CAPITAL BUDGETING AND INVESTMENT CRITERIA

1. Type of project:
- Independent project: more than 1 promising project can be chosen;
accepting or rejecting 1 project does not affect the decision of other
projects ( chọn tất cả project có NPV >0)
- Mutually exclusive projects: only one of several potential projects
can be chosen (chọn project có NPV cao nhất)
- Contingent project: acceptance of 1 project depends on the acceptance of
other projects
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2. Method to calculate:

a. NPV :

Example: You have the opportunity to purchase an office building. You have a
tenant lined up that will generate $16,000 per year in cash flows for three years.
At the end of three years you anticipate selling the building for $450,000. Assume
opportunity cost is 7%. How much would you be willing to pay for the building

Answer: NPV = 409,323

Problem with NPV:

- Face capital rationing : cty ko đủ vốn để đầu tư hết các dự án có NPV >0
-> dùng PI
- Mutually exclusive with different life time -> dùng EAA
 EAA (Equivalent annual annuity) compare when firm have 2 unequal projects

+ Revenue ( NPV>0) chọn highest EAA

+ Cost (NPV<0) chọn lowest EAC

b. Internal rate of return (IRR) : discount rate at which NPV = 0

IRR method: select all projects that have an internal rate of return equal or
greater than opportunity cost of capital. (IRR>r), choose the highest IRR

Example: You can purchase a building for $350,000. The investment will
generate $16,000 in cash flows (i.e. rent) during the first three years. At the end
of three years you will sell the building for $450,000. What is the IRR on this
investment? => IRR = 12.96%

Problem with IRR

• Borrowing or lending?
• Multiple IRRs
• Mutually exclusive projects
• Scale problem
Conventional cash flow: cash flow signs change more than once => multiple IRR
If NPV and IRR conflict, always use NPV.

c. Payback Period (PP) thời gian hoàn vốn

 PP = 2 + 3000/3500 = 2.9 years

PP = number of year prior to full recovery + uncovered cost at the start of the year/CF during
full recover year

Problem: + ignore TVM, CF after PP

+ biased against long-term project
+ Not have NPV >0

d. Profitability Index (PI) use when face capital rationing

PI = PV of future CF / Initial investment >1

Chọn highest PI
Textbook