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Financial Management Chapter 09 IM 10th Ed

# Financial Management Chapter 09 IM 10th Ed

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04/11/2012

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Prof. Rushen Chahal

CHAPTER 9
Capital Budgeting DecisionCriteria

CHAPTER ORIENTATION
Capital budgeting involves the decision making process with respect to the investment infixed assets; specifically, it involves measuring the incremental cash flows associated withinvestment proposals and evaluating the attractiveness of these cash flows relative to the project's costs. This chapter focuses on the various decision criteria.
CHAPTER OUTLINE
I.Methods for evaluating projectsA.The payback period method1.The payback period of an investment tells the number of yearsrequired to recover the initial investment. The payback period iscalculated by adding the cash inflows up until they are equal to theinitial fixed investment.2.Although this measure does, in fact, deal with cash flows and is easyto calculate and understand, it ignores any cash flows that occur after the payback period and does not consider the time value of moneywithin the payback period.3. To deal with the criticism that the payback period ignores the timevalue of money, some firms use the discounted payback periodmethod. The discounted payback period method is similar to thetraditional payback period except that it uses discounted free cashflows rather than actual undiscounted free cash flows in calculatingthe payback period.4. The discounted payback period is defined as the number of yearsneeded to recover the initial cash outlay from the discounted free cashflows.
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Prof. Rushen Chahal
B.Present-value methods1.The net present value of an investment project is the present value oits free cash flows less the investment’s initial outlay NPV=
ttn1t
k)(1FCF
+
=
- IOwhere:FCFt=the annual free cash flow in time period t (thiscan take on either positive or negative values)k=the required rate of return or appropriatediscount rate or cost of capitalIO=the initial cash outlayn= the project's expected lifea.The acceptance criteria areaccept if NPV
0reject if NPV
<
0 b.The advantage of this approach is that it takes the time valueof money into consideration in addition to dealing with cashflows.2.The profitability index is the ratio of the present value of the expectedfuture free cash flows to the initial cash outlay, or  profitability index =IOk)(1FCF
ttn1t
+
=
a.The acceptance criteria areaccept if PI
1.0reject if PI
<
1.0 b.The advantages of this method are the same as those for the net present value.c.Either of these present-value methods will give the sameaccept-reject decisions to a project.
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Prof. Rushen Chahal
C.The internal rate of return is the discount rate that equates the present value of the project's future net cash flows with the project's initial outlay. Thus theinternal rate of return is represented by IRR in the equation below:IO =
ttn1t
IRR)(1FCF
+
=
1.The acceptance-rejection criteria are:accept if IRR
required rate of returnreject if IRR
<
required rate of returnThe required rate of return is often taken to be the firm's cost of capital.2.The advantages of this method are that it deals with cash flows andrecognizes the time value of money; however, the procedure is rather complicated and time-consuming. The net present value profileallows you to graphically understand the relationship between theinternal rate of return and NPV. A net present value profile is simplya graph showing how a project’s net present value changes as thediscount rate changes. The IRR is the discount rate at which the NPVequals zero.3.The primary drawback of the internal rate of return deals with thereinvestment rate assumption it makes. The IRR implicitly assumesthat the cash flows received over the life of the project can bereinvested at the IRR while the NPV assumes that the cash flows over the life of the project are reinvested at the required rate of return.Since the NPV makes the preferred reinvestment rate assumption it isthe preferred decision technique. The modified internal rate of return(MIRR) allows the decision maker the intuitive appeal of the IRR coupled with the ability to directly specify the appropriatereinvestment rate.a.To calculate the MIRR we take all the annual free tax cash
in
flows, ACIFt's, and find their future value at the end of the project's life compounded at the required rate of return - this iscalled the terminal value or TV. All cash
out
flows, ACOFt,are then discounted back to present at the required rate of return. The MIRR is the discount rate that equates the presentvalue of the free cash outflows with the present value of the project's terminal value. b.If the MIRR is greater than or equal to the required rate oreturn, the project should be accepted.
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