Chapter 9 capital budgeting decision models
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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

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Chapter 9 Capital Budgeting Decision Models

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Chapter 9 capital budgeting decision models

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)


Short term versus long term decisions

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


Payback period

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


Payback period1

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


Payback period2

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


Discounted payback period

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


Discounted payback period1

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


Net present value npv

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


Net present value npv1

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


Net present value npv2

Net Present Value (NPV)

  • The Decision Model

    • Incorporates risk and return

    • Incorporates time value of money

    • Incorporates all cash flows


Internal rate of return irr

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


Internal rate of return irr1

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%


Internal rate of return irr2

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


Profitability index pi

Profitability Index (PI)

  • Modified version of NPV

  • Decision Criteria

    • PI > 1.0, accept project

    • PI < 1.0, reject project


Profitability index pi1

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


Profitability index pi2

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…


Problems

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


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