Order # 13515
tutorthammy
13515_CapitalBudgeting.pptxCapital Budgeting
Net Present Value and Other Investment Criteria
Prepared by Dr. Vigdis Boasson
Objectives
Compute the net present value and understand why it is the best decision criterion
Compute payback and discounted payback and understand their shortcomings
Understand accounting rates of return and their shortcomings
Compute the internal rate of return and understand its strengths and weaknesses
Compute the profitability index and understand its strengths and weaknesses
Main Topics
Net Present Value
The Payback Rule
The Discounted Payback
The Average Accounting Return
The Internal Rate of Return
The Profitability Index
Net Present Value (NPV)
Net Present Value (NPV) =
Total PV of future CF’s + Initial Investment
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
8.4
9-5
Project Example
You are looking at a new project and you have estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120; NI = 13,620
Year 2: CF = 70,800; NI = 3,300
Year 3: CF = 91,080; NI = 29,100
Average Book Value = 72,000
Your required return for assets of this risk is 12%.
8.5
9-6
Computing NPV for the Project
Using the formulas:
NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = 12,627.42
Using the calculator (TI- BA-II plus ):
CF0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.42
Do we accept or reject the project?
8.6
Calculating NPVs with Spreadsheets
Using the NPV function
The first component is the required return.
The second component is the range of cash flows beginning with year 1
Add the initial investment after computing the NPV.
8.7
Payback Period
How long does it take the project to “pay back” its initial investment?
Payback Period = number of years to recover initial costs
Decision Rule: Accept if the payback period is less than some preset limit
9-9
Computing Payback Period
Assume we will accept the project if it pays back within two years.
Year 1: 165,000 – 63,120 = 101,880 still to recover
Year 2: 101,880 – 70,800 = 31,080 still to recover
Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3
Do we accept or reject the project?
8.9
Advantages and Disadvantages of Payback
Advantages
Easy to understand
Adjusts for uncertainty of later cash flows
Biased toward liquidity
Disadvantages
Ignores the time value of money
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff date
Biased against long-term projects.
Discounted Payback Period
How long does it take the project to “pay back” its initial investment, taking the time value of money into account?
Decision Rule - Accept the project if it pays back on a discounted basis within the specified time.
9-12
Computing Discounted Payback Period
Assume we will accept the project if it pays back on a discounted basis in 2 years.
Compute the PV for each cash flow and determine the payback period using discounted cash flows
Year 1: 165,000 – 63,120/1.121 = 108,643
Year 2: 108,643 – 70,800/1.122 = 52,202
Year 3: 52,202 – 91,080/1.123 = -12,627 project pays back in year 3
Do we accept or reject the project?
8.12
Average Accounting Return
Ignores time value of money
Decision Rule:
Accept the project if the AAR is greater than a preset rate.
8.13
9-14
Computing AAR For The Project
Assume we require an average accounting return of 25%
Average Net Income:
(13,620 + 3,300 + 29,100) / 3 = 15,340
AAR = 15,340 / 72,000 = .213 = 21.3%
Do we accept or reject the project?
8.14
Internal Rate of Return
Definition: IRR: the return that sets NPV = 0
Decision Rule:
Accept the project if the IRR is greater than the required return.
Enter the cash flows as you did with NPV
Press IRR and then CPT
IRR = 16.13% > 12% required return
Do we accept or reject the project?
8.15
9-16
NPV Profile For The Project
IRR = 16.13%
Calculating IRR with Spreadsheets
You start with the cash flows the same as you did for the NPV.
You use the IRR function:
You first enter your range of cash flows, beginning with the initial cash flow.
You can enter a guess, but it is not necessary.
The default format is a whole percent – you will normally want to increase the decimal places to at least two.
17
Problem with IRR
NPV and IRR will generally give us the same decision
Exceptions
Non-conventional cash flows
– cash flow signs change more than once
Mutually exclusive projects
If you choose one, you can’t choose the other
Multiple IRRs
There are two IRRs for this project:
0 1 2 3
$200 $800
-$200
- $800
100% = IRR2
0% = IRR1
Which one should we use?
19
9-20
Mutually Exclusive Projects
| Period | Project A | Project B |
| 0 | -500 | -400 |
| 1 | 325 | 325 |
| 2 | 325 | 200 |
| IRR | 19.43% | 22.17% |
| NPV | 64.05 | 60.74 |
The required return for both projects is 10%.
Which project should you accept and why?
