4/1/2020
Techniques of capital budgeting
Payback Period.
Discounted Payback Period.
Net Present Value. Project Relationship
Independent
Accounting Rate of Return. Projects
Financial Management Internal Rate of Return.
FIN 8401 MIRR
Md Ali Ashraf Profitability Index.
1 2
Payback Period Payback Period
Payback period is the time in which the initial cash outflow of an Decision Rule
investment is expected to be recovered from the cash inflows Accept the project only if its payback period is LESS than the target payback
generated by the investment period.
Payback Period = Initial Investment / Cash flow per period Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105
million. The project is expected to generate $25 million per year for 7 years.
Calculate the payback period of the project.
Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial investment
of $50 million and is expected to generate $10 million in Year 1, $13 million in Year
2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate
the payback value of the project.
3 4
4/1/2020
PBP Strengths
and Weaknesses Discounted Payback Period
Strengths: Weaknesses: Same as Payback, but incorporates time value of money
Easy to use and Does not account Payback Period = Initial Investment / Discounted cash inflow per period
understand for TVM Discounted Cash Inflow = Actual cash inflow/ (1 + i)n
Can be used as a Does not consider PV = FV/(1+i)n
measure of cash flows beyond
liquidity the PBP
Easier to forecast Cutoff period is
ST than LT flows subjective
5 6
Discounted Payback Period Net Present Value (NPV)
Decision Rule Net present value (NPV) of a project is the potential change in an
If the discounted payback period is less that the target period, accept the investor's wealth caused by that project.
project. Otherwise reject.
Example
An initial investment of $2,324,000 is expected to generate $600,000 per year for 6
years. Calculate the discounted payback period of the investment if the R is the net cash inflow
discount rate is 11%. expected to be received
in each period;
i is the required rate of
return per period;
n are the number of
periods during which the
project is expected to
operate and generate
cash inflows.
7 8
4/1/2020
Net Present Value (NPV) Net Present Value (NPV)
Decision Rule Example 1: Even Cash Inflows: Calculate the net present value of a project
which requires an initial investment of $243,000 and it is expected to
In case of standalone projects, accept a project only if its NPV is generate a cash inflow of $50,000 each month for 12 months. Assume that
positive, reject it if its NPV is negative and stay indifferent between the salvage value of the project is zero. The target rate of return is 12% per
accepting or rejecting if NPV is zero. annum.
In case of mutually exclusive projects (i.e. competing projects), accept Example 2: Uneven Cash Inflows: An initial investment of $10 thousand on
the project with higher NPV. plant and machinery is expected to generate cash inflows of $3 thousand,
$4 thousand and 5 thousand at the end of first, second and third year
respectively. Calculate the net present value of the investment if the
discount rate is 5%. Round your answer to nearest thousand dollars.
9 10
NPV Strengths
and Weaknesses Internal Rate of Return (IRR)
Strengths: Weaknesses: Internal rate of return (IRR) is the discount rate at which the net
May not include present value of an investment becomes zero.
Cash flows
assumed to be managerial
reinvested at the options embedded
hurdle rate. in the project.
Accounts for TVM.
Considers all
cash flows.
11 12
4/1/2020
IRR Strengths
Internal Rate of Return (IRR) and Weaknesses
Decision Rule Strengths: Weaknesses:
A project should only be accepted if its IRR is equal or higher than the Accounts for Assumes all cash
target required rate of return (hurdle rate). When comparing two or
more mutually exclusive projects, the project having highest value of TVM flows reinvested at
IRR should be accepted.
Considers all the IRR
Example
cash flows Difficulties with
Find the IRR of an investment having initial cash outflow of $10,000. cash
inflows of $3 thousand, $4 thousand and 5 thousand at the end of first, Less project rankings and
second and third year respectively.
subjectivity Multiple IRRs
13 14
Modified/Multiple Internal Net Present Value Profile
Rate of Return (MIRR/MIRR)
$000s
Modified Internal Rate of Return, shortly referred to as MIRR, is the Sum of CF’s Plot NPV for each
internal rate of return of an investment that is modified to account 15 discount rate.
Net Present Value
for the difference between re-investment rate and investment
return. 10
Multiple IRRs occur when a project has more than one internal rate
of return. The problem arises where a project has non-normal cash
flow (non-conventional cash flow pattern). 5 IRR
NPV@13%
0
-4
0 3 6 9 12 15
Discount Rate (%)
15 16
4/1/2020
Profitability Index Profitability Index
Profitability index is an investment appraisal technique calculated Decision Rule
by dividing the present value of future cash flows of a project by the
Accept a project if the profitability index is greater than 1, stay
initial investment required for the project.
indifferent if the profitability index is zero and don't accept a project if
the profitability index is below 1.
Example
Company C is undertaking a project at a cost of $50 million which is
expected to generate future net cash flows with a present value of $65
million. Calculate the profitability index.
