chapter 9 - capital budgeting decision criteria learning objectives to describe the importance of...
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Chapter 9 - Chapter 9 - Capital Budgeting Capital Budgeting
Decision CriteriaDecision Criteria Learning ObjectivesLearning Objectives To describe the importance of long term To describe the importance of long term
investment decisionsinvestment decisions To calculate payback period, discounted pay To calculate payback period, discounted pay
back period, profitability index,internal rate of back period, profitability index,internal rate of return and net present valuereturn and net present value
To describe why is it the best decision To describe why is it the best decision criterioncriterion
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Capital BudgetingCapital Budgeting:: The process The process of planning for purchases of long-of planning for purchases of long-
term assets.term assets.
For exampleFor example: : Suppose our firm must Suppose our firm must decide whether to purchase a new plastic decide whether to purchase a new plastic molding machine for $125,000. How do molding machine for $125,000. How do we decide?we decide?
Will the machine be Will the machine be profitableprofitable?? Will our firm earn a Will our firm earn a high rate of returnhigh rate of return
on the investment?on the investment?
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TYPES OF PROJECTSTYPES OF PROJECTS
Independent Projects Independent Projects Is where an acceptance of one does not Is where an acceptance of one does not
eliminate the others from further eliminate the others from further consideration. This is because sometimes the consideration. This is because sometimes the firm will have unlimited fundsfirm will have unlimited funds
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Decision-making Criteria Decision-making Criteria in Capital Budgetingin Capital Budgeting
How do we decide How do we decide if a capital if a capital investment investment
project should project should be accepted or be accepted or
rejected?rejected?
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The ideal evaluation method should:The ideal evaluation method should:
a) include a) include all cash flowsall cash flows that occur that occur during the life of the project,during the life of the project,
b) consider the b) consider the time value of moneytime value of money, and, and
c) incorporate the c) incorporate the required rate of required rate of returnreturn on the project. on the project.
Decision-making Criteria in Decision-making Criteria in Capital BudgetingCapital Budgeting
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Payback PeriodPayback Period
How long will it take for the project How long will it take for the project to generate enough cash to pay for to generate enough cash to pay for itself?itself?
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Payback PeriodPayback Period
How long will it take for the project How long will it take for the project to generate enough cash to pay for to generate enough cash to pay for itself?itself?
0 1 2 3 4 5 86 7
(500) 150 150 150 150 150 150 150 150
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Payback PeriodPayback Period
How long will it take for the project How long will it take for the project to generate enough cash to pay for to generate enough cash to pay for itself?itself?
Payback period = 3.33 years
0 1 2 3 4 5 86 7
(500) 150 150 150 150 150 150 150 150
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Is a Is a 3.33 year3.33 year payback period good? payback period good? Is it acceptable?Is it acceptable? Firms that use this method will compare Firms that use this method will compare
the payback calculation to some the 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 of off 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..
Payback PeriodPayback Period
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Drawbacks of Payback PeriodDrawbacks of Payback Period
Firm cutoffs are Firm cutoffs are subjectivesubjective.. Does not consider Does not consider time value of time value of
moneymoney.. Does not consider any Does not consider any required required
rate of returnrate of return.. Does not consider all of the Does not consider all of the
project’s project’s cash flowscash flows..
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Drawbacks of Payback PeriodDrawbacks of Payback Period
Does not consider all of the Does 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
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Drawbacks of Payback PeriodDrawbacks of Payback Period
Does not consider all of the project’s Does not consider all of the project’s cash flows.cash flows.
This project is clearly unprofitable, but we This project is clearly unprofitable, but we would would acceptaccept it based on a 4-year payback it based on a 4-year payback criterion!criterion!
0 1 2 3 4 5 86 7
(500) 150 150 150 150 150 150 150 150
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Discounted PaybackDiscounted Payback
Discounts the cash flows at the firm’s Discounts the cash flows at the firm’s required rate of return.required rate of return.
Payback period is calculated using Payback 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.
