Week 4 - Capital Budgeting I: Techniques for Evaluation

Payback period 

1. Calculate how many years it takes to recover = year before recovery

2. Amount to be recovered year before recovery (investment until recovery year)

3. Next years CF

NPV

Accept a project if NPV > 0 

NPV = PV (benefits) - PV (cost) > 0 

• investment is subtracteed outside ofo excle sytax

Cash flows lasting for indefinite time - NPV

= (CashFlow / CostOfCapital) / (1 + CostOfCapital) - InitialInvestment

IRR

If IRR is greater than K then the projects rate of return is greater than its cost, some return is left over to boost stockholders returns

• investment is made insidee excel syntax

Calculating crossover - IRR

1. Project x - project y

2. Find IRR of differences
   If cost of capital < crossover rate:

   • The NPV of one project (usually long-term) is higher

   • But IRR might suggest the other project is better

   • ➡ Conflict between NPV and IRR decisions

   • ✅ You should rely on NPV, but know there's disagreement

3. If cost of capital > crossover rate:

   • No conflict — both NPV and IRR choose the same project

   • ✅ Easy decision

PI

= NPV/initial investment 

Accept a project if PI is greater than 0, stay indifferent if the PI is zero and don't accept a project if PI is below 0

Projects with different lives 

1. Calculate NPV of both projects

2. Then find PMT (eaa) of the NPV,

3. Decide based of the EAA (pmt)

Independent vs mutually exclusive

Projects are independent = can choose as many objects as long as they fulfil the requirement of the decision rule,

When both projects are less than cut off date if they are independent decision can be both

If mutually exclusive: Less than 3 years cut off point but can only be one so final decision needs to be least pay back time

PP adv + dis

Advantages

• Provides an indication of a projects risk and liquidity 

• Easy to calculate and understand 

Disadvantages

• Ignores the time value of money 

• Ignonres CFs occurring after the payback period

NPV adv + dis

Advantages NPV

• Uses cash flows (not earnings)

• Uses all cash flows of a project

• Discounts cash flows properly 

Disadvantages

• Relies on accurate estimate of cash flows and the discount rate

• Projects likely to be replicated with maturity of differing lengths

pitfalls of IRR

• Multiple IRRs: Happens with non-conventional cash flows (sign changes more than once).

• No IRR: Some projects don’t have a real IRR.

• Ignores scale: Doesn’t show which project creates more value.

• Assumes reinvestment at IRR: Unrealistic assumption.

• Conflicts with NPV: When projects differ in size or timing, IRR may give wrong choice.