Chapter 9 - Capital Budgeting Decision Criteria

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Chapter 9 - Capital Budgeting Decision
Criteria
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Capital Budgeting The process of planning for
purchases of long-term assets.

• For 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?

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Decision-making Criteria in Capital Budgeting

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

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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, and
• c) incorporate the required rate of return on the
  project.

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Payback Period

• How long will it take for the project to generate
  enough cash to pay for itself?

Payback period 3.33 years
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Payback Period

• 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.

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Drawbacks of Payback Period

• Projects A
  B
• Cash outlay -10,000 -10,000
• Annual CF
• Year 1 6,000
  5,000
• Year 2 4,000
  5,000
• Year 3 3,000
  0
• Year 4 2,000
  0
• Year 5 1,000
  0

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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 projects cash flows.

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Discounted Payback

• Discounts the cash flows at the firms 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.

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Discounted Payback

• Discounted
• Year Cash Flow CF (14)
• 0 -500 -500.00
• 1 250 219.30 1 year
• 280.70
• 2 250 192.37 2 years
• 88.33
• 3 250 168.74 .52 years

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Discounted Payback

• Discounted
• Year Cash Flow CF (14)
• 0 -500 -500.00
• 1 250 219.30 1 year
• 280.70
• 2 250 192.37 2 years
• 88.33
• 3 250 168.74 .52 years

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Advantages of Payback

• Use free cash flow, not accounting profits
• Easy understood and calculate
• Often used as a rough screening device

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Other Methods

• 1) Net Present Value (NPV)
• 2) Profitability Index (PI)
• 3) Internal Rate of Return (IRR)
• Consider each of these decision-making criteria
• All net cash flows.
• The time value of money.
• The required rate of return.

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Net Present Value

• NPV the total PV of the annual net cash flows -
  the initial outlay.

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Net Present Value

• Decision Rule
• If NPV is gt0, accept.
• If NPV is negative, reject.

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NPV Example

• Suppose we are considering a capital investment
  that costs 250,000 and provides annual net cash
  flows of 100,000 for five years. The firms
  required rate of return is 15.

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Net Present Value

• NPV is just the PV of the annual cash flows minus
  the initial outflow.
• N 5 I 15
• PMT 100,000
• PV of cash flows 335,216
• - Initial outflow (250,000)
• Net PV 85,216

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NPV with the TI BAII Plus

• Select CF mode.
• CFo? -250,000 ENTER
• C01? 100,000 ENTER
• F01 1 5 ENTER
• NPV I 15 ENTER CPT
• You should get NPV 85,215.51

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NPV Example

• Free Cash Flow
• Initial outlay -40,000
• Year 1 15,000
• Year 2 14,000
• Year 3 13,000
• Year 4 12,000
• Year 5 11,000
• 12 required rate of return, what is NPV?

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NPV Example

• Free Cash Flow Discount Factor
  PV
• Year 1 15,000 .893
  13,395
• Year 2 14,000 .797
  11,158
• Year 3 13,000 .712
  9,256
• Year 4 12,000 .636
  7,632
• Year 5 11,000 .567
  6,237
• Present Value of free cash flow
  47,678
• Initial outlay
  -40,000
• Net present value
  7,678

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NPV Example

• Financial calculator select CF mode
• Enter CF0 CF5 one by one
• Fre 1
• I 12
• NPV 7,678

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Features of NPV

• Deals with free cash flow
• Consider the time value of money
• Acceptance of a project using this criterion
  increases the value of firm

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Profitability Index
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Profitability Index

• Decision Rule
• If PI is greater than or equal to 1, accept.
• If PI is less than 1, reject.

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PI Example

• Free Cash Flow
• Initial outlay -40,000
• Year 1 15,000
• Year 2 14,000
• Year 3 13,000
• Year 4 12,000
• Year 5 11,000
• 12 required rate of return, what is PI?

