CAPITAL BUDGETING TECHNIQUES

Project A Project B --------------------------------------------------------------------------Initial investment $42,000 $45,000 --------------------------------------------------------------------------Year Operating cash inflows --------------------------------------------------------------------------1 $14,000 $28,000 2 14,000 12,000 3 14,000 10,000 4 14,000 10,000 5 14,000 10,000 ---------------------------------------------------------------------------

The payback period is the exact amount of time required for the firm to recover its initial investment in a project as calculated from cash inflows.

When the payback period is used to make accept-reject decisions, the decision criteria are as follows:
If the payback period is less than the maximum

acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project.

The payback period is widely used by (1) large firms to evaluate small projects and (2) small firms to evaluate most projects. The major weakness of the payback period is that the appropriate payback period is merely a subjectively determined number.

A second weakness is that this approach fails to take fully into account the time factor in the value of money.
A third weakness of payback is its failure to recognize cash flows that occur after the payback period.

NPV
t 1

CFt II (1 k ) t

Net present value (NPV) gives explicit consideration to the time value of money. NPV = present value of cash inflows - initial investment
NPV

t 1
n t 1

CFt CFo t (1 k )
PVIF k ,t ) CFo

(CF

When NPV is used to make accept-reject decisions, the decision criteria are as follows:
If the NPV is greater than $0, accept the project. If the NPV is less than $0, reject the project.

Please see the example!

The internal rate of return (IRR) is probably the most used sophisticated capital budgeting technique for evaluating investment alternatives. The internal rate of return (IRR) is the discount rate that equates the present value of cash inflows with the initial investment associated with a project.
$0 CFt (1 IRR ) t CFo t 1
n

When IRR is used to make accept-reject decisions, the decision criteria are as follows: If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project. The IRR can be found either by using trial-and-error techniques or with the aid of a sophisticated financial calculator or a computer. Please see the example!

Net present value (NPV) and internal rate of return (IRR) will always generate the same accept-reject decision, but differences in their underlying assumptions can cause them to rank projects differently.

Net present value Discount ------------------------------------------------Rate Project A Project B -------------------------------------------------------------0% $28,000 $25,000 10 11,074 10,914 20 0 22 0 --------------------------------------------------------------

Ranking is an important consideration when projects are mutually exclusive of when capital rationing is necessary. The underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows-cash inflows received prior to the termination of a project.