Chap 10

Chapter 10
Introduction
Capital budgeting was introduced in Chapter

9. The estimation of a projects cash flows
was covered, including both the net
investment and net cash flows.
The focus of this chapter is the analysis of a

projects cash flows in order to make a project
acceptance or rejection decision.
Hospitality Financial Management

By Robert E. Chatfield and Michael C. Dalbor
10-1
2005 Pearson Education, Inc.

Pearson Prentice Hall
Upper Saddle River, NJ 07458
Organization of Chapter 10
Capital budgeting decision methods:
Payback period
Discounted payback period
Net present value
Profitability index
Internal rate of return
Modified internal rate of return

10-2

Organization of Chapter 10
Capital budgeting decisions with:
Independent projects
Mutually exclusive projects
Projects with cash flows that are not normal
The advantages and disadvantages of each of

the capital budgeting decision methods

10-3

Project Cash Flows
The capital budgeting decision is essentially

based upon a cost/benefit analysis.
We call the cost of a project the net

investment.
The benefits from a project are the future cash

flows generated. We call these the net cash
flows.

10-4

Capital Budgeting Decision Methods
Capital budgeting decision methods essentially

compare a projects net investment with its net
cash flows. Project acceptance or rejection is
based upon this comparison.

10-5

Payback Period
A projects payback period is the number of

years its takes for a projects net cash flows to
pay back the net investment. Shorter paybacks
are better than longer paybacks.

10-6

Payback Period
Suppose a project has a $200,000 net

investment and net cash flows (NCFs) of
$70,000 annually for 7 years. What is the
payback?
In 3 years, the project will generate a total of

$210,000 from net cash flows. Therefore, the
payback must be a little less than 3 years. It is
more precisely:
$200,000
Payback Period
2.86 Years
$70,000
10-7

Payback Period
The payback period is useful as a measure of a

projects liquidity risk, but it has several
weaknesses:
Does not account for the time value of money
No objective criterion for what is an acceptable

payback period
Cash flows occurring after the payback period have

no impact upon the payback computation.

10-8

Discounted Payback Period
This improves upon the payback period by

taking into account the time value of money.
A projects discounted payback period is the

number of years it takes for the net cash flows
present values to pay back the net investment.
Again, shorter paybacks are better than longer
paybacks.

10-9

We will compute the discounted payback period

(DPP) using the same example. We will need a
required rate of return for the computation.
Lets use 10%.
The following table is used to compute the

projects DPP.

10-10


Year
0
1
2
3
4
5
Cash Flow
PV of Cash Flow
-$200,000
$70,000
$70,000
$70,000
$70,000
$70,000
-$200,000
$63,636
$57,851
$52,592
$47,811
$43,464
Cumulative
-$200,000
-$236,364
-$78,513
-$25,921
After 3 years there is still $25,921 that has not

been paid back by the present value of the net
cash flows.

10-11

The DPP will be 3 years plus whatever

proportion of year 4 is needed to pay back the
final $25,921.
$25,921
DPP 3
3.54
$47,811
The discounted payback is 3.54 years. This

project recovers its net investment in 3.54 years
when considering the time value of money.

10-12

The DPP is an improvement upon the payback

period in 2 ways:
The DPP takes into account the time value of

money.
There is an objective criterion for an acceptable

DPP if a project has normal cash flows. Under
these circumstances a project is acceptable if
the DPP is less than the economic life of the
project.

10-13

Net Present Value
A projects net present value (NPV) is the most

straightforward application of cost-benefit analysis.
The cost is the net investment.
The benefit is the sum of the present values.
NPV is the sum of the present values of the net cash

flows minus the net investment. The cash flows are
discounted at a projects required rate of return.

10-14

Net Present Value
Using the same example, the NPV with a 10%

required rate of return is:
1
1
1 + 10% 5
$200,000 = $65,355
NPV = $70,000 x
10%
A positive NPV indicates a project is acceptable.
A negative NPV indicates a project is not

acceptable.

10-15

Net Present Value
A projects NPV is also an estimate of the

change in a firms value caused by investment
in a project.
In the example, the firms value is expected to

increase by $65,355 if the project is accepted.

