FM10e_ch09

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2005, Pearson Prentice Hall

Chapter 9 -Chapter 9 -

Capital BudgetingCapital Budgeting

Decision CriteriaDecision Criteria

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Capital Budgeting

Capital Budgeting:: The processThe process

of planning for purchases of long-of planning for purchases of long-

term assets.term assets.

For exampleFor exam

ple:: Suppose our firm mustSuppose our firm must

decide whether to purchase a new plasticdecide whether to purchase a new plasticmolding machine for $12!""". #ow domolding machine for $12!""". #ow do

we decidewe decide

%ill the machine &e%ill the machine &e profita&leprofita&le

%ill our firm earn a%ill our firm earn a high rate of returnhigh rate of return

on the in'estmenton the in'estment

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(ecision-ma)ing Criteria(ecision-ma)ing Criteria

in Capital Budgetingin Capital Budgeting

#ow do we decide#ow do we decide

if a capitalif a capital

in'estmentin'estment

pro*ect shouldpro*ect should

&e accepted or&e accepted or

re*ectedre*ected

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The ideal e'aluation method should:The ideal e'aluation method should:

a+ includea+ include all cash flowsall cash flowsthat occurthat occurduring the life of the pro*ect!during the life of the pro*ect!

&+ consider the&+ consider the time 'alue of mone,time 'alue of

mone,! and! and

c+ incorporate thec+ incorporate the reuired rate ofre

uired rate of

returnreturnon the pro*ect.on the pro*ect.

(ecision-ma)ing Criteria in(ecision-ma)ing Criteria in

Capital BudgetingCapital Budgeting

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a,&ac) erioda,&ac) eriod

#ow long will it ta)e for the pro*ect#ow long will it ta)e for the pro*ect

to generate enough cash to pa, forto generate enough cash to pa, for

itselfitself

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itselfitself

" 1 2 / 0 3

4""+ 1" 1" 1" 1" 1" 1" 1" 1"

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itselfitself

a,&ac) period 5 /.// ,ears

" 1 2 / 0 3

4""+ 1" 1" 1" 1" 1" 1" 1" 1"

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6s a6s a /.// ,ear/.// ,earpa,&ac) period goodpa,&ac) period good

6s it accepta&le6s it accepta&le

Firms that use this method will compareFirms that use this method will comparethe pa,&ac) calculation to somethe pa,&ac) calculation to some

standard set &, the firm.standard set &, the firm.

6f our senior management had set a cut-6f our senior management had set a cut-

off ofoff of ,ears ,earsfor pro*ects li)e ours! whatfor pro*ects li)e ours! what

would &e our decisionwould &e our decision

7ccept the pro*ect7ccept the pro*ect..


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(raw&ac)s of a,&ac) eriod(raw&ac)s of a,&ac) eriod

Firm cutoffs areFirm cutoffs are su&*ecti'esu&*ecti'e..

(oes not consider(oes not consider time 'alue oftime 'alue of

mone,mone,.. (oes not consider an,(oes not consider an, reuiredreuired

rate of returnrate of return..

(oes not consider all of the(oes not consider all of the

pro*ect8spro*ect8s cash flowscash flows..

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(oes not consider all of the pro*ect8s(oes not consider all of the pro*ect8s

cash flows.cash flows.

Consider this cash flow stream9Consider this cash flow stream9

" 1 2 / 0 3

4""+ 1" 1" 1" 1" 1" 1" 1" 1"

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(oes not consider all of the pro*ect8s cash(oes not consider all of the pro*ect8s cash

flows.flows.

This pro*ect is clearl, unprofita&le! &ut weThis pro*ect is clearl, unprofita&le! &ut we

wouldwould acceptacceptit &ased on a 0-,ear pa,&ac)it &ased on a 0-,ear pa,&ac)

criterion9criterion9

" 1 2 / 0 3

4""+ 1" 1" 1" 1" 1" 1" 1" 1"

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(iscounted a,&ac)(iscounted a,&ac)

(iscounts the cash flows at the firm8s(iscounts the cash flows at the firm8s

reuired rate of return.reuired rate of return.

a,&ac) period is calculated usinga,&ac) period is calculated usingthese discounted net cash flows.these discounted net cash flows.

ProblemsProblems::

Cutoffs are still su&*ecti'e.Cutoffs are still su&*ecti'e.

Still does not examine all cash flows.Still does not examine all cash flows.

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" 1 2 / 0

4""+ 2" 2" 2" 2" 2"

(iscounted(iscounted

earear Cash FlowCash Flow CF 410;+CF 410;+ "" -""-"" -"".""-"".""

11 2"2" 21

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" 1 2 / 0

4""+ 2" 2" 2" 2" 2"



11 2"2" 21

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" 1 2 / 0

4""+ 2" 2" 2" 2" 2"



11 2"2" 21

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11 2"2" 21

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" 1 2 / 0

4""+ 2" 2" 2" 2" 2"



11 2"2" 21

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" 1 2 / 0

4""+ 2" 2" 2" 2" 2"



11 2"2" 21

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" 1 2 / 0

4""+ 2" 2" 2" 2" 2"



11 2"2" 21

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=ther >ethods=ther >ethods

1+1+ ?et resent @alue?et resent @alue4?@+4?@+

2+2+ rofita&ilit, 6ndexrofita&ilit, 6ndex46+46+

/+/+ 6nternal Aate of Aeturn6nternal Aate of Aeturn46AA+46AA+

Consider each of these decision-ma)ingConsider each of these decision-ma)ing

criteria:criteria: 7ll net cash flows.7ll net cash flows.

