Chapter 9
Chapter 9. Capital Budgeting Techniques and Practice 2000, Prentice Hall, Inc.
Dec 22, 2015
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Chapter 9
Capital BudgetingTechniques and
Practice
2000, Prentice Hall, Inc.
Capital Budgeting: the process of planning for purchases of long-term assets.
exampleexample: :
Suppose our firm must decide whether to Suppose our firm must decide whether to purchase a new plastic molding machine purchase a new plastic molding machine for $125,000. How do we decide?for $125,000. How do we decide?
Will the machine be Will the machine be profitableprofitable?? Will our firm earn a Will our firm earn a high rate of returnhigh rate of return
on the investment?on the investment?
Decision-making Criteria in Capital Budgeting
How do we decide if a capital How do we decide if a capital investment project should be investment project should be
accepted or rejected?accepted or rejected?
The Ideal Evaluation Method The Ideal Evaluation Method should:should:
a) include a) include all cash flowsall cash flows that occur that occur during the life of the project,during the life of the project,
b) consider the b) consider the time value of moneytime value of money,,
c) incorporate the c) incorporate the required rate of required rate of returnreturn on the project. on the project.
Decision-making Criteria in Capital Budgeting
Three Basic Methods of Evaluating Projects
1.1. Payback MethodPayback Method
2.2. Net Present Value (NPV)Net Present Value (NPV)
3.3. Internal Rate of Return (IRR)Internal Rate of Return (IRR)
Payback Period
How long will it take for the project How long will it take for the project to generate enough cash to pay for to generate enough cash to pay for itself?itself?
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 150 150 150 (500) 150 150 150 150 150 150 150 150
Payback period = Payback period = 3.33 years3.33 years..
Is a Is a 3.33 year3.33 year payback period good? payback period good? Is it acceptable?Is it acceptable? Firms that use this method will compare Firms that use this method will compare
the payback calculation to some the payback calculation to some standard set by the firm.standard set by the firm.
If our senior management had set a cut-If our senior management had set a cut-off of off of 5 years5 years for projects like ours, for projects like ours, what would be our decision?what would be our decision?
Accept the projectAccept the project..
Payback Period
Drawbacks of Payback Period
Firm cutoffs are Firm cutoffs are subjectivesubjective.. Does not consider Does not consider time value of time value of
moneymoney.. Does not consider any Does not consider any required required
rate of returnrate of return.. Does not consider all of the Does not consider all of the
project’s project’s cash flowscash flows..
Drawbacks of Payback Period
Does not consider all of the Does not consider all of the project’s cash flows.project’s cash flows.
This project is clearly unprofitable, but This project is clearly unprofitable, but we would we would acceptaccept it based on a 4-year it based on a 4-year payback criterion!payback criterion!
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 (300) 0 0 (500) 150 150 150 150 150 (300) 0 0
Other Methods
1) 1) Net Present ValueNet Present Value (NPV) (NPV)
2) 2) Internal Rate of ReturnInternal Rate of Return (IRR) (IRR)
Each of these decision-making criteria:Each of these decision-making criteria: Examines all net cash flows,Examines all net cash flows, Considers the time value of money, andConsiders the time value of money, and Considers the required rate of return.Considers the required rate of return.
Net Present ValueNet Present Value
NPV = the total PV of the annual net NPV = the total PV of the annual net cash flows - the initial outlay.cash flows - the initial outlay.
NPVNPV = - IO = - IO ACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=1
Net Present Value
Decision RuleDecision Rule::
If NPV is positive, If NPV is positive, acceptaccept.. If NPV is negative, If NPV is negative, rejectreject..
NPV ExampleNPV Example
0 1 2 3 4 5
250,000 100,000 100,000 100,000 100,000 100,000
Suppose we are considering a capital Suppose we are considering a capital investment that costs investment that costs $250,000$250,000 and and provides annual net cash flows of provides annual net cash flows of $100,000$100,000 for five years. The firm’s for five years. The firm’s required rate of return is required rate of return is 15%15%..
Net Present Value (NPV)
NPV is just the PV of the annual cash NPV is just the PV of the annual cash flows minus the initial outflow.flows minus the initial outflow.
Using TVM:Using TVM:
P/Y = 1 N = 5 I = 15 P/Y = 1 N = 5 I = 15
PMT = 100,000PMT = 100,000
PV of cash flows =PV of cash flows = $335,216$335,216
- Initial outflow:- Initial outflow: ($250,000)($250,000)
= Net PV= Net PV $85,216$85,216
NPV with the TI BAII Plus:
Select CF mode.Select CF mode. CFo=? CFo=? -250,000 -250,000 ENTERENTER C01=? C01=? 100,000 100,000 ENTERENTER F01= 1 F01= 1 5 5 ENTERENTER NPV NPV I= I= 15 15 ENTERENTER
CPTCPT You should get You should get NPV = 85,215.51NPV = 85,215.51
Internal Rate of Return (IRR)
IRRIRR:: the return on the firm’s the return on the firm’s invested capital. IRR is simply the invested capital. IRR is simply the rate of returnrate of return that the firm earns on that the firm earns on its capital budgeting projects.its capital budgeting projects.
Internal Rate of Return (IRR)
NPVNPV = - IO = - IO ACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=1
Internal Rate of Return (IRR)
NPVNPV = - IO = - IO ACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=1
n
t=1IRR: = IO
ACFt
(1 + IRR) t
Internal Rate of Return (IRR)
IRR is the IRR is the rate of returnrate of return that makes the that makes the PV PV of the cash flowsof the cash flows equalequal to the to the initial outlayinitial outlay..
