Chapter 9: Capital Budgeting Techniques

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Ó 1999, Prentice Hall, Inc.
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• 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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• How do we decide if a capital investment project
  should be accepted or rejected?

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

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• The number of years needed to recover the initial
  cash outlay.
• How long will it take for the project to generate
  enough cash to pay for itself?

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

(500) 150 150 150 150 150 150 150
150
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• 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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• 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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• 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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• Does not consider all of the projects cash flows.

(500) 150 150 150 150 150 (300) 0
0
Consider this cash flow stream!
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• Does not consider all of the projects cash flows.

(500) 150 150 150 150 150 (300) 0
0
This project is clearly unprofitable, but we
would accept it based on a 4-year
payback criterion!
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• 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
• Year Cash Flow CF (14)
• 0 -500 -500.00
• 1 250 219.30

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• Discounted
• Year Cash Flow CF (14)
• 0 -500 -500.00
• 1 250 219.30 1 year
• 280.70

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• Discounted
• Year Cash Flow CF (14)
• 0 -500 -500.00
• 1 250 219.30 1 year
• 280.70
• 2 250 192.38

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• Discounted
• Year Cash Flow CF (14)
• 0 -500 -500.00
• 1 250 219.30 1 year
• 280.70
• 2 250 192.38 2 years
• 88.32

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• Discounted
• Year Cash Flow CF (14)
• 0 -500 -500.00
• 1 250 219.30 1 year
• 280.70
• 2 250 192.38 2 years
• 88.32
• 3 250 168.75

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• Discounted
• Year Cash Flow CF (14)
• 0 -500 -500.00
• 1 250 219.30 1 year
• 280.70
• 2 250 192.38 2 years
• 88.32
• 3 250 168.75 .52 years

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• Discounted
• Year Cash Flow CF (14)
• 0 -500 -500.00
• 1 250 219.30 1 year
• 280.70
• 2 250 192.38 2 years
• 88.32
• 3 250 168.75 .52 years

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• 1) Net Present Value (NPV)
• 2) Profitability Index (PI)
• 3) Internal Rate of Return (IRR)
• Each of these decision-making criteria
• Examines all net cash flows,
• Considers the time value of money, and
• Considers the required rate of return.

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

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• Suppose we are considering a capital investment
  that costs 276,400 and provides annual net cash
  flows of 83,000 for four years and 116,000 at
  the end of the fifth year. The firms required
  rate of return is 15.

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• Suppose we are considering a capital investment
  that costs 276,400 and provides annual net cash
  flows of 83,000 for four years and 116,000 at
  the end of the fifth year. The firms required
  rate of return is 15.

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• -276,400 CFj
• 83,000 CFj
• 4 shift Nj
• 116,000 CFj
• 15 I/YR
• shift NPV
• You should get NPV 18,235.71.

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• Select CFLO mode.
• FLOW(0)? -276,400 INPUT
• FLOW(1)? 83,000 INPUT
• TIMES(1)1 4 INPUT
• FLOW(2)? 116,000 INPUT
• TIMES(2)1 INPUT EXIT
• CALC 15 I NPV
• You should get NPV 18,235.71

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• Select CF mode.

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• Select CF mode.
• CFo? -276,400 ENTER

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• Select CF mode.
• CFo? -276,400 ENTER
• C01? 83,000 ENTER

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• Select CF mode.
• CFo? -276,400 ENTER
• C01? 83,000 ENTER
• F01 1 4 ENTER

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• Select CF mode.
• CFo? -276,400 ENTER
• C01? 83,000 ENTER
• F01 1 4 ENTER
• C02? 116,000 ENTER

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• Select CF mode.
• CFo? -276,400 ENTER
• C01? 83,000 ENTER
• F01 1 4 ENTER
• C02? 116,000 ENTER
• F02 1 ENTER

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• Select CF mode.
• CFo? -276,400 ENTER
• C01? 83,000 ENTER
• F01 1 4 ENTER
• C02? 116,000 ENTER
• F02 1 ENTER
• NPV I 15 ENTER CPT

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• Select CF mode.
• CFo? -276,400 ENTER
• C01? 83,000 ENTER
• F01 1 4 ENTER
• C02? 116,000 ENTER
• F02 1 ENTER
• NPV I 15 ENTER CPT
• You should get NPV 18,235.71

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• -276,400 CFj
• 83,000 CFj
• 4 shift Nj
• 116,000 CFj
• 15 I/YR
• shift NPV
• You should get NPV 18,235.71.
• Add back IO 276,400
• Divide by IO / 276,400
• You should get PI 1.066

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• 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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• 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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• 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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• This is what we are actually doing
• 83,000 (PVIFA 4, IRR) 116,000 (PVIF 5, IRR)
• 276,400

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• This is what we are actually doing
• 83,000 (PVIFA 4, IRR) 116,000 (PVIF 5, IRR)
• 276,400
• This way, we have to solve for IRR by trial and
  error.

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• 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 17.63!

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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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• 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.
  (- - )

(500) 200 100 (200) 400
300
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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.
  (- - )

(500) 200 100 (200) 400
300
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• Problem If there are multiple sign changes in
  the cash flow stream, we could get multiple IRRs.
  (- - )
• We could find 3 different IRRs!

(500) 200 100 (200) 400
300
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• 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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• IRR 34.37.
• Using a discount rate of 15,
• NPV 510.52.
• PI 1.57.