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Capital Budgeting Techniques Summary with Example 1 Capital Budgeting Techniques 1)Payback Period (PBP) PBP = t at which the following equation holds: Where is initial cash outflow and cash inflow at the end of year t is 2)Discounted Payback Period(DPBP) DPBP = t at which the following equation holds, given cost of capital = K: where K = cost of capital 3) Net Present Value (NPV) 2 4)Internal Rate of Return(IRR) IRR is the solution to the following equation: IRR is discount rate at which NPV = 0 5)Profitability Index(PI) 3 6)Modified Internal Return(MIRR): is the discount rate at which the following equation holds: or where year t and year t. is cash outflow at the end of is cash inflow at the end of Example of capital Budgeting techniques Manager of Wax and Dusting Corporation (WDC) is considering the following investment project should he accept this project? WDC's WACC is 10% and its Target PBP cutoff (NT ) is 2.75 years. 4 Year CF) 0 (10,000) 1 5,000 2 5,000 3 2,000 4 0 5 0 1) Payback Period Approach: Year CF Cumulative CF 0 (10,000) (10,000) 1 5,000 (5,000) 2 5,000 0 3 2,000 2,000 4 0 2,000 5 0 2,000 PBP = 2 years 1, the project is accepted. 8 Decision Rule 6) MIRR PV of COF = 10,000 XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX XXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXXX Accounting Rate of Return (ARR) ARR = (AAI)/(Ave. I) Decision Rule: 9 1) Consider project i, if calculated ARR for this project, say ARRi is grater than firm's target ARR (denoted by ARRT), the project is accepted otherwise the project is rejected. Specifically, if ARRi > ARRT the project is accepted, if ARR i ARRT and ARR j ARR j >ARRT we reject j and accept i For example, suppose two projects S and L are being considered by Cinquetti Inc. and assume the firm's target ARR is 18%(i.e. ARRT =18%), which project should be accepted? t Cash Flow Project S Project L 0 -$1000 -$1,000 1 500 100 2 400 300 3 300 400 4 100 600 To calculate ARR for each project we take the following steps 10 First We calculate \"average annual income\" (AAI) by assuming that depreciation is computed using straight line method and salvage value is zero. Formally AAI = average cash inflow - annual depreciation For the above projects L and S: AAIS = 1300/4 - 250 = $75 AAIL = 1400/4 - 250 = $100 Note that annual depreciation with SV= 0, is $1,000/4 =$250 for both projects. Second we calculate\" average investment\" (Ave. I) as: Ave. I = I0 /2 Therefore, Ave. IS = I0/2 = 1000/2 = $500 Ave. IL = I0/2 = 1000/2 = $500 Third we calculate ARR as ARR = AAI/Ave. I For above projects: 11 ARRS =$75/$500 = 15% ARRL = $100/$500= 20% Given that ARRT =18%, project L is accepted and project S is rejected. Note: the main disadvantage of this technique is that it fails to recognize the TVM. 12 Capital Budgeting Techniques Summary 1) Payback Period (PBP) PBP = t at which the following equation holds: , Where flow and year t is initial cash out- is cash inflow at the end of 2) Discounted Payback Period(DPBP) DPBP = t at which the following equation holds, given cost of capital = K: where K = cost of capital 3) Net Present Value (NPV) 13 4) Internal Rate of Return(IRR) IRR is the solution to the following equation: that is IRR is discount rate at which NPV = 0 5) Profitability Index(PI) 6) Modified Internal Rate of Return(MIRR): is the discount rate at which the following equation holds: or 14 where and is cash outflow at the end of year t is cash inflow at the end of year t. 15 A (X) Company is considering purchasing a vegetable canning business. The initial cost of the business and expected cash flows that this business will generate are given in the table below (in 000 dollars): Year 0 1 2 3 4 5 Cash Flow -$200,000 50,000 100,000 150,000 40,000 25,000 (X) uses the following criterions in its capital budgeting process: WACC = 10% Target Payback Period (PBP) = 2.95 years Target Discounted Payback Period (DPBP)= 3.15 years Target Accounting Rate of Return (ARR) =25% Please use the following capital budgeting techniques to prepare a table to summarize your results and provide a short paragraph comment/interpretation about your findings . 1) Accounting Rate of Return 2) NPV 3 IRR 4) MIRR 5) PI Table 1 Year Cash flow Cumulative CF 0 $200,000 $200,000 1 $50,000 $150,000 2 $100,000 $50,000 3 $150,000 $100,000 4 $40,000 $140,000 5 $25,000 $165,000 WACC Target Payback Period (PBP) 10% 2.95 years Target Discounted Target Accounting Payback Period Rate of Return (DPBP) (ARR) 3.15 years 25%