Chapter 8 – Capital Budgeting Chapter 8 – Capital Budgeting Decision ModelsDecision Models

Learning ObjectivesLearning Objectives Differentiate between short term and long Differentiate between short term and long

term capital budgeting modelsterm capital budgeting models Apply the three basic decision modelsApply the three basic decision models

PaybackPayback NPVNPV IRRIRR

Calculate cross-over ratesCalculate cross-over rates Use modified decision modelsUse modified decision models Know the strength and weaknesses of each Know the strength and weaknesses of each

modelmodel

Short-term versus Long-termShort-term versus Long-term

Short-term decisionsShort-term decisions In general, repetitive decisionsIn general, repetitive decisions Low cost impactsLow cost impacts

Long-Term decisionsLong-Term decisions Capital budgeting decisionsCapital budgeting decisions Impacts over many yearsImpacts over many years

DifferenceDifference TimeTime CostCost Degree of InformationDegree of Information

Payback PeriodPayback Period

First and easiest model of capital First and easiest model of capital budgetingbudgeting

Answers the question, how soon will I get Answers the question, how soon will I get my money back?my money back?

Key FeaturesKey Features Need amount and timing of cash flowNeed amount and timing of cash flow Not concerned with cash flows after Not concerned with cash flows after

repaymentrepayment Ad hoc cutoff date for repaymentAd hoc cutoff date for repayment

Payback PeriodPayback Period Clinko Copiers (example 8.1)Clinko Copiers (example 8.1)

Initial investment is $5,000Initial investment is $5,000 Positive cash flow each yearPositive cash flow each year

Year 1 -- $1,500Year 1 -- $1,500 Year 2 -- $2,500Year 2 -- $2,500 Year 3 -- $3,000Year 3 -- $3,000 Year 4 -- $4,500Year 4 -- $4,500 Year 5 -- $5,500Year 5 -- $5,500

Payback in 2 and 1/3Payback in 2 and 1/3rdrd years…ignore years…ignore years 4 and 5 cash flowsyears 4 and 5 cash flows

Payback PeriodPayback Period StrengthensStrengthens

Easy to applyEasy to apply Initial cash flows most importantInitial cash flows most important Good for small dollar investmentsGood for small dollar investments

WeaknessesWeaknesses Ignores cash flow after cutoff periodIgnores cash flow after cutoff period Ignores time value of moneyIgnores time value of money

CorrectionsCorrections Discount cash flowDiscount cash flow

Discounted Payback PeriodDiscounted Payback Period

Attempt to correct one flaw of Payback Attempt to correct one flaw of Payback Period…time value of moneyPeriod…time value of money

Discount cash flow to present and see if Discount cash flow to present and see if the discount cash flow are sufficient to the discount cash flow are sufficient to cover initial cost within cutoff time periodcover initial cost within cutoff time period

Careful in consistencyCareful in consistency Discounting means cash flow at end of periodDiscounting means cash flow at end of period Appropriate discount rate for cash flowAppropriate discount rate for cash flow

Discounted Payback PeriodDiscounted Payback Period Discounted Cash Flow of Copiers A & BDiscounted Cash Flow of Copiers A & B

Discounted at 6% (APR)Discounted at 6% (APR) Both 3 year discounted paybacks with annual Both 3 year discounted paybacks with annual

cash flowcash flow Copier A – 26 months with monthly cash flowCopier A – 26 months with monthly cash flow Copier B – 29 months with monthly cash flowCopier B – 29 months with monthly cash flow

Potential for poor choicePotential for poor choice Large late positive cash flowLarge late positive cash flow Longer positive cash flowLonger positive cash flow

Net Present Value (NPV)Net Present Value (NPV)

Correction to discounted cash flowCorrection to discounted cash flow Includes all cash flow in decisionIncludes all cash flow in decision Changes decision (go vs. no-go) to dollars, Changes decision (go vs. no-go) to dollars,

not arbitrary cutoff periodnot arbitrary cutoff period The Decision Model (a.k.a. Discounted The Decision Model (a.k.a. Discounted

Cash Flow Model)Cash Flow Model) Need all cash flowNeed all cash flow Need appropriate discount rateNeed appropriate discount rate

Net Present Value (NPV)Net Present Value (NPV) Decision Decision

Accept all positive NPVsAccept all positive NPVs Reject all negative NPVsReject all negative NPVs

Copier ExampleCopier Example Copier A – NPV is $5,530.91 – AcceptCopier A – NPV is $5,530.91 – Accept Copier B – NPV is $9,253.09 – AcceptCopier B – NPV is $9,253.09 – Accept

Model good for comparing projectsModel good for comparing projects Select project with highest NPVSelect project with highest NPV Can assign different discount rates to projectsCan assign different discount rates to projects

Net Present Value (NPV)Net Present Value (NPV)

The Decision ModelThe Decision Model Incorporates risk and returnIncorporates risk and return Incorporates time value of moneyIncorporates time value of money Incorporates all cash flowIncorporates all cash flow

