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Chapter 9

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Capital Budgeting: the process of planning for purchases of long- term assets. n example: Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? n Will the machine be profitable? n Will our firm earn a high rate of return on the investment?

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n The Ideal Evaluation Method should: a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project. Decision-making Criteria in Capital Budgeting

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Three Basic Methods of Evaluating Projects 1. Payback Method 2. Net Present Value (NPV) 3. Internal Rate of Return (IRR)

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Payback Period n How long will it take for the project to generate enough cash to pay for itself? 012345 8 6 7 (500) 150 150 150 150 150 150 150 150 Payback period = 3.33 years.

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n Is a 3.33 year payback period good? n Is it acceptable? n Firms that use this method will compare the payback calculation to some standard set by the firm. n If our senior management had set a cut- off of 5 years for projects like ours, what would be our decision? n Accept the project. Payback Period

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Drawbacks of Payback Period n Firm cutoffs are subjective. n Does not consider time value of money. n Does not consider any required rate of return. n Does not consider all of the project’s cash flows.

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Other Methods 1) Net Present Value (NPV) 2) Internal Rate of Return (IRR) Each of these decision-making criteria: n Examines all net cash flows, n Considers the time value of money, and n Considers the required rate of return.

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NPV Example 0 1 2 3 4 5 250,000 100,000 100,000 100,000 100,000 100,000 n Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15%.

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Net Present Value (NPV) NPV is just the PV of the annual cash flows minus the initial outflow. Using TVM: P/Y = 1 N = 5 I = 15 PMT = 100,000 PV of cash flows = $335,216 PV of cash flows = $335,216 - Initial outflow: ($250,000) - Initial outflow: ($250,000) = Net PV $85,216 = Net PV $85,216

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NPV with the TI BAII Plus: n Select CF mode. n CFo=? -250,000 ENTER n C01=? 100,000 ENTER n F01= 1 5 ENTER n NPV I= 15 ENTER CPT n You should get NPV = 85,215.51

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Internal Rate of Return (IRR) n IRR: the return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

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Calculating IRR n Looking again at our problem: n The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay. 0 1 2 3 4 5 250,000 100,000 100,000 100,000 100,000 100,000

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IRR with your Calculator n IRR is easy to find with your financial calculator. n Just enter the cash flows as you did with the NPV problem and solve for IRR. n You should get IRR = 28.65%!

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IRR Decision Rule: If IRR is greater than or equal to the required rate of return, accept. If IRR is less than the required rate of return, reject.

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Summary Problem n Enter the cash flows only once. n Find the IRR. n Using a discount rate of 15%, find NPV. 0 1 2 3 4 5 (900) 300 400 400 500 600

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Summary Problem n IRR = 34.37%. n Using a discount rate of 15%, NPV = $510.52. NPV = $510.52. 0 1 2 3 4 5 (900) 300 400 400 500 600

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Problems with Project Ranking 1) Mutually exclusive projects of unequal size (the size disparity problem) n The NPV decision may not agree with IRR. n Solution: select the project with the largest NPV.

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Chapter 6 Capital Budgeting Techniques Sept 2010 Dr. B. Asiri © 2005 Thomson/South-Western.

Chapter 6 Capital Budgeting Techniques Sept 2010 Dr. B. Asiri © 2005 Thomson/South-Western.

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