Professional Documents
Culture Documents
Capital Budgeting
Techniques
13.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Project Evaluation:
Alternative Methods
Simple Method
• Payback Period (PBP)
Discounted Cash Flow (DCF) Method
• Internal Rate of Return (IRR)
• Net Present Value (NPV)
• Profitability Index (PI)
13.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Proposed Project Data
–40 K 10 K 12 K 15 K 10 K 7K
Cumulative
Inflows PBP =a+(b–c)/d
= 3 + (40 – 37) / 10
= 3 + (3) / 10
= 3.3 Years
13.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Payback Solution (#3)
0 1 2 3 4 5
–40 K 10 K 12 K 15 K 10 K 7K
–40 K –30 K –18 K –3 K 7K 14 K
PBP = 3 + ( 3K ) / 10K
Cumulative = 3.3 Years
Cash Flows Note: Take absolute value of last
negative cumulative cash flow value.
13.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PBP Acceptance Criterion
13.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Payback Period
(PBP)(Solution)
Payback period = Cash outflow/
Annual Cash inflow
$40,000 / 15,000 = 2.67
0.67 x 12 = 8.04
0.04 x 30 = 1.2
The (PBP) is 2 years and 8 month
13.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PBP Strengths
and Weaknesses
Strengths: Weaknesses:
• Easy to use and • Does not account
understand for TVM
• Can be used as a • Does not consider
measure of cash flows beyond
liquidity the PBP
• Easier to forecast • Cutoff period is
ST than LT flows subjective
13.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Internal Rate of Return (IRR)
13.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution
13.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Try 10%)
$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +
$15,000(PVIF10%,3) + $10,000(PVIF10%,4) +
$ 7,000(PVIF10%,5)
$40,000 = $10,000(0.909) + $12,000(0.826) +
$15,000(0.751) + $10,000(0.683) +
$ 7,000(0.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
13.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Try 10% )
Year Net Cash PVIF 10% Present
Flows Value
1 10,000 0.909 9,090
2 12,000 0.826 9,912
3 15,000 0.751 11,265
4 10,000 0.683 6,830
5 7,000 0.621 4,347
Total 41,444
Present
Value
13.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Try 15%)
$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +
$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +
$ 7,000(PVIF15%,5)
$40,000 = $10,000(0.870) + $12,000(0.756) +
$15,000(0.658) + $10,000(0.572) +
$ 7,000(0.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
13.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Try 15%)
Year Net Cash PVIF 15% Present
Flows Value
1 10,000 0.870 8,700
2 12,000 0.756 9,072
3 15,000 0.658 9,870
4 10,000 0.572 5,720
5 7,000 0.497 3,479
Total Present 36,841
Value
13.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Interpolate)
0.10 $41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15 $36,841
X $1,444
0.05 = $4,603
13.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Interpolate)
0.10 $41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15 $36,841
X $1,444
0.05 = $4,603
13.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Solution (Interpolate)
0.10 $41,444
X $1,444
0.05 IRR $40,000 $4,603
0.15 $36,841
X = ($1,444)(0.05) X = 0.0157
$4,603
IRR = 0.10 + 0.0157 = 0.1157 or 11.57%
13.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Acceptance Criterion
The management of Basket Wonders
has determined that the required rate
is 13% for projects of this type.
Should this project be accepted?
13.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
IRR Strengths
and Weaknesses
Strengths: Weaknesses:
• Accounts for • Assumes all cash
TVM flows reinvested at
• Considers all the IRR
cash flows • Difficulties with
• Less project rankings and
subjectivity Multiple IRRs
13.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Net Present Value (NPV)
13.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Solution
Basket Wonders has determined that the
appropriate discount rate (k) for this
project is 13%.
NPV = $10,000 +$12,000 +$15,000 +
(1.13)1 (1.13)2 (1.13)3
$10,000 $7,000
4 + 5 - $40,000
(1.13) (1.13)
13.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Solution
NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) +
$15,000(PVIF13%,3) + $10,000(PVIF13%,4) +
$ 7,000(PVIF13%,5) – $40,000
NPV = $10,000(0.885) + $12,000(0.783) +
$15,000(0.693) + $10,000(0.613) +
$ 7,000(0.543) – $40,000
NPV = $8,850 + $9,396 + $10,395 +
$6,130 + $3,801 – $40,000
= - $1,428
13.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Solution (Another
Method)
Year Cash Flows PVIF 13% Present
Value
1 10,000 0.885 8,850
2 12,000 0.783 9,396
3 15,000 0.693 10,396
4 10,000 0.613 6,130
5 7,000 0.543 3,801
Total PV 38,573
Cash outflow 40,000
Net PV (1,427)
13.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Acceptance Criterion
The management of Basket Wonders
has determined that the required
rate is 13% for projects of this type.
Should this project be accepted?
13.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
NPV Strengths
and Weaknesses
Strengths: Weaknesses:
• Cash flows •
May not include
assumed to be managerial
reinvested at the options embedded
required rate. in the project. See
• Accounts for TVM. Chapter 14.
• Considers all
13.37
cash flows.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Profitability Index (PI)
13.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PI Acceptance Criterion
PI = $38,573 / $40,000
= .9643 (Method #1, previous slide)
13.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
PI Strengths
and Weaknesses
Strengths: Weaknesses:
• Same as NPV • Same as NPV
• Allows • Provides only
comparison of relative profitability
different scale
• Potential Ranking
projects
Problems
13.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Evaluation Summary
13.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
13.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
A. Scale Differences
Compare a small (S) and a
large (L) project.
A. Scale Differences
project at various
Project I discount rates.
400
NPV@10%
200
IRR
Project D
0
-200
0 5 10 15 20 25
Discount Rate (%)
13.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
600
Net Present Value ($)
Fisher’s Rate of Intersection
Intersection
At k>10%, D is best!
0 5 10 15 20 25
Discount Rate ($)
13.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
C. Project Life Differences
Let us compare a long life (X) project
and a short life (Y) project.
13.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for
this capital budgeting period.
13.62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Available Projects for BW
Project ICO IRR NPV PI
A $ 500 18% $ 50 1.10
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
E 12,500 26 500 1.04
F 15,000 28 21,000 2.40
G 17,500 19 7,500 1.43
H 25,000 15 6,000 1.24
13.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Choosing by IRRs for BW
Project ICO IRR NPV PI
C $ 5,000 37% $ 5,500 2.10
F 15,000 28 21,000 2.40
E 12,500 26 500 1.04
B 5,000 25 6,500 2.30
Projects C, F, and E have the
three largest IRRs.
The resulting increase in shareholder wealth
is $27,000 with a $32,500 outlay.
13.64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Choosing by NPVs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40
G 17,500 19 7,500 1.43
B 5,000 25 6,500 2.30
Projects F and G have the
two largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
13.65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Choosing by PIs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
G 17,500 19 7,500 1.43
Projects F, B, C, and D have the four largest PIs.
The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
13.66 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Summary of Comparison
Method Projects Accepted Value Added
PI F, B, C, and D $38,000
NPV F and G $28,500
IRR C, F, and E $27,000