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

Model closely resembles NPV but…Model closely resembles NPV but… Finding the discount rate (internal rate) that Finding the discount rate (internal rate) that

implies an NPV of zeroimplies an NPV of zero Internal rate used to accept or reject projectInternal rate used to accept or reject project

If IRR > hurdle rate, acceptIf IRR > hurdle rate, accept If IRR < hurdle rate, rejectIf IRR < hurdle rate, reject

Very popular model as “managers” like the Very popular model as “managers” like the single return variable when evaluating single return variable when evaluating projectsprojects

Internal Rate of Return (IRR)Internal Rate of Return (IRR) Process difficult without calculator or Process difficult without calculator or

spreadsheet – iterative processspreadsheet – iterative process Need timing and amount of cash flowsNeed timing and amount of cash flows Popcorn Machine (Example 8.4)Popcorn Machine (Example 8.4)

Grannies IRR is 19.86%Grannies IRR is 19.86% Kettle Corn IRR is 20.35%Kettle Corn IRR is 20.35% Packaging Machine IRR is 14.91%Packaging Machine IRR is 14.91%

Decision RuleDecision Rule Requires hurdle rate for comparisonRequires hurdle rate for comparison Accept all with IRR > Hurdle RateAccept all with IRR > Hurdle Rate

Internal Rate of Return (IRR)Internal Rate of Return (IRR) Some problems with IRRSome problems with IRR

Cross-over Rates flip projectsCross-over Rates flip projects Using NPV profiles, project choice changes at cross-over Using NPV profiles, project choice changes at cross-over

rate so need to know both hurdle rate and cross-over raterate so need to know both hurdle rate and cross-over rate Cross-over rate is where two projects have same NPVCross-over rate is where two projects have same NPV

Multiple IRRsMultiple IRRs Projects with changing cash flows can have multiple IRRsProjects with changing cash flows can have multiple IRRs Which is the correct IRR? Don’t knowWhich is the correct IRR? Don’t know

Risk of Project is not includedRisk of Project is not included IRR calculation void of risk of projectIRR calculation void of risk of project Risk must be implied with different hurdle ratesRisk must be implied with different hurdle rates

Modified IRRModified IRR Major assumption of IRR is that all cash flow can Major assumption of IRR is that all cash flow can

be reinvested at IRR rate…be reinvested at IRR rate… Alternative (and better) assumption is that all Alternative (and better) assumption is that all

cash flow can be reinvested at hurdle ratecash flow can be reinvested at hurdle rate MIRRMIRR

Find future value of all cash inflow at hurdle rateFind future value of all cash inflow at hurdle rate Find present value of cash outflowFind present value of cash outflow Find interest rate that equates future values with Find interest rate that equates future values with

present valuepresent value Adjust comparison projects for differences in the Adjust comparison projects for differences in the

time horizontime horizon

Profitability Index (PI)Profitability Index (PI) Modified version of NPV Modified version of NPV Decision CriteriaDecision Criteria

PI > 1.0, accept projectPI > 1.0, accept project PI < 1.0, reject projectPI < 1.0, reject project

Profitability Index (PI)Profitability Index (PI) Close to NPV as we calculate present Close to NPV as we calculate present

value of future positive cash flows (present value of future positive cash flows (present value of benefits) and initial cash flow value of benefits) and initial cash flow (present value of costs)(present value of costs) PI = (NPV + Initial cost) / Initial CostPI = (NPV + Initial cost) / Initial Cost Answer is modified returnAnswer is modified return

Choosing between two different projects?Choosing between two different projects? Higher PI is best choice…Higher PI is best choice… Careful, cannot scale projects up and downCareful, cannot scale projects up and down

Profitability Index (PI)Profitability Index (PI) Example of Large Copier and Mini-Copier Example of Large Copier and Mini-Copier

(page 247)(page 247) Large Copier B PI is 2.85 (normal level of risk)Large Copier B PI is 2.85 (normal level of risk) Mini Copier PI is 2.95Mini Copier PI is 2.95 Pick Mini CopierPick Mini Copier

Problem with copier choiceProblem with copier choice Original investment in mini-copier only $500Original investment in mini-copier only $500 Original investment in Copier B is $5,000Original investment in Copier B is $5,000 Need to buy 10 mini-copiers to match Need to buy 10 mini-copiers to match

production of Copier B…production of Copier B…

ProblemsProblems

Problem 6 – Payback & Discounted PeriodProblem 6 – Payback & Discounted Period Problem 8 – Net Present ValueProblem 8 – Net Present Value Problem 12 – Internal Rate of Return & Problem 12 – Internal Rate of Return &

Modified Internal Rate of ReturnModified Internal Rate of Return Problem 16 – Profitability IndexProblem 16 – Profitability Index Problem 20 – NPV Profile of ProjectProblem 20 – NPV Profile of Project