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Capital Budgeting Evaluation Technique Pertemuan 7-10 Matakuliah: A0774/Information Technology Capital Budgeting Tahun: 2009

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Payback Period Techniques The payback period answers the question of : how long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial costs The shorter the pay back period the more attractive the investment. The reasons are that : –Earlier the investment is recovered, the sooner the cash funds can be used for other purpose –The risk of loss from obsolesces and changed economic conditions is less in a shorter payback - period

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Payback Period Techniques Disadvantages : –Ignores the time value of money –Ignores cash flows after the payback period –Biased against long term projects –Requires an arbitrary acceptance criteria –An accepted project based on the payback criteria may not have a positive NPV Advantages: –Easy to understand –Biased toward liquidity

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The Discounted Payback Period Rule How long does it take the project to “pay back” its initial investment taking the time value of money into account? However, by the time you have discounted the cash flow, you might as well calculate the NPV

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Net Present Value Technique The primary capital budgeting method that uses discounted cash low techniques is called the Net Present Value (NPV). Under the NPV net cash flows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts is referred to as the NPV. The interest rate used to discount the future cash lows is the required rate of return. A project is accepted when the net present value is zero or positive.

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Net Present Value Technique The Net Present Value (NPV) Rule Net Present Value (NPV) = Total PV of future CF’s – Initial Investment

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Net Present Value Technique Why To Use Net Present Value? –Accepting positive NPV projects benefits shareholders, for the following reasons : NPV uses cash flows NPV uses all the cash flows of the project NPV discounts the cash flows properly

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Net Present Value Technique Estimating NPV –Three variables should be considered:: Estimate future cash flows : how much? And when? Estimate discount rate Estimate initial costs –Minimum Acceptance Criteria : Accept if NPV > 0 –Raking Criteria : Choose the highest NPV

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Net Present Value Technique Good Attribute of the NPV Rules –Uses cash flows –Uses all cash flow of the project –Discounts all cash flows properly

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The Profitability Index (PI) Rule PI = Total PV of Future Cash Flows Initial Investment Minimum Acceptance Criteria : Accept if PI > 1 Ranking Criteria : Select alternative with highest PI

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The Profitability Index (PI) Rule Disadvantages : –Problems with mutually exclusive investments Advantages: –May be useful when available investment funds are limited –Easy to understand and communicate –Correct decision when evaluating independent projects

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The Internal Rate of Return (IRR) Rule IRR is the discount rate that sets NPV to zero. The IRR differs from the NPV in that it results in finding the internal yield of the potential investment. The IRR is calculated by discounting the net cash flows using different discount rates till it gives a net present value of zero (Trial and Error).

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The Internal Rate of Return (IRR) Rule Minimum Acceptance Criteria –Accept if the IRR exceeds the required return. –Ranking Criteria Select alternative with the highest IRR Reinvestment assumption : All future cash flows assumed reinvested at the IRR

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The Internal Rate of Return (IRR) Rule Disadvantages –Does not distinguish between investing and borrowing ? –IRR may not exist or there may be multiple IRR –Problems with mutually exclusive investments Advantages –Easy to understand and communicate

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Modified Internal Rate of Return Technique Three steps in the calculation of MIRR –Step 1 : Calculate the present value of all cash outflows, using the reinvestment rate as the discount rate –Step 2 : Calculate the future value of all cash inflows reinvested at some rate –Step 3 : Solve for rate - the MIRR - that causes future value of cash inflows to equal present value of outflows

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Comparing Evaluation Techniques The discounted cash low techniques - NPV, PI, IRR, MIRR (1) all cash flows, (2) the time value of money (3) the risk of future cash flows.

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Comparing Evaluation Techniques The discounted cash flow techniques are also usefully because we can apply objective decision criteria, criteria we can actually use that tells us when a project increases wealth and when it does not.

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Comparing Evaluation Techniques There are question need to ask when evaluating an investment and the answers will determine which technique is the one to use for that investment: Are the projects mutually exclusive or independent ? Are the projects subject to capital rationing? Are the projects of the same risk ? Are the projects of the same scale of investment?

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Comparing Evaluation Techniques If projects are independent and not subject to capital rationing we can evaluate them and determine the ones that maximize wealth based on any of the discounted cash flow techniques. If the projects are mutually exclusive, have the same investment outlay, and have the same risk, we must use only the NPV or the MIRR techniques to determine the projects that maximize wealth. If projects are mutually exclusive and are of different risks or are of different scale, NPV is preferred over MIRR. IF the capital budget is limited, we can use either the NPV or the PI.

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