Capital Budgeting Techniquesu Project Evaluation and Selectionu Potential Difficultiesu Capital Rationingu Project Monitoring第一页Project Evaluation: Alternative Methodsu Payback Period (PBP)u Internal Rate of Return (IRR)u Net Present Value (NPV)u Profitability Index (PI)第二页Proposed Project DataJulie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.第三页Independent Projectu uIndependentIndependent - A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.uFor this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.第四页Payback Period (PBP)PBPPBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K第五页(c)10 K 22 K 37 K 47 K 54 KPayback Solution (#1)PBPPBP = a + ( b - c ) / d= 3 + (40 - 37) / 10= 3 + (3) / 10= 3.3 Years3.3 Years0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 KCumulativeInflows(a)(-b)(d)第六页Payback Solution (#2)PBPPBP = 3 + ( 3K ) / 10K= 3.3 Years3.3 YearsNote: Take absolute value of last negative cumulative cash flow value.CumulativeCash Flows -40 K 10 K 12 K 15 K 10 K 7 K0 1 2 3 4 5-40 K -30 K -18 K -3 K 7 K 14 K第七页PBP Acceptance CriterionYes! The firm will receive back the initial cash outlay in less than 3.5 years. 3.3 Years 3.5 Year Max.The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type.Should this project be accepted?第八页PBP Strengths and WeaknessesStrengthsStrengths: :u Easy to use and understandu Can be used as a measure of liquidityu Easier to forecast ST than LT flowsWeaknessesWeaknesses: :u Does not account for TVMu Does not consider cash flows beyond the PBPu Cutoff period is subjective第九页Internal Rate of Return (IRR)IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the projects initial cash outflow.CF1 CF2 CFn (1+IRR)1 (1+IRR)2 (1+IRR)n+ . . . +ICO =第十页$15,000 $10,000 $7,000 IRR Solution$10,000 $12,000(1+IRR)1 (1+IRR)2Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000.+$40,000 =(1+IRR)3 (1+IRR)4 (1+IRR)5第十一页IRR Solution (Try 10%)$40,000$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) +$15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5) $40,000$40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) + $ 7,000(.621)$40,000$40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 =$41,444$41,444 Rate is too low!Rate is too low! 第十二页IRR Solution (Try 15%)$40,000$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5) $40,000$40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) + $10,000(.572) + $ 7,000(.497)$40,000$40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 =$36,841$36,841 Rate is too high!Rate is too high! 第十三页.10$41,444.05IRR$40,000 $4,603.15$36,841 X$1,444.05$4,603IRR Solution (Interpolate)$1,444X=第十四页.10$41,444.05IRR$40,000 $4,603.15$36,841 X$1,444.05$4,603IRR Solution (Interpolate)$1,444X=第十五页.10$41,444.05IRR$40,000 $4,603.15$36,841($1,444)(0.05) $4,603IRR Solution (Interpolate)$1,444XX =X = .0157IRR = .10 + .0157 = .1157 or 11.57%第十六页IRR Acceptance Criterion No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. IRR Hurdle Rate The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted?第十七页IRR Strengths and Weaknesses StrengthsStrengths: : u Accounts for TVMu Considers all cash flowsu Less subjectivityWeaknessesWeaknesses: : u Assumes all cash flows reinvested at the IRRu Difficulties with project rankings and Multiple IRRs第十八页Net Present Value (NPV) NPV is the present value of an investment projects net cash flows minus the projects initial cash outflow.CF1 CF2 CFn (1+k)1 (1+k)2 (1+k)n+ . . . +- ICOICONPV =第十九页Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%.$10,000 $7,000 NPV Solution$10,000 $12,000 $15,000 (1.13)1 (1.13)2 (1.13)3 +- $40,000$40,000(1.13)4 (1.13)5NPVNPV =+第二十页NPV SolutionNPVNPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $ 7,000(PVIF13%,5) - $40,000$40,000NPVNPV = $10,000(.885) + $12,000(.783) + $15,000(.693) + $10,000(.613) + $ 7,000(.543) - $40,000$40,000NPVNPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000$40,000 =- $1,428$1,428第二十一页NPV Acceptance Criterion No! The NPV is negative. This means that the project is reducing shareholder wealth. Reject Reject as NPVNPV 0 0 The management of Basket Wonders has determined that the required rate is 13% for projects of this type.Should this project b