Investment Criteria

Timothy R. Mayes, Ph.D.

FIN 3300: Chapter 9 1

What is Capital Budgeting?

 Capital budgeting refers to the process of deciding how to allocate the firm’s scarce capital resources (land, labor, and capital) to its various investment alternatives 2

Overview

  All of these techniques attempt to compare the costs and benefits of a project The over-riding rule of capital budgeting is to accept all projects for which the cost is less than, or equal to, the benefit: • Accept if:Cost  Benefit • Reject if: Cost > Benefit 3

The Six Criteria

 There are six criteria that we will use: • The payback period • The discounted payback period • Internal rate of return (IRR) • Modified internal rate of return (MIRR) • Net present value (NPV) • Profitability index (PI) 4

The Example

  We will use the following example to demonstrate the techniques of capital budgeting Assume that your company is investigating a new labor-saving machine that will cost $10,000. The machine is expected to provide cost savings each year as shown in the following timeline: -10,000 2000 2500 3000 3500 4000 0 1 2 3 4 5  If your required return is 12%, should this machine be purchased?

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The Payback Period

     The payback period measures the time that it takes to recoup the cost of the investment.

If the cash flows are an annuity, then we can simply divide the cost by the annual cash flow to determine the payback period Otherwise, as in the example, we subtract the cash flows from the cost until the remainder is zero The shorter the payback period, the better Generally, firms will have some maximum allowable payback period against which all investments are compared 6

The Payback Period: An Example

  For our example project, we will subtract the cash flows from the initial outlay until the entire cost is recovered: 10,000 2,000 Cumulative Payback 1 year = = 8,000 2,500 5,500 3,000 2 years 3 years = 2,500 3 years < Payback < 4 years Since it will take 0.7143 years (= 2500/3500) to recover the last 2,500, the payback period must be 3.7143 years 7

Problems with the Payback Period

  The payback period suffers from two primary problems that limit its usefulness in evaluating investments: • It ignores the time value of money • It ignores all cash flows beyond the payback period Still, it has a couple of redeeming qualities • It is quick and easy to calculate • It gives a measure of the liquidity of the project 8

The Discounted Payback Period

  The discounted payback period is exactly the same as the regular payback period, except that we use the present values of the cash flows in the calculation Since our required return (WACC) is 12%, the timeline with the PVs looks like this: -10,000 1785.71 1992.98 2135.34 2224.31 2269.71

0 1 2 3 4 5   The discounted payback period is 4.82 years Note that the discounted payback period is always longer than the regular payback period 9

Problems with Discounted Payback

   The discounted payback period solves the time value problem, but it still ignores the cash flows beyond the payback period Therefore, you may reject projects that have large cash flows in the outlying years that make it very profitable In other words, any measure of payback can lead to a focus on short-run profits at the expense of larger long-term profits 10

The Internal Rate of Return

   The internal rate of return (IRR) is the discount rate that equates the present value of the cash flows and the cost of the investment Usually, we cannot calculate the IRR directly, instead we must use a trial and error process For our example, the IRR is found by solving the following:   1  2000 IRR  1   1  2500 IRR  2   1  3000 IRR  3   1  3500 IRR  4   1  4000 IRR  5  In this case, the solution is 13.45% 11

Problems with the IRR

  The IRR is a popular technique primarily because it is a percentage which is easily compared to the WACC However, it suffers from a couple of flaws: • The calculation of the IRR implicitly assumes that the cash flows are reinvested at the IRR. This may not always be realistic.

• Percentages can be misleading (would you rather earn 100% on a $100 investment, or 10% on a $10,000 investment?) 12

The Modified Internal Rate of Return

  The modified IRR (MIRR) is the average annual rate of return that will be earned on an investment if the cash flows are reinvested at the specified rate of return (usually, the WACC) To calculate the MIRR, first find the total future value of the cash flows at the reinvestment rate, and then apply the formula: MIRR  N FVCF  1 IO 13

The MIRR: An Example

 To calculate the MIRR for our example, first find the FV of the cash flows at 12% (the WACC): FVCF    4    3    2    1  4000    This is the amount that you will have accumulated by the end of the life of the investment Now, find the average annual rate of return: MIRR  5 10000  Since the MIRR is greater than the WACC, this project is acceptable 14

The Net Present Value

 The net present value (NPV) is the difference between the present value of the cash flows (the benefit) and the cost of the investment (IO): NPV  PVCF  IO   In other words, this is the increase in wealth that the shareholders will receive if the project is accepted All projects with NPV greater than or equal to zero should be accepted 15

The NPV: An Example

  NPV is calculated by subtracting the initial outlay (cost) from the present value of the cash flows Note that the discount rate is the WACC (12% in this example) 2000 2500  3000  3500  4000           5 10000    Since the NPV is positive, the project is acceptable Note that a positive NPV also means that the IRR is greater than the WACC 16

The Profitability Index

 The profitability index is the same as the NPV, except that we divide the PVCF by the initial outlay: PI  PVCF IO   Accept all projects with PI greater than or equal to 1.00

For the example, the PI is: PI   17