10-16

Profitability Index
A projects profitability index (PI) also

compares a projects costs to its benefits.
Cost and benefits for the PI are measured the same

as for the NPV.
The comparison of costs and benefits is different for

the PI than for the NPV. It is the ratio of a projects
benefit to its cost.
A projects PI is the sum of the present values of

the net cash flows divided by the net investment.

10-17

Profitability Index
Using the same example and a 10% required

rate of return, the projects PI is
1 - 1 + 10% 5
$70,000 x
10%
$265,355
PI =
=
= 1.33
$200,000
$200,000

10-18

Profitability Index
The PI can also be computed as follows:
NPV
$65,355
PI 1
1
1.33
Net Investment
$200,000
A PI of 1.33 indicates a project is expected to

generate $0.33 of NPV for every $1.00 invested
in the project. Keep in mind, NPV is a measure
of value over and above the projects net
investment.

10-19

Profitability Index
A PI greater than 1.0 indicates a project is

acceptable.
A PI less than 1.0 indicates a project is not

acceptable.
The PI is most useful when a firm is facing

capital rationing. The PI indicates which
projects generate the greatest NPV per dollar
invested.

10-20

Internal Rate of Return
An internal rate of return (IRR) is a projects

true annual percentage rate of return based
upon the estimated cash flows.
IRR can also be defined as the interest rate

causing a projects NPV to be equal to zero.
Therefore, the IRR equation is adapted from the
NPV equation.

10-21

Using the same example, the IRR equation is:

1
1
1 + IRR 5
$200,000 = 0
$70,000 x
IRR
IRR equals 22.11%.

10-22

The IRR equation can also be expressed as:

1
1
1 + IRR 5
= $200,000
$70,000 x
IRR
And of course the IRR still equals 22.11%.

10-23

A project is:
Acceptable if the IRR > required rate of return.
Unacceptable if the IRR < required rate of return.

10-24

Notice we did not use the 10% required rate of

return to compute the IRR in our example. But
we do determine project acceptability by
comparing the IRR to the required rate of
return.
In our example, the project is acceptable since

the 22.11% IRR is greater than the 10%
required rate of return.

10-25

Modified Internal Rate of Return
A projects modified internal rate of return

(MIRR) is the interest rate equating a projects
investment costs with the terminal value of the
projects net cash flows.
The present value of a projects investment

costs is called the beginning value.
The future value of a projects net cash flows is

called the terminal value.

10-26

A projects beginning value is the sum of the

present values of all investment cash outflows
for a project.
If all investment cash outflows occur at the very

beginning (time = 0), then the beginning value
equals the net investment.
If investment outlays occur over several years,

the discount rate used to compute present
values is usually the required rate of return.

10-27

A projects terminal value is the sum of the

future values of the net cash flows at the end of
the projects economic life.
The interest rate used to compute the future

values is usually the required rate of return.

10-28

Using the same example, the projects

beginning value is just the net investment of
$200,000. The projects terminal value (TV) is:
1 + 10% 5 1
TV = $70,000 x
= $427,357
10%

10-29

The projects MIRR equates the PV of the

beginning value with the FV of the terminal
value:
$427,357
$200,000 =
5
1 + MIRR
The MIRR equals 16.40%.

10-30

A project is:
Acceptable if the MIRR > required rate of return.
Unacceptable if the MIRR < required rate of

return.
In our example, the project is acceptable since

the 16.40% MIRR is greater than the 10%
required rate of return.

10-31

Independent Projects and Decision Making
An independent capital budget project presents

a standalone decision. A single project is
simply evaluated to determine if it is expected to
increase firm value or decrease firm value.
If a project has normal cash flows and is

independent, then any of the methods besides
payback period can be used to determine
acceptability.

10-32

Independent Projects and Decision Making
An independent, normal project is

acceptable if
Discounted payback period < economic life
Net present value > 0
Profitability index > 1.0
Internal rate of return > required rate of return
Modified IRR > required rate of return

10-33

Mutually Exclusive Projects and Decision Making
Mutually exclusive capital budgeting decisions

require the evaluation of several projects to
determine the one project that maximizes firm
value.
All the mutually exclusive projects need to be

ranked with only the best project accepted.
The project with the highest NPV is by definition

the project expected to maximize firm value.

