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The Basics of Capital Budgeting

What is capital budgeting? ,[object Object],[object Object],[object Object]

Examples: ,[object Object],[object Object],[object Object],[object Object],[object Object]

Problems: ,[object Object],[object Object],[object Object]

Types of capital ,[object Object],[object Object],[object Object],[object Object],[object Object]

methods ,[object Object],[object Object],[object Object],[object Object]

Steps to capital budgeting ,[object Object],[object Object],[object Object],[object Object],[object Object]

What is the difference between independent and mutually exclusive projects? ,[object Object],[object Object]

What is the difference between normal and nonnormal cash flow streams? ,[object Object],[object Object]

What is the payback period? ,[object Object],[object Object]

Calculating payback Payback L = 2 + / = 2.375 years CF t -100 10 60 100 Cumulative -100 -90 0 50 0 1 2 3 = 2.4 30 80 80 -30 Project L Payback S = 1 + / = 1.6 years CF t -100 70 100 20 Cumulative -100 0 20 40 0 1 2 3 = 1.6 30 50 50 -30 Project S

Strengths and weaknesses of payback ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Discounted payback period ,[object Object],Disc Payback L = 2 + / = 2.7 years CF t -100 10 60 80 Cumulative -100 -90.91 18.79 0 1 2 3 = 2.7 60.11 -41.32 PV of CF t -100 9.09 49.59 41.32 60.11 10%

Accounting rate of return ,[object Object],[object Object],[object Object]

Net Present Value (NPV) ,[object Object]

What is Project L’s NPV? ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Rationale for the NPV method ,[object Object],[object Object],[object Object],[object Object],[object Object]

Internal Rate of Return (IRR) ,[object Object],[object Object]

How is a project’s IRR similar to a bond’s YTM? ,[object Object],[object Object],[object Object],[object Object]

Rationale for the IRR method ,[object Object]

IRR Acceptance Criteria ,[object Object],[object Object],[object Object],[object Object]

NPV Profiles ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Comparing the NPV and IRR methods ,[object Object],[object Object],[object Object],[object Object]

Comparisons : proposals Initial inv Annual cash flow Life in years 1 60,000 12000 15 2 88,000 22,500 22 3 2150 1,500 3 4 20,500 4500 10 5 4,25,000 2,25000 20

Pay back method Pay back period = Initial investment/annual cash flow 1 60,000/12,000 5 2 88,00/22500 3.9 3 21,50/1500 1.4 4 2,5000/4500 4.6 5 4,25000/2,25000 1.9

Accounting rate proposal Initial investment Annual cash flow Life in years Annual depreciation Net profits Rate of return 1 60,000 12000 15 4000 8000 26.67 2 88,000 22,500 22 4000 18,500 42 3 2150 1500 3 717 783 72.84 4 20,500 4500 10 2050 2450 23.9 5 4,25000 2,25000 20 21,250 203750 95.88

NPV proposal Initial inv Annual cash low life Pv(10%) Pv npvi 1 60,000 12,000 15 7.7688 93225.6 1.55 2 88,000 22,500 22 8.8919 200,067.75 2.27 3 2150 1500 3 2.5918 3887.7 1.81 4 20,500 4500 10 6.3213 28445.8 1.39 5 425,000 2,25000 20 8.6466 1945485 4.56

[object Object],methods payback accounting DCF NPV Proposal rank ranks ranks ranks 1 5 4 4 4 2 3 3 3 2 3 1 2 2 3 4 4 5 5 5 5 2 1 1 1

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