Foundations of Finance

Chapter 9
Capital-Budgeting Decision Criteria

MBA SMS UOFK 2013 Prof.Abdelgadir

Concepts and Learning Objectives

Be able to compute payback and discounted payback and understand their shortcomings Understand accounting rates of return and their shortcomings Be able to compute the internal rate of return and understand its strengths and weaknesses Be able to compute the net present value and understand why it is the best decision criterion
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Capital Budgeting

Investments in fixed assets An approach to source and evaluate profitable projects Evaluating the profitability of projects Often choosing between one or more projects

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Decision-making Criteria in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected? 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, and c) incorporate the required rate of return on the project.

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Good Decision Criteria

We need to ask ourselves the following questions when evaluating capital budgeting decision rules:
1.

2. 3.

Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm?
MBA SMS UOFK 2013 Prof.Abdelgadir

Techniques of capital budgeting

The Payback Rule The Discounted Payback Net Present Value The Profitability Index The Internal Rate of Return The Average Accounting Return

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1-Payback Period

How long does it take to get the initial cost back in a nominal sense? Computation

Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered

Decision Rule Accept if the payback period is less than some preset limit
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Payback Period: example 1

How long will it take for the project to generate enough cash to pay for itself? 150

(500) 150 150 150 150 150 150 150

Payback period = 3.33 years

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Payback: Example2
Project A investment 15000 Project 27000

N
OCF 1 2 3 4

5000 5000 5000 5000

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7500 7500 7500 18000

Advantages and Disadvantages of Payback

Advantages

Disadvantages

Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity

Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long-term projects, such as research and development, and new projects

MBA SMS UOFK 2013 Prof.Abdelgadir

Drawbacks of Payback Period

Does not consider all of the projects cash flows.

(500) 150 150 150 150 150 150 150

150

This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!
MBA SMS UOFK 2013 Prof.Abdelgadir

2- Discounted Payback Period

Compute the present value of each cash flow and then determine how long it takes to payback on a discounted basis Compare to a specified required period Decision Rule - Accept the project if it pays back on a discounted basis within the specified time
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Discounted Payback: example 1

(500) 0 250 1 250 2 250 3 250 250 4 5

Year 0 1
2
3

Cash Flow -500 250

250
250

Discounted CF (14%) -500.00 219.30 1 year 280.70 192.37 2 years 88.33

168.74 .52 years

MBA SMS UOFK 2013 Prof.Abdelgadir

Discounted payback: Example2

A project costs 13000 and has an economic life of 4 years. The annual operating cash flows are:7000, 7500, 8000 and 8500 respectively. Required: If the discount rate 12% what will be the discounted payback period for this project?
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Advantages and Disadvantages of Discounted Payback

Advantages

Disadvantages

Includes time value of money Easy to understand Does not accept negative estimated NPV investments when all future cash flows are positive Biased towards liquidity

May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff point Biased against long-term projects, such as R&D and new products

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3- Net Present Value

The difference between the market value of a project and its cost How much value is created from undertaking an investment? Steps in calculating NPV:
1. 2. 3. 4.

Estimate the expected future cash flows. Estimate the required return for projects of this risk level. Find the present value of the cash flows. Subtract the initial investment from the total present value of future cash flows to get NPV
MBA SMS UOFK 2013 Prof.Abdelgadir

3- Net Present Value

NPV = the total PV of the annual net cash flows - the initial outlay.

NPV =

S
t=1

FCFt (1 + k) t

- IO

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NPV Decision Rule

If the NPV is positive, accept the project If you have to select one project out of many projects accept the one with the highest positive NPV A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.
MBA SMS UOFK 2013 Prof.Abdelgadir

NPV Example

The initial investment = $ 165000 Discount Rate 12%

year 1 2 3

cash flows 63,120 70,800 91,080

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Computing NPV for the Project

Using the formulas:

NPV = 63,120 /(1.12) + 70,800 /(1.12)2 + 91,080 /(1.12)3 165,000 = 12,627.42 CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.42

Using the calculator:

Do we accept or reject the project?

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Calculating NPVs with a Spreadsheet

Spreadsheets are an excellent way to compute NPVs, especially when you have to compute the cash flows as well. Using the NPV function

The first component is the required return entered as a decimal The second component is the range of cash flows beginning with year 1 Subtract the initial investment after computing the NPV
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Advantages & Disadvantages of NPV

Includes the time value of money. Easy to understand Includes all cash flows It accounts for risk of cash flows

Assumes a single rate through the life of the project. Ignores the size of the project.

