FIN 504: Financial ManagementLecture 9: Capital-Budgeting Decision Criteria
2FIN 504: Financial ManagementTopicsDecision Rules in Capital BudgetingThe Decision Rules:Payback PeriodDiscounted Payback Period Net Present Value (NPV)Internal Rate of Return (IRR)Profitability Index (PI)Modified Internal Rate of Return (MIRR)Some Additional Issues
3FIN 504: Financial ManagementDecision Rules in Capital BudgetingWe need some rule for judging whether a project should be done. The goal (G) is that we should only do projects that increase firm value and this rule should meet the following criteria:C1) The rule should recognize the time value of money.C2) The rule should incorporate all relevant free cash flows.
4FIN 504: Financial ManagementDecision Rules in Capital BudgetingWe would also like the rule to avoid (if possible):C3) Arbitrary assumptions,C4) The need for data that has great uncertainty,C5) Excessive complexity of calculation, andC6) Technical problems.Unfortunately, we shall need to make some compromises.
The Five Decision Rules
6FIN 504: Financial ManagementDataFor simplicity, we shall use the following cash flows for many of our examples (r = 10%):01234-1,000300200400700
7FIN 504: Financial Management
8FIN 504: Financial ManagementPayback PeriodEXAMPLE:3 Year Payback Period Calculation300 + 200 + 400 = 900 < 1,000Result: $900.00 < $1,000.00 Bad Project01234-1,000300200400700
9FIN 504: Financial ManagementPayback PeriodEvaluationC1) Fails (no discounting)C2) Fails (not after payback period)C3) Fails (length of payback period)C4) PassesC5) PassesC6) PassesResult: G) Fails
10FIN 504: Financial ManagementDiscounted Payback PeriodThe discounted payback period rule says to undertake any project for which the present valueof the cash flows within the payback period is greater than the required investment.
11FIN 504: Financial ManagementDiscounted Payback PeriodEXAMPLE (r = 10%):3 Year Discounted Payback Period Calculation:Result: $738.54 < $1,000.00 Bad Project01234-1,000300200400700(29(29(2923300.00200.00400.00$738.54$1,000.001.11.11.1++=<