KeyConceptsandSkillsBeabletocomputepaybackanddiscountedpaybackandunderstandtheirshortcomingsUnderstandaccountingratesofreturnandtheirshortcomingsBeabletocomputetheinternalrateofreturnandprofitabilityindex,understandingthestrengthsandweaknessesofbothapproachesBeabletocomputethenetpresentvalueandunderstandwhyitisthebestdecisioncriterionChapterOutline7.1WhyUseNetPresentValue?7.2ThePaybackPeriodMethod7.3TheDiscountedPaybackPeriodMethod7.4TheAverageAccountingReturnMethod7.5TheInternalRateofReturn7.6TheProfitabilityIndex7.7ThePracticeofCapitalBudgeting7.1WhyUseNetPresentValue?AcceptingpositiveNPVprojectsbenefitsshareholders.NPVusescashflowsNPVusesallthecashflowsoftheprojectNPVdiscountsthecashflowsproperlyReinvestmentassumption:theNPVruleassumesthatallcashflowscanbereinvestedatthediscountrate.TheNetPresentValue(NPV)RuleNetPresentValue(NPV)=TotalPVoffutureCFs-InitialInvestmentEstimatingNPV:1.Estimatefuturecashflows:howmuch?andwhen?2.Estimatediscountrate3.EstimateinitialcostsMinimumAcceptanceCriteria:AcceptifNPV>0RankingCriteria:ChoosethehighestNPVConsiderthefollowingthreeprojectsavailabletoafirm:ABCNICFNICFNICF0(20000)(9000)(12000)1180011800(1800)1200600460023240132403000600060046003300060006004600Theappropriatediscountratefortheprojectsis10%.PleasecalculatetheNPVforeachproject.Example7.2ThePaybackPeriodMethodHowlongdoesittaketheprojectto“payback”itsinitialinvestment?PaybackPeriod=numberofyearstorecoverinitialcostsMinimumAcceptanceCriteria:SetbymanagementRankingCriteria:SetbymanagementConsiderthefollowingthreeprojectsavailabletoafirm:ABCNICFNICFNICF0(20000)(9000)(12000)1180011800(1800)1200600460023240132403000600060046003300060006004600Pleasecalculatethepaybackperiodforeachproject.ExampleDisadvantages:IgnoresthetimevalueofmoneyIgnorescashflowsafterthepaybackperiodBiasedagainstlong-termprojectsRequiresarbitraryacceptancecriteriaAprojectacceptedbasedonthepaybackcriteriamaynothaveapositiveNPVAdvantages:EasytounderstandBiasedtowardliquidityExample

ABC0-100-100-1001205050230303035020204606060000paybackperiod3337.3TheDiscountedPaybackPeriodHowlongdoesittaketheprojectto“payback”itsinitialinvestment,takingthetimevalueofmoneyintoaccount?Decisionrule:Accepttheprojectifitpaysbackonadiscountedbasiswithinthespecifiedtime.0123$50,000$50,000$20,000-$100,000PP=1+1=2yeardiscountthecashfollow(-100,00045,454.5541,322.3115,026.3)DPP=1+1+(100000-45454.55-41322.31)/15026.3=2+0.88=2.88yearExample(discountrate=10%)PVIFABCCFPVCFPVCFPV0(20000)(9000)(12000)10.90911180010727.3812001090.9246004181.8620.82641324010941.5460004958.446003801.4430.751360004507.846003455.98DPP=1+(20000-10727.38)/10941.54=1.85DPP=2+(9000-6049.32)/4507.8=2.65DPP>3年Example(discountrate=10%)PPA=1.62,PPB=2.3,PPC=2.617.4AverageAccountingReturnAnotherattractive,butfatallyflawed,approachRankingCriteriaandMinimumAcceptanceCriteria:SetbymanagementConsiderthefollowingthreeprojectsavailabletoafirm:ABCNICFNICFNICF0(20000)(9000)(12000)1180011800(1800)1200600460023240132403000600060046003300060006004600Pleasecalculatetheaverageaccountingreturnforeachproject.ExampleDisadvantages:IgnoresthetimevalueofmoneyUsesanarbitrarybenchmarkcutoffrateBasedonbookvalues,notcashflowsandmarketvaluesAdvantages:TheaccountinginformationisusuallyavailableEasytocalculate

