Investment Criteria

1
Investment Criteria

• Timothy R. Mayes, Ph.D.
• FIN 3300 Chapter 9

2
What is Capital Budgeting?

• Capital budgeting refers to the process of
  deciding how to allocate the firms scarce
  capital resources (land, labor, and capital) to
  its various investment alternatives

3
Overview

• All of these techniques attempt to compare the
  costs and benefits of a project
• The over-riding rule of capital budgeting is to
  accept all projects for which the cost is less
  than, or equal to, the benefit
• Accept if Cost Benefit
• Reject if Cost gt Benefit

4
The Six Criteria

• There are six criteria that we will use
• The payback period
• The discounted payback period
• Internal rate of return (IRR)
• Modified internal rate of return (MIRR)
• Net present value (NPV)
• Profitability index (PI)

5
The Example

• We will use the following example to demonstrate
  the techniques of capital budgeting
• Assume that your company is investigating a new
  labor-saving machine that will cost 10,000. The
  machine is expected to provide cost savings each
  year as shown in the following timeline

• If your required return is 12, should this
  machine be purchased?

6
The Payback Period

• The payback period measures the time that it
  takes to recoup the cost of the investment.
• If the cash flows are an annuity, then we can
  simply divide the cost by the annual cash flow to
  determine the payback period
• Otherwise, as in the example, we subtract the
  cash flows from the cost until the remainder is
  zero
• The shorter the payback period, the better
• Generally, firms will have some maximum allowable
  payback period against which all investments are
  compared

7
The Payback Period An Example

• For our example project, we will subtract the
  cash flows from the initial outlay until the
  entire cost is recovered

• Since it will take 0.7143 years ( 2500/3500) to
  recover the last 2,500, the payback period must
  be 3.7143 years

8
Problems with the Payback Period

• The payback period suffers from two primary
  problems that limit its usefulness in evaluating
  investments
• It ignores the time value of money
• It ignores all cash flows beyond the payback
  period
• Still, it has a couple of redeeming qualities
• It is quick and easy to calculate
• It gives a measure of the liquidity of the project

9
The Discounted Payback Period

• The discounted payback period is exactly the same
  as the regular payback period, except that we use
  the present values of the cash flows in the
  calculation
• Since our required return (WACC) is 12, the
  timeline with the PVs looks like this

• The discounted payback period is 4.82 years
• Note that the discounted payback period is always
  longer than the regular payback period

10
Problems with Discounted Payback

• The discounted payback period solves the time
  value problem, but it still ignores the cash
  flows beyond the payback period
• Therefore, you may reject projects that have
  large cash flows in the outlying years that make
  it very profitable
• In other words, any measure of payback can lead
  to a focus on short-run profits at the expense of
  larger long-term profits

11
The Internal Rate of Return

• The internal rate of return (IRR) is the discount
  rate that equates the present value of the cash
  flows and the cost of the investment
• Usually, we cannot calculate the IRR directly,
  instead we must use a trial and error process
• For our example, the IRR is found by solving the
  following

• In this case, the solution is 13.45

12
Problems with the IRR

• The IRR is a popular technique primarily because
  it is a percentage which is easily compared to
  the WACC
• However, it suffers from a couple of flaws
• The calculation of the IRR implicitly assumes
  that the cash flows are reinvested at the IRR.
  This may not always be realistic.
• Percentages can be misleading (would you rather
  earn 100 on a 100 investment, or 10 on a
  10,000 investment?)

13
The Modified Internal Rate of Return

• The modified IRR (MIRR) is the average annual
  rate of return that will be earned on an
  investment if the cash flows are reinvested at
  the specified rate of return (usually, the WACC)
• To calculate the MIRR, first find the total
  future value of the cash flows at the
  reinvestment rate, and then apply the formula

14
The MIRR An Example

• To calculate the MIRR for our example, first find
  the FV of the cash flows at 12 (the WACC)

• This is the amount that you will have accumulated
  by the end of the life of the investment
• Now, find the average annual rate of return

• Since the MIRR is greater than the WACC, this
  project is acceptable

15
The Net Present Value

• The net present value (NPV) is the difference
  between the present value of the cash flows (the
  benefit) and the cost of the investment (IO)

• In other words, this is the increase in wealth
  that the shareholders will receive if the project
  is accepted
• All projects with NPV greater than or equal to
  zero should be accepted

16
The NPV An Example

• NPV is calculated by subtracting the initial
  outlay (cost) from the present value of the cash
  flows
• Note that the discount rate is the WACC (12 in
  this example)

• Since the NPV is positive, the project is
  acceptable
• Note that a positive NPV also means that the IRR
  is greater than the WACC

17
The Profitability Index

• The profitability index is the same as the NPV,
  except that we divide the PVCF by the initial
  outlay

• Accept all projects with PI greater than or equal
  to 1.00
• For the example, the PI is