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CAPITAL BUDGETING

TECHNIQUES

Traditional methods

accounting rate of return (ARR)

payback period (PP)

Discounted cash flow techniques

internal rate of return (IRR)

net present value (NPV)

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Lecture example

project cost $28 550

estimated life 4 years

estimated residual value zero

annual net cash inflow $10 000

required rate of return 10%

Average net profit $2862

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Traditional methods of

project evaluation

Accounting rate of return

ARR = av net profit

av book value of investment

or = av net profit

total initial investment value

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Traditional methods of

project evaluation

Accounting rate of return example

ARR = 2 862 =20%

14 275

or = 2 862 =10%

28 550

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Accounting rate of

return (ARR)

advantages

easy to understand

managers are familiar with the

key concepts

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Payback period

a risk-related measure used inpractice to supplement othertechniques

payback period

time required to recover the initialinvestment

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Payback period

calculated by dividing the initialinvestment by the net cash inflow

project with the lowest payback periodis selected

Payback = initial investment

net cash inflow

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Payback period

example

Payb w

Payback = 28 550 = 2.855 years

10 000

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Payback period

advantages

easy to understand

provides some assessment of risk

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Payback period

disadvantages

ignores cash flows after thepayback period and does notmeasure profitability

ignores time value of moneybecause cash flows are notdiscounted

overcome by using the discountedpayback method

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Lecture 15

Capital decision cont

Reference - Chapter 16

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Internal rate of

return (IRR)

Rate that equates the resent value

of theexpectedcashoutflowswiththepresent valueof theexpectedcash inflows

Accept projectswhichoffer an IRRaboveacertain ini umdesiredrateof return

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IRR

OC = NCF1 + NCF2 ++ NCFn

(1+R)1 (1+R)2 (1+R)n

where

OC = original cost

NCF1 = net cash flow in year 1R = IRR 100

n = number of periods

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IRR example

PVF = 28 550 = 2.855

10 000

From Table 4 appendix 2, we need tofind the factor of 2.855 for four periods

it equates to 15%ACCEPT PROJECT since IRR > cost of

capital

To help calculation when the cash flow isuneven, apply the rule

If NPV > 0 then IRR > cost of capital

If NPV < 0 then IRR < cost of capital

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Internal rate of return

(IRR)

disadvantages

with certain cash flows there canbe multiple IRRs or no IRR

for mutually exclusive projects,

IRR can provide an incorrectranking of projects

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NPV formula

OC = NCF1 + NCF2 ++ NCFn

(1+R)1 (1+R)2 (1+R)n

where

OC = original cost

NCF1 = net cash flow in year 1

R = required rate of return

n = number of periods

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NPV example

NPV = -20 000 + 10 000 x PVF (10, 4)

= -20 000 + 10 000 x 3.1698

= $11 698

ACCEPT PROJECT

Decision rule is to accept project if theNPV is positive

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Net present value (NPV)

advantages

recognises the time value of money

dollars can be added as they are inpresent valuescorrect ranking of mutually exclusive

projects

dependent on forecast cash flowsand opportunity cost of capital,rather than arbitrary guess bymanagement

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Net present value (NPV)

disadvantages

how do we determine theminimum rate of return?

how accurate are forecast cashflows?

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Comparison of IRR and NPV

independent projects

mutually exclusive projects

IRR and NPV rankings

reinvestment assumptions

qualitative factors

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Group activity for

Tutorial next weekReview exercises:1, 2, &3. Page 500

Example 16.2 page 503

Example 16.3 page 505

Example 16.4 page508

Review Exercise4 page 510Review exercise5 page 510