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Unformatted text preview: Chapter 9: Capital Project Evaluation Techniques 1. Payback Technique How many years until we recoup the initial investment, based on the cash ﬂows (OCI and
Terminal Value) of this investment? Simple Case: If OCI’s are annuity:
Payback Period = (Initial Investment)/ (Annuity OCI) Let’s say the initial investment is $100; the OCI’s:
1. $40
2. $40
3. $45
Payback Period = ?
leg Cash Flow Cumulative CF
1 $40 $40
2 $40 80
3 $45 125 We need to start with the last year BEFORE payback: 2 + (Amount Yet Needed/N ext Year’s CF)
=2 + $20/$45
=7 =2.44 years
Decision Criterion: Accept if PP 5 Company Standard. Advantages of Payback:
1. Simple to Understand
2. Does Give Crude Measure of Risk, if we measure risk by uncertainty of cash ﬂows.
WHY? because tends to overlook far—off cash ﬂows, which are the ones the
forecaster is most unsure of.
Does take Liquidity into account.
Computational Simplicity.
Intuitive Appeal.
Considers cash ﬂows rather than accounting proﬁts. Gives implicit consideration to the timing of cash ﬂows and therefore to the time value of
money. NQ‘SAPS“ Disadvantages of Payback: 1. Ignores Time Value of Money. 2. Ignores PostPayback Cash Flows. 3. No link to Shareholder Wealth. 4. Poor Risk Measure. 5. Appropriate Payback Period is a Subj ectively Determined Number. 11. BETTER MEASURE: Net Present Value NPV = (P.V. of ALL CASH INFLOWS — P.V. of Initial Investment) Decision Criteria:
IF NPV Z O, ACCEPT: increases shareholder wealth by this amount.
IF NPV < O, REJECT: erodes shareholder wealth by this amount. Advantages of NPV:
1. Direct linkage to SWM.
2. Incorporates time value of money.
3. Incorporates risk, through adjustment to discount rate.
4. Works with various cash ﬂow streams.
5. Proper reinvestment rate assumption (cost of capital). Disadvantages of NPV:
1. Hard for executives to understand. III. ANOTHER GOOD MEASURE: Internal Rate of Return
“the discount rate that equates the PV of Cash Inﬂows with the Initial Investment;”
(mathematically, makes NPV = 0) Decision Criteria:
IF IRR _>_ cost of capital, accept;
IF [RR < cost of capital, reject. Advantages of IR:
1. Percentage format — easily understandable
2. Usually links to SWM, with possible exception of mutually exclusive projects.
3. Incorporates time value of money.
4. Incorporates risk, through adjustment to cost of capital. Disadvantages of IR:
1. Breakdown with nonnormal projects.
2. Breakdown with mutually exclusive projects’ rankings, due to reinvestment rate
assumption (at RR). Disagrees, in these cases, with NPV accept/rej ect signal. ...
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 Spring '12
 JohnZietlow
 Finance

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