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PI Example

• Free Cash Flow Discount Factor
  PV
• Year 1 15,000 .893
  13,395
• Year 2 14,000 .797
  11,158
• Year 3 13,000 .712
  9,256
• Year 4 12,000 .636
  7,632
• Year 5 11,000 .567
  6,237
• Present Value of free cash flow
  47,678
• Initial outlay
  -40,000
• PI 47,678 / 40,000 1.19

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Compare NPV and PI

• Yield the same accept-reject decision
• NPV absolute dollar
• PI relative measure

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Compare NPV and PI

• Example
• Project A NPV 10
• Project B NPV 20
• Which one is relatively better from the
  perspective of profitability?

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Compare NPV and PI

• Example
• It depends on your initial outlay.
• Suppose initial outlay of A 50
• Suppose initial outlay of B 150
• PI of A (10 50) / 50 1.2
• PI of B (20 150) / 150 1.13
• As profitability is higher

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Internal Rate of Return (IRR)

• IRR The return on the firms invested capital.
  IRR is simply the rate of return that the firm
  earns on its capital budgeting projects.

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Internal Rate of Return (IRR)
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Internal Rate of Return (IRR)

• 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.

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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.

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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 28.65!

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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.

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Example

• A
  B C
• Initial outlay -10,000 -10,000
  -10,000
• FCF year 1 3,362 0
  1,000
• FCF year 2 3,362 0
  3,000
• FCF year 3 3,362 0
  6,000
• FCF year 4 3,362 13,605
  7,000
• Required rate of return 10
• Will we accept these projects?

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Example

• IRR for A 13 gt10 accept
• IRR for B 8 lt 10 reject
• IRR for C 19.04 gt 10 accept

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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.

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Summary Problem

• IRR 34.37.
• Using a discount rate of 15,
• NPV 510.52.
• PI 1.57.

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Relationships of Methods

• If NPV is , IRR must be greater than the
  required rate of return. Also, PI is gt1.
• All three discounted cash flow criteria are
  consistent and give similar accept-reject
  decision.

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Relationships of Methods

• NPV assumes cash flow can be reinvested at the
  projects required rate of return
• IRR assumes cash flow can be reinvested at the
  projects IRR
• NPV is superior to IRR
• As discount rate increases, PNV drops

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One Drawback of IRR

• 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.
  (- - )

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• 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.
  (- - )

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Modified Internal Rate of Return(MIRR)

• IRR assumes that all cash flows are reinvested at
  the IRR.
• MIRR provides a rate of return measure that
  assumes cash flows are reinvested at the required
  rate of return.

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MIRR Steps

• Calculate the PV of the cash outflows.
• Using the required rate of return.
• Calculate the FV of the cash inflows at the last
  year of the projects time line. This is called
  the terminal value (TV).
• Using the required rate of return.
• MIRR the discount rate that equates the PV of
  the cash outflows with the PV of the terminal
  value, ie, that makes
• PVoutflows PVinflows

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MIRR

• Using our time line and a 15 rate
• PV outflows (900).
• FV inflows (at the end of year 5) 2,837.
• MIRR FV 2837, PV (900), N 5.
• Solve I 25.81.

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MIRR

• Using our time line and a 15 rate
• PV outflows (900).
• FV inflows (at the end of year 5) 2,837.
• MIRR FV 2837, PV (900), N 5.
• Solve I 25.81.
• Conclusion The projects IRR of 34.37 assumes
  that cash flows are reinvested at 34.37.
• Assuming a reinvestment rate of 15, the
  projects MIRR is 25.81.

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MIRR

• Decision rule
• If MIRR is greater than or equal to the required
  rate of return, accept.
• If MIRR is less than the required rate of return,
  reject.

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How to Use Evaluating Criteria

• Find profitable projects, and make accurate cash
  flow forecasting
• Correctly evaluate them
• Choose one as main criterion
• Use others as robustness check