Unit 4 – Capital Budgeting Decision Methods

• This last unit ties together everything we have covered in the first three units – the time value of money, risk and return, and cash flow forecasting – by covering methods firms can use to determine if long-term investment alternatives should be accepted or rejected

• The goal is to utilize decision techniques that lead to profitable investment decisions and increase firm value

Three criteria we will apply for comparing different Capital Budgeting Decision

Methods

• A good method should incorporate the time value of money

• A good method should incorporate all the relevant cash flows of the investment

• A good method should provide unambiguous decisions on whether to invest or reject investment proposals

Decision Methods

• Payback Period

• Net Present Value (NPV)

• Internal Rate of Return (IRR)

Method 1 – Payback Period

• The payback period answers the question “How long will it take to recover the initial cost of this investment?”

• The method involves summing the annual cash flows until the sum is greater than or equal to the initial project investment

• The payback decision rule is: If the project payback is less than or equal to our firm’s required payback period, accept. Otherwise, reject.

An example of the payback period

Initial cost 300,000 eurosYear Cash Flow Cumulative Cash Flow1 25,000 25,0002 50,000 75,0003 100,000 175,0004 150,000 325,0005 150,000 475,000

Payback period = 3 + (300,000 - 175,000) /150,000Payback Period = 3..83 years

Evaluating the Payback Period Method

• First, realize this method gives you a measure of project time, or liquidity; it does not provide any insight into the profitability of the investment

• It does not incorporate the time value of money into the analysis

• It does not consider all of the project cash flows – note that the cash flow from year 5 was note included in the payback analysis

• Finally, is this a good investment proposal? It depends on the firm’s internal payback requirement – if it is 2 years, this proposal would be rejected, but if it is 4 years, this is an acceptable investment. Realize the payback rule is therefore subjective and arbitrary

Method 2 - The Net Present Value Method

• The NPV method answers the question “How much will this investment increase the firm’s value today?”

• The method involves finding the present value of the future cash flow stream, and subtracting the initial investment

• The NPV rule is: if the project’s NPV > 0 then accept, NPV < 0 then reject

An example of the Net Present Value method – assume the firm’s cost of capital, or hurdle

rate, is 10%

Initial cost 300,000 eurosYear Cash Flow Present Value Cash Flow @ 10%1 25,000 227272 50,000 413223 100,000 751314 150,000 1024525 150,000 93138

334771NPV = 334771 - 300,000NPV = 34771

Evaluating the NPV method

• Since the example NPV is positive, the decision is to invest in the project

• NPV is a measure of project profitability – it indicates how much the project adds to the firm’s value in present value money

• NPV considers the time value of money through the discounting process

• NPV considers all of the project’s cash flows, since all are discounted and summed

• The NPV decision rule is clear – positive NPV projects increase firm value, while negative NPV projects decrease firm value

Method 3 – The Internal Rate of Return Method

• The IRR method answers the question “What is the expected rate of return on this investment?”

• IRR is the unique discount rate that makes the present value of the future cash flow stream equal to the initial project cost

• IRR decision rule: if IRR > firm’s cost of capital (required rate of return) then invest; if IRR < cost of capital do not invest

An example of the Internal Rate of Return Method

Year Cash Flow0 -300,0001 25,0002 50,0003 100,0004 150,0005 150,000

IRR 13%

Evaluating the IRR Method

• The IRR function is a built in financial function in Microsoft Excel, as well as in financial calculators

• Since the IRR > 10% in this example, the decision is to invest

• The IRR method considers the time value of money, since it is the discount rate used in the analysis

• The IRR does consider all of the cash flows forecasted for the projects

• For independent project proposals, IRR and NPV will give consistent invest/reject decisions

Comparing and Contrasting NPV and IRR capital investment methods

• IRR is the geometric, or compound, expected return on investment

• IRR assumes all cash flows from the project are reinvested at the IRR rate

• While NPV is consistent with the goal of maximizing firm value, many firms like to use IRR because it is easier to communicate an expected rate of return (a relative profitability measure) rather than an absolute euro increase in firm value

Possible Conflicts between NPV and IRR

• If a firm is considering mutually exclusive project proposals, there are two situations where IRR and NPV may give conflicting ranking decisions

• If one project is much larger than the other in terms of required investment, IRR and NPV may conflict on which is more profitable for the firm

• Also, if the timing of when the cash flows occur is dramatically different between the two projects, IRR and NPV may give conflicting rankings

An example of conflicting rankings due to differences in the timing of the respective cash flow streams

Project K Project LYear Cash Flow Cash Flow

0 -150,000 -150,0001 47,000 75,0002 47,000 60,0003 47,000 30,0004 47,000 30,0005 47,000 30,0006 47,000 30,000

NPV @ 10% $54,697.25 $46,360.30IRR 22% 23%

Comments on previous example

• Note that, while Project K has a steady cash flow stream throughout the life of the project, Project L generates the larger cash flows in its early years

• Because IRR assumes reinvestment of cash flows, the larger cash flows early results in Project L having the higher IRR

• However, Project K has the higher NPV• In the case of conflicts for mutually exclusive choices,

NPV provides the most theoretically sound decision method, since it indicates the investment choice that provides the largest increase in firm value

Comparing Investments of Different Size – the Profitability Index

• For two investments of different size (required amounts of investment), the NPV method can be altered to provide a relative ranking index

• The Profitability Index is the ratio of the present value of the future cash flows divided by the project cost

• The result is the present euro benefit per euro of required investment

An Example of Profitability Index

Project D Present Value Project E Present ValueYear Cash Flow Cash Flow Cash Flow Cash Flow

0 -500000 -3250001 100000 90909 140000 1272732 120000 99174 120000 991743 150000 112697 95000 713754 190000 129773 70000 478115 250000 155230 50000 31046

Sum 587783 376678PI = 587,783/500,000 PI = 376,678/325,000

Profitability = 1.18 Profitability = 1.16Index Index

Notes on Profitability Index example

• First,these two proposed projects have different sizes, with Project D having a much higher required investment cost

• By taking the ratio of the present value of the future cash flows to the cost, we see that Project D is expected to provide 1.18 euros per each euro invested, compared to 1.16 euros per euro invested for Project E.

• The decision rule for PI is; the > the PI, the better