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Specifically, CB involves: Generating investment project proposals consistent with the firms strategic objectives; Estimating after-tax incremental operating cash flows for the investment projects; Evaluating project incremental cash flows; Selecting projects based on a valuemaximizing acceptance criterion; and Continually reevaluating implemented investment projects.
Since CASH is central to all decisions of the firm, the expected benefits to be received from the project is expressed in terms of Cash Flows and not income flows. Cash flows should be measured on an incremental, after-tax basis. In addition, the stress is on operating, not financing flows. It is helpful to place project CFs into 3 categories based on timing: (1) the initial CF, (2) interim incremental net CFs, and (3) the terminal-year incremental net CF.
Payback Period
How long will it take for the project to generate enough cash to pay for itself?
Payback Period
How long will it take for the project to generate enough cash to pay for itself?
(500) 150 150 150 150 150 150 150 150
Payback Period
How long will it take for the project to generate enough cash to pay for itself?
(500) 150 150 150 150 150 150 150 150
Payback Period
(Acceptance Criterion)
Is a 3.33 year payback period good? Is it acceptable? Firms that use this method will compare the payback calculation to some standard (maximum acceptable PB period) set by the firm. If our senior management had set a cutoff of 5 years for projects like ours, what would be our decision? Accept the project.
This project is clearly unprofitable, but we would accept it based on a 4year payback criterion!
Discounted Payback
Discounts the cash flows at the firms required rate of return. Payback period is calculated using these discounted net cash flows. Problems: Cutoffs are still subjective. Still does not examine all cash flows.
Discounted Payback
(500) 0 250 1 250 2 250 3 250 250 4 5
Discounted
CF (14%)
-500.00 219.30
Discounted Payback
(500) 0 250 1 250 2 250 3 250 250 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 1 year
Discounted Payback
(500) 0 250 1 250 2 250 3 250 250 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 192.37 1 year
Discounted Payback
(500) 0 250 1 250 2 250 3 250 250 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 192.37 88.33 1 year 2 years
Discounted Payback
(500) 0 250 1 250 2 250 3 250 250 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 192.37 88.33 168.74 1 year 2 years
Discounted Payback
(500) 0 250 1 250 2 250 3 250 250 4 5
Discounted
CF (14%)
-500.00 219.30 280.70 192.37 88.33 168.74 1 year 2 years .52 years
Discounted Payback
(500) 0 250 1 250 2 250 3 250 250 4 5
Discounted
Other Methods
1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR)
Each of these decision-making criteria: Examines all net cash flows, Considers the time value of money, and Considers the required rate of return.
NPV =
S
t=1
CFt ICO (1 + k) t
NPV Example
Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firms required rate of return is 15%.
NPV Example
Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firms required rate of return is 15%.
(250,000) 100,000 100,000 100,000 100,000 100,000
Profitability Index
Profitability Index
NPV =
S
t=1
CFt t (1 + k)
- ICO
Profitability Index
NPV =
S
t=1
CFt t (1 + k)
- ICO
PI =
S
t=1
CFt t (1 + k)
ICO
Profitability Index
PI Example
We know that from the previous example PV of cash flows is $335,216 and the Initial cash outflow is $250,000.
Therefore, PI = 335,216 / 250,000 = 1.34 You should accept as PI = 1.34, which is more than 1.
NPV =
S
t=1
CFt (1 + k) t
- ICO
NPV =
S
t=1
n
CFt (1 + k) t
- ICO
IRR:
S
t=1
CFt t (1 + IRR)
= ICO
IRR:
S
t=1
CFt t (1 + IRR)
= ICO
IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay. This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.
Calculating IRR
Looking again at our problem: The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.
(250,000) 100,000 100,000 100,000 100,000 100,000
IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
(500)
0
200
1
100
2
(200)
3
400
4
300
5
IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
1
(500)
0
200
1
100
2
(200)
3
400
4
300
5
IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
1 2
(500)
0
200
1
100
2
(200)
3
400
4
300
5
IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
1 2 3
(500)
0
200
1
100
2
(200)
3
400
4
300
5
Summary Problem
Enter the cash flows only once. Find the IRR. Using a discount rate of 15%, find NPV. Add back IO and divide by IO to get PI.
(900)
0
300
1
400
2
400
3
500
4
600
5
Summary Problem
IRR = 34.37%. Using a discount rate of 15%, NPV = $510.52. PI = 1.57. (900)
0
300
1
400
2
400
3
500
4
600
5
Capital Rationing
A final potential difficulty related to implementing the alternative methods of project evaluation and selection. Refers to a situation where a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period. Constraints come when there is a policy of financing all capital expenditures.
CR also occurs when a division of a large company is allowed to make capital expenditure only upto a specified budget ceiling, over which the division usually has no control. With such a constraint, the firm attempts to select the combination of investment proposals that will provide the greatest increase in the value of the firm subject to not exceeding the budget ceiling constraint.