Investment Criteria
• Capital budgeting: process by which
organization evaluates and selects long-term
investment projects
– Ex. Investments in capital equipment, purchase or
lease of buildings, purchase or lease of vehicles,
etc.
• There are various techniques used to make
capital budgeting decisions.
Payback
• Small businesses use this method because it is
simple
• Requires calculation of number of years required
to pay back original investment
• Payback-based decisions:
– Between two mutually exclusive investment projects,
choose project with shortest payback period
– Set a predetermined standard
• Ex. “Accept all projects with payback of less than 5 years and
reject all others”
Payback
• Poor method on which to rely for allocation of scarce capital
resources because:
1. Payback ignores time value of money
2. Payback ignores expected cash flows beyond payback period.
• Ex.: PROJECT A PROJECT B
Cost = $100,000 Cost = $100,000
Expected Future Cash Flow: Expected Future Cash Flow:
Year 1 $50,000 Year 1 $100,000
Year 2 $50,000 Year 2 $5,000
Year 3 $110,000 Year 3 $5,000
Year 4 and thereafter: None Year 4 and thereafter: None
Total = $210,000 Total = $110,000
Payback = 2 years Payback = 1 year
-Payback period for Project B is shorter, but Project A provides higher return
-Project A is superior to Project B.
Net Present Value
• Difference between present value of expected
future benefits of project to present value of
expected cost of project
• If NPV is positive (if present value of benefits
exceeds present value of cost), then project is
accepted.
• If NPV is negative (if present value of costs exceeds
present value of benefits), then project is rejected.
• NPV = PVB – PVC
– Where NPV = net present value
PVB = present value of benefits
PVC = present value of costs
Net Present Value
• Between two mutually exclusive projects, choose project
with highest net present value.
• Ex.: Consider Project A and Project B and 12% discount rate