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Capital Budgeting:
The process of planning for purchases of longterm assets.
- Accept or Reject?
- Focus on Cash Flow
For
Decision-making Criteria in
Capital Budgeting
How do we
decide if a
capital
investment
project should
be accepted or
rejected?
Decision-making Criteria in
Capital Budgeting
The
Decision-making Criteria in
Capital Budgeting
Firms invest in 2 categories of projects:
1) Independent
2) Mutually
Techniques in Capital
Budgeting
1)
2)
3)
4)
5)
Payback period
Discounted Payback Period
Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
1) Payback Period
The
Example:
Initial outlay
Payback Period
Initial outlay = $500.00
Project A
Year Cash flow
1
$100
2
$250
3
$50
4
$300
5
$300
6
($150)
7
($150)
8
($150)
500 - 100
400 - 250
150 - 50
Year 4 : $300
We know that the payback period is 3 years ++ and the
remaining $100 can be recaptured during year 4, but how
to
find the remaining period?
To determine the remaining period:
= $ 100 (balance left in year 3)
$ 300 (cash flow in year 4)
= 0.33 year.
So the payback period for this project is 3.33 years.
Payback Period
3
DECISION RULE :
ACCEPT if payback < maximum acceptable payback
period.
REJECT if payback > maximum acceptable payback
period.
250
250
250
250
250
250
219.30
280.70
250
192.37
88.33
250
168.74
FCF
(1 + k)n
= 0.52 year.
So the payback period for this project is
2.52 years.
Exercise:
You are considering a project with an initial outlay of $70,000 and
expected free cash flows of $20,000 at the end of each year for six years.
The required rate of return for this project is 10%.
a.What is the projects payback period?
b.What is the projects discounted payback period?
Exercise:
You are considering a project with an initial outlay of $70,000 and
expected free cash flows of $20,000 at the end of each year for six years.
The required rate of return for this project is 10%.
a.What is the projects payback period?
b.What is the projects discounted payback period?
Solution:
Payback period
Year
Year
Year
Year
Year
0
1
2
3
4
Cash Flow
(70,000)
20,000
20,000
20,000
20,000
Balance left
-70,000
-50,000
-30,000
-10,000
Exercise:
You are considering a project with an initial outlay of $70,000 and
expected free cash flows of $20,000 at the end of each year for six years.
The required rate of return for this project is 10%.
a.What is the projects payback period?
b.What is the projects discounted payback period?
Solution:
FCF
(1 + k)n
Balance left
-70,000
-51,818.18
-35,289.25
-20,262.95
-6,602.68
Exercise:
You are considering 3 independent projects; project A, project B and
project C. The required rate of return is 10% on each. Given the following
free cash flow information, calculate the payback period and discounted
payback period for each .
YEAR
PROJECT A
PROJECT B
PROJECT C
- $ 10, 000
- $5, 000
- $ 1,000
600
5,000
1,000
300
3,000
1,000
200
3,000
2,000
100
3,000
2,000
500
3,000
2,000
Other Methods
3) Net Present Value (NPV)
4) Profitability Index (PI)
5) Internal Rate of Return (IRR)
Consider each of these decision-making
criteria:
All net cash flows.
The time value of money.
The required rate of return.
NPV Example
Suppose we are considering a capital investment
that costs $250,000 and provides annual net cash
flows of $100,000 for five years. The firms
required rate of return is 15%.
(250,000)
0
100,000
1
100,000
2
100,000
3
100,000
4
100,000
5
NPV Example
Suppose we are considering a capital investment
that costs $250,000 and provides annual net cash
flows of $100,000 for five years. The firms
required rate of return is 15%.
(250,000)
100,000
100,000
100,000
100,000
4
(n=1)
(n=2)
(n=3)
(n=4)
(n=5)
100,000
5
Solution:
Year
1
2
3
4
5
Cash flow
$100,000
$100,000
$100,000
$100,000
$100,000
PVIFk,n
(0.870)
(0.756)
(0.658)
(0.572)
(0.497)
PV of cash flows
=$87,000
=$75,600
=$65,800
=$57,200
=$49,700
PV =$335,300
minus IO = (250,000)
NPV = $85,300
Solution:
NPV = 100,000
+
(1.15)1
100,000
+
(1.15)2
100,000
+
(1.15)3
100,000
+
(1.15)4
100,000
- 250,000
(1.15)5
Alternative Solution:
Since the amount of annual cash flow is
equal for each period (an annuity), total PV
can be determined as follows:
n=5
k = 15%
PMT = 100,000
Exercise:
Find the NPV of project A if the expected free
cash flows are as follows. The firm required
rate of return is 10%.
Year
0
1
2
3
4
Exercise:
Find the NPV of project A if the expected free
cash flows are as follows. The firm required
rate of return is 10%.
Year
0
1
2
3
4
Decision rule :
ACCEPT if PI is greater than or equal to one { PI >
1.0}
REJECT if PI is less than one { PI < 1.0 }
Profitability Index
Advantages:
Uses free cash flows
Recognizes the time value of money
Consistent with the firms goal of
shareholder wealth maximization.
Disadvantages:
Requires detailed long-term forecasts
of a projects free cash flows.
Example:
Emerald Corp. is considering an
investment with a cost of $250,000
and future benefits of $100,000
every year.
If the companys
required rate of return is 15%, based
on the profitability index (PI), should
the Emerald accept the project?
Year
1
2
3
4
5
PI = $335,300/250,000
= 1.3412 (Accept)
Decision rule :
ACCEPT if IRR > required rate of return
REJECT if IRR < required rate of return
IRR:
FCFt
= IO
t
(1 + IRR)
t=1
IRR
Calculating IRR
Calculating IRR
Method: trial and error/Interpolation
Choose any discount rate [(randomly) TIPs used req. rate as a base].
2. Compare ACF in step 1 with IO. If ACF = IO, we successfully find the IRR.
If not, try again (step 3).
3. If ACF > IO , you should increased the discount rate.
BUT, if ACF < IO, you should reduced the discount rate. Continue until
you find the exact IRR (approximately).
4.After we have decide IRR is between the TWO discount rate that we
choose, then use the interpolation method.
1.
RM253,000
IRR
RM250,000
29%
______
1%
___________
3,000
PVA =CF/(1+IRR)n
RM253,000
RM248,300
__________
4,700
EXAMPLE:
Example:
Syarikat ABC is considering one project with an
initial investment of RM49,900. This project is
expected to produce ACF RM15,146 for the next
5 years. If the cost of capital (discount rate) is
13%, what is Syarikat ABC IRR?
(500)
200
100
(200)
400
300
Summary Problem
Enter the cash flows only once.
Find the IRR.
Using a discount rate of 15%, find NPV.
Add back IO and divide by IO to get PI.
(900)
300
400
400
500
600
45
Summary Problem
IRR = 34.37%.
Using a discount rate of 15%,
NPV = $510.52.
PI = 1.57.
(900)
300
400
400
500
600