Budgeting :

Pre Investment Criteria

The Budgeting Process
⚫ “Capital Budgeting”, the decision-making process of
accepting or rejecting project.
 Investment Criteria
■How should a firm make an investment decision
■What assets do we buy?
■What is the underlying goal?
■What is the right decision criterion?

■Capital Budgeting

■Evaluate different decision rules → tools!

■Implement using the Super Project case study
The Most Popular Investment
Criteria
1. Payback Period Rule
2. Net Present Value
3. Average accounting return rule
4. The internal rate of return
5. Profitability Index
 The Payback Period Rule
⚫ “Payback period” rule is the decision
rule where we accept the project if the
initial investment can be paid back
within pre-determined criteria period.

⚫ For example, if the predetermined

criteria period is 4 years, then you will
accept the investment project if the initial
investment can be paid back within 4
years.
Problem With “Payback Method”
1. When the payback period is computed
(number of years to recover initial costs),
typically the cash flow is not discounted
2. Minimum Acceptance Criteria (criteria
period) is set arbitrary by management
3. There may be several projects that can be
accepted. Then criteria to rank amount these
project is set arbitrary by the management.
 Payback Period Rule
Example
• Consider a project with the following
cash flow.
Year Cash
•If the minimum criteria for payback
flow
period is 3 years, is this project accepted? 0 -100
•You could see that payback period rule
gives an easy-to-understand, and 1 20
easy-to-compute investment decision
rule: You do not have to consider the cash 2 30
flow after the criteria period.
•However, this also causes a problem. 3 50
4 60
: :
 Example 2 Year Project Project Project
• Now consider the three A B C
project given in the table. 0 -100 -100 -100
Exercise
1 20 50 50
If the minimum criteria is
3 years, which project will 2 30 30 30
be accepted?
3 50 20 10
•This example shows some
disadvantages of the 4 60 60 60000
payback period rule.
: : : :
The Payback Period Rule (continued)
⚫ Disadvantages:
⚫ Ignores the time value of money
⚫ Ignores cash flows after the payback period
⚫ Biased against long-term projects
⚫ Requires an arbitrary acceptance criteria
⚫ A project accepted based on the payback criteria may not
have a positive NPV
⚫ Advantages:
⚫ Easy to understand
 The Discounted Payback Period Rule
⚫ Since one of the problems with the payback method is
that it does not discount the cash flow, one way to
modify the method is to discount the cash flow and
find out the payback period.
⚫ However, major problems still remain: You still have
to arbitrarily set the criteria periods; the decision still
have a bias against long term project since it still
ignores the cash flow after the criteria period.
⚫ Also, by the time you have discounted the cash flows,
you might as well calculate the NPV.
The Discounted Payback Rule
⚫ Discounted Payback period: The length of time until the
accumulated discounted cash flows from the investment equal
or exceed the original cost. (We will assume that cash flows
are generated continuously during a period)

⚫ The Discounted Payback Rule: An investment is accepted if its

calculated discounted payback period is less than or equal to
some pre-specified number of years.
Example: Discounted Payback
Example: The initial cost is $600 million. The discounted payback period
cutoff is 3 years. The appropriate discount rate for these cash flows is
20%. Using the discounted payback rule, should the firm invest in the
new product?

(1.20)1 166.67
(1.20)2 152.78 319.45
(1.20)3 130.21 449.66
(1.20)4 101.27 550.93
 Analyzing
the Discounted Payback
Rule
⚫ Advantages
⚫ Disadvantages
⚫ Bottom Line:

⚫
 Net Present Value
⚫ NPV = –Initial Cost + Market Value
⚫ NPV = – Initial Cost + PV(Expected Future CF’s)

where r reflects the risk of the project’s cash flows

Note that this is a generic formula, and we really use the tools from time
value of money (annuities, perpetuities, etc.) from before.

⚫ Net Present Value (NPV) Rule:

⚫ NPV > 0 Accept the project.
⚫ NPV < 0 Reject the project.
 More on the Appropriate
Discount Rate, r
⚫ Discount rate = opportunity cost of capital
⚫ Expected rate of return given up by investing in the project
⚫ Reflects the risk of the cash flows from the project

⚫ Discount rate does not reflect the risk of the firm or

the risk of the firm’s previous projects (remember:
the past is irrelevant)
 Using the NPV Rule
⚫ Your firm is considering whether to invest in a new product. The costs
associated with introducing this new product and the expected cash flows
over the next four years are listed below. (Assume these cash flows are
100% likely). The appropriate discount rate for these cash flows is 20%
per year. Should the firm invest in this new product?

