Transcript Chapter 9

Chapter 9
Capital Budgeting Decision Models
 Short-term versus Long-term Decisions
 Payback Period
 Discounted Payback Period
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Profitability Index (PI)
Short-term versus Long-term
Decisions
 Short-term decisions
 Working capital decisions (Chapter 13)
 In general, repetitive decisions
 Long-Term decisions
 Capital budgeting decisions (Chapter 9)
 Impacts over many years
 Difference
 Time
 Cost
 Degree of Information
Payback Period
 First and easiest model of capital
budgeting
 Answers the question, how soon will I get
my money back?
 Key Features
 Need amount and timing of cash flows
 Not concerned with cash flows after
repayment
 Ad hoc cutoff date for repayment
Payback Period
 Clinko Copiers (example 9.1)
 Initial investment is $5,000
 Positive cash flow each year
 Year 1 -- $1,500
 Year 2 -- $2,500
 Year 3 -- $3,000
 Year 4 -- $4,500
 Year 5 -- $5,500
 Payback in 2 and 1/3rd years…ignore
years 4 and 5 cash flows
Payback Period
 Strengthens
 Easy to apply
 Initial cash flows most important
 Good for small dollar investments
 Weaknesses
 Ignores cash flows after cutoff period
 Ignores time value of money
 Corrections
 Discount cash flows
Discounted Payback Period
 Attempt to correct one flaw of Payback
Period…time value of money
 Discount cash flows to present and see if
the discount cash flows are sufficient to
cover initial cost within cutoff time period
 Careful in consistency
 Discounting means cash flow at end of period
 Appropriate discount rate for cash flows
Discounted Payback Period
 Discounted Cash Flows of Copiers A & B
 Discounted at 6% (APR)
 Both 3 year discounted paybacks with annual
cash flows
 Copier A – 26 months with monthly cash flows
 Copier B – 29 months with monthly cash flows
 Potential for poor choice
 Large late positive cash flows
 Longer positive cash flows
Net Present Value (NPV)
 Correction to discounted cash flows
 Includes all cash flows in decision
 Changes decision (go vs. no-go) to dollars,
not arbitrary cutoff period
 The Decision Model (a.k.a. Discounted
Cash Flow Model)
 Need all cash flows
 Need appropriate discount rate
Net Present Value (NPV)
 Decision
 Accept all positive NPVs
 Reject all negative NPVs
 Copier Example
 Copier A – NPV is $5,530.91 – Accept
 Copier B – NPV is $9,253.09 – Accept
 Model good for comparing projects
 Select project with highest NPV
 Can assign different discount rates to projects
Net Present Value (NPV)
 The Decision Model
 Incorporates risk and return
 Incorporates time value of money
 Incorporates all cash flows
Internal Rate of Return (IRR)
 Model closely resembles NPV but…
 Finding the discount rate (internal rate) that
implies an NPV of zero
 Internal rate used to accept or reject project
 If IRR > hurdle rate, accept
 If IRR < hurdle rate, reject
 Very popular model as “managers” like the
single return variable when evaluating
projects
Internal Rate of Return (IRR)
 Process difficult without calculator or
spreadsheet – iterative process
 Need timing and amount of cash flows
 Examples
 Copier A – IRR is 41%
 High return…accept project
 Assumes can borrow funds for project for less
than 41%
Internal Rate of Return (IRR)
 Some problems with IRR
 Cross-over Rates flip projects
 Using NPV profiles, project choice changes at cross-over
rate so need to know both hurdle rate and cross-over rate
 Cross-over rate is where two projects have same NPV
 Multiple IRRs
 Projects with changing cash flows can have multiple IRRs
 Which is the correct IRR? Don’t know
 Risk of Project is not included
 IRR calculation void of risk of project
 Risk must be implied with different hurdle rates
Profitability Index (PI)
 Modified version of NPV
 Decision Criteria
 PI > 1.0, accept project
 PI < 1.0, reject project
Profitability Index (PI)
 Close to NPV as we calculate present
value of future positive cash flows (present
value of benefits) and initial cash flow
(present value of costs)
 PI = (NPV + Initial cost) / Initial Cost
 Answer is modified return
 Choosing between two different projects?
 Higher PI is best choice…
 Careful, cannot scale projects up and down
Profitability Index (PI)
 Example of Large Copier and Mini-Copier
 Large Copier B PI is 2.85 (normal level of risk)
 Mini Copier PI is 2.95
 Pick Mini Copier
 Problem with copier choice
 Original investment in mini-copier only $500
 Original investment in Copier B is $5,000
 Need to buy 10 mini-copiers to match
production of Copier B…
Problems
 Problem 1 – Payback Period
 Problem 3 – Discounted Payback Period
 Problem 7 – Net Present Value
 Problem 11 – Internal Rate of Return
 Problem 15 – Profitability Index
 Problem 19 – NPV Profile of Project