Chapter 9

Capital Budgeting Techniques

Learning Goals
1.

Understand the role of capital budgeting techniques in the capital budgeting process. Calculate, interpret, and evaluate the payback period. Calculate, interpret, and evaluate the net present value (NPV).

2.

3.

Learning Goals (cont.)

4. 5. 6.

Calculate, interpret, and evaluate the internal rate of return (IRR). Use net present value profiles to compare NPV and IRR techniques. Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach.

Capital Budgeting Techniques

When firms have developed relevant cash flows, they analyze them: To assess whether a project is acceptable To rank projects. Preferred approaches integrate: Time value procedures Risk and return considerations Valuation concepts to select capital expenditures that are consistent with the firms goal of maximizing owners wealth.

Capital Budgeting Techniques

Chapter Problem
Bennett Company is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial investment of $42,000, project B an initial investment of $45,000. The relevant operating cash flows for the two projects are presented in Table 9.1 and depicted on the time lines in Figure 9.1.

Capital Budgeting Techniques

Capital Budgeting Techniques

Payback Period
The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. The maximum acceptable payback period is determined by management. If the payback period is < the maximum acceptable payback period, accept the project. If the payback period is > the maximum acceptable payback period, reject the project.

Capital Budgeting Techniques

Payback Period annuity = Initial Investment
Annual Cash Flows
Project A payback period= $42,000/ $14,000 = 3.0 years

Payback Period mixed stream is where

Initial Investment = Cumulative Annual Cash Flows
Project B: $45,000 = $28,000 + $12,000 + 50%($10,000) Payback period = 2.5 years

Capital Budgeting Techniques

Payback Period mixed stream is where
Initial Investment = Cumulative Annual Cash Flows

Payback period = 2 years + 5,000/10,000 = 2.5 years

Pros and Cons of Payback Periods

The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. It is simple, intuitive, and considers cash flows rather than accounting profits. It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.

Pros and Cons of Payback Periods

One major weakness of the payback method is that the appropriate payback period is a subjectively determined number. It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value. Thus, payback fails to fully consider the time value of money. It also fails to recognize cash flows that occur after the payback period.

Pros and Cons of Payback Periods

More of $50,000 initial investment in Project Silver is recovered sooner, so this project will be preferred considering time value of money.

Pros and Cons of Payback Periods

Strict adherence to the payback approach suggests Project X preferable to Project Y. But cash flows of Project Y after pay back period are greater.

Net Present Value (NPV)

Net Present Value (NPV) Gives explicit consideration of the time value of money, so is considered a sophisticated capital budgeting technique Such techniques discount the firms cash flows at a specified rate called: Discount rate Required rate of return Cost of capital or (WACC) Opportunity cost

Net Present Value (NPV)

Net Present Value (NPV) Specified rate called: Discount rate Required rate of return Cost of capital or (WACC) Opportunity cost Minimum return that must be earned on a project to leave the firms market value unchanged.

Net Present Value (NPV)

Net Present Value (NPV): Net Present Value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows.

Net Present Value (NPV)

Decision Criteria

If NPV > 0, accept the project

If NPV < 0, reject the project If NPV = 0, technically indifferent

Net Present Value (NPV)

Using the Bennett Company data from Table 9.1, assume the firm has a 10% cost of capital. Based

on the given cash flows and cost of capital (required

return), the NPV can be calculated as shown in Figure 9.2

Net Present Value (NPV)

Net Present Value (NPV)

Net Present Value (NPV)

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the projects intrinsic rate of return.

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate that will equate the present value of the outflows with the present value of the inflows. The IRR is the projects intrinsic rate of return.

Decision Criteria If IRR > k, accept the project If IRR < k, reject the project If IRR = k, technically indifferent

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

Project A NPV IRR

Project B $10,924 21.7%

$11,071 19.9%

There is no guarantee that NPV and IRR will rank projects in the same order. But both methods should reach the same conclusion about the acceptability of the projects.