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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
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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