Capital Budgeting
Selection Rules

Chapter Outline
The Payback Period Rule
The Discounted Payback Period Rule
The Internal Rate of Return
Problems with the IRR Approach
The Profitability Index
Why Use Net Present Value?
The Practice of Capital Budgeting
Summary and Conclusions
The Payback Period Rule
The Discounted Payback Period Rule
The Internal Rate of Return
Problems with the IRR Approach
The Profitability Index
Why Use Net Present Value?
The Practice of Capital Budgeting
Summary and Conclusions

The Payback Period Rule
How long does it take the project to “pay back”
its initial investment?
Payback Period = number of years to recover
initial costs
Minimum Acceptance Criteria:
set by management
How long does it take the project to “pay back”
its initial investment?
Payback Period = number of years to recover
initial costs
Minimum Acceptance Criteria:
set by management

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
Advantages:
Easy to understand
Quick to execute
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
Advantages:
Easy to understand
Quick to execute

In-Class Problem
You have been hired by Widget Co. last week.
Your first job is to choose between the following two projects:
Project 1 requires an investment of -$200M in year 0 and will
produce positive cash flows of $40M, $100M, $60M, and
$10M in the next 4 years.
Project 2 requires an investment of -$200M in year 0 and will
produce positive cash flows of $40M, $100M, $60M, and
$400M in the next 4 years.
You know that the payback method is not the best way to
judge new projects, but your boss insists that that is the
method they use (and the only one he can understand).
Calculate the Payback period for the 2 projects.
You have been hired by Widget Co. last week.
Your first job is to choose between the following two projects:
Project 1 requires an investment of -$200M in year 0 and will
produce positive cash flows of $40M, $100M, $60M, and
$10M in the next 4 years.
Project 2 requires an investment of -$200M in year 0 and will
produce positive cash flows of $40M, $100M, $60M, and
$400M in the next 4 years.
You know that the payback method is not the best way to
judge new projects, but your boss insists that that is the
method they use (and the only one he can understand).
Calculate the Payback period for the 2 projects.

Solution
Project 1:
unpaid balance in year 1= -200+40=-160M $
unpaid balance in year 2= -160+100=-60M $
unpaid balance in year 3= -60+60=
0
$
Payback period = 3 years
Project 2:
unpaid balance in year 1= -200+40=-160M $
unpaid balance in year 2= -160+100=-60M $
unpaid balance in year 3= -60+60=
0
$
Payback period = 3 years
Project 1:
unpaid balance in year 1= -200+40=-160M $
unpaid balance in year 2= -160+100=-60M $
unpaid balance in year 3= -60+60=
0
$
Payback period = 3 years
Project 2:
unpaid balance in year 1= -200+40=-160M $
unpaid balance in year 2= -160+100=-60M $
unpaid balance in year 3= -60+60=
0
$
Payback period = 3 years