Accounting & Financial

Management
Session 12
Capital Budgeting Decision Rules

Decision Rules
Six key methods are used to rank projects
and to decide whether or not they should
be accepted for inclusion in the capital
budget.
(1) Payback period (2) discounted payback
(3) NPV (4) IRR (5) Modified IRR
(6)Profitability Index

Payback period
The amount of time taken to break even on
an investment. Since this method ignores
the time value of money and cash flows
after the payback period, it can provide
only a partial picture of whether the
investment is worthwhile.
The amount of time needed to break even
on an investment OR
How long will it take to get money back?

Example 1
A new machine will cost you $10,000. It
will generate income before depreciation
of $3,000 the first year; $4,000 the second
year and $3,000 the third year. The
payback period is 3 years.

Payback Rule
for independent projects: accept if payback
<= threshold
for mutually exclusive projects: accept project
with shortest payback <=threshold

Example 2
Consider the two examples of $1 million projects
shown in the chart at right. A bank can spend $1
million on server consolidations and save onethird that amount in each of the following three
years on reduced license fees,
telecommunications costs and systems
administration labor. Or it could spend the same
amount to install ATMs, eliminate four teller
positions and save $250,000 per year
indefinitely.
Which is a better investment?

Solution

Result
The bank could spend the same amount
on ATMs and recoup its costs in four
years. The server project is the payback
winner, but the ATM project saves
$250,000 per year indefinitely.
Payback Period

Exercise
Determine which
alternative should be
selected on the basis
of payback period
analysis.
Expected cash flow is
given in the table.

year
0

Alt: X

Alt: Y

-$1000 -$1000

500

100

400

300

300

400

100

600

Exact Payback Period

Paybacks = year before full recovery +

(unrecovered cost at start of year / cash
flow during year)

Strengths of Payback
It's easy to compute, easy to understand
and
It provides some indication of risk by
separating long-term projects from shortterm projects.

Weaknesses
There are two main problems with the
payback period method:
1) It ignores any benefits that occur after
the payback period, and so does not
measure profitability
2) It ignores the time value of money

Discounted Payback Period

The discounted payback period is the time

required for an investment to recover its
cost, after discounting the project cash
flows

Discounted payback rule

for independent projects:
accept if discounted payback<= threshold
for mutually exclusive projects:
accept project with shortest discounted
payback <= threshold

Exercise
Determine which
alternative should be
selected on the basis
of payback period
analysis. Assume i =
10%.
Expected cash flow is
given in the table
below.

year
0

Alt: X

Alt: Y

-$1000 -$1000

500

100

400

300

300

400

100

600

Solution
Discounted paybacks A= 2 + $214 /
$225
= 2.95 years
Discounted paybacks B= 3 + 360 / 410
= 3.88 years
Alternative A preferred to Alternative B

Profitability Index
An index that attempts to identify the
relationship between the costs and
benefits of a proposed project through the
use of a ratio calculated as:
PI

PI Decision Rules
for independent projects: accept if PI >= 1
for mutually exclusive projects: accept
project with highest PI>= 1 (if they are the
same size)

Rule Analysis
Advantages
-reflects time value of
money
- considers

all cash flows

Disadvantages
- mutually exclusive ignores scale
- can be hard to estimate
discount rate

Result
PIA = $1078.82 / 1000 = 1.079
PIB = 1049 / 1000 = 1.049
Alternative A is expected to produce $1.079
for each $1 of investment.
Alternative B is expected to produce $1.049
for each $1 of investment.
Both alternatives are accepted as their PI>1
and the higher the PI, higher the rank

Exercise

Calculate PI
Initial investment$12,950
Estimated life10 years
Annual cash inflows$ 3,000
Cost of capital is 12%

Internal Rate Of Return

IRR is the discount rate which results in
NPV = 0 OR PWB = PWC

Decision Rules
for independent projects: accept if IRR >
discount rate
for mutually exclusive projects: accept
project with highest
IRR > discount rate (if the projects are the
same size)

Exercise
Determine which
alternative should be
selected on the basis
of IRR analysis.
Assume i = 10%.
Expected cash flow is
given in the table
below.

year
0

Alt: X

Alt: Y

-$1000 -$1000

500

100

400

300

300

400

100

600

Result
IRRA = 14.5%
IRRB = 11.8%
IRRA > IRRB :
Alternative A is better than Alternative B

Example

COST OF CAPITAL
The cost of capital is the expected return that is
required on investments to compensate you for
the required risk.
It represents the discount rate that should be
used for capital budgeting calculations.
The cost of capital is generally calculated on a
weighted average basis (WACC).
It is alternatively referred to as the opportunity
cost of capital or the required rate of return.

