Chapter outline. Capital budgeting decision criteria

CHAPTER 9

Capital Budgeting Decision Criteria

CHAPTER ORIENTATION

Capital budgeting involves the decision making process with respect to the investment in fixed assets; specifically, it involves measuring the incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project's costs. This chapter focuses on the various decision criteria.

CHAPTER OUTLINE

I. Methods for evaluating projects

A. The payback period method

1. The payback period of an investment tells the number of years required to recover the initial investment. The payback period is calculated by adding the cash inflows up until they are equal to the initial fixed investment.

2. Although this measure does, in fact, deal with cash flows and is easy to calculate and understand, it ignores any cash flows that occur after the payback period and does not consider the time value of money within the payback period.

3. To deal with the criticism that the payback period ignores the time value of money, some firms use the discounted payback period method. The discounted payback period method is similar to the traditional payback period except that it uses discounted free cash flows rather than actual undiscounted free cash flows in calculating the payback period.

4. The discounted payback period is defined as the number of years needed to recover the initial cash outlay from the discounted free cash flows.

B. Present-value methods

1. The net present value of an investment project is the present value of its free cash flows less the investment’s initial outlay

NPV = - IO

where:

FCFt = the annual free cash flow in time period t (this can take on either positive or negative values)

k = the required rate of return or appropriate discount rate or cost of capital

IO = the initial cash outlay

n = the project's expected life

a. The acceptance criteria are

accept if NPV ³ 0

reject if NPV < 0

b. The advantage of this approach is that it takes the time value of money into consideration in addition to dealing with cash flows.

2. The profitability index is the ratio of the present value of the expected future free cash flows to the initial cash outlay, or

profitability index =

a. The acceptance criteria are

accept if PI ³ 1.0

reject if PI < 1.0

b. The advantages of this method are the same as those for the net present value.

c. Either of these present-value methods will give the same accept-reject decisions to a project.

C. The internal rate of return is the discount rate that equates the present value of the project's future net cash flows with the project's initial outlay. Thus the internal rate of return is represented by IRR in the equation below:

IO =

1. The acceptance-rejection criteria are:

accept if IRR ³ required rate of return

reject if IRR < required rate of return

The required rate of return is often taken to be the firm's cost of capital.

2. The advantages of this method are that it deals with cash flows and recognizes the time value of money; however, the procedure is rather complicated and time-consuming. The net present value profile allows you to graphically understand the relationship between the internal rate of return and NPV. A net present value profile is simply a graph showing how a project’s net present value changes as the discount rate changes. The IRR is the discount rate at which the NPV equals zero.

3. The primary drawback of the internal rate of return deals with the reinvestment rate assumption it makes. The IRR implicitly assumes that the cash flows received over the life of the project can be reinvested at the IRR while the NPV assumes that the cash flows over the life of the project are reinvested at the required rate of return. Since the NPV makes the preferred reinvestment rate assumption it is the preferred decision technique. The modified internal rate of return (MIRR) allows the decision maker the intuitive appeal of the IRR coupled with the ability to directly specify the appropriate reinvestment rate.

a. To calculate the MIRR we take all the annual free tax cash in flows, ACIFt's, and find their future value at the end of the project's life compounded at the required rate of return - this is called the terminal value or TV. All cash out flows, ACOFt, are then discounted back to present at the required rate of return. The MIRR is the discount rate that equates the present value of the free cash outflows with the present value of the project's terminal value.

b. If the MIRR is greater than or equal to the required rate of return, the project should be accepted.

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