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CHAPTER 9
Capital Budgeting Decision
Criteria
CHAPTER ORIENTATION
Capital budgeting involves the decision making process with respect to investment in fixed
assets; specifically, it involves measuring the incremental cash flows associated with
investment proposals and evaluating the attractiveness of these cash flows relative to the
project's costs. This chapter focuses on the various decision criteria.
It also examines how
to deal with complications in the capital budgeting process including mutually exclusive
projects and capital rationing.
CHAPTER OUTLINE
I.
Methods for evaluating projects
A.
The payback period method
1.
The payback period of an investment tells the number of years
required to recover the initial investment. The payback period is
calculated by adding the cash flows up until they are equal to the
initial fixed investment.
2.
Although this measure does, in fact, deal with cash flows and is easy
to calculate and understand, it ignores any cash flows that occur after
the payback period and does not consider the time value of money
within the payback period.
3.
To deal with the criticism that the payback period ignores the time
value of money some firms use the discounted payback period. The
discounted payback period method is similar to the traditional
payback period except that it uses discounted net cash flows rather
than actual undiscounted net cash flows in calculating the payback
period.
4.
The discounted payback period is defined as the number of years
needed to recover the initial cash outlay from the discounted net cash
flows.
222
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Presentvalue methods
1.
The net present value of an investment project is the present value of
the cash inflows less the present value of the cash outflows. By
assigning negative values to cash outflows, it becomes
NPV
=
t
t
n
1
t
k)
(1
FCF
+
∑
=

IO
where FCF
t
=
the annual free cash flow in time period t (this
can take on either positive or negative values)
k
=
the required rate of return or appropriate discount rate
or cost of capital
IO
=
the initial cash outlay
n
=
the project's expected life
a.
The acceptance criteria are
accept if NPV
≥
0
reject if NPV
<
0
b.
The advantage of this approach is that it takes the time value
of money into consideration in addition to dealing with cash
flows.
2.
The profitability index is the ratio of the present value of the expected
future net cash flows to the initial cash outlay, or
profitability index
=
IO
k)
(1
FCF
t
t
n
1
t
+
∑
=
a.
The acceptance criteria are
accept if PI
≥
1.0
reject if PI
<
1.0
b.
The advantages of this method are the same as those for the
net present value.
c.
Either of these presentvalue methods will give the same
acceptreject decisions to a project.
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This note was uploaded on 07/29/2011 for the course FIN 202 taught by Professor Hung during the Spring '11 term at Keuka.
 Spring '11
 Hung

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