Chapter 9 Capital Budgeting Techniques and Practice

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Chapter 9 Capital Budgeting Techniques and
Practice
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• Capital Budgeting is the decision-making process
  regarding investment in fixed assets.
• Should a proposed project be accepted or should
  it be rejected?

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Steps of Capital Budgeting

• Estimate the projects cash flows.
• Assess the riskiness of cash flows.
• Determine the required rate of return
  (risk-adjusted discount rate).
• Apply capital budgeting techniques.
• Make decision accept or reject the project.

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What is a good decision criterion?
A good capital budgeting decision criterion should

• Focus on cash flows.
• Include all cash flows relevant to the project.
• Consider the time value of money.
• Incorporate the projects riskiness into the
  analysis.

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A Capital Budgeting Example
Net Cash Flows of Project
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Payback Period

• How long does it take for the project to recover
  its initial cash outlay?

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Payback Period

• Is a 2.85 year payback period acceptable?
• A firm that uses this method needs to compare the
  calculated payback with some standard set by the
  firm.
• If the management has decided a maximum
  acceptable payback of 4 years for projects like
  this, the project should be accepted.

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Drawbacks of Payback

• Firm cutoffs are subjective.
• It does not consider all of the projects cash
  flows.
• It does not consider the time value of money.
• It does not incorporate riskiness of the project.

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Net Present Value
Net present value (NPV) is equal to the present
value of a projects annual net cash flows less
the investments initial outlay.
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Net Present Value

• Decision Rule
• If NPV is positive, accept the project.
• If NPV is negative, reject the project.

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Using Financial Calculator

• CF0 40,000 /-
• CF1 15,000
• CF2 14,000
• CF3 13,000
• CF4 12,000
• CF5 11,000
• I 12

• NPV 7,674.63
• Accept the project.

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Profitability Index
Profitability index (PI) is the ratio of the
present value of future net cash flows to the
initial outlay.
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Profitability Index

• Decision Rule
• If PI is greater than 1, accept the project.
• If PI is less than 1, reject the project.

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Using Financial Calculator

• NPV 7,674.63
• Add back IO to find PV of future cash flows.
• PV of future cash flows 47,674.63
• PI 47,674.63 / 40,000 1.19
• Accept the project.

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Internal Rate of Return

• Internal rate of return (IRR) is the discount
  rate that equates the present value of the
  projects future cash flows with its initial cash
  outlay.

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Internal Rate of Return

• Decision Rule
• If IRR is greater than the required rate of
  return, accept the project.
• If IRR is less than the required rate of return,
  reject the project.

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Using Financial Calculator

• IRR is difficult to calculate without using a
  financial calculator.
• Input cash flows.
• IRR 19.94
• Accept the project.

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Practice Problem

• Find the NPV, PI, and IRR of the following
  project.

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0 1 2 3 4
5
(900) 300 400 400 500
600
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Using Financial Calculator

• Enter the cash flows into calculator.
• Find the IRR.
• Using a discount rate of 15, find NPV.
• Add back IO and divide by IO to get PI.

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Practice Problem

• IRR 34.37.
• Using a discount rate of 15, NPV 510.52.
• PI 1.57.
• The project should be accepted.