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Chapter 10: The Basics Of Capital Budgeting

Chapter 10: The Basics Of Capital Budgeting. The Basics Of Capital Budgeting :. Chapter Outline:. Introduction. Capital Budgeting Decision Rules: Payback Period. Discounted payback Period. Net Present Value (NPV). Internal Rate of Return (IRR). Profitability Index (PI).

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Chapter 10: The Basics Of Capital Budgeting

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  1. Chapter 10:The Basics Of Capital Budgeting

  2. The Basics Of Capital Budgeting :

  3. Chapter Outline: • Introduction. • Capital Budgeting Decision Rules: • Payback Period. • Discounted payback Period. • Net Present Value (NPV). • Internal Rate of Return (IRR). • Profitability Index (PI).

  4. Capital Budgeting: • The process of planning expenditures on assets whose cash flows are expected to extend beyond one year.

  5. Capital Budgeting: • Analysis of potential additions to fixed assets. • Long-term decisions; involve large expenditures. • Very important to firm’s future.

  6. Steps to Capital Budgeting: • Estimate Cash Flow (inflows & outflows). • Assess riskiness of CFs. • Determine the appropriate cost of capital. • Find NPV and/or IRR. • Accept if NPV > 0 and/or IRR > WACC.

  7. Payback Period: • The number of years required to recover a project’s cost, or “How long does it take to get our money back?”

  8. 2.4 3 0 1 2 Project L 80 CFt-100 10 60 100 Cumulative -100 -90 0 50 -30 30 80 PaybackL = 2 + / = 2.375 years = 1.6 3 0 1 2 Project S CFt-100 70 100 20 50 Cumulative -100 0 20 40 -30 30 50 PaybackS = 1 + / = 1.6 years = Calculating Payback:

  9. Example: • 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

  10. Strengths and Weaknesses of Payback: • Strengths • Easy to calculate and understand. • Initial cash flows most important • Good for small dollar investments • Weaknesses • Ignores the time value of money. • Ignores CFs occurring after the payback period.

  11. 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

  12. 2.7 3 0 1 2 10% CFt -100 10 60 80 PV of CFt -100 9.09 49.59 60.11 Cumulative -100 -90.91 18.79 -41.32 Disc PaybackL = 2 + / = 2.7 years = 41.32 60.11 Discounted payback period: • Uses discounted cash flows rather than raw CFs.

  13. 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 • Need all cash flow • Need appropriate discount rate

  14. Net Present Value (NPV): • NPV = PV of inflows minus Cost = Net gain in wealth. • Acceptance of a project with a NPV > 0 will add value to the firm. • Decision Rule: • Accept if NPV >0, • Reject if NPV < 0

  15. Net Present Value (NPV): • Sum of the PVs of all cash inflows and outflows of a project:

  16. Net Present Value (NPV): • Sum of the PVs of all cash inflows and outflows of a project:

  17. Calculating the NPV: YearCFtPV of CFt 0 -100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPVL = $18.79 NPVS = $19.98

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

  19. NPV Profile and Shareholder Wealth:

  20. 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 > Cost of Capital, accept • If IRR < Cost of Capital, reject • Very popular model as “managers” like the single return variable when evaluating projects

  21. Internal Rate of Return (IRR):

  22. Calculating the IRR:

  23. Comparing the NPV and IRR methods: • If projects are independent, the two methods always lead to the same accept/reject decisions. • If projects are mutually exclusive … • If k > crossover point, the two methods lead to the same decision and there is no conflict. • If k < crossover point, the two methods lead to different accept/reject decisions.

  24. 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

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

  26. Capital Budgeting: Methods to generate, review, analyze, select, and implement long-term investment proposals: • Payback Period • Discounted payback period • Net Present Value (NPV) • Internal rate of return (IRR) • Profitability index (PI)

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