Capital Budgeting Techniques Kandarp Mehta

Net Present Value PV of the stream of future CFs from a project minus the project’s net investment

NPV Characteristics NPV > 0 acceptable above-normal profits Considers the time value of money Absolute measure of wealth –Positive NPVs increase owner’s wealth –Negative NPVs decrease owner’s wealth NPV not easily understood CF’s over the projects life reinvested at k

NPV Strengthsand Weaknesses Strengths: – Cash flows assumed to be reinvested at the hurdle rate. – Accounts for TVM. – Considers all cash flows. Weaknesses: – May not include managerial options embedded in the project.

IRR Rate of discount that equates the PV of net cash flows of a project with the PV of the NINV

IRR Characteristics IRR > k acceptable Considers the time value of money Unusual CF pattern can result in multiple rates of return CFs contain more than one sign change If the NPV & IRR criteria disagree, NPV is preferred Always agree if NPV > 0, then IRR > k; and if NPV < 0, then IRR < k IRR assumes that CF is reinvested at IRR

IRR Strengths and Weaknesses Strengths:  Accounts for TVM  Considers all cash flows  Less Subjectivity Weaknesses:  Assumes all cash flows reinvested at the IRR  Difficulties with project rankings and Multiple IRRs

Profitability Index Ratio of the PV of future cash flows over the life of the project to the NINV

PI Characteristics PI > 1 acceptable Considers the time value of money CFs reinvested at k Relative measure showing wealth increase per dollar of investment

PI Strengths and Weaknesses Strengths:   Same as NPV  Allows comparison of different scale projects Weaknesses:   Same as NPV  Provides only relative profitability  Potential Ranking Problems

Payback Period Number of years for the cumulative net cash flows from a project to equal the initial cash outlay Net Investment Annual net CF PB = When net CFs are unequal, interpolation is required

PB Characteristics Simple Provides a measure of project liquidity Measure of risk longer the time, greater the risk Not a true measure of profitability Ignores CFs after the payback period Ignores the time value of money

PBP Strengths and Weaknesses Strengths:Strengths: – Easy to use and understand – Can be used as a measure of liquidity – Easier to forecast ST than LT flows Weaknesses:Weaknesses: – Does not account for TVM – Does not consider cash flows beyond the PBP – Cutoff period is subjective

Capital Budgeting Under Capital Rationing Calculate the PI for projects Order the projects from the highest to the lowest PI Accept the projects with the highest PI until the entire capital budget is spent