Basics of Capital Budgeting

Capital Budgeting -

Methods/Decisions Rules for Evaluating Capital Projects

Example Projects

Year Oklahoma Oil Outpost

Western Windmill Warehouse

0 ($10,000,000) ($10,000,000) 1 $5,000,000 $2,000,000 2 $4,000,000 $3,000,000 3 $3,000,000 $4,000,000 4 $2,000,000 $5,000,000 5 $1,000,000 $6,000,000

Note: No cashflows are expected after year five for either

project, and the marginal cost of capital is 10% for each project.

Payback Period

Payback Period -

What is the Payback Period for Oklahoma Oil Outpost?

What is the Payback Period for Western Windmill Warehouse?

Interpreting the Payback Period

Decision Rules:

» Mutually Exclusive Projects -

» Independent Projects -

Deficiencies:

Discounted Payback Period

Discounted Payback Period -

What is the Discounted Payback Period for Oklahoma Oil Outpost?

What is the Discounted Payback Period for Western Windmill Warehouse?

Interpreting the Discounted Payback Period

Decision Rules:

» Mutually Exclusive Projects -

» Independent Projects -

Deficiencies:

Net Present Value (NPV)

Net Present Value -

What is the Net Present Value for Oklahoma Oil Outpost?

What is the Net Present Value for Western Windmill Warehouse?

Interpreting the Net Present Value

Decision Rules:

» Mutually Exclusive Projects -

» Independent Projects -

Deficiencies:

Internal Rate of Return (IRR)

Internal Rate of Return -

What is the Internal Rate of Return for Oklahoma Oil Outpost?

What is the Internal Rate of Return for Western Windmill Warehouse?

Interpreting the Internal Rate of Return (IRR)

Decision Rules:

» Mutually Exclusive Projects -

» Independent Projects -

Deficiencies:

Crossover Rate

Crossover Rate -

What is the Crossover rate between Oklahoma Oil Outpost (OOO) and Western Windmill Warehouse (WWW)?

Modified Internal Rate of Return (MIRR)

Modified Internal Rate of Return (MIRR) -

What is the MIRR for Oklahoma Oil Outpost?

What is the MIRR for Western Windmill Warehouse?

Interpreting the Modified Internal Rate of Return (MIRR)

Decision Rules:

» Mutually Exclusive Projects -

» Independent Projects -

Deficiencies:

Profitability Index (PI)

Profitability Index -

What is the Profitability Index for Oklahoma Oil Outpost?

What is the Profitability Index for Western Windmill Warehouse?

Interpreting the Profitability Index (PI)

Decision Rules:

» Mutually Exclusive Projects -

» Independent Projects -

Deficiencies: