Unit 4

1
Unit 4 Capital Budgeting Decision Methods

• This last unit ties together everything we have
  covered in the first three units the time value
  of money, risk and return, and cash flow
  forecasting by covering methods firms can use
  to determine if long-term investment alternatives
  should be accepted or rejected
• The goal is to utilize decision techniques that
  lead to profitable investment decisions and
  increase firm value

2
Three criteria we will apply for comparing
different Capital Budgeting Decision Methods

• A good method should incorporate the time value
  of money
• A good method should incorporate all the relevant
  cash flows of the investment
• A good method should provide unambiguous
  decisions on whether to invest or reject
  investment proposals

3
Decision Methods

• Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)

4
Method 1 Payback Period

• The payback period answers the question How long
  will it take to recover the initial cost of this
  investment?
• The method involves summing the annual cash flows
  until the sum is greater than or equal to the
  initial project investment
• The payback decision rule is If the project
  payback is less than or equal to our firms
  required payback period, accept. Otherwise,
  reject.

5
An example of the payback period

6
Evaluating the Payback Period Method

• First, realize this method gives you a measure of
  project time, or liquidity it does not provide
  any insight into the profitability of the
  investment
• It does not incorporate the time value of money
  into the analysis
• It does not consider all of the project cash
  flows note that the cash flow from year 5 was
  note included in the payback analysis
• Finally, is this a good investment proposal? It
  depends on the firms internal payback
  requirement if it is 2 years, this proposal
  would be rejected, but if it is 4 years, this is
  an acceptable investment. Realize the payback
  rule is therefore subjective and arbitrary

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Method 2 - The Net Present Value Method

• The NPV method answers the question How much
  will this investment increase the firms value
  today?
• The method involves finding the present value of
  the future cash flow stream, and subtracting the
  initial investment
• The NPV rule is if the projects NPV gt 0 then
  accept, NPV lt 0 then reject

8
An example of the Net Present Value method
assume the firms cost of capital, or hurdle
rate, is 10
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Evaluating the NPV method

• Since the example NPV is positive, the decision
  is to invest in the project
• NPV is a measure of project profitability it
  indicates how much the project adds to the firms
  value in present value money
• NPV considers the time value of money through the
  discounting process
• NPV considers all of the projects cash flows,
  since all are discounted and summed
• The NPV decision rule is clear positive NPV
  projects increase firm value, while negative NPV
  projects decrease firm value

10
Method 3 The Internal Rate of Return Method

• The IRR method answers the question What is the
  expected rate of return on this investment?
• IRR is the unique discount rate that makes the
  present value of the future cash flow stream
  equal to the initial project cost
• IRR decision rule if IRR gt firms cost of
  capital (required rate of return) then invest if
  IRR lt cost of capital do not invest

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An example of the Internal Rate of Return Method
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Evaluating the IRR Method

• The IRR function is a built in financial function
  in Microsoft Excel, as well as in financial
  calculators
• Since the IRR gt 10 in this example, the decision
  is to invest
• The IRR method considers the time value of money,
  since it is the discount rate used in the
  analysis
• The IRR does consider all of the cash flows
  forecasted for the projects
• For independent project proposals, IRR and NPV
  will give consistent invest/reject decisions

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Comparing and Contrasting NPV and IRR capital
investment methods

• IRR is the geometric, or compound, expected
  return on investment
• IRR assumes all cash flows from the project are
  reinvested at the IRR rate
• While NPV is consistent with the goal of
  maximizing firm value, many firms like to use IRR
  because it is easier to communicate an expected
  rate of return (a relative profitability measure)
  rather than an absolute euro increase in firm
  value

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Possible Conflicts between NPV and IRR

• If a firm is considering mutually exclusive
  project proposals, there are two situations where
  IRR and NPV may give conflicting ranking
  decisions
• If one project is much larger than the other in
  terms of required investment, IRR and NPV may
  conflict on which is more profitable for the firm
• Also, if the timing of when the cash flows occur
  is dramatically different between the two
  projects, IRR and NPV may give conflicting
  rankings

15
An example of conflicting rankings due to
differences in the timing of the respective cash
flow streams
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Comments on previous example

• Note that, while Project K has a steady cash flow
  stream throughout the life of the project,
  Project L generates the larger cash flows in its
  early years
• Because IRR assumes reinvestment of cash flows,
  the larger cash flows early results in Project L
  having the higher IRR
• However, Project K has the higher NPV
• In the case of conflicts for mutually exclusive
  choices, NPV provides the most theoretically
  sound decision method, since it indicates the
  investment choice that provides the largest
  increase in firm value

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Comparing Investments of Different Size the
Profitability Index

• For two investments of different size (required
  amounts of investment), the NPV method can be
  altered to provide a relative ranking index
• The Profitability Index is the ratio of the
  present value of the future cash flows divided by
  the project cost
• The result is the present euro benefit per euro
  of required investment

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An Example of Profitability Index
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Notes on Profitability Index example

• First,these two proposed projects have different
  sizes, with Project D having a much higher
  required investment cost
• By taking the ratio of the present value of the
  future cash flows to the cost, we see that
  Project D is expected to provide 1.18 euros per
  each euro invested, compared to 1.16 euros per
  euro invested for Project E.
• The decision rule for PI is the gt the PI, the
  better