Capital Budgeting
Capital Budgeting
Capital Budgeting
Capital Budgeting: Budgeting: the process of planning for purchases of longlongterm assets.
example 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?
a) include all cash flows that occur during the life of the project, b) consider the time value of money, money, c) incorporate the required rate of return on the project.
Payback Period
The
number of years needed to recover the initial cash outlay. How long will it take for the project to generate enough cash to pay for itself?
Payback Period
How
long will it take for the project to generate enough cash to pay for itself?
150
Payback Period
How
long will it take for the project to generate enough cash to pay for itself?
150
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 cutcut -off of 5 years for projects like ours, what would be our decision? Accept the project. project.
subjective. . cutoffs are subjective money. Does not consider time value of money. Does not consider any required rate of return. return . Does not consider all of the projects cash flows. flows.
This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!
Discounted Payback
the cash flows at the firms required rate of return. Payback period is calculated using these discounted net cash flows. Problems Problems: : Cutoffs are still subjective. Still does not examine all cash flows.
Discounts
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
CF (14%)
-500.00 219.30
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 1 year
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 192.38 1 year
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 192.38 88.32 1 year 2 years
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years .52 years
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
CF (14%)
1 year 2 years .52 years
Other Methods
1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Each of these decisiondecision-making criteria: Examines all net cash flows, Considers the time value of money, and Considers the required rate of return.
NPV =
7
t=1
ACFt (1 + k) t
- IO
NPV Example
Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firms required rate of return is 15%.
NPV Example
Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firms required rate of return is 15%.
CF mode.
ENTER
ENTER ENTER
CF mode. -276,400 CFo=? C01=? 83,000 F01= 1 4 C02=? 116,000 F02= 1 NPV I= 15
CPT
CF mode. -276,400 ENTER CFo=? C01=? 83,000 ENTER F01= 1 4 ENTER C02=? 116,000 ENTER F02= 1 ENTER NPV I= 15 ENTER You should get NPV = 18,235.71
CPT
Profitability Index
n
NPV =
7
t=1
ACFt t (1 + k)
- IO
Profitability Index
n
NPV =
7
t=1 n
ACFt t (1 + k)
- IO
PI =
7
t=1
ACFt t (1 + k)
IO
Profitability Index
y
NPV 18,235.71. . You should get NPV = 18,235.71 Add back IO: + 276,400 Divide by IO: / 276,400 = You should get PI = 1.066
NPV =
7
t=1
ACFt (1 + k) t
- IO
NPV =
7
t=1 n
ACFt (1 + k) t
- IO
IRR:
7
t=1
ACFt t (1 + IRR)
= IO
IRR:
IRR
7
t=1
ACFt t (1 + IRR)
= IO
is the rate of return that makes the PV of the cash flows equal to the initial outlay. This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.
Calculating IRR
Looking again
at our problem: The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.
83,000 83,000 83,000 83,000 116,000 (276,400)
0
This
IRR
y y
Decision Rule: 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.
IRR
is a good decisiondecision-making tool as long as cash flows are . (- + + + + +) conventional. conventional Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
IRR
is a good decisiondecision-making tool as long as cash flows are . (- + + + + +) conventional. conventional Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
(500) 200 0 1 100 2 (200) 3 400 4 300 5
IRR
is a good decisiondecision-making tool as long as cash flows are . (- + + + + +) conventional. conventional Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
(500) 200 0 1 100 2 (200) 3 400 4 300 5
Problem:
If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) We could find 3 different IRRs!
1 (500) 200 0 1 100 2 2 (200) 3 3 400 4 300 5
Summary Problem:
the cash flows only once. IRR. . Find the IRR V. . Using a discount rate of 15%, find NPV I. Add back IO and divide by IO to get PI. (900) 300 0 1 400 2 400 3 500 4 600 5
Enter
Summary Problem:
= 34.37%. Using a discount rate of 15%, NPV = $510.52. PI = 1.57.
IRR
(900) 300 0 1
400 2
400 3
500 4
600 5