The time 'alue of mone,.The time 'alue of mone,.

The reuired rate of return.The reuired rate of return.

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?@ 5 the total @ of the annual netcash flows - the initial outla,.

?@?@ 5 - 6=5 - 6=FCFFCFtt

41 )+41 )+ tt

nn

t51t51

?et resent @alue?et resent @alue

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(ecision Aule(ecision Aule::

6f ?@ is positi'e!6f ?@ is positi'e! acceptaccept.. 6f ?@ is negati'e!6f ?@ is negati'e! re*ectre*ect..

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NPV ExampleNPV Example

Suppose we are considering a capitalSuppose we are considering a capital

in'estment that costsin'estment that costs $2"!"""$2"!"""andand

pro'ides annual net cash flows ofpro'ides annual net cash flows of

$1""!"""$1""!"""for fi'e ,ears. The firm8sfor fi'e ,ears. The firm8s

reuired rate of return isreuired rate of return is 1;1;..

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NPV ExampleNPV Example

" 1 2 / 0

42"!"""+ 1""!""" 1""!""" 1""!""" 1""!""" 1""!"""

Suppose we are considering a capitalSuppose we are considering a capital

in'estment that costsin'estment that costs $2"!"""$2"!"""andand

pro'ides annual net cash flows ofpro'ides annual net cash flows of

$1""!"""$1""!"""for fi'e ,ears. The firm8sfor fi'e ,ears. The firm8s

reuired rate of return isreuired rate of return is 1;1;..

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?@ is *ust the @ of the annual cash?@ is *ust the @ of the annual cashflows minus the initial outflow.flows minus the initial outflow.

Using TVM:Using TVM:

5 1 ? 5 6 5 1 5 1 ? 5 6 5 1

>T 5 1""!""">T 5 1""!"""

@ of cash flows 5@ of cash flows 5 $//!21$//!21

- 6nitial outflow:- 6nitial outflow: 4$2"!"""+4$2"!"""+

5 ?et @5 ?et @ $!21$!21

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?@ with the #1"B:?@ with the #1"B:

-2"!"""-2"!""" CF*CF*

1""!"""1""!""" CF*CF*

shift ?*shift ?*

11 6A6A

shift ?@shift ?@

ou should get ?@ 5ou should get ?@ 5 !21.1!21.1..

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?@ with the #13B66:?@ with the #13B66:

SelectSelect CFD=CFD=mode.mode.

FD=%4"+5FD=%4"+5 -2"!""" 6?ET-2"!""" 6?ET

FD=%41+5FD=%41+5 1""!""" 6?ET1""!""" 6?ET

T6>GS41+51T6>GS41+51 6?ET 6?ET

GH6TGH6T

C7DC 1 6; ?@C7DC 1 6; ?@

ou should get ?@ 5ou should get ?@ 5 !21.1!21.1

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?@ with the T6 B766 lus:?@ with the T6 B766 lus:

Select CF mode.Select CF mode.

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CFo5CFo5 -2"!"""-2"!""" G?TGAG?TGA

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C"15C"15 1""!"""1""!""" G?TGAG?TGA

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C"15C"15 1""!"""1""!""" G?TGAG?TGA

F"15 1F"15 1 G?TGAG?TGA

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C"15C"15 1""!"""1""!""" G?TGAG?TGA


?@?@ 6565 11 G?TGAG?TGA

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C"15C"15 1""!"""1""!""" G?TGAG?TGA


?@?@ 6565 11 G?TGAG?TGA CTCT

ou should getou should get ?@ 5 !21.1?@ 5 !21.1

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Profitability Index

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Profitability Index

?@ 5 - 6=FCFt

41 )+ t

n

t51

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Profitability Index

6 5 6=FCFt41 )+

n

t51

t

?@ 5 - 6=FCFt

41 )+ t

n

t51

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(ecision Aule:

6f 6 is greater than or eualto 1! accept.

6f 6 is less than 1! re*ect.

Profitability Index

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6 with the #1"B:6 with the #1"B:

-2"!"""-2"!""" CF*CF*

1""!"""1""!""" CF*CF*

shift ?*shift ?* 11 6A6A

shift ?@shift ?@

7dd &ac) 6=:7dd &ac) 6=: 2"!""" 2"!""" (i'ide &, 6=:(i'ide &, 6=: 2"!""" 5 2"!""" 5

ou should getou should get 6 5 1./06 5 1./0

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6nternal Aate of Aeturn 46AA+6nternal Aate of Aeturn 46AA+

6AA6AA::The return on the firm8sThe return on the firm8s

in'ested capital. 6AA is simpl, thein'ested capital. 6AA is simpl, the

rate of returnrate of returnthat the firm earns onthat the firm earns onits capital &udgeting pro*ects.its capital &udgeting pro*ects.