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Discounted PaybackDiscounted Payback
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
11 250 250 219.30219.30
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Discounted PaybackDiscounted Payback
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
11 250 250 219.30219.30 1 year1 year
280.70280.70
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Discounted PaybackDiscounted Payback
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
11 250 250 219.30219.30 1 year1 year
280.70280.70
22 250 250 192.37192.37
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DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 -500-500 -500.00-500.00
11 250 250 219.30219.30 1 year1 year
280.70280.70
22 250 250 192.37192.37 2 years2 years
88.3388.33
Discounted PaybackDiscounted Payback
0 1 2 3 4 5
(500) 250 250 250 250 250
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Discounted PaybackDiscounted Payback
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
11 250 250 219.30219.30 1 year1 year
280.70280.70
22 250 250 192.37192.37 2 years2 years
88.3388.33
33 250 250 168.74 168.74
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Discounted PaybackDiscounted Payback
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
11 250 250 219.30219.30 1 year1 year
280.70280.70
22 250 250 192.37192.37 2 years2 years
88.3388.33
33 250 250 168.74 168.74 .52 years.52 years
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Discounted PaybackDiscounted Payback
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
11 250 250 219.30219.30 1 year1 year
280.70280.70
22 250 250 192.37192.37 2 years2 years
88.3388.33
33 250 250 168.74 168.74 .52 years.52 years
The Discounted Payback
is 2.52 years
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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-making Consider 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.
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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
Net Present ValueNet Present Value
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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..
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NPV ExampleNPV Example
Suppose we are considering a capital Suppose we are considering a capital investment that costs investment that costs Rm250,000Rm250,000 and and provides annual net cash flows of provides annual net cash flows of Rm100,000Rm100,000 for five years. The firm’s for five years. The firm’s required rate of return is required rate of return is 15%15%..
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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 capital Suppose we are considering a capital investment that costs investment that costs Rm250,000Rm250,000 and and provides annual net cash flows of provides annual net cash flows of Rm100,000Rm100,000 for five years. The firm’s for five years. The firm’s required rate of return is required rate of return is 15%15%..
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Net Present ValueNet Present Value
NPV is just the PV of the annual cash NPV 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 = 15 P/Y = 1 N = 5 I = 15
PMT = 100,000PMT = 100,000
PV of cash flows =PV of cash flows = Rm Rm335,216335,216
- Initial outflow:- Initial outflow: (Rm250,000)(Rm250,000)
= Net PV= Net PV Rm85,216Rm85,216
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NPV with the HP10B:NPV with the HP10B:
-250,000 -250,000 CFjCFj 100,000 100,000 CFjCFj 5 5 shift Nj shift Nj 15 15 I/YR I/YR shift NPVshift NPV You should get NPV = You should get NPV = 85,215.5185,215.51..
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NPV with the HP17BII:NPV with the HP17BII:
Select Select 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 INPUT 5 INPUT
EXITEXIT CALC 15 I% NPVCALC 15 I% NPV You should get NPV = You should get NPV = 85,215.5185,215.51
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NPV with the TI BAII Plus:NPV with the TI BAII Plus:
Select CF mode.Select CF mode.
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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
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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=? 100,000 100,000 ENTERENTER
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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=? 100,000 100,000 ENTERENTER F01= 1 F01= 1 5 5 ENTERENTER
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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=? 100,000 100,000 ENTERENTER F01= 1 F01= 1 5 5 ENTERENTER NPV NPV I= I= 15 15 ENTERENTER
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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=? 100,000 100,000 ENTERENTER F01= 1 F01= 1 5 5 ENTERENTER NPV NPV I= I= 15 15 ENTERENTER
CPTCPT
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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=? 100,000 100,000 ENTERENTER F01= 1 F01= 1 5 5 ENTERENTER NPV NPV I= I= 15 15 ENTERENTER
CPTCPT You should get You should get NPV = 85,215.51NPV = 85,215.51
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Profitability Index
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Profitability Index
NPV = - IO FCFt
(1 + k) t
n
t=1
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Profitability Index
PI = IO FCFt
(1 + k)
n
t=1 t
NPV = - IO FCFt
(1 + k) t
n
t=1
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Decision Rule:
If PI is greater than or equal to 1, accept.
If PI is less than 1, reject.
Profitability Index
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PI with the HP10B:PI with the HP10B:
-250,000-250,000 CFjCFj 100,000 100,000 CFjCFj 5 5 shift Nj shift Nj 15 15 I/YR I/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 get You should get PI = 1.34PI = 1.34
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRRIRR:: The return on the firm’s The return on the firm’s invested capital. IRR is simply the invested capital. IRR is simply the rate of returnrate of return that the firm earns on that the firm earns on its capital budgeting projects.its capital budgeting projects.
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
NPV = - IO FCFt
(1 + k) t
n
t=1
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
NPV = - IO FCFt
(1 + k) t
n
t=1
n
t=1IRR: = IO
FCFt
(1 + IRR) t
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRR is the IRR is the rate of returnrate of return that makes the that makes the PV PV of the cash flowsof the cash flows equalequal to the to the initial outlayinitial outlay..