7.5TheInternalRateofReturnIRR:thediscountratethatsetsNPVtozeroMinimumAcceptanceCriteria:AcceptiftheIRRexceedstherequiredreturnRankingCriteria:SelectalternativewiththehighestIRRReinvestmentassumption:AllfuturecashflowsassumedreinvestedattheIRRExampleConsiderthefollowingproject:0123$50$100$150-$200Theinternalrateofreturnforthisprojectisabout19.44%.IfwegraphNPVversusthediscountrate,wecanseetheIRRasthex-axisintercept.IRR=19.44%Considerthefollowingthreeprojectsavailabletoafirm:ABCNICFNICFNICF0(20000)(9000)(12000)1180011800(1800)1200600460023240132403000600060046003300060006004600Pleasecalculatetheinternalrateofreturnforeachproject.ExampleProblemswithIRRInvestingorFinancing?MultipleIRRsTheScaleProblemTheTimingProblemIndependentandMutuallyExclusiveProjectsMutuallyExclusivevs.IndependentMutuallyExclusiveProjects:onlyONEofseveralpotentialprojectscanbechosenRANKallalternatives,andselectthebestone.IndependentProjects:acceptingorrejectingoneprojectdoesnotaffectthedecisionoftheotherprojectsMustexceedaMINIMUMacceptancecriteriaTwoGeneralProblemsAffectingBothIndependentandMutuallyExclusiveProjectsProblem1:InvestingorFinancing?ProjectAProjectBProjectCDates0101012Cashflows-100130100-130-100230-132IRR30%30%10%and20%NPV(10%)18.2-18.20Acceptifmarketrate<30%>30%>10%but<20%FinancingorinvestingInvestingFinancingMixtureTheNPVofprojectAisnegativelyrelatedtothediscountrate.TheNPVofprojectBispositivelyrelatedtothediscountrate.Projectswithmorethanonechangeofsigncanhavemultipleratesofreturn.SomeconclusionsoftheexampleInvestingprojectsAcceptifIRRismorethanmarket(discount)rateRejectifIRRislessthanmarket(discount)rateFinancingprojectsAcceptifIRRislessthanmarket(discount)rateRejectifIRRismorethanmarket(discount)rateMixtureprojectsCanhavemultipleIRRsShoulduseNPVruleorMIRRmethodModifiedIRRCalculatethenetpresentvalueofallcashoutflowsusingthegivendiscountrate.Calculatethenetfuturevalueofallcashinflowsusingthegivendiscountrate.Findtherateofreturnthatequatesthesevalues.MIRRassumescashinflowsarereinvestedatWACCBenefits:singleanswerandspecificratesforborrowingandreinvestmentProblem2:MultipleIRRsExample(r=10%)0123-1,0005004003004-120-81.96330.00484.00665.50-1,081.96PVofallthecostsoftheproject,discountedatthecostofcapitalFVofalltheprojectsincome,reinvestedatthecostofcapital(TerminalValue)1,497.50ProblemsSpecifictoMutuallyExclusiveProjects

Wouldyourathermake100%or50%onyourinvestments?Whatifthe100%returnisona$1investment,whilethe50%returnisona$1,000investment?Problem3:TheScaleProblem0 1 2 3$10,000$1,000 $1,000-$10,000ProjectA0 1 2 3$1,000 $1,000 $12,000-$10,000ProjectBProblem4:TheTimingProblem10.55%=crossoverrate16.04%=IRRA12.94%=IRRBSomeconclusionsoftheexampleWecanselectthebetterprojectwithoneofthethreedifferentmethods:CompareNPVsoftheTwoProjectsCompareIncrementalIRRtoDiscountRateCalculateNPVonIncrementalCashFlowsNPVversusIRRNPVandIRRwillgenerallygivethesamedecision.Exceptions:Non-conventionalcashflows–cashflowsignschangemorethanonceMutuallyexclusiveprojectsInitialinvestmentsaresubstantiallydifferentTimingofcashflowsissubstantiallydifferentATestYoumustknowthediscountratetocomputetheNPVofaproject,butyoucomputetheIRRwithoutreferringtothediscountrate.Hence,theIRRruleiseasiertoapplythantheNPVrulebecauseyoudon’tusethediscountratewhenapplyingIRR.7.6TheProfitabilityIndex(PI)MinimumAcceptanceCriteria:AcceptifPI>1RankingCriteria:SelectalternativewithhighestPIConsiderthefollowingthreeprojectsavailabletoafirm:ABCNICFNICFNICF0(20000)(9000)(12000)1180011800(1800)1200600460023240132403000600060046003300060006004600Pleasecalculatetheprofitabilityindexforeachproject.(NPVA=1669,NPVB=1557,NPVc=-560)ExampleDisadvantages:ProblemswithmutuallyexclusiveinvestmentsAdvantages:MaybeusefulwhenavailableinvestmentfundsarelimitedEasytounderstandandcommunicateCorrectdecisionwhenevaluatingindependentprojects7.7ThePracticeofCapitalBudgetingVariesbyindustry:Somefirmsusepayback,othersuseaccountingrateofreturn.ThemostfrequentlyusedtechniqueforlargecorporationsisIRRorNPV.Summary–DiscountedCashFlowNetpresentvalueDifferencebetweenmarketvalueandcostAccepttheprojectiftheNPVispositiveHasnoseriousproblemsPreferreddecisioncriterionInternalrateofreturnDiscountratethatmakesNPV=0TaketheprojectiftheIRRisgreaterthantherequiredreturnSamedecisionasNPVwithconventionalcashflowsIRRisunreliablewithnon-conventionalcashflowsormutuallyexclusiv