HB 311 1st Edition Lecture 16 Capital Budget Techniques Payback Payback period is time it takes to recover early cash outflows o Shorter is better Payback decision rules o Stand alone projects If the payback period policy maximum accept reject o Mutually exclusive projects If paybackA PaybackB choose Project A Weaknesses of Payback o Ignores Time Value of Money o Ignores cash flows after the payback period Why use payback o It s quick and easy o Serves as rough screening method The present value payback method o Involves finding present value of the project s cash flows then calculating the project s payback Capital Budgeting Techniques Net Present Value NPV is the sum of the present values of a project s cash flows at the cost of capital If PV inflows PV outflows NPV 0 NPV and shareholder wealth o Project s NPV is net effect that undertaking a project is expected to have on the firm s value Since the firm desires to maximize shareholder wealth it should select the capital spending program with the highest NPV These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute Decision Rules o Stand alone projects NPV 0 accept NPV 0 reject o Mutually exclusive projects NPV A NPV B Choose project A over B Techniques Internal Rate of Return IRR IRR is the return it generates on the investment of its cash outflows Defining IRR through the NPV equation o The IRR is the interest rate that makes a project s NPV zero o Decision Rules o Stand alone projects If IRR cost of capital or k accept If IRR cost of capital or k reject o Mutually exclusive projects IRR A IRR B choose Project A over Project B Calculating IRRs o Finding IRRs usually requires an iterative trial and error technique o Guess at the project s IRR o Calculate the project s NPV using this interest rate If NPV is zero the guessed interest rate is project s IRR If NPV 0 try a new higher interest rate Projects with a Single Outflow and Regular Inflows Many projects have one outflow at time 0 and inflows representing an annuity stream Consider the following cash flows In this case the NPV formula can be rewritten as o NPV C0 C PVFAk n The IRR formula can be rewritten as o 0 C0 C PVFAIRR n Profitability Index PI Variation of NPV Represents ratio of present value of a project s inflows to the present value of a project s outflows Projects are acceptable if PI 1 Larger PIs are preferred for mutually exclusive projects Known as benefit cost ratio o Positive future cash flows are the benefit o Negative initial outlay is the cost C1 PI 1 k 1 C2 1 k 2 Cn 1 k n C0 or PI present value of inflows present value of outflows Decision Rules o Stand alone projects If PI 1 0 accept If PI 1 0 reject o Mutually exclusive projects PI A PI B choose project A over project B o Comparison with NPV With mutually exclusive projects two methods may not lead to same choices