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9: Capital
Budgeting
Decision
Criteria
How do we decide
if a capital
investment
project should
be accepted or
rejected?
Decision-making Criteria in
Capital Budgeting
• The Ideal Evaluation Method
should:
a) include all cash flows that occur
during the life of the project,
b) consider the time value of money,
c) incorporate the required rate of
return on the project.
Payback Period
0 1 2 3 4 5 6 7 8
Payback Period
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.37
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.37 2 years
88.33
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.37 2 years
88.33
3 250 168.74
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.37 2 years
88.33
3 250 168.74 .52 years
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
The Discounted
0 -500Payback
-500.00
1 250 219.30 1 year
is 2.52 years
280.70
2 250 192.37 2 years
88.33
3 250 168.74 .52 years
Other Methods
S
FCFt
NPV = - IO
(1 + k) t
t=1
Net Present Value
Decision Rule:
0 1 2 3 4 5
Net Present Value (NPV)
NPV is just the PV of the annual cash
flows minus the initial outflow.
Using TVM:
P/Y = 1 N = 5 I = 15
PMT = 100,000
• -250,000 CFj
• 100,000 CFj
• 5 shift Nj
• 15 I/YR
• shift NPV
• You should get NPV = 85,215.51.
NPV with the HP17BII:
• Select CF mode.
NPV with the TI BAII Plus:
• Select CF mode.
• CFo=? -250,000 ENTER
NPV with the TI BAII Plus:
• Select CF mode.
• CFo=? -250,000 ENTER
• C01=? 100,000 ENTER
NPV with the TI BAII Plus:
• Select CF mode.
• CFo=? -250,000 ENTER
• C01=? 100,000 ENTER
• F01= 1 5 ENTER
NPV with the TI BAII Plus:
• Select CF mode.
• CFo=? -250,000 ENTER
• C01=? 100,000 ENTER
• F01= 1 5 ENTER
• NPV I= 15 ENTER
NPV with the TI BAII Plus:
• Select CF mode.
• CFo=? -250,000 ENTER
• C01=? 100,000 ENTER
• F01= 1 5 ENTER
• NPV I= 15 ENTER
CPT
NPV with the TI BAII Plus:
• Select CF mode.
• CFo=? -250,000ENTER
• C01=? 100,000ENTER
• F01= 1 5ENTER
• NPV I= 15 ENTER
CPT
• You should get NPV = 85,215.51
Profitability Index
Profitability Index
n
S
FCFt
NPV = t - IO
(1 + k)
t=1
Profitability Index
n
S
FCFt
NPV = t - IO
(1 + k)
t=1
S
FCFt
PI = t IO
(1 + k)
t=1
Profitability Index
Decision Rule:
S
FCFt
NPV = - IO
(1 + k) t
t=1
Internal Rate of Return (IRR)
S
FCFt
NPV = - IO
(1 + k) t
t=1
S
FCFt
IRR: t = IO
(1 + IRR)
t=1
Internal Rate of Return (IRR)
S
FCFt
IRR: t = IO
(1 + IRR)
t=1
• 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
0 1 2 3 4 5
IRR with your Calculator
0 1 2 3 4 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) 200 100 (200) 400 300
0 1 2 3 4 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) 200 100 (200) 400 300
0 1 2 3 4 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) 200 100 (200) 400 300
0 1 2 3 4 5
Summary Problem
0 1 2 3 4 5
Summary Problem
• IRR = 34.37%.
• Using a discount rate of 15%,
NPV = $510.52.
• PI = 1.57.
0 1 2 3 4 5
Modified Internal Rate of Return
(MIRR)
• IRR assumes that all cash flows are
reinvested at the IRR.
• MIRR provides a rate of return
measure that assumes cash flows are
reinvested at the required rate of
return.
MIRR Steps:
• Calculate the PV of the cash outflows.
– Using the required rate of return.
• Calculate the FV of the cash inflows at
the last year of the project’s time line.
This is called the terminal value (TV).
– Using the required rate of return.
• MIRR: the discount rate that equates
the PV of the cash outflows with the PV
of the terminal value, ie, that makes:
• PVoutflows = PVinflows
MIRR
• Using our time line and a 15% rate:
• PV outflows = (900)
• FV inflows (at the end of year 5) = 2,837.
• MIRR: FV = 2837, PV = (900), N = 5
• solve: I = 25.81%.
0 1 2 3 4 5
MIRR
• Using our time line and a 15% rate:
• PV outflows = (900)
• FV inflows (at the end of year 5) = 2,837.
• MIRR: FV = 2837, PV = (900), N = 5
• solve: I = 25.81%.
• Conclusion: The project’s IRR of
34.37%, assumes that cash flows are
reinvested at 34.37%.
MIRR
• Using our time line and a 15% rate:
• PV outflows = (900)
• FV inflows (at the end of year 5) = 2,837.
• MIRR: FV = 2837, PV = (900), N = 5
• solve: I = 25.81%.
• Conclusion: The project’s IRR of
34.37%, assumes that cash flows are
reinvested at 34.37%.
• Assuming a reinvestment rate of 15%,
the project’s MIRR is 25.81%.