Numerical Example

Moon Investments Balance Sheet shows:

Bonds
$ 200,000
Common shares
$ 200,000
Retained Earnings $ 100,000
------------
$ 500,000

Numerical Example
Bonds:
Annual interest rate 6%
Years to maturity is 9 years
Common shares:
Shares held 100,000
Current share price $5
Market return over next year 12%
Beta (somewhat risky) 1.15
Treasury bills currently yield 4%
Tax rate 25%

Calculation of Cost of Capital

First, determine market values
Bonds:
FV = $200,000
Interest per year = $200,000 x 0.06 = $12,000
N (number of years) = 9
i (interest rate) = 6%
PV (present value of the bonds) = $129,870.12
Common Shares:
100,000 shares x $ 5 = $ 500,000

Lets check it out

Interest per year = $129,870.12 x 0.06 =
$7,792.21
Interest for nine years = $ 7,792.21 x 9 = $
70,129.88
Amount to be paid at maturity =
$ 129,870.12 + $ 70,129.88 = $ 200,000
(this is the face value)

weightings based on market values

Second, determine weightings based on
market values
Bonds

$ i29,870

0.2062

Common Share $ 500.000

0.7938

Total

1.0000

$ 629,870

Third, determine costs

Common shares:
Rate of return = Risk-free rate (treasury bills rate) + [market
return over next year risk free rate] Beta
= 0.04 +(0.12 -0.04)1.15
= 0.04 + 0.092 = 0.132

Bonds:
PV = $ 129,870
FV = $ 200,000
i (after tax) = $ 12,000 (1 0.25)
= $ 12,000 x 0.75
= $ 9,000
Effective rate = $ 9,000/$ 200,000 = 0.045 or 4.5%

Finally, determine cost of capital

Cost of Capital = 11.41%
Assets

Weightings Cost

WXC

Bonds

0.2062

0.045

0.0093

Common
Share

0.7938

0.132

0.1048
0.1141

Cost of Capital
The cost of capital for a firm is a weighted
sum of the cost of equity and the cost of debt .
It is also known as the "Hurdle Rate" or
"Discount Rate".

Capital asset pricing model

The capital asset pricing model (CAPM) is used
in finance to determine a theoretically
appropriate price of an asset such as a security.
The expected return on equity according to the
capital asset pricing model.
The market risk is normally characterized by the
parameter. Thus, the investors would expect
(or demand) to receive:

CAPM Model
The expected return (%) = risk-free return (%) +
sensitivity to market risk * (historical return (%)
- risk-free return (%))
Put another way
the expected rate of return (%) = the yield on
the treasury note closest to the term of your
project + the beta of your project or security *
(the market risk premium)
the market risk premium has historically been
between 3-5%

Mathematical form

Es = Rf + Bs (Rm Rf)
Where:
Es : The expected return for a security
Rf :The expected risk-free return in that market
(government bond yield)
s :The sensitivity to market risk for the security
Rm :The historical return of the equity market
(Rm-Rf) :The risk premium of market assets
over risk free assets.

The sensitivity to market risk ()

The sensitivity to market risk () is unique
for each firm and depends on everything
from management to its business and
capital structure. This value cannot be
known "ex ante" (beforehand), but can be
estimated from "ex post" (past) returns
and past experience with similar firms.

Key Points (model)

The models states that investors will expect a
return that is the risk-free return plus the
security's sensitivity to market risk times the
market risk premium.
The risk free rate is taken from the lowest yielding
bonds in the particular market, such as
government bonds.
The risk premium varies over time and place, but
in some developed countries during the twentieth
century it has averaged around 5%.
The equity market real capital gain return has been
about the same as annual real GDP growth