Chapter 8 Capital Budgeting

Decision Models
Learning Objectives
Differentiate between short term and long
term capital budgeting models
Apply the three basic decision models
Payback
NPV
IRR
Calculate cross-over rates
Use modified decision models
Know the strength and weaknesses of each
model
Short-term versus Long-term
Short-term decisions
In general, repetitive decisions
Low cost impacts
Long-Term decisions
Capital budgeting decisions
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 flow
Not concerned with cash flows after
repayment
Ad hoc cutoff date for repayment
Payback Period
Clinko Copiers (example 8.1)
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 1/3
rd
yearsignore
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 flow after cutoff period
Ignores time value of money
Corrections
Discount cash flow
Discounted Payback Period
Attempt to correct one flaw of Payback
Periodtime value of money
Discount cash flow to present and see if
the discount cash flow 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 flow
Discounted Payback Period
Discounted Cash Flow of Copiers A & B
Discounted at 6% (APR)
Both 3 year discounted paybacks with annual
cash flow
Copier A 26 months with monthly cash flow
Copier B 29 months with monthly cash flow
Potential for poor choice
Large late positive cash flow
Longer positive cash flow

Net Present Value (NPV)
Correction to discounted cash flow
Includes all cash flow 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 flow
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 flow
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
Popcorn Machine (Example 8.4)
Grannies IRR is 19.86%
Kettle Corn IRR is 20.35%
Packaging Machine IRR is 14.91%
Decision Rule
Requires hurdle rate for comparison
Accept all with IRR > Hurdle Rate
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? Dont know
Risk of Project is not included
IRR calculation void of risk of project
Risk must be implied with different hurdle rates

Modified IRR
Major assumption of IRR is that all cash flow can
be reinvested at IRR rate
Alternative (and better) assumption is that all
cash flow can be reinvested at hurdle rate
MIRR
Find future value of all cash inflow at hurdle rate
Find present value of cash outflow
Find interest rate that equates future values with
present value
Adjust comparison projects for differences in the
time horizon
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
(page 247)
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 6 Payback & Discounted Period
Problem 8 Net Present Value
Problem 12 Internal Rate of Return &
Modified Internal Rate of Return
Problem 16 Profitability Index
Problem 20 NPV Profile of Project