This looks very similar to our Yield to This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM Maturity formula for bonds. In fact, YTM isis the IRR of a bond. the IRR of a bond.
n
t=1IRR: = IO
FCFt
(1 + IRR) t
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Calculating IRRCalculating IRR
Looking again at our problem:Looking again at our problem: The IRR is the discount rate that The IRR is the discount rate that
makes the PV of the projected cash makes the PV of the projected cash flows flows 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
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IRR with your CalculatorIRR with your Calculator
IRR is easy to find with your financial IRR is easy to find with your financial calculator.calculator.
Just enter the cash flows as you did Just enter the cash flows as you did with the NPV problem and solve for with the NPV problem and solve for IRR.IRR.
You should get You should get IRR = 28.65%!IRR = 28.65%!
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IRRIRR
Decision RuleDecision Rule::
If IRR is greater than or equal to If IRR is greater than or equal to the required rate of return, the required rate of return, acceptaccept..
If IRR is less than the required If IRR is less than the required rate of return, rate of return, rejectreject..
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IRR is a good decision-making tool as IRR is a good decision-making tool as long as cash flows are long as cash flows are conventionalconventional. . (- + + + + +)(- + + + + +)
Problem:Problem: If there are multiple sign If there are multiple sign changes in the cash flow stream, we changes in the cash flow stream, we could get multiple IRRs. could get multiple IRRs. (- + + - + +)(- + + - + +)
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IRR is a good decision-making tool as IRR is a good decision-making tool as long as cash flows are long as cash flows are conventionalconventional. . (- + + + + +)(- + + + + +)
Problem:Problem: If there are multiple sign If there are multiple sign changes in the cash flow stream, we changes 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
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IRR is a good decision-making tool as IRR is a good decision-making tool as long as cash flows are long as cash flows are conventionalconventional. . (- + + + + +)(- + + + + +)
Problem:Problem: If there are multiple sign If there are multiple sign changes in the cash flow stream, we changes 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
1 1
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IRR is a good decision-making tool as IRR is a good decision-making tool as long as cash flows are long as cash flows are conventionalconventional. . (- + + + + +)(- + + + + +)
Problem:Problem: If there are multiple sign If there are multiple sign changes in the cash flow stream, we changes 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
1 2
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IRR is a good decision-making tool as IRR is a good decision-making tool as long as cash flows are long as cash flows are conventionalconventional. . (- + + + + +)(- + + + + +)
Problem:Problem: If there are multiple sign If there are multiple sign changes in the cash flow stream, we changes 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
1 2 3
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Summary ProblemSummary Problem
Enter the cash flows only once.Enter the cash flows only once. Find the Find the IRRIRR.. Using a discount rate of Using a discount rate of 15%,15%, find find NPVNPV.. Add back IO and divide by IO to get Add back IO and divide by IO to get PIPI..
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(900) 300 400 400 500 600
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Summary ProblemSummary Problem
IRR = 34.37%.IRR = 34.37%. Using a discount rate of 15%, Using a discount rate of 15%,
NPV = Rm510.52.NPV = Rm510.52. PI = 1.57PI = 1.57..
0 1 2 3 4 5
(900) 300 400 400 500 600
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Modified Internal Rate of ReturnModified Internal Rate of Return(MIRR)(MIRR)
IRRIRR assumes that all cash flows are assumes that all cash flows are reinvested at the reinvested at the IRRIRR..
MIRRMIRR provides a rate of return provides a rate of return measure that assumes cash flows are measure that assumes cash flows are reinvested at the reinvested at the required rate of required rate of returnreturn..
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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 at Calculate 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 equates MIRR: the discount rate that equates the PV of the cash outflows with the PV the 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
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MIRRMIRRUsing 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
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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%.
ConclusionConclusion: : The project’s IRR of The project’s IRR of 34.37%34.37% assumes that cash flows are reinvested at assumes that cash flows are reinvested at 34.37%.34.37%.
MIRRMIRR
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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%.
ConclusionConclusion: : The project’s IRR of The project’s IRR of 34.37%34.37% assumes that cash flows are reinvested at assumes that cash flows are reinvested at 34.37%.34.37%.
Assuming a reinvestment rate of Assuming a reinvestment rate of 15%,15%, the project’s MIRR is the project’s MIRR is 25.81%.25.81%.
MIRRMIRR
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CLASS EXERCISECLASS EXERCISE