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4- Profitability Index

Measures the benefit per unit cost, based on the time value of money A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value This measure can be very useful in situations in which we have limited capital

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Profitability Index

NPV =

S
t=1

FCFt t (1 + k)

- IO

PI =

S
t=1

FCFt t (1 + k)

IO

MBA SMS UOFK 2013 Prof.Abdelgadir

Profitability index

It is the ratio of present value of OCF to the present value of the cost of the project. The decision Rule:

1- We accept the project if PI > 1. 2- We reject the project if PI < 1. 4- If we have to select one of two mutually exclusive projects we select the one with the highest PI. 5- If the projects are independent we select all projects that have PIs more than 1 provided that we have enough.

In general the project with PI > 1 will have positive NPV. In most cases if we accept under NPV we will accept it under PI.
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Profitability Index
A firm with a 10% required rate of return is considering investing in a new machine with an expected life of six years. The initial cash outlay is $50,000.

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Profitability Index
FCF
Initial Outlay Year 1 Year 2 -$50,000 15,000 8,000

PVF @ 10%
1.000 0.909 0.826

PV
-$50,000 13,635 6,608

Year 3
Year 4 Year 5 Year 6

10,000
12,000 14,000 16,000

0.751
0.683 0.621 0.564

7,510
8,196 8,694 9,024

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Profitability Index
PI = ($13,635 + $6,608+$7,510 + $8,196 + $8,694
+ $9,024) / $50,000

=$53,667/$50,000 = 1.0733 Project PI > 1

Therefore, accept.
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Advantages and Disadvantages of Profitability Index

Advantages

Disadvantages

Closely related to NPV, generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited

May lead to incorrect decisions in comparisons of mutually exclusive investments

MBA SMS UOFK 2013 Prof.Abdelgadir

5- Internal Rate of Return

This is the most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere
Definition: IRR is the return that makes the NPV = 0 Decision Rule: Accept the project if the IRR is greater than the required return
MBA SMS UOFK 2013 Prof.Abdelgadir

Internal Rate of Return (IRR)

NPV =

S
t=1
n

FCFt (1 + k) t

- IO

IRR:

S
t=1

FCFt t (1 + IRR)
MBA SMS UOFK 2013 Prof.Abdelgadir

= IO

IRR: Example 1
A project costs 100 and has one year as an economic life. At the end of that year it will generate 110. What is the IRR for this project?

MBA SMS UOFK 2013 Prof.Abdelgadir

NPV Example 2

The initial investment = $ 165000 Discount Rate 12%

year 1 2 3

cash flows 63,120 70,800 91,080

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Computing IRR For The Project

If you do not have a financial calculator, then this becomes a trial and error process Calculator

Enter the cash flows as you did with NPV Press IRR and then CPT IRR = 16.13% > 12% required return

Do we accept or reject the project?

MBA SMS UOFK 2013 Prof.Abdelgadir

NPV Profile For The Project

70,000 60,000 50,000 40,000

IRR = 16.13%

NPV

30,000 20,000 10,000 0 -10,000 0 -20,000 Discount Rate

MBA SMS UOFK 2013 Prof.Abdelgadir

0.02 0.04 0.06 0.08

0.1

0.12 0.14 0.16 0.18

0.2

0.22

Calculating IRRs With A Spreadsheet

You start with the cash flows the same as you did for the NPV You use the IRR function

You first enter your range of cash flows, beginning with the initial cash flow You can enter a guess, but it is not necessary The default format is a whole percent you will normally want to increase the decimal places to at least two
MBA SMS UOFK 2013 Prof.Abdelgadir

Advantages of IRR

Knowing a return is intuitively appealing It is a simple way to communicate the value of a project to someone who doesnt know all the estimation details If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task

MBA SMS UOFK 2013 Prof.Abdelgadir

6- Average Accounting Return

average net income average book value

average net income= Total Net Income No. of years average book value :

= (Beginning investment + ending investment) 2 Need to have a target cutoff rate Decision Rule: Accept the project if the AAR is greater than a preset rate.
MBA SMS UOFK 2013 Prof.Abdelgadir

Project Example Information

You are looking at a new project and you have estimated the following cash flows:

Year 1: 13,620 Year 2: 3,300 Year 3: 29,100 Average Book Value = 72,000

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Computing AAR For The Project

Assume we require an average accounting return of 25% Average Net Income:

(13,620 + 3,300 + 29,100) / 3 = 15,340

AAR = 15,340 / 72,000 = .213 = 21.3%

Do we accept or reject the project?

MBA SMS UOFK 2013 Prof.Abdelgadir

Advantages and Disadvantages of AAR

Advantages

Disadvantages

Easy to calculate Needed information will usually be available

Not a true rate of return; time value of money is ignored Uses an arbitrary benchmark cutoff rate Based on accounting net income and book values, not cash flows and market values

MBA SMS UOFK 2013 Prof.Abdelgadir