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Should we
build this
plant?
Generating Ideas
Step 2
Step 3
Analyze the fit of the proposed projects with the companys strategy
Step 4
Payback Period
The payback period is the length of time it takes to recover the initial cash
outlay of a project from future incremental cash flows.
(millions)
$1,000
200
300
400
100
600
Accumulated
Cash flows
$1,000
$800
$500
$100
0
+600
Payback Period
When the numbers do not work out exactly, it is customary to work with
fractional years. For example:
Initial investment
Net cash flow year 1
Net cash flow year 2
Net cash flow year 3
:
:
:
:
R60 000
R20 000
R90 000
R100 000
The cash flows over the first 2 years are R110 000, so the project obviously
pays back sometime in the second year.
After year 1, the project has paid back R20 000, leaving R40 000 to be
recovered.
To figure out the fractional year, note that this R40 000, is R40 000/R90
000 = 4/9 of the second years cash flow.
Assuming that the R90 000 cash flow is paid uniformly throughout the
year, the payback would thus be 1 4/9 years. (1.44 years)
Weaknesses:
Other Methods
1. Net Present Value
2. Profitability Index
3. Internal Rate of Return
Each of these decisions making criteria:
Examines all net cash flows
Considers time value of money
Considers required rate of return
CF2
+
(1+k)2
CFn
- ICO
+...+
n
(1+k)
k=10%
0
(10,000)
500
500
4,600
10,000
k=10%
0
(10,000)
455
500
$500
(1.10)
500
4,600
10,000
k=10%
0
(10,000)
500
455
413
500
$500
(1.10) 2
4,600
10,000
k=10%
0
(10,000)
500
455
413
3,456
500
4,600
$4,600
(1.10) 3
10,000
k=10%
0
(10,000)
500
455
413
3,456
6,830
500
4,600
10,000
$10,000
(1.10) 4
k=10%
0
(10,000)
500
455
413
3,456
6,830
$11,154
500
4,600
10,000
k=10%
0
(10,000)
500
455
413
3,456
6,830
$11,154
500
4,600
10,000
k=10%
0
(10,000)
500
500
4,600
455
PV Benefits > PV Costs
413
$11,154 > $ 10,000
3,456
6,830
$11,154
$1,154 = NPV
10,000
NPV > $0
$1,154 > $0
Profitability index
Profitability Index
Profitability Index for Project B
PI =
500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
10,000
Time
0
1
2
3
4
P R O J E C T
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000
500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
10,000
11,154
= 1.1154
10,000
Time
0
1
2
3
4
A
(10,000.)
3,500
3,500
3,500
3,500
B
(10,000.)
500
500
4,600
10,000
Profitability Index
PI =
PI =
500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
10,000
11,154
= 1.1154
10,000
PI =
Time
0
1
2
3
4
P R O J E C T
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000
PI =
PI =
500
4,600
10,000
500
+
+
+
(1+ .1 ) (1+ .1)2 (1+ .1 )3 (1+ .1 )4
10,000
11,154
= 1.1154
10,000
PI =
PI =
1
4
.10(1+.10) )
10,000
11,095
= 1.1095
10,000
Time
0
1
2
3
4
P R O J E C T
A
B
(10,000.) (10,000.)
3,500
500
3,500
500
3,500
4,600
3,500
10,000
Independent Projects
Accept
Project if PI 1
Highest PI 1 Project
Measures the rate of return that will make the PV of future CF equal to the
initial outlay.
Definition:
The IRR is that discount rate at which
NPV = 0
IRR Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3
(1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.
$10,000(PVIF10%,1) + $12,000(PVIF10%,2)
$15,000(PVIF10%,3) + $10,000(PVIF10%,4)
$ 7,000(PVIF10%,5)
$10,000(.909) + $12,000(.826) +
$15,000(.751) + $10,000(.683) +
$ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 +
$6,830 + $4,347
= $41,444 [Rate is too low!!]
$10,000(PVIF15%,1) + $12,000(PVIF15%,2)
$15,000(PVIF15%,3) + $10,000(PVIF15%,4)
$ 7,000(PVIF15%,5)
$10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) +
$ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 +
$5,720 + $3,479
= $36,841 [Rate is too high!!]
.05
X
.05
.10 $41,444
IRR $40,000
.15 $36,841
$1,444
$4,603
$1,444
$4,603
X
.05
.10 $41,444
IRR $40,000
.15 $36,841
$1,444
$4,603
$1,444
$4,603
.10 $41,444
IRR $40,000
.15 $36,841
($1,444)(0.05)
X=
$4,603
$1,444
$4,603
X = .0157
Capital Rationing
Capital Rationing occurs when a constraint
(or budget ceiling) is placed on the total
size of capital expenditures during a
particular period.
Example: Julie Miller must determine what
investment opportunities to undertake for
Basket Wonders (BW). She is limited to a
maximum expenditure of $32,500 only for this
capital budgeting period.
ICO
$
500
5,000
5,000
7,500
12,500
15,000
17,500
25,000
IRR
18%
25
37
20
26
28
19
15
NPV
PI
50
6,500
5,500
5,000
500
21,000
7,500
6,000
1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24
ICO
IRR
NPV
$ 5,000
37%
$ 5,500
15,000
28
21,000
12,500
26
500
5,000
25
6,500
Projects C, F, and E have the
three largest IRRs.
PI
2.10
2.40
1.04
2.30
ICO
$
500
5,000
5,000
7,500
12,500
15,000
17,500
25,000
IRR
18%
25
37
20
26
28
19
15
NPV
PI
50
6,500
5,500
5,000
500
21,000
7,500
6,000
1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24
ICO
IRR
NPV
$15,000
17,500
5,000
28%
19
25
$21,000
7,500
6,500
PI
2.40
1.43
2.30
ICO
$
500
5,000
5,000
7,500
12,500
15,000
17,500
25,000
IRR
18%
25
37
20
26
28
19
15
NPV
PI
50
6,500
5,500
5,000
500
21,000
7,500
6,000
1.10
2.30
2.10
1.67
1.04
2.40
1.43
1.24
ICO
IRR
NPV
PI
F
$15,000
28%
$21,000 2.40
B
5,000
25
6,500 2.30
C
5,000
37
5,500 2.10
D
7,500
20
5,000 1.67
G
17,500
19
7,500 1.43
Projects F, B, C, and D have the four largest PIs.
The resulting increase in shareholder wealth is $38,000
with a $32,500 outlay
PI generates the greatest increase in shareholders
wealth when a limited capital budget exists for a single
period
Practice Question