8.20
The Profitability Index (PI)
Minimum Acceptance Criteria: Accept if PI > 1
Ranking Criteria: Select a project with highest PI
Disadvantages:
Problems with mutually exclusive investments
21
9-22
Summary – Discounted Cash Flow Criteria
Net present value
Difference between market value and cost
Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually exclusive projects
Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing
Sheet1
| Year | 0 | 1 | 2 | 3 |
| Cash Flows | -165000 | 63120 | 70800 | 91080 |
| Required Return | 0.12 | |||
| NPV - WRONG | $11,274.48 | $177,627.41 | ||
| NPV - RIGHT | $12,627.41 |
Sheet2
Sheet3
Investment of ValueBook Average
IncomeNet Average
AAR
32
)1(
91080
)1(
70800
)1(
63120
1650000
IRRIRR
IRR
NPV
-20,000
-10,000
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
00.020.040.060.080.10.120.140.160.180.20.22
Discount Rate
NPV
Sheet1
| Year | 0 | 1 | 2 | 3 |
| Cash Flows | -165000 | 63120 | 70800 | 91080 |
| Required Return | 0.12 | |||
| NPV - Incorrect | $11,274.48 | |||
| NPV - Correct | $12,627.41 | |||
| IRR | 16% | 16.13% | ||
| Default Format |
Sheet2
Sheet3
($100.00)
($50.00)
$0.00
$50.00
$100.00
-50%0%50%100%150%200%
Discount rate
NPV
Chart4
| -0.1 |
| -0.05 |
| 0 |
| 0.05 |
| 0.1 |
| 0.15 |
| 0.2 |
| 0.25 |
| 0.3 |
| 0.35 |
| 0.4 |
| 0.45 |
| 0.5 |
| 0.55 |
| 0.6 |
| 0.65 |
| 0.7 |
| 0.75 |
| 0.8 |
| 0.85 |
| 0.9 |
| 0.95 |
| 1 |
| 1.05 |
| 1.1 |
| 1.15 |
| 1.2 |
| 1.25 |
| 1.3 |
| 1.35 |
| 1.4 |
| 1.45 |
| 1.5 |
| 1.55 |
| 1.6 |
| 1.65 |
| 1.7 |
| 1.75 |
| 1.8 |
| 1.85 |
| 1.9 |
Sheet1
| 0 | 1 | 2 | 3 |
| -200 | 200 | 800 | -800 |
| -0.00% | |||
| Discount Rate | NPV | ||
| -10% | ($87.52) | ||
| -5% | ($36.13) | ||
| 0% | $0.00 | ||
| 5% | $25.03 | ||
| 10% | $41.92 | ||
| 15% | $52.81 | ||
| 20% | $59.26 | ||
| 25% | $62.40 | ||
| 30% | $63.09 | ||
| 35% | $61.95 | ||
| 40% | $59.48 | ||
| 45% | $56.02 | ||
| 50% | $51.85 | ||
| 55% | $47.19 | ||
| 60% | $42.19 | ||
| 65% | $36.97 | ||
| 70% | $31.63 | ||
| 75% | $26.24 | ||
| 80% | $20.85 | ||
| 85% | $15.51 | ||
| 90% | $10.23 | ||
| 95% | $5.06 | ||
| 100% | $0.00 | ||
| 105% | ($4.94) | ||
| 110% | ($9.74) | ||
| 115% | ($14.41) | ||
| 120% | ($18.93) | ||
| 125% | ($23.32) | ||
| 130% | ($27.57) | ||
| 135% | ($31.68) | ||
| 140% | ($35.65) | ||
| 145% | ($39.49) | ||
| 150% | ($43.20) | ||
| 155% | ($46.79) | ||
| 160% | ($50.25) | ||
| 165% | ($53.60) | ||
| 170% | ($56.83) | ||
| 175% | ($59.95) | ||
| 180% | ($62.97) | ||
| 185% | ($65.89) | ||
| 190% | ($68.71) | ||
| Discount Rate | NPV | ||
| 0% | $0.00 | ||
| 4% | $20.76 | ||
| 8% | $35.99 | ||
| 12% | $46.90 | ||
| 16% | $54.42 | ||
| 20% | $59.26 | ||
| 24% | $61.99 | ||
| 28% | $63.06 | ||
| 32% | $62.82 | ||
| 36% | $61.55 | ||
| 40% | $59.48 | ||
| 44% | $56.77 | ||
| 48% | $53.59 | ||
| 52% | $50.04 | ||
| 56% | $46.21 | ||
| 60% | $42.19 | ||
| 64% | $38.03 | ||
| 17% | $55.85 | ||
| 18% | $57.13 | ||
| 19% | $58.27 | ||
| 20% | $59.26 | ||
| 21% | $60.12 | ||
| 22% | $60.86 | ||
| 23% | $61.48 | ||
| 24% | $61.99 | ||
| 25% | $62.40 | ||
| 26% | $62.71 | ||
| 27% | $62.93 | ||
| 28% | $63.06 | ||
| 29% | $63.11 | ||
| 30% | $63.09 | ||
| 31% | $62.99 | ||
| 32% | $62.82 | ||
| 33% | $62.59 | ||
| 34% | $62.30 | ||
| 35% | $61.95 | ||
| 36% | $61.55 | ||
| 37% | $61.10 | ||
| 38% | $60.60 | ||
| 39% | $60.06 | ||
| 40% | $59.48 |
Sheet1
| -87.5171467764 |
| -38.0291741162 |
| 0 |
| 23.8378042071 |
| 38.1121508094 |
| 45.9260794523 |
| 49.3827160494 |
| 49.92 |
| 48.5277126151 |
| 45.890324608 |
| 42.4822990421 |
| 38.6324530137 |
| 34.5679012346 |
| 30.4443537288 |
| 26.3671875 |
| 22.4062142419 |
| 18.6060990649 |
| 14.9937526031 |
| 11.583600061 |
| 8.3813503749 |
| 5.3866989971 |
| 2.5952682606 |
| 0 |
| -2.4078469481 |
| -4.6379852016 |
| -6.7005947407 |
| -8.6059695376 |
| -10.3642737388 |
| -11.9853774107 |
| -13.4787499429 |
| -14.8533950617 |
| -16.1178156887 |
| -17.28 |
| -18.3474223456 |
| -19.3270543748 |
| -20.2253829646 |
| -21.0484324695 |
| -21.8017894953 |
| -22.4906289046 |
| -23.1197401364 |
| -23.6935531988 |
Sheet2
Sheet3
Investent Initial
FlowsCash Future of PV Total
PI
08.1
165000
)12.1/(91080)12.1/(7080012.1/63120
32
PI
