Chapter 13 Capital Budgeting Techniques 13-1
13-1 Chapter 13 Capital Budgeting Techniques
Capital Budgeting Techniques a Project Evaluation and Selection n Potential difficulties n Capital Rationing n Project Monitoring n Post-Completion Audit 13-2
13-2 Capital Budgeting Techniques Project Evaluation and Selection Potential Difficulties Capital Rationing Project Monitoring Post-Completion Audit
Project Evaluation: Alternative ethods n Payback Period(PBP) n Internal Rate of Return ( IRR) n Net Present Value(NPV) n Profitability Index(PI) 13-3
13-3 Project Evaluation: Alternative Methods Payback Period (PBP) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI)
Proposed Project Data Julie Miller is evaluating a new project for her firm Basket Wonders( Bw She has determined that the after -tax cash flows for the project will be $10,000,$12,000,$15,000,$10,000, and $7,000 respectively for each of the Years 1 through 5. The initial cash outlay will be $40,000 13-4
13-4 Proposed Project Data Julie Miller is evaluating a new project for her firm Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000, $12,000, $15,000, $10,000, and $7,000 respectively for each of the Years 1 through 5. The initial cash outlay will be $40,000
Independent Project For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake o Independent -A project whose acceptance(or rejection does not prevent the acceptance of other projects under consideration 13-5
13-5 Independent Project Independent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake
Payback Period(PBP) 0 3 5 40K 10K 12K 15K 10K 7K PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow 13-6
13-6 Payback Period (PBP) PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K
Payback Solution(1) 0 3(a) 5 40K(b)10K 12K 15K 10K(d)7K 10K 22K 37Kc)47K54K Cumulative Inflows PBP =a+(b-c)/d =3+(40-37)/10 =3+(3)/10 = 3.3 Years 13-7
13-7 10 K 22 K 37 K(c) 47 K 54 K Payback Solution (#1) PBP = a + ( b - c ) / d = 3 + (40 - 37) / 10 = 3 + (3) / 10 = 3.3 Years 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K Cumulative Inflows (a) (-b) (d)
Payback Solution(2) 0 3 5 40K 10K 12K 15K (10K 7 K 40K 30K -18K 3K 7K 14K PBP=3+(3K)/10K Cumulative = 3.3 Years Cash flows Note: Take absolute value of last negative cumulative cash flow 13-8 value
13-8 -40 K -30 K -18 K -3 K 7 K 14 K Payback Solution (#2) PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K Cumulative Cash Flows
PBP Acceptance Criterion The management of Basket Wonders has set a maximum pbp of 3 5 Years for projects of this type Should this project be accepted? Yes! The firm will receive back the initial cash outlay in less than 3.5 Years. [3.3 Years 3.5 Year Max 13-9
13-9 PBP Acceptance Criterion Yes! The firm will receive back the initial cash outlay in less than 3.5 Years. [3.3 Years < 3.5 Year Max.] The management of Basket Wonders has set a maximum PBP of 3.5 Years for projects of this type. Should this project be accepted?
PBP Strengths and Weaknesses Strengths Weaknesses o Easy to use and Does not account understand for Tvm Can be used as a Does not consider measure of cash flows beyond liquidity the PBP n Easier to forecast Cutoff period is ST than LT flows subjective 13-10
13-10 PBP Strengths and Weaknesses Strengths: Easy to use and understand Can be used as a measure of liquidity Easier to forecast ST than LT flows Weaknesses: Does not account for TVM Does not consider cash flows beyond the PBP Cutoff period is subjective
