EFB210 Lecture Notes - Lecture 5: Payback Period, Cash Flow, Net Present Value
Week 5 Finance 1 Lecture Notes
Capital Budgeting 1
Capital Budgeting Overview
• Investment project:
o … interpreted very broadly to include any proposal to outlay cash in
the expectation that future cash flows will result. Peirson et al. (2015)
p.104.
• Note that projects can be classified as
o Independent
▪ Investment in one does not prohibit investment in another.
o Mutually Exclusive
▪ Investment in one prohibits (financial or physical constraint) the
investment in another.
o Mutually Inclusive
▪ Investment in one requires investment in the other
• Capital expenditure Process
1. Generation of investment proposals
2. Evaluation and selection (forward)
3. Approval and control of capital expenditure
4. Post-completion audit (forward & backward)
Evaluation Methods
• Percentage of Australian CFOs who responded use a particular evaluation metric
Payback period:
• The length of time it takes to recover our initial investment.
• Decision Rule:
o Accept project if Payback < Target Payback Otherwise Reject
o Target is set arbitrarily (usually 2 - 5 years).
• Example 1
Method Percentage
(approx)*
Discounted Cash
Flow Method#
Internal Rate of Return (IRR) 72 Yes
Net Present Value (NPV) 70 Yes
Payback Period (PB) 57 No
Real Option Analysis 27 Yes
Accounting Rate of Return (ARR) 26 No
Project
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 PB
A
-9,000
3,000 3,000 3,000 3
B
-9,000
7,000 1,000 1,000 3
C
-9,000
3,000 3,000 3,000 9,000 3
D
-9,000
3,000 3,000 3,000 3
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• Problems
o Does not account for Size, Timing and Risk of Cash Flows
o Selected projects are not necessarily profitable in the economic sense –
positive NPV
• Advantages
o Simple and asks a really important question
o Can be used in conjunction with other measures
o Places greater importance on early cash flows that can be considered less
uncertain than later cash flows
ARR:
• Accounting Rate of Return
o Uses accounting profits as a ratio of investment to measure the return on
investment. Common Definitions:
▪ ARRnet = Avg Acc Profit/ Average Investment
▪ ARRgross = Avg Acc Profit/ Initial Investment
• Decision rule:
o Accept project if ARR > Target ARR otherwise Reject
• Problems
o Does not use cash flows and ignores timing
o Target is set arbitrarily
• Advantages
o Can be used in conjunction with other measures
• Example 2: A firm proposes to install a labour-saving machine (cost $15,000) that will
save some cash operating expenses each year. Life of five years, no salvage value
and no tax.
o Payback
o ARR Gross
Year Outlay Saving
0
-
15,000
1 3,800
2 4,200
3 5,000
4 8,000
5 9,000
Year Outlay
Saving
Depr.*Profit
0 -15,000
1 3,800 -3,000 800
2 4,200 -3,000 1,200
3 5,000 -3,000 2,000
4 8,000 -3,000 5,000
5 9,000 -3,000 6,000
Average
3,000
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• Discounted Cash Flow (DCF) Methods
o Net Present Value (NPV)
o Internal Rate of Return (IRR)
o Benefit-Cost Ratio (BCR)
o Annual Equivalents (AE)
• All account for cash flows, timing and risk
• They are all linked to NPV
o IRR corresponds to NPV = 0
o BCR indicates value created per dollar invested
o AE is NPV annuitised (if thats a word, turned in to an annuity…)
• Assume - timing of cash flows known and cash flows (except initial outlay) occur at
end of year
NPV:
• NPV represents the increase in value of the firm which accrues from a project
o To be consistent with the objective of the firm, the firm should
▪ Accept all +NPV projects
▪ Reject all -NPV projects
Example 3: NPV
IRR
• IRR is that rate of return which produces a zero NPV
• Found by trial and error
• IRR rule is accept project if IRR > r otherwise reject
• Project may not necessarily have one IRR. It may have no IRR (e.g. all negative cash
flows) or multiple IRRs (e.g. if the project has more than one negative Cash Flow)
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Document Summary
Investment project: (cid:1688) interpreted very broadly to include any proposal to outlay cash in the expectation that future cash flows will result. (cid:1689) peirson et al. (2015) p. 104, note that projects can be classified as. Investment in one does not prohibit investment in another: mutually exclusive. Investment in one prohibits (financial or physical constraint) the investment in another: mutually inclusive. Investment in one requires investment in the other: capital expenditure process, generation of investment proposals, evaluation and selection (forward, approval and control of capital expenditure, post-completion audit (forward & backward) Internal rate of return (irr: percentage of australian cfos who responded use a particular evaluation metric. Payback period: the length of time it takes to recover our initial investment, decision rule, accept project if payback < target payback otherwise reject, target is set arbitrarily (usually 2 - 5 years), example 1. Arr: accounting rate of return, uses accounting profits as a ratio of investment to measure the return on investment.