10-34


Other methods besides NPV may not rank
projects correctly if:
Projects have scale differencesnet

investments are different sizes.
Projects have cash flow timing differences.
Cash flows are not normalone or more future

net cash flows are negative.

10-35


When projects have scale differences:
Only the NPV will definitely rank projects

correctly.
The payback period, DPP, PI, IRR, and MIRR

may not rank projects correctly.

10-36

When projects have cash flow timing

differences:
The NPV, PI, and MIRR will rank projects

correctly.
The payback period, DPP, and IRR may not rank

projects correctly.

10-37

When a projects cash flows are not normal:
The NPV, PI, and MIRR will rank projects

correctly.
The payback period, DPP, and IRR may not rank

projects correctly.

10-38

Capital Budgeting Methods Pros and Cons
Payback Period
A measure of liquidity and risk
Does not take into account the time value of

money
No information on project profitability

10-39

Discounted Payback
A better measure of liquidity and risk than the

ordinary payback period
Does take into account the time value of

money
Provides an objective criterion for normal

projects: DPP < economic life

10-40

Net Present Value
Best measure of project profitability.
Does not provide much information about

project risk.
Is consistent with maximizing firm value.

10-41

Profitability Index
A relative measure of profitability
Provides some information about project risk
May not rank mutually exclusive projects

correctly

10-42



correctly

10-43


correctly if scale differences exist between
projects

10-44

Summary of Chapter 10 Topics
The NPV is the single best measure of a

projects profitability.
The PI, IRR, and MIRR provide a measure of a

projects margin of safety.
The payback period and DPP provide a

measure of liquidity risk.

10-45

Summary of Chapter 10 Topics
We have covered the following in this chapter:
Computation of 6 capital budgeting decision

methods and their pros and cons
Making decisions with independent projects
Making decisions with mutually exclusive

projects

10-46


Chap 10

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Chap 10

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Chapter 10

Capital budgeting was introduced in Chapter

The focus of this chapter is the analysis of a

Hospitality Financial Management

2005 Pearson Education, Inc.

Capital budgeting decision methods:

Hospitality Financial Management

2005 Pearson Education, Inc.

Capital budgeting decisions with:

The advantages and disadvantages of each of

Hospitality Financial Management

2005 Pearson Education, Inc.

Project Cash Flows

The capital budgeting decision is essentially

We call the cost of a project the net

The benefits from a project are the future cash

Hospitality Financial Management

2005 Pearson Education, Inc.

Capital Budgeting Decision Methods

Capital budgeting decision methods essentially

Hospitality Financial Management

2005 Pearson Education, Inc.

A projects payback period is the number of

Hospitality Financial Management

2005 Pearson Education, Inc.

Suppose a project has a $200,000 net

In 3 years, the project will generate a total of

2005 Pearson Education, Inc.

The payback period is useful as a measure of a

Does not account for the time value of money

No objective criterion for what is an acceptable

Cash flows occurring after the payback period have

Hospitality Financial Management

2005 Pearson Education, Inc.

Discounted Payback Period

This improves upon the payback period by

A projects discounted payback period is the

Hospitality Financial Management

2005 Pearson Education, Inc.

Discounted Payback Period

We will compute the discounted payback period

The following table is used to compute the

Hospitality Financial Management

2005 Pearson Education, Inc.

Discounted Payback Period

After 3 years there is still $25,921 that has not

Hospitality Financial Management

2005 Pearson Education, Inc.

Discounted Payback Period

The DPP will be 3 years plus whatever

The discounted payback is 3.54 years. This

Hospitality Financial Management

2005 Pearson Education, Inc.

Discounted Payback Period

The DPP is an improvement upon the payback

The DPP takes into account the time value of

There is an objective criterion for an acceptable

Hospitality Financial Management

2005 Pearson Education, Inc.

Net Present Value

A projects net present value (NPV) is the most

The cost is the net investment.