Chapter 9 - Capital Budgeting

Decision Criteria

2005, Pearson Prentice Hall

Capital Budgeting: The process

of planning for purchases of longterm 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?

Decision-making Criteria
in Capital Budgeting
How do we decide
if a capital
investment
project should
be accepted or
rejected?

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.

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

Payback Period
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

Payback Period
How long will it take for the project
to generate enough cash to pay for
itself?
(500)

150 150 150 150 150 150 150

Payback period = 3.33 years

150

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 cutoff of 5 years for projects like ours, what
would be our decision?
Accept the project.

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.

Drawbacks of Payback Period

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

150 150 150 150 150 150 150

Consider this cash flow stream!

150

Drawbacks of Payback Period

Does not consider all of the projects cash
flows.

(500)

150 150 150 150 150 150 150

This project is clearly unprofitable, but we

would accept it based on a 4-year payback
criterion!

150

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.

Discounted Payback
(500)

250

250 250 250 250

2

Discounted

Year Cash Flow

0
1

-500
250

CF (14%)
-500.00
219.30

Discounted Payback
(500)

250

250 250 250 250

2

Discounted

Year Cash Flow

0
1

-500
250

CF (14%)
-500.00
219.30
280.70

1 year

Discounted Payback
(500)

250

250 250 250 250

2

Discounted

Year Cash Flow

0
1

-500
250

250

CF (14%)
-500.00
219.30
280.70
192.37

1 year

Discounted Payback
(500)

250

250 250 250 250

2

Discounted

Year Cash Flow

0
1

-500
250

250

CF (14%)
-500.00
219.30
280.70
192.37
88.33

1 year
2 years

Discounted Payback
(500)

250

250 250 250 250

2

Discounted

Year Cash Flow

0
1

-500
250
280.70
2
250
88.33
3
250

CF (14%)

-500.00
219.30

1 year

192.37

2 years

168.74

Discounted Payback
(500)

250

250 250 250 250

2

Discounted

Year Cash Flow

0
1

-500
250
280.70
2
250
88.33
3
250

CF (14%)

-500.00
219.30

1 year

192.37

2 years

168.74

.52 years

Discounted Payback
(500)

250

250 250 250 250

2

Discounted

Year Cash Flow CF (14%)

The Discounted
0
1

-500
250
280.70
2
250
88.33
3
250

-500.00
Payback
219.30
1 year

is 2.52 years

192.37

2 years

168.74

.52 years

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.

Net Present Value

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

NPV =

t=1

FCFt
(1 + k) t

- IO

Net Present Value

Decision Rule:

If NPV is positive, accept.

If NPV is negative, reject.

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%.

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%.
(250,000) 100,000 100,000 100,000 100,000 100,000

Net Present Value

NPV is just the PV of the annual cash
flows minus the initial outflow.
Using TVM:

P/Y = 1 N = 5
PMT = 100,000

I = 15

PV of cash flows = $335,216

- Initial outflow: ($250,000)
= Net PV
$85,216

NPV with the HP10B:

-250,000
CFj
100,000
CFj
5
shift Nj
15
I/YR
shift NPV
You should get NPV = 85,215.51.

NPV with the HP17BII:

Select CFLO mode.
FLOW(0)=? -250,000 INPUT
FLOW(1)=?
100,000 INPUT
#TIMES(1)=1
5 INPUT
EXIT
CALC 15 I%
NPV
You should get NPV = 85,215.51

NPV with the TI BAII Plus:

Select CF mode.

NPV with the TI BAII Plus:

Select CF mode.
CFo=? -250,000

ENTER

NPV with the TI BAII Plus:

Select CF mode.
CFo=? -250,000
C01=?
100,000

ENTER
ENTER

NPV with the TI BAII Plus:

Select CF mode.
CFo=? -250,000
C01=?
100,000
F01= 1
5

ENTER
ENTER
ENTER

NPV with the TI BAII Plus:

Select CF mode.
CFo=? -250,000
C01=?
100,000
F01= 1
5
NPV I= 15

ENTER
ENTER
ENTER
ENTER

NPV with the TI BAII Plus:

Select CF mode.
CFo=? -250,000
C01=?
100,000
F01= 1
5
NPV I= 15

ENTER
ENTER
ENTER
ENTER
CPT

NPV with the TI BAII Plus:

Select CF mode.
CFo=? -250,000
C01=?
100,000
F01= 1
5
NPV I= 15

ENTER
ENTER
ENTER
ENTER
CPT
You should get NPV = 85,215.51

Profitability Index

Profitability Index
n

NPV =

t=1

FCFt
t
(1 + k)

- IO

Profitability Index
n

NPV =

t=1
n

PI

t=1

FCFt
t
(1 + k)

- IO

FCFt
(1 + k) t

IO

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

PI with the HP10B:

-250,000 CFj
100,000
CFj
5
shift Nj
15
I/YR
shift NPV
Add back IO: + 250,000
Divide by IO: / 250,000 =
You should get PI = 1.34

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.

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

n

NPV =

t=1

FCFt
(1 + k) t

- IO

Internal Rate of Return (IRR)

n

NPV =

t=1

IRR:

t=1

FCFt
(1 + k) t

FCFt
t
(1 + IRR)

- IO

= IO

Internal Rate of Return (IRR)

n

IRR:

FCFt
t
(1 + IRR)

= IO

t=1

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.

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.
(250,000) 100,000 100,000 100,000 100,000 100,000

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%!

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.

 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. (- + + - + +)

 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

 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. (- + + - + +)
1
(500)

200

100

(200)

400

300

 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. (- + + - + +)
1

(500)

200

100

(200)

400

300

 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. (- + + - + +)
1

(500)

200

100

(200)

400

300

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.
(900)

300

400

400

500

600

Summary Problem

IRR = 34.37%.
Using a discount rate of 15%,
NPV = $510.52.
PI = 1.57.
(900)

300

400

400

500

600

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.

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

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%.

(900)

300

400

400

500

600

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%.

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%.