Costs: ($ million)
Promotion and advertising 100
Production & related costs 400
Other 100
Total Cost 600
⚫ Initial Cost: $600 million and r = 20%
⚫ The cash flows ($million) over the next four years:
⚫ Year 1: $200; Year 2: $220; Year 3: $225; Year 4: $210
⚫ Should the firm proceed with the project?
Using NPV, concluded

(1.20)1 166.67
(1.20)2 152.78

(1.20)3 130.21

(1.20)4 101.27
(49.07)
The Discounted Payback Rule
⚫ Discounted Payback period: The length of time until the
accumulated discounted cash flows from the investment equal
or exceed the original cost. (We will assume that cash flows
are generated continuously during a period)

⚫ The Discounted Payback Rule: An investment is accepted if its

calculated discounted payback period is less than or equal to
some pre-specified number of years.
Example: Discounted Payback
Example: Consider the previous investment project analyzed with the
NPV rule. The initial cost is $600 million. The discounted payback
period cutoff is 3 years. The appropriate discount rate for these cash
flows is 20%. Using the discounted payback rule, should the firm
invest in the new product?

(1.20)1 166.67
(1.20)2 152.78 319.45
(1.20)3 130.21 449.66
(1.20)4 101.27 550.93
 Analyzing
the Discounted Payback
Rule
⚫ Advantages
⚫ Disadvantages
⚫ Bottom Line:
 Internal Rate of Return (IRR) Rule
IRR is that discount rate, r, that makes the NPV equal to zero. In other words, it makes the
present value of future cash flows equal to the initial cost of the investment.
 IRR Rule
⚫ Accept the project if the IRR is greater than the
required rate of return (discount rate). Otherwise,
reject the project.

⚫ Calculating IRR: Like Yield-to-Maturity, IRR is

difficult to calculate.
⚫ Need financial calculator
⚫ Trial and error
⚫ Excel or Lotus Spreadsheet
⚫ Easy to first calculate NPV then use the answer to get a first good
guess about the IRR!!!
 IRR Illustrated
Initial outlay = -$200
Year Cash flow
1 50
2 100
3 150

Find the IRR such that NPV = 0

50 100 150
0 = -200 + 1
+ +
(1+IRR) (1+IRR)2 (1+IRR)3

50 100 150
200 = 1
+ 2
+
(1+IRR) (1+IRR) (1+IRR)3
 IRR Illustrated
⚫ Trial and Error
Discount rates NPV
0% $100
5% 68
10% 41
15% 18
20% –2
IRR is just under 20% -- about 19.44%
 Net Present Value Profile
Net present value

120 Year Cash flow

0 – $200
100 1 50
2 100
80 3 150
4 0
60

40

20

– 20

– 40 Discount rate
2% 6% 10% 14% 18% 22%

IRR
Comparison of IRR and NPV
⚫ IRR and NPV rules lead to identical decisions IF the
following conditions are satisfied:
⚫ Conventional Cash Flows: The first cash flow (the initial
investment) is negative and all the remaining cash flows are positive
⚫ Project is independent: A project is independent if the decision to
accept or reject the project does not affect the decision to accept or
reject any other project.
⚫ When one or both of these conditions are not met, problems
with using the IRR rule can result!
Unconventional Cash Flows
● Unconventional Cash Flows: Cash flows come first and
investment cost is paid later. In this case, the cash flows are
like those of a loan and the IRR is like a borrowing rate. Thus,
in this case a lower IRR is better than a higher IRR.

⚫ Multiple rates of return problem: Multiple sign changes in the

cash flows introduce the possibility that more than one discount
rate makes the NPV of an investment project zero.
 Example: Unconventional Cash Flows
⚫ Example: A strip-mining project requires an initial investment of $60.
The cash flow in the first year is $155. In the second year, the mine is
depleted, but the firm has to spend $100 to restore the land.
⚫ $60 = 155/(1 + IRR) – 100/(1 + IRR)2

Discount Rate (IRR) NPV

0.0% – $5.00
10.00 – 1.74
20.00 – 0.28
25.00 0.00
30.00 0.06
33.33 0.00
40.00 – 0.31

⚫ Generally, the number of possible IRRs is equal to the number of

changes in the sign of the cash flows.
 Aspects of Incremental
Cash Flows
■Sunk Costs N

■Opportunity Costs Y

■Side Effects (Erosion) Y

■Net Working Capital Y

■Financing Costs N

All Cash Flows should be

after-tax cash flows