17 18
PI Strengths
and Weaknesses Evaluation Summary
Basket Wonders Independent Project
Strengths: Weaknesses:
Same as NPV Same as NPV Method Project Comparison Decision
Allows Provides only PBP 3.3 3.5 Accept
comparison of relative profitability
different scale Potential Ranking IRR 11.47% 13% Reject
projects Problems NPV -$1,424 $0 Reject
PI .96 1.00 Reject
13-20
19 20
4/1/2020
Other Project Potential Problems
Relationships Under Mutual Exclusivity
Dependent -- A project whose Ranking of project proposals may
acceptance depends on the create contradictory results.
acceptance of one or more other
projects. A. Scale of Investment
Mutually Exclusive -- A project
whose acceptance precludes the
B. Cash-flow Pattern
acceptance of one or more C. Project Life
alternative projects.
13-21 13-22
21 22
A. Scale Differences Scale Differences
Compare a small (S) and a Calculate the PBP, IRR, NPV@10%,
large (L) project. and PI@10%.
NET CASH FLOWS Which project is preferred? Why?
END OF YEAR Project S Project L Project IRR NPV PI
0 -$100 -$100,000
S 100% $ 231 3.31
1 0 0
L 25% $29,132 1.29
2 $400 $156,250
13-23 13-24
23 24
4/1/2020
B. Cash Flow Pattern Cash Flow Pattern
Let us compare a decreasing cash-flow (D) Calculate the IRR, NPV@10%,
project and an increasing cash-flow (I) project.
and PI@10%.
NET CASH FLOWS Which project is preferred?
END OF YEAR Project D Project I
0 -$1,200 -$1,200 Project IRR NPV PI
1 1,000 100
2 500 600
D 23% $198 1.17
3 100 1,080 I 17% $198 1.17
13-25 13-26
25 26
Examine NPV Profiles Fisher’s Rate of Intersection
Plot NPV for each
600
600
Net Present Value ($)
Net Present Value ($)
project at various
At k<10%, I is best! Fisher’s Rate of
Project I discount rates.
Intersection
400
0 200 400
NPV@10%
200
IRR At k>10%, D is best!
Project D
0
-200
-200
0 5 10 15 20 25 0 5 10 15 20 25
Discount Rate (%) Discount Rate ($)
13-27 13-28
27 28
4/1/2020
C. Project Life Differences Project Life Differences
Let us compare a long life (X) project Calculate the PBP, IRR, NPV@10%,
and a short life (Y) project. and PI@10%.
NET CASH FLOWS Which project is preferred? Why?
END OF YEAR Project X Project Y
Project IRR NPV PI
0 -$1,000 -$1,000
1 0 2,000 X 50% $1,536 2.54
2 0 0
Y 100% $ 818 1.82
3 3,375 0
13-29 13-30
29 30
Capital Rationing Available Projects for BW
Capital Rationing occurs when a Project ICO IRR NPV PI
constraint (or budget ceiling) is placed
A $ 500 18% $ 50 1.10
on the total size of capital expenditures B 5,000 25 6,500 2.30
during a particular period. C 5,000 37 5,500 2.10
D 7,500 20 5,000 1.67
Example: Julie Miller must determine what E 12,500 26 500 1.04
investment opportunities to undertake for F 15,000 28 21,000 2.40
Basket Wonders (BW). She is limited to a G 17,500 19 7,500 1.43
maximum expenditure of $32,500 only for H 25,000 15 6,000 1.24
this capital budgeting period.
13-31 13-32
31 32
4/1/2020
Choosing by IRRs for BW Choosing by NPVs for BW
Project ICO IRR NPV PI Project ICO IRR NPV PI
C $ 5,000 37% $ 5,500 2.10 F $15,000 28% $21,000 2.40
F 15,000 28 21,000 2.40 G 17,500 19 7,500 1.43
E 12,500 26 500 1.04 B 5,000 25 6,500 2.30
B 5,000 25 6,500 2.30
Projects C, F, and E have the Projects F and G have the
three largest IRRs. two largest NPVs.
The resulting increase in shareholder wealth The resulting increase in shareholder wealth
is $27,000 with a $32,500 outlay. is $28,500 with a $32,500 outlay.
13-33 13-34
33 34
Choosing by PIs for BW Summary of Comparison
Project ICO IRR NPV PI Method Projects Accepted Value Added
F $15,000 28% $21,000 2.40 PI F, B, C, and D $38,000
B 5,000 25 6,500 2.30
C 5,000 37 5,500 2.10 NPV F and G $28,500
D 7,500 20 5,000 1.67 IRR C, F, and E $27,000
G 17,500 19 7,500 1.43
Projects F, B, C, and D have the four largest PIs. PI generates the greatest increase in
The resulting increase in shareholder wealth is shareholder wealth when a limited capital
$38,000 with a $32,500 outlay. budget exists for a single period.
13-35 13-36
35 36
