FINMAN 05/04

CAPITAL BUDGETING

Decision Rules Accept Tools/Techniques Independent

Reject Mutually Exclusive

(One is better than the other)

Criteria to Accept Independent (Per Mutually Exclusive

Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Payback Period
Discounted Payback Period
project) (All projects)
Amount Must be positive Same with general Highest positive
amount
% Must exceed WACC Same with general Highest percentage
Ratio Must be greater than 1 Same with general Highest ratio
Years Must be within the Same with general Shortest years
desired year/s of the BOD
Years Must be within the Same with general Shortest years
desired year/s of the BOD

Sample Problem – WACC 10% Negative because cash outflow

Time 0 1 2 3 4 5
Project Long -20M +10M +8M +6M +2M +1M
Project Short -20M +2M +4M +6M +8M +7M

1. Net Present Value (NPV) = PV of Cash Inflow – PV of Cash Outflow

PV of 1 = (1+i)-n Project Short Project Long
Year PV Factor Future Present Value Future Present Value
Cash Inflow Cash Inflow Cash Inflow Cash Inflow
1 0.9091 10M 9,091,000 2M 1,818,200
2 0.8264 8M 6,611,200 4M 3,305,600
3 0.7513 6M 4,507,800 6M 4,507,800
4 0.6830 2M 1,366,000 8M 5,464,000
5 0.6209 1M 620,900 7M 4,346,300
PV of Net Cash Inflow 22,196,900 19,441,900

NPV Short = 22,196,900 – 20M = 2,196,900

NPV Long = 19,441,900 – 20M = (558,100)
2. Internal Rate of Return (IRR) = *will be given in the problem; use the criterias to accept
3. Profitability Index (PI) = PV of Net Cash Inflow/PV of Cash Outflow
PI Short = 22,196,900/20M = 1.11
PI Long = 19,441,900/20M = 0.97

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 4. Payback Period
Project Short Project Long
Year Future Remaining Equivalent Future Remaining Equivalent
Cash Cash Inflow Year Cash Cash Inflow Year
Inflow Inflow
1 10M 10M 1 2M 18M 1
2 8M 2M 1 4M 14M 1
3 6M 2M/6M 0.33 6M 8M 1
*less than or equal
4 2M 8M 8M/8M 1
5 1M 7M
(20M – Future CI) 2.33 years 4 years

5. Discounted Payback Period

Project Short Project Long
Year PV of Remaining Cash Equivalent PV of Remaining Equivalent
Cash Inflow Year Cash Cash Inflow Year
Inflow Inflow
1 9,091,000 10,909,000 1 1,818,200 18,181,800 1
2 6,611,200 4,297,800 1 3,305,600 14,876,200 1
3 4,507,800 4,297,800/4,507,800 0.95 4,507,800 10,368,400 1
*less than or equal
4 1,366,000 5,464,000 4,904,400 1
5 620,900 4,346,300 558,100
(20M – PV of CI) 2.95 years More than
5 years

Project Short Project Long Independent Mutually Exclusive

NPV 2,196,900 (558,100) S S
IRR 10.48% 9.75% S S
PI 1.11 of 1 0.97 of 1 S S
Payback Period 2.33 years 4 years S, L S
Disc. Payback Period 2.95 years More than 5 years S S

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