This looks very similar to our Yield to This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM Maturity formula for bonds. In fact, YTM isis the IRR of a bond. the IRR of a bond.
n
t=1IRR: = IO
ACFt
(1 + IRR) t
Calculating IRR
Looking again at our problem:Looking again at our problem: The IRR is the discount rate that The IRR is the discount rate that
makes the PV of the projected cash makes the PV of the projected cash flows flows equalequal to the initial outlay. to the initial outlay.
0 1 2 3 4 5
250,000 100,000 100,000 100,000 100,000 100,000
IRR with your Calculator
IRR is easy to find with your IRR is easy to find with your financial calculator.financial calculator.
Just enter the cash flows as you did Just enter the cash flows as you did with the NPV problem and solve for with the NPV problem and solve for IRR.IRR.
You should get You should get IRR = 28.65%!IRR = 28.65%!
IRR
Decision RuleDecision Rule::
If IRR is greater than or equal to If IRR is greater than or equal to the required rate of return, the required rate of return, acceptaccept..
If IRR is less than the required If IRR is less than the required rate of return, rate of return, rejectreject..
Summary Problem
Enter the cash flows only once.Enter the cash flows only once. Find the Find the IRRIRR.. Using a discount rate of Using a discount rate of 15%,15%, find find NPVNPV..
0 1 2 3 4 50 1 2 3 4 5
(900) 300 400 400 500 600(900) 300 400 400 500 600
Summary Problem
IRR = 34.37%.IRR = 34.37%. Using a discount rate of 15%, Using a discount rate of 15%,
NPV = $510.52.NPV = $510.52.
0 1 2 3 4 50 1 2 3 4 5
(900) 300 400 400 500 600(900) 300 400 400 500 600
Capital RationingCapital Rationing
Suppose that you have evaluated Suppose that you have evaluated 5 capital investment projects5 capital investment projects for for your company.your company.
Suppose that the VP of Finance Suppose that the VP of Finance has given you a has given you a limited capital limited capital budgetbudget..
How do you decide which How do you decide which projects to select?projects to select?
Capital RationingCapital Rationing
You could rank the projects by IRR:You could rank the projects by IRR:IRRIRR
5%5%
10%10%
15%15%
20%20%
25%25%
$$
11 22 33 44 55
Capital RationingCapital Rationing
You could rank the projects by IRR:You could rank the projects by IRR:IRRIRR
5%5%
10%10%
15%15%
20%20%
25%25%
$$
11 22 33 44 55
$X
Our budget is limitedOur budget is limitedso we accept only so we accept only projects 1, 2, and 3.projects 1, 2, and 3.
Capital RationingCapital Rationing
You could rank the projects by IRR:You could rank the projects by IRR:IRRIRR
5%5%
10%10%
15%15%
20%20%
25%25%
$$
11 22 33
$X
Our budget is limitedOur budget is limitedso we accept only so we accept only projects 1, 2, and 3.projects 1, 2, and 3.
Problems with Project RankingProblems with Project Ranking
1) Mutually exclusive projects of 1) Mutually exclusive projects of unequal unequal sizesize (the (the size disparitysize disparity problem) problem)
The NPV decision may not agree with The NPV decision may not agree with IRR.IRR.
Solution:Solution: select the project with the select the project with the largest largest NPVNPV..
Size Disparity exampleSize Disparity example
Project AProject A yearyear cash flowcash flow 00 (135,000)(135,000) 11 60,000 60,000 22 60,000 60,000 33 60,000 60,000required return = 12%required return = 12%IRR = 15.89%IRR = 15.89%NPV = $9,110NPV = $9,110
Size Disparity exampleSize Disparity example
Project BProject B
yearyear cash flowcash flow
00 (30,000) (30,000)
11 15,000 15,000
22 15,000 15,000
33 15,000 15,000
required return = 12%required return = 12%
IRR = 23.38%IRR = 23.38%
NPV = $6,027NPV = $6,027
Project AProject A
yearyear cash flowcash flow
00 (135,000)(135,000)
11 60,000 60,000
22 60,000 60,000
33 60,000 60,000
required return = 12%required return = 12%
IRR = 15.89%IRR = 15.89%
NPV = $9,110NPV = $9,110
Problems with Project RankingProblems with Project Ranking
2) The 2) The time disparitytime disparity problem with mutually problem with mutually exclusive projects.exclusive projects.
NPV assumes cash flows are NPV assumes cash flows are reinvested at reinvested at the required rate of returnthe required rate of return for the project. for the project.
IRR assumes cash flows are IRR assumes cash flows are reinvested at reinvested at the IRR.the IRR.
The NPV decision may not agree with the The NPV decision may not agree with the IRR. IRR.
Solution:Solution: select the largest select the largest NPVNPV..
Time Disparity exampleTime Disparity example
Project BProject B yearyear cash flowcash flow
00 (46,500) (46,500)
11 36,500 36,500
22 24,000 24,000
33 2,400 2,400
44 2,400 2,400
required return = 12%required return = 12%
IRR = 25.51%IRR = 25.51%
NPV = $8,455NPV = $8,455
Project AProject A yearyear cash flowcash flow
00 (48,000) (48,000)
11 1,200 1,200
22 2,400 2,400
33 39,000 39,000
44 42,000 42,000
required return = 12%required return = 12%
IRR = 18.10%IRR = 18.10%
NPV = $9,436NPV = $9,436
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