Chapter 8 – Capital Budgeting Decision Models

1. Chapter 8 – Capital Budgeting Decision Models • Learning Objectives • Differentiate between short term and long term capital budgeting models • Apply the three basic decision models • Payback • NPV • IRR • Calculate cross-over rates • Use modified decision models • Know the strength and weaknesses of each model

2. Short-term versus Long-term • Short-term decisions • In general, repetitive decisions • Low cost impacts • Long-Term decisions • Capital budgeting decisions • 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 flow • Not concerned with cash flows after repayment • Ad hoc cutoff date for repayment

4. Payback Period • Clinko Copiers (example 8.1) • 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 flow after cutoff period • Ignores time value of money • Corrections • Discount cash flow

6. Discounted Payback Period • Attempt to correct one flaw of Payback Period…time value of money • Discount cash flow to present and see if the discount cash flow 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 flow

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

8. Net Present Value (NPV) • Correction to discounted cash flow • Includes all cash flow 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 flow • 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 flow

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 • Popcorn Machine (Example 8.4) • Grannies IRR is 19.86% • Kettle Corn IRR is 20.35% • Packaging Machine IRR is 14.91% • Decision Rule • Requires hurdle rate for comparison • Accept all with IRR > Hurdle Rate

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. Modified IRR • Major assumption of IRR is that all cash flow can be reinvested at IRR rate… • Alternative (and better) assumption is that all cash flow can be reinvested at hurdle rate • MIRR • Find future value of all cash inflow at hurdle rate • Find present value of cash outflow • Find interest rate that equates future values with present value • Adjust comparison projects for differences in the time horizon

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

16. 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

17. Profitability Index (PI) • Example of Large Copier and Mini-Copier (page 247) • 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…

18. Problems • Problem 6 – Payback & Discounted Period • Problem 8 – Net Present Value • Problem 12 – Internal Rate of Return & Modified Internal Rate of Return • Problem 16 – Profitability Index • Problem 20 – NPV Profile of Project