Ch 9: Capital Budgeting Decision Criteria o 2002 Prentice Hall. Inc
© 2002, Prentice Hall, Inc. Ch. 9: Capital Budgeting Decision Criteria
Capital Budgeting: the process of planning for purchases of long term assets ° example Suppose our firm must decide whether to purchase a new plastic molding machine for S125.000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment
Capital Budgeting: the process of planning for purchases of longterm assets. • example: Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? • Will the machine be profitable? • Will our firm earn a high rate of return on the investment?
Decision-making criteria in Capital Budgeting how do we decide if a capital investment project should be accepted or rejected?
Decision-making Criteria in Capital Budgeting How do we decide if a capital investment project should be accepted or rejected?
Decision-making Criteria in Capital Budgeting The ideal evaluation method should a) include all cash flows that occur during the life of the project, b)consider the time value of money, c) incorporate the required rate of return on the project
• The Ideal Evaluation Method should: a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project. Decision-making Criteria in Capital Budgeting
Payback period How long will it take for the project to generate enough cash to pay for itself?
Payback Period • How long will it take for the project to generate enough cash to pay for itself?
Payback period How long will it take for the project to generate enough cash to pay for itself? (500)150150150150150150150150 0 1234567 8
Payback Period • How long will it take for the project to generate enough cash to pay for itself? 0 1 2 3 4 5 6 7 8 (500) 150 150 150 150 150 150 150 150
Payback period How long will it take for the project to generate enough cash to pay for itself? (500)150150150150150150150150 0 1234567 8 Payback period=3.33 years
Payback Period • How long will it take for the project to generate enough cash to pay for itself? 0 1 2 3 4 5 6 7 8 (500) 150 150 150 150 150 150 150 150 Payback period = 3.33 years
Payback period Is a 3.33 year payback period good? Is it acceptable? Firms that use this method will compare the pay back calculation to some standard set by the firm If our senior management had set a cut- off of 5 years for projects like ours, what would be our decision? Accept the project
• Is a 3.33 year payback period good? • Is it acceptable? • Firms that use this method will compare the payback calculation to some standard set by the firm. • If our senior management had set a cutoff of 5 years for projects like ours, what would be our decision? • Accept the project. Payback Period
Drawbacks of payback period Firm cutoffs are subjective Does not consider time value of money. Does not consider any required rate of return Does not consider all of the project's cash flows
Drawbacks of Payback Period • Firm cutoffs are subjective. • Does not consider time value of money. • Does not consider any required rate of return. • Does not consider all of the project’s cash flows
Drawbacks of payback period Does not consider all of the project’ s cash flows. (500150150150150150(300)00 012345678 Consider this cash flow stream!
Drawbacks of Payback Period • Does not consider all of the project’s cash flows. • Consider this cash flow stream! 0 1 2 3 4 5 6 7 8 (500) 150 150 150 150 150 (300) 0 0
