CHAPTER 11: C A P I TA L - B U D G E T I N G DECISION CRITERIA

Net Present Value

! The net present value (NPV) is the
difference between the present value of cash inows and outows. It estimates the amount of wealth the project creates" ! Decision Criteria: " ACCEPT if NPV # 0" REJECT if NPV < 0"

Profitability Index
! The protability index (PI) is a cost-benet
ratio equal to the present value of an investments future cash ows divided by its initial cost" ! Decision Criteria:" ACCEPT if PI # 1.0" indicates that the present value of the investments future cash ows exceeds the cost of making the investment! REJECT if PI < 1.0" the NPV will be negative"

Internal Rate of Return

! The internal rate of return (IRR) of an
investment is analogous to the yield to maturity (YTM) of a bond" ! Decision Criteria:" ACCEPT if IRR # required rate of return" REJECT if IRR < required rate of return"

Independence Versus Mutually Exclusive Investment Projects

! An independent investment project
stands alone and can be undertaken without inuencing the acceptance or rejection of another project" ! A mutually exclusive project prevents another project from being accepted"

Complications with IRR

! Unconventional Cash Flows" Typically, an initial outlay is followed by a
period of cash inows. The NPV will always be positive if IRR is greater than 1" If the cash ow pattern is reverse (cash inow followed by a series of outows), NPV > 0 indicates that IRR < required rate of return" NPV leads to appropriate decision in both conventional and unconventional cash ow pattern. It is prudent to use NPV while evaluating projects with unconventional cash ow pattern." Multiple Rates of Return" ! Construct an NPV prole that reports the several discount rates and use them in increments to calculate"

Evaluating Mutually Exclusive Investment Opportunities

! 2 situations where the rm is faced with
mutually exclusive projects:" Substitutes - The rm is trying to pick between alternatives that perform the same function. There may be many good options, but the rm only needs one." Firm Constraints - Such as limited managerial time or nancial capital that may limit its ability to invest in all the positive NPV opportunities"

Choosing Between Mutually Exclusive Investments

! If mutually exclusive investments have
equal lives, calculate the NPVs and choose the higher NPV" ! If mutually exclusive investments dont have equal lives, calculate the EAC, the cost per year. Select the lower EAC! Requires (1) computation of NPV to determine the PV of cash ows and (2) computation of EAC"

Using the IRR with Mutually Exclusive Investments

! When comparing two mutually exclusive
projects, IRR and NPV may not have the same conclusion" ! Use NPV as it will give the correct ranking for the projects"

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Modified Internal Rate of Return

! The modied internal rate of return
(MIRR) deals with the problem of multiple IRRs" ! Done by rearranging the cash ows so that there is only one change of sign of the cash ows over the life of the project" ! MIRR Process: 2 Steps" Modify the projects cash ow stream by discounting the negative future cash ows back to the present, using the same discount rate used to calculate NPV" Calculate the MIRR as the IRR of the modied cash ow stream" Modied cash ows are discounted based on the discount rate used to calculate NPV! Changing the discount rate will also change the MIRR!

Attractiveness of Payback Methods

1. Both CPB and DPB are more intuitive and relatively easier to understand than NPV or IRR" 2. CPB can be seen as a crude indicator of risk as payback favors initial year cash ows - less risky than more distant ! 3. DPB is used as a supplemental analytical tool in cases where obsolescence is a risk and getting the money back before the market disappears or the product comes obsolete is more important" 4. Payback method is useful when the capital is being rationed and managers would like to know how long a project will tie up capital"

Key Terms
! ! ! ! ! ! ! ! ! ! !
Capital rationing" Discounted payback (DPB)" Equivalent annual cost (EAC)" Independent investment project" Internal rate of return (IRR)" Modied internal rate of return (MIRR)" Mutually exclusive investments" Net present value (NPV)" Net present value prole" Payback period (CPB)" Protability index

Cash Payback (CPB)

! The payback period of an investment
opportunity is the number of years needed to recover the initial cash outlay required to make the investment" ! Decision Criteria:" ACCEPT if CPB < pre-specied number of years" " Limitations of Payback Period" Ignores time value of money" Ignores cash ows that are generated by the project beyond the end of the payback period" No clear-cut way to dene the cutoff criterion for the payback period that is tied to the value creation potential of the investment"

Discounted Payback (DPB)

! Discounted payback period is similar to CPB
except it uses discounted cash ows to calculate the discounted period. The discount rate is the same as the one used to calculate the NPV" ! Decision Criteria:" ACCEPT if DPB < pre-specied number of years"

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