HB 311 1st EditionLecture 16 Capital Budget Techniques - Payback- Payback period is time it takes to recover early cash outflowso Shorter is better- Payback decision ruleso Stand-alone projects If the payback period < (>) policy maximum accept (reject)o Mutually exclusive projects  If paybackA < PaybackB -> choose Project A- Weaknesses of Paybacko Ignores Time Value of Money o Ignores cash flows after the payback period - Why use payback? o It’s quick and easyo 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 paybackCapital 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 wealtho 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 NPVThese 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 Ruleso Stand-alone projects NPV > 0 -> accept NPV < 0 -> rejecto 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 equationo The IRR is the interest rate that makes a project’s NPV zero o Decision Ruleso Stand-alone projects If IRR > cost of capital (or k) -> accept If IRR < cost of capital (or k) -> rejecto Mutually exclusive projects IRR(A) > IRR(B) -> choose Project A over Project B  Calculating IRRso Finding IRRs usually requires an iterative, trial-and-error technique o Guess at the project’s IRRo 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 aso NPV = C0 + C[PVFAk, n] The IRR formula can be rewritten aso 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 ratioo Positive future cash flows are the benefito Negative initial outlay is the cost  Decision Ruleso 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 choicesPI = C111+k( ) +C221+k( ) +…+ Cnn1+k( )C0orPI = present value of inflowspresent value of