Chapter

Capital Budgeting

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Net Present Value

Net Present Value - Present value of cash flows minus initial investments.

Opportunity Cost of Capital - Expected rate of return given up by investing in a project

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Net Present Value

NPV = PV of all cash inflows - initial investment

Ct NPV C0 (1 r ) t
C1 C2 Ct NPV C0 ... 1 2 (1 r ) (1 r ) (1 r ) t
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Net Present Value

Terminology C = Cash Flow and C0 = Initial Investment t = time period of the investment r = opportunity cost of capital

The Cash Flow could be positive or negative at any time period.

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Net Present Value

Net Present Value Rule Managers increase shareholders wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value.

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Payback Method
Payback Period - Time until cash flows recover the initial investment of the project. The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period. The following example will demonstrate the absurdity of this statement.

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Payback Method
Example The three project below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact our decision. Cash Flows Project C0 C1 C2 C3 A -2000 +1000 +1000 +10000 B -2000 +1000 +1000 0 C -2000 0 +2000 0

Payback 2 2 2

NPV@10% + 7,249 264 347

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Other Investment Criteria

Internal Rate of Return (IRR) - Discount rate at which NPV = 0. Rate of Return Rule - Invest in any project offering a rate of return that is higher than the opportunity cost of capital.

C1 - investment Rate of Return = investment

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Internal Rate of Return

IRR is the discount rate that makes your NPV equals to zero thus following relationship hold: PV (inflows) = PV (Outflow)

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Internal Rate of Return

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Internal Rate of Return

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Discounted Payback Period

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Discounted Payback Period

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Profitability Index

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Profitability Index

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Profitability Index

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Modified IRR (MIRR)

While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project.

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