Solution to Problem 9.3

(concluded)
Project A:
Payback period = 1 + 1 + ($30,000 25,000)/10,000
= 2.50 years

Project B:
Payback period = 1 + 1 + 1 + ($45,000 - 35,000)/
$250,000
= 3.04 years
Project As payback period is 2.50 years and project
Bs payback period is 3.04 years. Since the
maximum acceptable payback period is 3 years, the
firm should accept project A and reject project B.

T9.17 Solution to Problem

9.7
A firm evaluates all of its projects by
applying the IRR rule. If the required
return is 18 percent, should the firm
accept the following project?
Year Cash Flow
0 -$30,000
1
25,000
2
0
3
15,000

T9.17 Solution of Problem 9.7

(concluded)

To find the IRR, set the NPV equal to 0 and

solve for the discount rate:
NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 +
$0/(1 + IRR) 2
+$15,000/(1 + IRR)3
At 18 percent, the computed NPV is ____.
So the IRR must be (greater/less) than 18
percent. How did you know?

T9.17 Solution of Problem 9.7

(concluded)

To find the IRR, set the NPV equal to 0 and solve

for the discount rate:
NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 +
$0/(1 + IRR)2
+$15,000/(1 + IRR)3
At 18 percent, the computed NPV is $316.

So the IRR must be greater than 18 percent. We

know this because the computed NPV is positive.
By trial-and-error, we find that the IRR is 18.78
percent.

Evaluation Techniques

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