# Dgeting criteria 49 capital budgeting criteria

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dgeting criteria - 49Capital Budgeting Criteria: PaybackComputing and applying payback in 5 easy stepsStep 4: determine the payback periodSuppose the followingInvestment – (cumulative expected CFs produced through year t), which is the amount of cash that needs to be produced after t years for the project to reach payback, is positiveInvestment – (cumulative expected CFs produced through year t+1), which is the amount of cash that needs to be produced after t+1 years for the project to reach payback, is negativeThen the project is expected to reach payback between t and t+1 yearsAssume that the expected cash flow produced by a project for a given year is produced at a uniform rate throughout the year The portion of year t+1 that it will take to produce the cash needed for payback isExpected CF needed for payback after t years / expected CF in year t+1 = [investment – cumulative expected CFs produced through time t] / expected CF in year t+1= [investment – (C1+ C2+ ... + Ct)] / Ct+1The payback period is t + {[investment – (C1+ C2+ … + Ct)] / Ct+1}tt+1paybackExpected CF needed for payback after t yearsExpected CF in year t+1
dgeting criteria - 50Capital Budgeting Criteria: PaybackComputing and applying payback in 5 easy stepsStep 5: decide whether to invest or notAccept project if the payback period is less than or equal to the limit set by the firmReject project if the payback period is greater than the limit set by the firm
dgeting criteria - 51Capital Budgeting Criteria: PaybackWith tables, it is helpful to note that Expected CFs needed for payback after t+1 years = investment – cumulative expected CF produced through year t+1 = expected CF needed for payback after t years – expected CF in year t+1= [investment – cumulative expected CF produced through year t] – expected CF in year t+1
dgeting criteria - 52Capital Budgeting Criteria:Payback – ExampleYearExpected cash flow (CF) during yearPresent value of expected CF during yearProject expected CF needed after end of year = project expected CF needed after end of previous year minus expected CF during year0-165,000Not relevant for payback period165,000165,000165,000 – 65,000 = 100,000270,000100,000 – 70,000 = 30,000390,00030,000 – 90,000 = -60,000We see that payback is between the end of years 2 and 3After 2 years, 30,000 in expected cash flows are neededIn year 3, expected cash flows are 90,000Assume expected cash flows occur uniformly throughout the yearTherefore, it would take (30,000/90,000) = 0.33 of year 3 to reach paybackPayback = 2 + 0.33 = 2.33 years Finance-tutor project
dgeting criteria - 53Capital Budgeting Criteria:Payback – ExampleIf Patriot Theaters believes that opening a Boston multiplex would cost \$550,000 today and would produce cash flows of \$100,000, \$200,000, \$300,000, and \$400,000 in 1, 2, 3, and 4 years, would the firm choose to expand, based on payback, if the cost of capital associated with the project is 23.4 percent and the payback limit is 2.9 years?