Learning Objectives

Learning Objectives • Define capital budgeting decisions as long-run investment decisions. (LO1) • Explain that cash flows rather than accounting earnings are evaluated in the capital budgeting decision. (LO2) • Evaluate investments by the average accounting return, the payback period, the internal rate of return, the net present value and the profitability index. (LO3)

LO3 5 Methods of Evaluating Investment Proposals • Average Accounting Return (AAR) • Payback Period (PB) • Internal Rate of Return (IRR) • Net Present Value (NPV) • Profitability Index (PI)

LO3 Average Accounting Return (AAR) AAR = Average Earnings Aftertax Average Book Value of Investment Advantage: Relatively easy to calculate Disadvantages: Uses accounting earnings, not cash flows Ignores the timing of the earnings Uses book value, not market value of investment Does not suggest an objective evaluation yardstick

LO3 Payback Period • computes the amount of time required to recoup the initial investment • a cutoff period is arbitrarily established • Advantages: • easy to use (“quick and dirty” approach) • emphasizes liquidity • one measure of the risk of an investment • Disadvantages: • ignores inflows after the cutoff period and • fails to consider the time value of money • does not have an objective yardstick • not a good measures of risk

LO3 Net Present Value Net Present Value (NPV): • the present value of the cash inflows minus the present value of the cash outflows • the future cash flows are discounted back over the life of the investment • the basic discount rate is usually the firm’s cost of capital (WACC)(assuming similar risk)

LO3 Internal Rate of Return • Yield on an investment or a rate of return • Discount rate that equates the initial cash outflow (cost) with the future cash inflows (benefits) • Discount rate where the cash outflows equal the cash inflows (or NPV = 0)

LO3 Profitability Index P.I. = Present value of the inflows Present value of the outflows • an alternative presentation of the NPV method • used to compare investments of different sizes especially in a capital rationing situation

LO3 Capital Budgeting: An Example Table 12-3 Investment alternatives

LO3 Evaluating These 2 Investments • Payback Period: Investment A: $5,000 + $5,000 = $10,000 (2 years) Investment B: $1,500 + $2,000 + $2,500 + $4,000 ( = 0.8 of $5,000) = $10,000 (3.8 years) • Net Present Value: Investment A: $5,000 $5,000 $2,000 0 1 2 3 |----------------|-----------------|-------------------| PV = -$10,000 n = 3 %i = 10% Using the NPV function in a financial calculator: CF0= -10000; C01= 5000; F01 = 2; C02 = 2000; F02 = 1;I = 10; Compute NPV = 180.32

LO3 Evaluating These 2 Investments • Net Present Value: Investment B: $1,500 $2,000 $2,500 $5,000 $5,000 0 1 2 3 4 5 |---------------|---------------|---------------|----------------|---------------| PV= -$10,000 n = 5 i% = 10 Using the NPV function in a financial calculator: CF0= -10000; C01= 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; I = 10; Compute NPV = 1414.49

LO3 Evaluating These 2 Investments • Internal Rate of Return: Investment A: Investment B: • Profitability Index: Investment A: PI = $10,180/$10,000 = 1.0180 Investment B: PI = $11,414/$10,000 = 1.1414 Using the IRR function in a financial calculator: CF0= -10000;C01= 5000; F01 = 2; C02 = 2000; F02 = 1; Compute IRR = 11.16(%) Using the IRR function in a financial calculator: CF0= -10000; C01= 1500; F01 = 1; C02 = 2000; F02 = 1; C03 = 2500; F03 = 1; C04 = 5000; F04 = 2; Compute IRR = 14.33 (%)

LO3 Table 12-4Capital budgeting results

LO3 Accept/Reject Decision Payback Method (PB): – if PB period < cutoff period, accept the project – if PB period > cutoff period, reject the project Internal Rate of Return (IRR): – if IRR > cost of capital, accept the project – if IRR < cost of capital, reject the project Net Present Value (NPV): – if NPV > 0, accept the project – if NPV < 0, reject the project Profitability Index (PI): – if PI > 1, accept the project – if PI < 1, reject the project

LO3 Comparing Methods • PI is a variation of NPV method. • IRR and NPV methods are superior to PB and AAR methods, because – IRR and NPV evaluate all the resultant cash flows – they employ the time value of money – they have an objective yardstick – the cost of capital • IRR method has some flaws: – inconsistency with NPV for some mutually exclusive projects – discounting considerations – multiple IRRs • NPV is the best methodology.

LO3 Modified Internal Rate of Return • The reinvestment assumption of the IRR method may be unrealistic. • To remedy this flaw, the more realistic reinvestment assumption of the NPV method is combined with the IRR method, producing the modified internal rate of return (MIRR). • MIRR is the discount rate that will equate the initial investment with the future value of inflows. • Each of these inflows grows at the cost of capital.

LO3 Modified Internal Rate of Return Cost of capital = 10% $6,000 FV = $7,260 $5,000 FV = $5,500 $2,850 FV = $2,850 0 1 2 3 FV = $15,610 PV = -$10,000 Using the PV function in a financial calculator N = 3; PV = -10000; PMT = 0; FV = $15,610; Compute I/Y = 16(%) MIRR = 16%

LO3 Table 12-6Multiple IRRs

LO3 Capital Rationing • A limit or constraint on the amount of funds that can be invested • Firm must rank investments based on their NPVs • Those with positive NPVs are accepted until all funds are exhausted

LO3 Table 12-7Capital rationing

Learning Objectives