PHAM NG VAN GIANG

CHAP 6: CAPITAL BUDGETING AND INVESTMENT CRITERIA

I. Independent vs Mutually exclusive vs Contigent Projects
- Independent projects: Acceptance/rejection of one project would not influence the decision
regarding other projects. Keyword: không ảnh hưởng
- Mutually exclusive projects: Only one of a number of projects can be accepted. The acceptance
of one particular project means the rejection of other projects. Keyword: chỉ được chọn 1
- Contigent projects: Acceptance of one project depends on the acceptance of other projects.
Keyword: có ảnh hưởng
- Capital Rationing: Fixed amount of total funds available limits which projects may be accepted.
Keyword: chọn projects để tối ưu hóa được nguồn tiền giới hạn.

II. Net Present Value Method (NPV)

- The NPV measures the amount by which the value of the firm’s stock will increase if the project is
accepted.
- NPV rules:
+ Independent projects:
• (1) Calculate NPV, (2) Accept if NPV > 0
• (1) Calculate NPV, (2) Reject if NPV < 0
+ Mutually exclusive projects:
• Projects have equal lives → (1) Calcualte NPV, (2) Choose highest NPV
• Projects do not have equal lives. → (1) Calculate NPV, (2) Calculate AE, (3) Choose highest
AE
- Disadvantage of NPV: Capital rationing → Cannot use NPV → Use Profitability Index
- General formula:
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝒏
𝐍𝐏𝐕 = −𝐂𝐅𝟎 + + + ⋯ +
𝟏 + 𝒓 (𝟏 + 𝒓)𝟐 (𝟏 + 𝒓)𝒏
- When all CFs are the same, we can use:
𝑪𝑭 𝟏
𝑵𝑷𝑽 = −𝑪𝑭𝟎 + ∗ [𝟏 − ]
𝒓 (𝟏 + 𝒓)𝒏
PHAM NG VAN GIANG

III. Annual Equivalent (AE)

- Use AE when comparing two mutually-exclusive projects with different lives
- Step to do:
+ Step 1: Calculate NPV
+ Step 2: Calculate AE
𝑵𝑷𝑽
𝑨𝑬 =
𝟏 𝟏
𝒓 ∗ [𝟏 − (𝟏 + 𝒓)𝒏 ]
+ Step 3: Select the highest AE

IV. Payback method

- The payback period is the amount of time required for firm to recover or payback the initial
investment.
- PP rule:
+ If the project’s payback period is less than the maximum acceptable payback period (cut-off
point), accept the project.
+ If the project’s payback period is greater than the maximum acceptable payback period (cut-off
point), reject the project.
𝑹𝒆𝒎𝒂𝒊𝒏𝒊𝒏𝒈 𝒄𝒐𝒔𝒕 𝒕𝒐 𝒓𝒆𝒄𝒐𝒗𝒆𝒓
- 𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 = 𝒀𝒆𝒂𝒓𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝒄𝒐𝒔𝒕 𝒓𝒆𝒄𝒐𝒗𝒆𝒓𝒚 + 𝑪𝑭 𝒅𝒖𝒓𝒊𝒏𝒈 𝒕𝒉𝒆 𝒚𝒆𝒂𝒓
- Disadvantage of PP:
(1) Ignore the time value of money.
(2) Ignore cash flows that occur after the payback period

V. Internal rate of return

- Internal rate of return (IRR) is the discount rate that results in a zero NPV for the project.
PHAM NG VAN GIANG

𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝒏

𝐍𝐏𝐕 = 𝐂𝐅𝟎 + + 𝟐
+⋯+ =𝟎
𝟏 + 𝑰𝑹𝑹 (𝟏 + 𝑰𝑹𝑹) (𝟏 + 𝑰𝑹𝑹)𝒏
- IRR decision rule:
+ If IRR is greater than the cost of capital, accept the project.
+ If IRR is less than the cost of capital, reject the project.
- Disadvantage of IRR:
+ Financing project (the early CF is positive)
+ Non-conventional CFs (sign changes more than once => multiple IRRs)
+ Mutually exclusive projects (project with higher IRR may have lower NPV)
✓ The timing problem: prefer time sooner → a project higher
✓ The scale problem: IRR does not take into account project scale (size)

VI. Profitability Index

- When capital is scarce, accept projects with highest PIs
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑
𝑷𝑽 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 + + ⋯+
(𝟏 + 𝒓) (𝟏 + 𝒓)𝟐 (𝟏 + 𝒓)𝟑
𝑷𝑰 = =
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑪𝑭𝟎
- Disadvantage of PI: Mutually exclusive