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