Chapter 9Learning Objectives9.1 Short-Term and Long-Term Decisions9.1 Short-Term and Long-Term Decisions (continued)9.2 Payback Period9.2 Payback Period (continued)Slide 7Slide 89.2 (A) Discounted Payback Period9.2 (A) Discounted Payback Period (continued)9.2 (A) Discounted Payback Period (continued)9.3 Net Present Value (NPV)9.3 Net Present Value (NPV) (continued)9.3 (A) Mutually Exclusive versus Independent Projects9.3 (A) Mutually Exclusive versus Independent Projects (continued)Slide 169.3 (B) Unequal Lives of ProjectsSlide 189.3 (B) Unequal Lives of Projects (continued)Slide 20Slide 21Slide 22Slide 239.3 (C) Net Present Value Example: Equation and Calculator Function9.3 (C) Net Present Value Example: Equation and Calculator Function (continued)Slide 26Slide 27Slide 289.4 Internal Rate of ReturnSlide 309.4 Internal Rate of Return (calculator)9.4 (A) Appropriate Discount Rate or Hurdle Rate:9.4 (A) Appropriate Discount Rate or Hurdle Rate (continued)9.4 (B) Problems with the IRR9.4 (C) Multiple Internal Rates of Return9.4 (C) Multiple Internal Rates of Return (continued)9.4 (D) Reinvestment Rate9.4 (E) Crossover NPV profiles9.4 (E) Crossover NPV profiles (continued)Slide 40Slide 419.4 (F) Modified Internal Rate of Return (MIRR) (continued)9.4 (F) Modified Internal Rate of Return (MIRR) (continued)Slide 44Slide 459.5 Profitability Index9.5 Profitability Index (continued)9.6 Overview of Six Decision Models9.6 Overview of Six Decision Models (continued)Table 9.4 Summary of Six Decision Models9.6 (A) Capital Budgeting Using a Spreadsheet9.6 (A) Capital Budgeting Using a Spreadsheet (continued)Slide 53ADDITIONAL PROBLEMS WITH ANSWERS Problem 1ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (ANSWER)ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (ANSWER continued)ADDITIONAL PROBLEMS WITH ANSWERS Problem 2ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 (ANSWER)ADDITIONAL PROBLEMS WITH ANSWERS Problem 3ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 (ANSWER)ADDITIONAL PROBLEMS WITH ANSWERS Problem 4ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (ANSWER)Slide 63PowerPoint PresentationADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (ANSWER)ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (ANSWER continued)Slide 67FIGURE 9.1 Initial cash outflow and future cash inflow of copiers A and BTABLE 9.1 Discounted Cash Flow of Copiers A and BFIGURE 9.2 Net present value of a low-tech packaging machineTABLE 9.2 NPVs for Copier A with Varying Risk LevelsFIGURE 9.3 Net present value profile of copier ATABLE 9.3 Project Rankings Based on the Internal Rate of Return and the Net Present ValueFIGURE 9.6 Crossover rate for two projectsTABLE 9.5 Corporate Use of Different Decision Models: What Capital Budgeting Decision Models Do You Use?Copyright © 2010 Pearson Prentice Hall. All rights reserved.Chapter 9Capital Budgeting Decision ModelsCopyright © 2010 Pearson Prentice Hall. All rights reserved.9-2Learning Objectives1. Explain capital budgeting and differentiate between short-term and long-term budgeting decisions.2. Explain the payback model and its two significant weaknesses and how the discounted payback period model addresses one of the problems.3. Understand the net present value (NPV) decision model and appreciate why it is the preferred criterion for evaluating proposed investments.4. Calculate the most popular capital budgeting alternative to the NPV, the internal rate of return (IRR); and explain how the modified internal rate of return (MIRR) model attempts to address the IRR’s problems.5. Understand the profitability index (PI) as a modification of the NPV model.6. Compare and contrast the strengths and weaknesses of each decision model in a holistic way.Copyright © 2010 Pearson Prentice Hall. All rights reserved.9-39.1 Short-Term and Long-Term Decisions•Long-term decisions vs. short-term decisions:–Involve longer time horizons –cost larger sums of money–require a lot more information to be collected as part of their analysis •Capital budgeting meets all three criteriaCopyright © 2010 Pearson Prentice Hall. All rights reserved.9-49.1 Short-Term and Long-Term Decisions (continued)Three keys points to remember about capital budgeting decisions include:A1. Typically, a go or no-go decision on a product, service, facility, or activity of the firm. 2. Requires sound estimates of the timing and amount of cash flow for the proposal.3. The capital budgeting model has a predetermined accept or reject criterion.Copyright © 2010 Pearson Prentice Hall. All rights reserved.9-59.2 Payback Period•The length of time in which an investment pays back its original cost. A•Payback period <= the cutoff period and vice-versa. •Thus, its main focus is on cost recovery or liquidity. A•The method assumes that all cash outflows occur right at the beginning of the project’s life, followed by a stream of inflows.•Also assumes that cash inflows occur uniformly over the year. •Thus if Cost =$40,000; CF = $15,000 per year for 3 years; PP = 2 .67 yrs.Copyright © 2010 Pearson Prentice Hall. All rights reserved.9-69.2 Payback Period (continued)Example 1 Payback Period of a New MachineProblem•Let’s say that the owner of Perfect Images Salon is considering the purchase of a new tanning bed.•It costs $10,000 and is likely to bring in after-tax cash inflows of $4000 in the first year, $4,500 in the second year, $10,000 in the third year, and $8,000 in the fourth year. •The firm has a policy of buying equipment only if the payback period is 2 years or less. • Calculate the payback period of the tanning bed and state whether the owner would buy it or not.Copyright © 2010 Pearson Prentice Hall. All rights reserved.9-79.2 Payback Period (continued)SolutionYear Cash Flow Yet to be recoveredPercent of Year Recovered/Inflow0 (10,000) (10,000)1 4,000 (6,000)2 4,500 (1,500)3 10,000 0 (recovered) 15%4 8,000 Not used in decisionPayback Period = 2.15 yrs.Reject >2 yearsCopyright © 2010 Pearson Prentice Hall. All rights reserved.9-89.2 Payback Period (continued)•The payback period method has two major flaws:1. It ignores all cash flow after the initial cash outflow has been recovered.2. It ignores the time value of money.Copyright © 2010 Pearson Prentice Hall. All rights reserved.9-99.2 (A) Discounted Payback Period•Calculates the time it takes to recover the initial investment in current or discounted dollars. A•Incorporates time value of money by adding up the discounted cash inflows at time 0, using the