Introduction to Capital Budgeting•We want to invest is new capital projects that make a net contribution to shareholders wealth.
Investment Criteria•Rules for decision making•Net Present Value (NPV)•Internal Rate of Return (IRR)•Profitability Index (PI)•Payback Period
NPV •Estimate future expected cash flows•Estimate the cost of capital (i.e. required return)•Calculate the NPV
IRR•Discount Rate that make NPV=0
NPV / IRR Example
Problems with IRR•Mutually exclusive projects•Proceeding with one project precludes proceeding with another project. (e.g. an electric utility might build an gas fired power plant or a coal fired plant, but not both)•Given a choice you should accept the project with the higher NPV.•This is not necessarily the project with the higher IRR.
Problems with IRR1.IRR can favour small projects with high returns.