1. Capital Budgeting Net Present Value Rule Payback Period Rule
Discounted Payback Period Rule
Average Accounting Return
Internal Rate of Return
Profitability Index
Practice of Capital Budgeting
Incremental Cash Flow
Chapters 6 & 7 – MBA504

2. Net Present Value (NPV) Rule
Total PV of future CF’s + Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
Chapters 6 & 7 – MBA504

3. Example Assume you have the following information on Project X:
Initial outlay -$1,100 Required return = 10%
Annual cash revenues and expenses are as follows:
Year Revenues Expenses
$1, $500
, ,000
Calculate its NPV.
Chapters 6 & 7 – MBA504

4. The Payback Period Rule
How long does it take the project to “pay back” its initial investment?
Payback Period = number of years to recover initial costs
Minimum Acceptance Criteria:
set by management
Disadvantages
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Chapters 6 & 7 – MBA504

5. Initial outlay -$1,000 Year Cash flow 1 $200 2 400 3 600 Accumulated 1
1 $200
2 400
3 600
Accumulated 1 2 3
Payback period =
Chapters 6 & 7 – MBA504

6. 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?
By the time you have discounted the cash flows, you might as well calculate the NPV.
Chapters 6 & 7 – MBA504

7. Example 1 $ 200 $ 182 Initial outlay -$1,000 R = 10% PV of
Year Cash flow Cash flow
$ $ 182
Accumulated:
Year discounted cash flow
$ 182
3 1,039
4 1,244
Discounted payback period is
Chapters 6 & 7 – MBA504

8. Average Accounting Return Rule
Another attractive but fatally flawed approach.
Ranking Criteria and Minimum Acceptance Criteria set by management
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values
Advantages:
The accounting information is usually available
Easy to calculate
Chapters 6 & 7 – MBA504

9. Internal Rate of Return (IRR) Rule
IRR: the discount that sets NPV to zero
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.
Chapters 6 & 7 – MBA504

10. Example Consider the following project:1 2 3
$50
$100
$150
-$200
The internal rate of return for this project is 19.44%
Chapters 6 & 7 – MBA504

11. NPV Payoff Profile for The Example
If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.
IRR = 19.44%
Chapters 6 & 7 – MBA504

12. Problems with the IRR Approach
Multiple IRRs.
The Scale Problem.
The Timing Problem.
Chapters 6 & 7 – MBA504

13. Multiple IRRs There are two IRRs for this project:
$ $800
-$200
- $800
Which one should we use?
100% = IRR2
0% = IRR1
Chapters 6 & 7 – MBA504

14. The Scale Problem
Would you rather make 100% or 50% on your investments?
What if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment?
Chapters 6 & 7 – MBA504

15. The Timing Problem (page 161)
$10, $1,000 $1,000
-$10,000
Project A
$1, $1, $12,000
-$10,000
Project B
The preferred project in this case depends on the discount rate, not the IRR.
Chapters 6 & 7 – MBA504

16. Mutually Exclusive vs. Independent Project
Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g. acquiring an accounting system.
RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria.
Chapters 6 & 7 – MBA504

17. Which project is good? Chapters 6 & 7 – MBA504 Net present value Year
Project A: – $
Project B: – $
160
140
120
100 80 60 40
Crossover Point 20
– 20
– 40
– 60
– 80
– 100
Discount rate 2% 6%
10%
14%
18%
22%
26%
IRR A IRR B
Chapters 6 & 7 – MBA504

18. Chapters 6 & 7 – MBA504

19. Decision Rule
If required rate of return < crossover return, take the project with lower IRR
If required rate of return > crossover return, take the project with higher IRR
Don’t think a project with higher IRR is always good
Projects with higher NPV is always good
Chapters 6 & 7 – MBA504

20. Profitability Index (PI) Rule
Minimum Acceptance Criteria: Accept if PI > 1
Ranking Criteria: Select alternative with highest PI
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
Chapters 6 & 7 – MBA504

21. Practice of Capital Budgeting
Varies by industry:
Some firms use payback, others use accounting rate of return.
The most frequently used technique for large corporations is IRR or NPV.
Chapters 6 & 7 – MBA504

22. Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the following two projects. Assume the required return is 10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
Chapters 6 & 7 – MBA504

23. Incremental Cash Flows
Cash flows matter—not accounting earnings.
Sunk costs don’t matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like cannibalism and erosion matter.
Taxes matter: we want incremental after-tax cash flows.
Inflation matters.
Chapters 6 & 7 – MBA504

24. Cash Flows—Not Accounting Earnings
Consider depreciation expense.
You never write a check made out to “depreciation”.
Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.
Chapters 6 & 7 – MBA504

25. Incremental Cash Flows
Sunk costs are not relevant
Just because “we have come this far” does not mean that we should continue to throw good money after bad.
Opportunity costs do matter. Just because a project has a positive NPV that does not mean that it should also have automatic acceptance. Specifically if another project with a higher NPV would have to be passed up we should not proceed.
When I was an undergrad at the University of Missouri-Rolla, a good friend of mine abandoned college three credit hours shy of graduation. Really. Entreaties from his friends and parents regarding how far he had come and how hard he had worked could not change Louis’ mind. That was all a sunk cost to Louis. He already had a job and didn’t value the degree as much as the incremental work of an easy three-hour required class called ET-10 engineering drafting. Fifteen years later, he still has a good job, a great wife and two charming daughters. Louis taught me a lot about sunk costs.
Chapters 6 & 7 – MBA504

26. Incremental Cash Flows
Side effects matter (page 180)
Erosion
Synergy
When I was an undergrad at the University of Missouri-Rolla, a good friend of mine abandoned college three credit hours shy of graduation. Really. Entreaties from his friends and parents regarding how far he had come and how hard he had worked could not change Louis’ mind. That was all a sunk cost to Louis. He already had a job and didn’t value the degree as much as the incremental work of an easy three-hour required class called ET-10 engineering drafting. Fifteen years later, he still has a good job, a great wife and two charming daughters. Louis taught me a lot about sunk costs.
Chapters 6 & 7 – MBA504

27. Estimating Cash Flows Cash Flows from Operations Net Capital Spending
Recall that:
Operating Cash Flow = EBIT – Taxes + Depreciation
Net Capital Spending
Don’t forget salvage value (after tax, of course).
Changes in Net Working Capital
Recall that when the project winds down, we enjoy a return of net working capital.
Chapters 6 & 7 – MBA504

28. The Baldwin Company: An Example (page 181)
Costs of test marketing (already spent): $250,000.
Current market value of proposed factory site (which we own): $150,000.
Cost of bowling ball machine: $100,000 (depreciated according to ACRS 5-year life). Salvage value of 30,000.
Increase in net working capital: $10,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000.
Price during first year is $20; price increases 2% per year thereafter.
Production costs during first year are $10 per unit and increase 10% per year thereafter.
Annual inflation rate: 5%
Tax rate is 34 percent
Working Capital: initially $10,000 changes with sales.
See the text for the details of the case.
Chapters 6 & 7 – MBA504

29. Key Issues Dis-regard sunk costs
Consider incremental cash flow – additional cash flows
Figure out revenue, cost, depreciation, tax, capital spending, addition to net work capital
Refer to this example when you take advanced corporate finance to deal with capital budgeting or meet this kind of problem in your work
Chapters 6 & 7 – MBA504