2064 words - 9 pages

Capital Budgeting Techniques

Mona School of Business Financial Management Lecturer: Kathya Beckford

By the end of this session you will understand:

1.

What capital budgeting is

How to calculate and interpret a project’s:

2.

Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI)

3.

How to choose projects when capital is rationed

What is capital budgeting?

Capital budgeting is the process of planning expenditure on assets or projects that can have a long-term impact on an institution.

Examples of capital projects

Adopting a new enterprise-wide software system Launching a ...view middle of the document...

67 years

Payback Period- Example cont’d

If projects with a payback period of up to 4 years are acceptable, should the firm accept this project? Answer: Yes, since the payback period is less than 4 years.

Payback Period- The Pros

It is easy to calculate

It is easy to explain

It uses cashflows (not accounting profits) It gives a measure of the liquidity of a project

Payback Period- The Cons

How

to decide maximum allowable payback period? Very subjective value of money not taken into consideration riskiness not accounted for properly

Time

Project’s

Cashflows

beyond the payback period are ignored

No

connection to maximizing the firm’s value

Discounted Payback PeriodThe Concept

What is it? The discounted payback period for a project is the expected time it will take for the discounted cash flows to recover the original investment. The decision rule: Accept project if its discounted payback period is less than the maximum allowed.

Discounted Payback PeriodExample

A project requires a $100,000,000 investment and is expected to generate the following cash flows in the years after the investment is made

Year

1 2 3 4 5

Cashflow ($)

20,000,000 40,000,000 60,000,000 30,000,000 10,000,000

What is the discounted payback period based on a discount rate of 10%?

Discounted Payback PeriodExample cont’d

Workings:

Year 1 2 3 4 5 Cashflow ($) 20,000,000 40,000,000 60,000,000 30,000,000 10,000,000 PV of Cashflow ($) 18,181,818 33,057,851 45,078,888 20,490,404 6,209,213 Cumulative PV of cashflow ($) 18,181,818 51,239,669 96,318,557 116,808,961 123,018,174

The discounted payback period is somewhere between the end of year 3 and the end of year 4

Discounted Payback PeriodExample cont’d

Use linear interpolation to find the exact figure for the discounted payback period By using linear interpolation, the assumption is that the discounted cashflows occur evenly throughout the year We get: Y–3 = 4–3

100,000,000 – 96,318,557 116,808,961 – 96,318,557 (This is the discounted payback period)

Y = 3.18 years

Discounted Payback PeriodExample cont’d

If projects with a discounted payback period of up to 5 years are acceptable, should the firm accept this project? Answer: Yes, since the discounted payback period is less than 5 years.

Discounted Payback PeriodThe Pros & Cons

The pros and cons are almost the same as with the basic payback period technique Only improvement is that cashflows are discounted However, since cashflows beyond discounted payback period are ignored, TVM still not handled adequately

Net Present Value (NPV)The Concept

What is it? The net present value of a project is the sum of the present values of its expected cash flows.

The decision rule: Accept project if its NPV > 0.

NPV- An Example

A project requires a $100,000,000 investment and is expected to generate the following cash flows in the years after...

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