Corporate Finance
A Comparison of Capital Budgeting Techniques
Capital budgeting deals with setting the criteria and prescribing the process required for making capital investment choices. Choosing an investment project, that is, making a capital investment choice is ultimately a cost/benefit analysis. It requires valuing the project by comparing the payoff to its costs.
Problem
Value, rank and select investment projects
Example 1.
Project A
Required rate year 1: year 2 year 3 year 4 year 5
Initial Cost
Project B
Project C
7.7%
$400
$1,250
$900.00
$3,000.00
$1,000
$5,045
3%
$100.00
$200
$150.00
$100
$50
$490.67
6%
$5,200
$4,000
$1,000
$200
$100
$9,687.23
1
Capital Budgeting Techniques
A collection of methods allowing the manager to choose among a variety of investment projects.
Methods:
•
•
•
•
•
•
•
Average Accounting Return
Payback
Discounted payback
Internal Rate of Return
Modified Internal Rate of Return
Net Present Value
Profitability Index
Average Accounting Return (AAR)
AAR is the ratio of the Average Net Income to the Average Book Value.
Decision rule: Take the project if AAR is greater than some target ratio set by accountants.
Disadvantages: It has too many flaws, don't ever use it.
Payback period
Payback is the time it takes to recover the initial cost of the investment. Payback is usually measured in years. Decision rule: Take the project with the shortest payback period
Disadvantages
It ignores time value of money
It ignores risk
It ignores cash inflows beyond the cutoff point
Project A: Payback calculation
Period
Cash flow
Amount left to recover
0
-$5,045.00
-$5,045.00
1
$400
$4,645.00
2
$1,250
$3,395.00
3
$900.00
$2,495.00
0.83
$3,000.00
$0.00
Notice that in the fourth year, there is $2,495 left to recuperate, and the annual cash flow equals $3,000
2
Obviously, $2,495/$3,000 = 0.83
Payback here is interpreted as
Capital budgeting deals with setting the criteria and prescribing the process required for making capital investment choices. Choosing an investment project, that is, making a capital investment choice is ultimately a cost/benefit analysis. It requires valuing the project by comparing the payoff to its costs.
Problem
Value, rank and select investment projects
Example 1.
Project A
Required rate year 1: year 2 year 3 year 4 year 5
Initial Cost
Project B
Project C
7.7%
$400
$1,250
$900.00
$3,000.00
$1,000
$5,045
3%
$100.00
$200
$150.00
$100
$50
$490.67
6%
$5,200
$4,000
$1,000
$200
$100
$9,687.23
1
Capital Budgeting Techniques
A collection of methods allowing the manager to choose among a variety of investment projects.
Methods:
•
•
•
•
•
•
•
Average Accounting Return
Payback
Discounted payback
Internal Rate of Return
Modified Internal Rate of Return
Net Present Value
Profitability Index
Average Accounting Return (AAR)
AAR is the ratio of the Average Net Income to the Average Book Value.
Decision rule: Take the project if AAR is greater than some target ratio set by accountants.
Disadvantages: It has too many flaws, don't ever use it.
Payback period
Payback is the time it takes to recover the initial cost of the investment. Payback is usually measured in years. Decision rule: Take the project with the shortest payback period
Disadvantages
It ignores time value of money
It ignores risk
It ignores cash inflows beyond the cutoff point
Project A: Payback calculation
Period
Cash flow
Amount left to recover
0
-$5,045.00
-$5,045.00
1
$400
$4,645.00
2
$1,250
$3,395.00
3
$900.00
$2,495.00
0.83
$3,000.00
$0.00
Notice that in the fourth year, there is $2,495 left to recuperate, and the annual cash flow equals $3,000
2
Obviously, $2,495/$3,000 = 0.83
Payback here is interpreted as