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Chapter 9 Capital Budgeting Decision Models

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- 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 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

- 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

- 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

- 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

- 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

- 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

- 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

- 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

- The Decision Model
- Incorporates risk and return
- Incorporates time value of money
- Incorporates all cash flows

- 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

- 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%

- 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

- Cross-over Rates flip projects
- Risk of Project is not included
- IRR calculation void of risk of project
- Risk must be implied with different hurdle rates

- Modified version of NPV
- Decision Criteria
- PI > 1.0, accept project
- PI < 1.0, reject project

- 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

- 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…

- 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