Once we have determined the relevant cash-flow information necessary to make capital budgeting decisions, we need to evaluate the attractiveness of the various investment proposals under consideration. The investment decision will be to either accept or reject each proposal. In this chapter we study alternative methods of project evaluation and selection. In addition, we address some of the potential difficulties encountered in trying to implement these methods. | Chapter 13 Capital Budgeting Techniques © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, . Carroll College, Waukesha, WI Capital Budgeting Techniques Project Evaluation and Selection Potential Difficulties Capital Rationing Project Monitoring Post-Completion Audit Project Evaluation: Alternative Methods Payback Period (PBP) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI) Proposed Project Data Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000. Independent Project Independent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake. Payback Period (PBP) PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K (c) 10 K 22 K 37 K 47 K 54 K Payback Solution (#1) PBP = a + ( b - c ) / d = 3 + (40 - 37) / 10 = 3 + (3) / 10 = Years 0 1 2 3 4 5 -40 K 10 K 12 K 15 K 10 K 7 K Cumulative Inflows (a) (-b) (d) Payback Solution (#2) PBP = 3 + ( 3K ) / 10K = Years Note: Take absolute value of last negative cumulative cash flow value. Cumulative Cash Flows -40 K 10 K 12 K 15 K 10 K 7 K 0 1 2 3 4 5 -40 K -30 K -18 K -3 K 7 K 14 K PBP Acceptance Criterion Yes! The firm will receive back the initial cash outlay in less than years. [ Years < Year Max.] The management of Basket Wonders has set a maximum PBP of years for projects of this type. Should this project be accepted? PBP Strengths and Weaknesses Strengths: Easy to use and understand Can be used . | Chapter 13 Capital Budgeting Techniques © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, . Carroll College, Waukesha, WI Capital Budgeting Techniques Project Evaluation and Selection Potential Difficulties Capital Rationing Project Monitoring Post-Completion Audit Project Evaluation: Alternative Methods Payback Period (PBP) Internal Rate of Return (IRR) Net Present Value (NPV) Profitability Index (PI) Proposed Project Data Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000. Independent Project Independent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. For this project, assume that it is independent of any other potential .
