1 / 17

Chapter 9 Capital Budgeting Decision Models

Chapter 9 Capital Budgeting Decision Models. Short-term versus Long-term Decisions Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI). Short-term versus Long-term Decisions. Short-term decisions

kylynn-cantu
Download Presentation

Chapter 9 Capital Budgeting Decision Models

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 9Capital Budgeting Decision Models • Short-term versus Long-term Decisions • Payback Period • Discounted Payback Period • Net Present Value (NPV) • Internal Rate of Return (IRR) • Profitability Index (PI)

  2. Short-term versus Long-term Decisions • Short-term decisions • Working capital decisions (Chapter 13) • In general, repetitive decisions • Long-Term decisions • Capital budgeting decisions (Chapter 9) • Impacts over many years • Difference • Time • Cost • Degree of Information

  3. Payback Period • First and easiest model of capital budgeting • Answers the question, how soon will I get my money back? • Key Features • Need amount and timing of cash flows • Not concerned with cash flows after repayment • Ad hoc cutoff date for repayment

  4. Payback Period • Clinko Copiers (example 9.1) • Initial investment is $5,000 • Positive cash flow each year • Year 1 -- $1,500 • Year 2 -- $2,500 • Year 3 -- $3,000 • Year 4 -- $4,500 • Year 5 -- $5,500 • Payback in 2 and 1/3rd years…ignore years 4 and 5 cash flows

  5. Payback Period • Strengthens • Easy to apply • Initial cash flows most important • Good for small dollar investments • Weaknesses • Ignores cash flows after cutoff period • Ignores time value of money • Corrections • Discount cash flows

  6. Discounted Payback Period • Attempt to correct one flaw of Payback Period…time value of money • Discount cash flows to present and see if the discount cash flows are sufficient to cover initial cost within cutoff time period • Careful in consistency • Discounting means cash flow at end of period • Appropriate discount rate for cash flows

  7. Discounted Payback Period • Discounted Cash Flows of Copiers A & B • Discounted at 6% (APR) • Both 3 year discounted paybacks with annual cash flows • Copier A – 26 months with monthly cash flows • Copier B – 29 months with monthly cash flows • Potential for poor choice • Large late positive cash flows • Longer positive cash flows

  8. Net Present Value (NPV) • Correction to discounted cash flows • Includes all cash flows in decision • Changes decision (go vs. no-go) to dollars, not arbitrary cutoff period • The Decision Model (a.k.a. Discounted Cash Flow Model) • Need all cash flows • Need appropriate discount rate

  9. Net Present Value (NPV) • Decision • Accept all positive NPVs • Reject all negative NPVs • Copier Example • Copier A – NPV is $5,530.91 – Accept • Copier B – NPV is $9,253.09 – Accept • Model good for comparing projects • Select project with highest NPV • Can assign different discount rates to projects

  10. Net Present Value (NPV) • The Decision Model • Incorporates risk and return • Incorporates time value of money • Incorporates all cash flows

  11. Internal Rate of Return (IRR) • Model closely resembles NPV but… • Finding the discount rate (internal rate) that implies an NPV of zero • Internal rate used to accept or reject project • If IRR > hurdle rate, accept • If IRR < hurdle rate, reject • Very popular model as “managers” like the single return variable when evaluating projects

  12. Internal Rate of Return (IRR) • Process difficult without calculator or spreadsheet – iterative process • Need timing and amount of cash flows • Examples • Copier A – IRR is 41% • High return…accept project • Assumes can borrow funds for project for less than 41%

  13. Internal Rate of Return (IRR) • Some problems with IRR • Cross-over Rates flip projects • Using NPV profiles, project choice changes at cross-over rate so need to know both hurdle rate and cross-over rate • Cross-over rate is where two projects have same NPV • Multiple IRRs • Projects with changing cash flows can have multiple IRRs • Which is the correct IRR? Don’t know • Risk of Project is not included • IRR calculation void of risk of project • Risk must be implied with different hurdle rates

  14. Profitability Index (PI) • Modified version of NPV • Decision Criteria • PI > 1.0, accept project • PI < 1.0, reject project

  15. Profitability Index (PI) • Close to NPV as we calculate present value of future positive cash flows (present value of benefits) and initial cash flow (present value of costs) • PI = (NPV + Initial cost) / Initial Cost • Answer is modified return • Choosing between two different projects? • Higher PI is best choice… • Careful, cannot scale projects up and down

  16. Profitability Index (PI) • Example of Large Copier and Mini-Copier • Large Copier B PI is 2.85 (normal level of risk) • Mini Copier PI is 2.95 • Pick Mini Copier • Problem with copier choice • Original investment in mini-copier only $500 • Original investment in Copier B is $5,000 • Need to buy 10 mini-copiers to match production of Copier B…

  17. Problems • Problem 1 – Payback Period • Problem 3 – Discounted Payback Period • Problem 7 – Net Present Value • Problem 11 – Internal Rate of Return • Problem 15 – Profitability Index • Problem 19 – NPV Profile of Project

More Related