Corporate Finance

Topics: Net present value, Cash flow, Time value of money Pages: 54 (4436 words) Published: March 2, 2014
A Comparison of Capital Budgeting Techniques

Capital budgeting deals with setting the criteria and prescribing the process required for making capital investment choices. Choosing an investment project, that is, making a capital investment choice is ultimately a cost/benefit analysis. It requires valuing the project by comparing the payoff to its costs.

Problem
Value, rank and select investment projects

Example 1.
Project A
Required rate
year 1:
year 2
year 3
year 4
year 5
Initial Cost

Project B

Project C

7.7%
$400
$1,250
$900.00
$3,000.00
$1,000
$5,045

3%
$100.00
$200
$150.00
$100
$50
$490.67

6%
$5,200
$4,000
$1,000
$200
$100
$9,687.23

1

Capital Budgeting Techniques
A collection of methods allowing the manager to choose among a variety of investment projects. Methods:








Average Accounting Return
Payback
Discounted payback
Internal Rate of Return
Modified Internal Rate of Return
Net Present Value
Profitability Index

Average Accounting Return (AAR)
AAR is the ratio of the Average Net Income to the Average Book Value. Decision rule: Take the project if AAR is greater than some target ratio set by accountants. Disadvantages: It has too many flaws, don't ever use it.

Payback period
Payback is the time it takes to recover the initial cost of the investment. Payback is usually measured in years.
Decision rule: Take the project with the shortest payback period Disadvantages
It ignores time value of money
It ignores risk
It ignores cash inflows beyond the cutoff point
Project A: Payback calculation
Period

Cash flow

Amount left to recover

0

-$5,045.00

-$5,045.00

1

$400

$4,645.00

2

$1,250

$3,395.00

3

$900.00

$2,495.00

0.83

$3,000.00

$0.00

Notice that in the fourth year, there is $2,495 left to recuperate, and the annual cash flow equals $3,000 2

Obviously, $2,495/$3,000 = 0.83
Payback here is interpreted as follows: It takes between three and four years to recuperate the initial cost of the project.
Project B: Payback calculation
Period

Cash flow

Amount left to recover

0

-$490.67

-$490.67

1

$100.00

$390.67

2

$200

$190.67

3

$150.00

$40.67

0.41

$100

$0.00

The payback period of project B is also between three and four years (3.41 years) Notice that $40.67/$100 = 0.41 (approximately)

Project C: Payback calculation
Period

Cash flow

Amount left to recover

0

-$9,687.23

-$9,687.23

1

$5,200

$4,487.23

2

$4,000

$487.23

0.49

$1,000

$0.00

The payback of project C is 2.49 years. Notice that $487.23/$1,000 = 0.49 (approximately) Ranking:
1. project C: 2.49 years
2. project B: 3.41 years
3. project A: 3.83 years
All three projects are viable, but project C is the first to recover its initial cost.

3

Discounted payback period (DPB)
DPB is the time it takes to recover the initial cost of the investment. Payback uses nominal CF; DPB uses discounted CF
Decision rule: Take the project with the shortest discounted payback period. Disadvantages: DPB ignores cash inflows beyond the cutoff point The calculation of discounted payback is exactly the same as that of payback, except that instead of using nominal cash flow, we use present values.

Project A: Discounted payback calculation
Period

Cash flow at 7.7%

Amount left to recover

0

-$5,045.00

-$5,045.00

1

$371.40

$4,673.60

2

$1,077.65

$3,595.95

3

$720.44

$2,875.51

4

$2,229.76

$645.75

0.94

$690.12

0

The discounted payback of project A is just under 5 years (4.94) Notice that $645.75/$690.12 = 0.94

Project B: Discounted payback calculation
Period

Cash flow at 3%

Amount left to recover

0

-$490.67

-$490.67

1

$97.09

$393.58

2

$188.52

$205.06

3

$137.27

$67.79

0.76

$88.85

$0.00

The discounted payback of project B is just...
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