L. Jean Dunn, Jr.

July 1, 2015

Good Decision Criteria Capital Budgeting

• We need to ask ourselves the following questions when evaluating capital budgeting decision rules

• Does the decision rule adjust for the time value of money?

• Does the decision rule adjust for risk? • Does the decision rule provide information on whether we are creating value for the firm?

Net Present Value: Is equal to the difference between the present value of a project’s expected cash flows and its cost • How much value is created from undertaking an investment? • The first step is to estimate the expected future cash flows. • The second step is to estimate the required return for projects of this risk level.

• The third step is to find the present value of the cash flows and subtract the initial investment.

Net Present Value Decision Rule

• If the NPV is positive, accept the project • A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

• Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

NPV Calculation

Decision Criteria Test - NPV

• Does the NPV rule account for the time value of money?

• Does the NPV rule account for the risk of the cash flows?

• Does the NPV rule provide an indication about the increase in value?

• Should we consider the NPV rule for our primary decision rule? Payback

Payback: When evaluating a project the length of time it takes to get the initial cost back.

Computation

Estimate the cash flows

Subtract the future cash flows from the initial cost until the initial investment has been recovered

Decision Rule – Accept if the payback period is less than some pre-established rule

Payback Calculation

Decision Criteria Rule - Payback

• Does the payback rule account for the time value of money?

• Does the payback rule account for the risk of the cash flows?

• Does the payback rule provide an indication about the increase in value?

• Should we consider the payback rule for our primary decision rule? Payback

Advantages

Disadvantages

Easy to understand

Ignores the time value of money

Adjusts for uncertainty of later cash flows

Requires an arbitrary cutoff point

Biased toward liquidity

Ignores cash flows beyond the cutoff date

Biased against long-term projects, such as research and development, and new projects

Internal Rate of Return

• This is the most important alternative to NPV

• It is often used in practice and is intuitively appealing

• It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere

IRR Definition and Decision Rule

IRR is the discount rate that causes the NPV of the cash flows to equal zero

Decision Rule: Accept the project if the IRR is greater than the required return

Decision Criteria Rule Test - IRR

Does the IRR rule account for the time value of money?

Does the IRR rule account for the risk of the cash flows?

Does the IRR rule provide an indication about the increase in value? Should we consider the IRR rule for our primary decision criteria? Advantages of IRR

• Knowing a return is intuitively appealing

• It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details

• If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task

NPV vs. IRR

NPV and IRR will generally give us the same decision

Exceptions

• Non-conventional cash flows – cash flow signs change more than once

• Mutually exclusive projects

• Initial investments are substantially different

• Timing of cash flows is substantially different

IRR and Non-Conventional Cash Flows

• When the cash flows change sign more than once, there is more than one IRR

• When you solve for IRR you are solving for the root of an equation and when you cross the x-axis more than once, there will be more than one return that solves the…