9a Capital Budgeting

9.
A
CAPITAL
BUDGETING
Decision Criteria
12/08/22 1
Decision-making Criteria in
Capital Budgeting
How do we decide
if a capital
investment
project should
be accepted or
rejected?
12/08/22 2
Payback Period
 The number of years needed to

recover the initial cash outlay.
 How long will it take for the project
to generate enough cash to pay for
itself?
12/08/22 3
Payback Period

itself?
(500) 150 150 150 150 150 150 150 150
0 1 2 3 4 5 6 7 8
12/08/22 4
Payback Period
itself?
(500) 150 150 150 150 150 150 150 150
0 1 2 3 4 5 6 7 8
Payback period = 3.33 years.

12/08/22 5
 Is a 3.33 year payback period good?
 Is it acceptable?
 Firms that use this method will
compare the payback calculation to
some standard set by the firm.
 If our senior management had set a
cut-off of 5 years for projects like
ours, what would be our decision?
 Accept the project.
12/08/22 6
Drawbacks of Payback Period:
 Firm cutoffs are subjective.

 Does not consider time value of money.
 Does not consider any required rate of
return.
 Does not consider all of the project’s
cash flows.
12/08/22 7

cash flows.
(500) 150 150 150 150 150 (300) 0 0
0 1 2 3 4 5 6 7 8
Consider this cash flow stream!

12/08/22 8

cash flows.
(500) 150 150 150 150 150 (300) 0 0
0 1 2 3 4 5 6 7 8
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
12/08/22 9
Discounted Payback
 Discounts the cash flows at the firm’s

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.
12/08/22 10
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
12/08/22 11
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
0 -500 -500.00
1 250 219.30 1 year
-280.70
12/08/22 12
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
0 -500 -500.00
1 250 219.30 1 year
- 280.70
2 250 192.38
12/08/22 13
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
0 -500 -500.00
1 250 219.30 1 year
-280.70
2 250 192.38 2 years
-88.32
12/08/22 14
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
12/08/22 3 250 168.75 15
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
12/08/22 3 250 168.75 .52 years 16
Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
The Discounted
0 -500 -500.00
Payback
1 250 219.30 1 year
280.70
is 2.52 years
2 250 192.38 2 years
88.32
12/08/22 3 250 168.75 .52 years 17
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.
12/08/22 18
Net Present Value
 NPV = the total PV of the annual net

cash flows - the initial outlay.
NPV =
t=1
ACFt
(1 + k) t
- IO
12/08/22 19
Net Present Value
 Decision Rule:
 If NPV is positive, ACCEPT.

 If NPV is negative, REJECT.
12/08/22 20
NPV Example
 Suppose we are considering a capital investment that
costs $276,400 and provides annual net cash flows of
$83,000 for four years and $116,000 at the end of the
fifth year. The firm’s required rate of return is 15%.
12/08/22 21
NPV Example
 Suppose we are considering a capital investment that
costs $276,400 and provides annual net cash flows of
$83,000 for four years and $116,000 at the end of the
fifth year. The firm’s required rate of return is 15%.
83,000 83,000 83,000 83,000 116,000

(276,400)
0 1 2 3 4 5
12/08/22 22
Profitability Index

ACFt
NPV = t - IO
(1 + k)
t=1
12/08/22 23
Profitability Index

ACFt
NPV = t - IO
(1 + k)
t=1

ACFt
PI = IO
(1 + k) t
t=1
12/08/22 24
Profitability Index
 Decision Rule:
 If PI is greater than or equal

to 1, ACCEPT.
 If PI is less than 1, REJECT.
12/08/22 25
Internal Rate of Return (IRR)
 IRR: the return on the firm’s

invested capital. IRR is simply
the rate of return that the firm
earns on its capital budgeting
projects.
12/08/22 26

ACFt
NPV = - IO
(1 + k) t
t=1
12/08/22 27

ACFt
NPV = - IO
(1 + k) t
t=1
n
ACFt
IRR:

t=1
(1 + IRR) t = IO
12/08/22 28
n
ACFt
IRR:

t=1
(1 + IRR) t = IO
 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.
12/08/22 29

9a Capital Budgeting

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9.

 The number of years needed to

 How long will it take for the project

Payback period = 3.33 years.

 Firm cutoffs are subjective.

 Does not consider all of the project’s

Consider this cash flow stream!

 Does not consider all of the project’s

 Discounts the cash flows at the firm’s

1) Net Present Value (NPV)

Each of these decision-making criteria:

 NPV = the total PV of the annual net

 If NPV is positive, ACCEPT.

83,000 83,000 83,000 83,000 116,000

 If PI is greater than or equal

 IRR: the return on the firm’s

 IRR is the rate of return that makes the PV

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