Capital Budgeting Decision-making Criteria

1. Capital Budgeting Decision-making Criteria • Capital Budgeting • Payback Period • Discounted Payback • Net Present Value (NPV) • Internal Rate of Return (IRR) • Modified Internal Rate of Return (MIRR)

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

3. Decision-making Criteria in Capital Budgeting • The Ideal Evaluation Method should: • Include all cash flows that occur during the life of the project • Consider the time value of money • Incorporate the required rate of return on the project

4. (500) 150 150 150 150 150 150 150 150 8 7 0 1 2 3 4 5 6 Payback Period • How long will it take for the project to generate enough cash to pay for itself?

5. Payback Period (PB) Cumulative Years Cash Flow Cash Flow 0 -500 1 150 150 2 150 300 3 150 450 4 150 600 5 150 750 6 150 900 7 150 1050 8 150 1200 • It takes more than 3, but less than 4 years

6. Payback Period (Continued) • To find the fraction of the 4th year, we first assume that cash flows are evenly distributed throughout the year • Payback = Number of Full Years + [(Initial Investment – Cumulative Cash Flow at the end of Last Full Year) / The Next Year’s Cash Flow] • Payback = 3 + (500 – 450) / 150 = 3.33 years

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

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

9. (500) 150 150 150 150 150 (300) 0 0 8 7 0 1 2 3 4 5 6 Drawbacks of Payback Period (Continued) • Does not consider all of the project’s cash flows. • This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!

10. Discounted Payback (DPB) • Discounts the cash flows at the firm’s required rate of return • Payback period is calculated using these discounted net cash flows • Problems: • Cutoffs are still subjective • Still does not examine all cash flows

11. (500) 250 250 250 250 250 1 2 3 4 5 0 Discounted Payback – Example Cumulative Year Cash Flow PVCIF (14%) PVCIF 0 -500 -500.00 0.00 1 250 219.30 219.30 2 250 192.37 411.67 3 250 168.74 580.41 • Payback = 2 + [(500 – 411.67) / 168.74] = 2.52 years

12. Other Methods • Net Present Value (NPV) • Profitability Index (PI) • Internal Rate of Return (IRR) • Each of these decision-making criteria: • Examines all net cash flows • Considers the time value of money • Considers the required rate of return

13. Net Present Value (NPV) • NPV = the total PV of the annual net cash flows – the initial outlay. • Where, FCF is the Free Cash Flow k is the required return t is the time subscript • Decision Rule: • If NPV is positive, accept • If NPV is negative, reject

14. Profitability Index (PI) • Decision Rule: • If PI is greater than or equal to 1, accept • If PI is less than 1, reject

15. Internal Rate of Return (IRR) • 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 • IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay or NPV = 0 • This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond

16. Internal Rate of Return (IRR) (Continued) • 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

17. 1 2 3 (500) 200 100 (200) 400 300 0 1 2 3 4 5 Internal Rate of Return (IRR) (Continued) • IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)

18. Internal Rate of Return (IRR) (Continued) • We know that the IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay or NPV = 0 • Above table shows a trial and error procedure is applied to determine the IRR. Using different discount rates we check if NPV = 0

19. Internal Rate of Return (IRR) (Continued)

20. Modified Internal Rate of Return (MIRR) • IRR assumes that all cash flows are reinvested at the IRR • MIRR provides a rate of return measure that assumes cash flows are reinvested at the required rate of return

21. Modified Internal Rate of Return (MIRR) • Calculate the PV of the cash outflows (PVCOF) using the required rate of return – this is usually the investment amount • Calculate the FV of the cash inflows (FVCIF) at the last year of the project’s time line. This is also called the terminal value (TV) • Using the required rate of return • MIRR is the growth rate of money from initial investment to terminal value over the life of the investment

22. Modified Internal Rate of Return (MIRR) (Continued) • Finding FV of Uneven Cash Flows: • Cumulate CF one year at a time taking FV into account • Find FV of each CF at the end of project life and then sum FVs • Use of NPV function (faster): First, find the PVCIF (NPV) (exclude initial investment) using required return. Second, change the sign of NPV and store it in PV (now a single cash flow as PV of all cash inflows) to find FV at the end of project life