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Decision Criteria
How do we decide
if a capital
investment
project should
be accepted or
rejected?
Decision-making Criteria in
Capital Budgeting
■ The Ideal Evaluation Method should:
0 1 2 3 4 5 6 7 8
Payback Period
■ How long will it take for the project
to generate enough cash to pay for
itself?
(500) 150 150 150 150 150 150 150 150
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
Discounted Payback
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
The Discounted
0 -500 -500.00
Payback
1 250 219.30 1 year
is 2.52 years
280.70
280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years
Other Methods
Σ
ACFt
NPV = - IO
(1 + k) t
t=1
Net Present Value
• Decision Rule:
0 1 2 3 4 5
NPV with the HP10B:
■ -276,400 CFj
■ 83,000 CFj
■4 shift Nj
■ 116,000 CFj
■ 15 I/YR
■ shiftNPV
■ You should get NPV = 18,235.71.
NPV with the HP17BII:
■ Select CFLO mode.
■ FLOW(0)=? -276,400 INPUT
■ FLOW(1)=? 83,000 INPUT
■ #TIMES(1)=1 4 INPUT
■ FLOW(2)=? 116,000 INPUT
■ #TIMES(2)=1 INPUT EXIT
■ CALC 15 I% NPV
■ You should get NPV = 18,235.71
NPV with the TI BAII Plus:
■ Select CF mode.
NPV with the TI BAII Plus:
■ Select CF mode.
■ CFo=? -276,400 ENTER
NPV with the TI BAII Plus:
■ Select CF mode.
■ CFo=? -276,400 ENTER
■ C01=? 83,000 ENTER
NPV with the TI BAII Plus:
■ Select CF mode.
■ CFo=? -276,400 ENTER
■ C01=? 83,000 ENTER
■ F01= 1 4 ENTER
NPV with the TI BAII Plus:
■ Select CF mode.
■ CFo=? -276,400 ENTER
■ C01=? 83,000 ENTER
■ F01= 1 4 ENTER
■ C02=? 116,000 ENTER
NPV with the TI BAII Plus:
■ Select CF mode.
■ CFo=? -276,400 ENTER
■ C01=? 83,000 ENTER
■ F01= 1 4 ENTER
■ C02=? 116,000 ENTER
■ F02= 1 ENTER
NPV with the TI BAII Plus:
■ Select CF mode.
■ CFo=? -276,400 ENTER
■ C01=? 83,000 ENTER
■ F01= 1 4 ENTER
■ C02=? 116,000 ENTER
■ F02= 1 ENTER
■ NPV I= 15 ENTER CPT
NPV with the TI BAII Plus:
■ Select CF mode.
■ CFo=? -276,400 ENTER
■ C01=? 83,000 ENTER
■ F01= 1 4 ENTER
■ C02=? 116,000 ENTER
■ F02= 1 ENTER
■ NPV I= 15 ENTER CPT
■ You should get NPV = 18,235.71
Profitability Index
Σ
ACFt
NPV = t - IO
(1 + k)
t=1
Profitability Index
Σ
ACFt
NPV = t - IO
(1 + k)
t=1
Σ
ACFt
PI = IO
(1 + k) t
t=1
Profitability Index
• Decision Rule:
Σ
ACFt
NPV = - IO
(1 + k) t
t=1
Internal Rate of Return (IRR)
Σ
ACFt
NPV = - IO
(1 + k) t
t=1
n
ACFt
IRR:
Σ
t=1
(1 + IRR) t = IO
Internal Rate of Return (IRR)
n
ACFt
IRR:
Σt=1
(1 + IRR) t = IO
0 1 2 3 4 5
83,000 83,000 83,000 83,000 116,000
(276,400)
0 1 2 3 4 5
■ This is what we are actually doing:
0 1 2 3 4 5
■ This is what we are actually doing:
0 1 2 3 4 5
■ IRR is a good decision-making
tool as long as cash flows are
conventional. (- + + + + +)
■ Problem: If there are multiple
sign changes in the cash flow
stream, we could get multiple
IRRs. (- + + - + +)
0 1 2 3 4 5
■ Problem: If there are multiple
sign changes in the cash flow
stream, we could get multiple
IRRs. (- + + - + +)
■ We could find 3 different IRRs!
1 2 3
(500) 200 100 (200) 400 300
0 1 2 3 4 5
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.
0 1 2 3 4 5
Summary Problem:
■ IRR = 34.37%.
■ Using a discount rate of 15%,
NPV = $510.52.
■ PI = 1.57.
0 1 2 3 4 5