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?@ 5 - 6=FCFt

41 )+

t

n

t51

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?@ 5 - 6=FCFt

41 )+

t

n

t51

n

t51

6AA: 5 6=FCFt41 6AA+ t

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6AA is the6AA is the rate of returnrate of returnthat ma)es thethat ma)es the@@

of the cash flowsof the cash flowseualeualto theto the initial outla,initial outla,.. This loo)s 'er, similar to our ield toThis loo)s 'er, similar to our ield to

>aturit, formula for &onds. 6n fact! T>>aturit, formula for &onds. 6n fact! T>

isisthe 6AA of a &ond.the 6AA of a &ond.

n

t51

6AA: 5 6=FCFt

41 6AA+ t

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Calculating 6AACalculating 6AA

Doo)ing again at our pro&lem:Doo)ing again at our pro&lem:

The 6AA is the discount rate thatThe 6AA is the discount rate that

ma)es the @ of the pro*ected cashma)es the @ of the pro*ected cash

flowsflows eualeualto the initial outla,.to the initial outla,.

" 1 2 / 0

42"!"""+ 1""!""" 1""!""" 1""!""" 1""!""" 1""!"""

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6AA with ,our Calculator6AA with ,our Calculator

6AA is eas, to find with ,our financial6AA is eas, to find with ,our financial

calculator.calculator.

Iust enter the cash flows as ,ou didIust enter the cash flows as ,ou didwith the ?@ pro&lem and sol'e forwith the ?@ pro&lem and sol'e for

6AA.6AA.

ou should getou should get 6AA 5 2.;96AA 5 2.;9

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6AA6AA

(ecision Aule(ecision Aule::

6f 6AA is greater than or eual to6f 6AA is greater than or eual tothe reuired rate of return!the reuired rate of return!

acceptaccept..

6f 6AA is less than the reuired6f 6AA is less than the reuired

rate of return!rate of return! re*ectre*ect..

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6AA is a good decision-ma)ing tool as6AA is a good decision-ma)ing tool as

long as cash flows arelong as cash flows are con'entionalcon'entional..

4- +4- +

Problem:Problem:6f there are multiple sign6f there are multiple sign

changes in the cash flow stream! wechanges in the cash flow stream! we

could get multiple 6AAs.could get multiple 6AAs. 4- - +4- - +

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4- +4- +




" 1 2 / 0

4""+ 2"" 1"" 42""+ 0"" /""

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4- +4- +




" 1 2 / 0

4""+ 2"" 1"" 42""+ 0"" /""

11

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4- +4- +




" 1 2 / 0

4""+ 2"" 1"" 42""+ 0"" /""

1 2

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4- +4- +




" 1 2 / 0

4""+ 2"" 1"" 42""+ 0"" /""

1 2 /

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Summar, ro&lemSummar, ro&lem

Gnter the cash flows onl, once.Gnter the cash flows onl, once.

Find theFind the 6AA6AA..

Esing a discount rate ofEsing a discount rate of 1;!1;!findfind ?@?@.. 7dd &ac) 6= and di'ide &, 6= to get7dd &ac) 6= and di'ide &, 6= to get 66..

" 1 2 / 0

4

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Summar, ro&lemSummar, ro&lem

6AA 5 /0./3;.6AA 5 /0./3;.

Esing a discount rate of 1;!Esing a discount rate of 1;!

?@ 5 $1".2.?@ 5 $1".2.

6 5 1.36 5 1.3..

" 1 2 / 0

4

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>odified 6nternal Aate of Aeturn>odified 6nternal Aate of Aeturn

4>6AA+4>6AA+

6AA6AAassumes that all cash flows areassumes that all cash flows are

rein'ested at therein'ested at the 6AA6AA..

>6AA>6AApro'ides a rate of returnpro'ides a rate of returnmeasure that assumes cash flows aremeasure that assumes cash flows are

rein'ested at therein'ested at the reuired rate ofreuired rate of

returnreturn..

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>6AA Steps:>6AA Steps:

Calculate the @ of the cash outflows.Calculate the @ of the cash outflows. Esing the reuired rate of return.Esing the reuired rate of return.

Calculate the F@ of the cash inflows atCalculate the F@ of the cash inflows at

the last ,ear of the pro*ect8s time line.the last ,ear of the pro*ect8s time line.This is called the terminal 'alue 4T@+.This is called the terminal 'alue 4T@+.

Esing the reuired rate of return.Esing the reuired rate of return.

>6AA: the discount rate that euates>6AA: the discount rate that euatesthe @ of the cash outflows with the @the @ of the cash outflows with the @

of the terminal 'alue! ie! that ma)es:of the terminal 'alue! ie! that ma)es:

@@outflowsoutflows

5 @5 @inflowsinflows

>6AA>6AA

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>6AA>6AA

Esing our time line and a 1; rate:Esing our time line and a 1; rate:

@ outflows 5@ outflows 5 4

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@ outflows 5@ outflows 5 46AA

>6AA>6AA

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@ outflows 5@ outflows 5 46AA

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