Capital Budgeting Techniques

When firms have developed relevant cash flows, they analyze them to assess whether a project
is acceptable or to rank projects.

Bennett Company's Relevant Cash Flows

The problem concerns Bennett Company, a medium-sized metal fabricator that is currently
contemplating two projects: Project A requires an initial investment of $42,000; project B
requires an initial investment of $45,000. The projected relevant cash flows for the two projects
are presented in Table 9.1 and depicted on the time lines in Figure 9.1. Three most popular
capital budgeting techniques are:
- payback period,
- net present value, and
- internal rate Of return
Table 9.1 Capital Expenditure Data for Bennett Company

Project A Project B
Initial investment $42,000 $45,000
Year Operating cash inflows
1 $14,000 $28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000

$14000 $14000 $14000 $14000 $14000

0 0 0 0 0
Project A
0
1 2 3 4 5

End of Year
$42000
0

$28000 $12000 $10000 $10000 $10000

0 0 0 0 0
Project B
0
1 2 3 4 5

End of Year
$45000
0
Payback Period
Payback periods are commonly used to evaluate proposed investments. The payback period is the
amount of time required for the firm to recover its initial investment in a project. In the case of an
annuity, the payback period can be found by dividing the initial investment by the annual cash
inflow. For a mixed stream of cash inflows, the yearly cash inflows must be accumulated until the
initial investment is recovered. Although popular, the payback period is generally viewed as an
unsophisticated capital budgeting technique, because it does not explicitly consider the time value
of money.

Decision Criteria
When the payback period is used to make accept—reject decisions, the following decision
criteria apply.
• If the payback period is less than the maximum acceptable payback period, accept the
project.

• If the payback period is greater than the maximum acceptable payback period, reject the
project.

The length of the maximum acceptable payback period is determined by management. This
value is set subjectively on the basis of a number of factors, including the type of project
(expansion, replacement or renewal, other), the perceived risk of the project, and the
perceived relationship between the payback period and the share value. It is simply a value
that management feels, on average, will result in value-creating investment decisions.

Example We can calculate the payback period for Bennett Company's projects A and B using
the data in Table 9.1. For project A, which is an annuity, the payback period is 3.0 years ($42,000
initial investment +$14,000 annual cash inflow), Because project B generates a mixed stream of
cash inflows, the calculation of its payback period is not as clear-cut. In year 1, the firm will
recover $28,000 of its $45,000 initial investment. By the end of year 2, $40,000 ($28,000 from
year 1 + $12,000 from year 2) will have been recovered. At the end of year 3, $50,000 will have
been recovered. Only 50% of the year-3 cash inflow of $10,000 is needed to complete the
payback of the initial $45,000. The payback period for project B is therefore 2.5 years (2 years
+50% of year 3).

If Bennett's maximum acceptable payback period were 2.75 years, project A would be rejected
and project B would be accepted. If the maximum payback were 2.25 years, both projects would
be rejected. If the projects were being ranked, B would be preferred over A, because it has a
shorter payback period.
Pros and Cons of Payback Periods
- Large firms usually use the payback period to evaluate small project, and small firms use it to
evaluate most project.
- The longer the firm must wait to recover its invested funds, the greater the possibility of a calamity.
Therefore, the shorter the payback period, the lower the firm's exposure to such risk.
- The major weakness of the payback period is that the appropriate payback period is merely a
subjectively determined number.
- A second weakness is that this approach fails to take fully into account the time factor in the value
of money. This weakness can be illustrated by an example.
- A third weakness of payback is its failure to recognize cash flows that occur after the payback
period.

Example Seema Mehdi is considering investing $20,000 in a 5% interest in a rental property. Her good
friend and real estate agent, Akbar Ahmed, put the deal together, and he conservatively estimates that
Seema should receive between $4,000 and $6,000 per year in cash from her 5% interest in the property.
The deal is structured in a way that forces all investors to maintain their investment in the property for at
least 10 years. Seema expects to remain in the 25% income tax bracket for quite a while. In order to be
acceptable, Seema requires the investment to pay itself back in terms of after-tax cash flows in less than 7
years.

Seema's calculation of the payback period on this deal begins with calculation of the range of annual after-
tax cash flow:

After-tax cash flow = (1 — tax rate) X Pre-tax cash flow

= (1 — 0.25) x $4,000 = $3,000
= (1 — 0.25) x $6,000 = $4,500
The after-tax cash flow ranges from $3,000 to $4,500. Dividing the $20,000 initial investment by
each of the estimated after-tax cash flows, we get the payback period:
Payback period = Initial investment ÷ After-tax cash flow
= $20,000 ÷ $3,000 = 6.67 years
= $20,000 ÷ $4,500 = 4.44 years

Because Seema's proposed rental property investment will pay itself back between 4.44 and 6.67
years, which is a range below her maximum payback of 7 years, the investment is acceptable.
Table 9.2 Relevant Cash Flows and Payback Periods for DeYarman Enterprises'
Projects
Project Gold Project Silver
Initial investment $50,000 $50,000
Year Operating cash inflows
1 $5,000 $40,000
2 5,000 2,000
3 40,000 8,000
4 10,000 10,000
5 10,000 10,000
Payback period 3 years 3 years

DeYarman Enterprises, a small medical appliance manufacturer, is considering two mutually

exclusive projects, which it has named projects Gold and Silver. The firm uses only the payback
period to choose projects. The relevant cash flows and a back period for each project are given in
Table 9.2. Both projects have 3-years payback periods, which would suggest that they are equally
desirable. But comparison of the pattern of cash inflows over the first 3 years shows that more of
the $50,000 initial investment in project Silver is recovered sooner than is recovered for project
Gold. For example, in year 1, $40,000 of the $50,000 invested in project Silver is recovered,
whereas only $5,000 of the $50,000 investment in project Gold is recovered. Given the time value
of money, project Silver would clearly be preferred over project Gold, in spite of the fact that both
have identical 3-years payback period. The payback approach does not fully account for the time
value of money, which, if recognized, would cause project Silver to be preferred over project Gold.

Rashid Company, a software developer, has two investment opportunities, X and Y. Data for X and Y are
given in Table 9.3. The payback period for project X is 2 years; for project Y it is 3 years. Strict adherence to
the payback approach suggests that project X is preferable to project Y. However, if we look beyond the
payback period, we see that project X returns only an additional $1,200 ($1,000 in year 3 + $100 in year 4
+ $100 in year 5), whereas project Y returns an additional $7,000 ($4,000 in year 4 + $3,000 in year 5). On
the basis of this information, project Y appears preferable to X. The payback approach ignored the cash
inflows occurring after the end of the payback period.

Table 9.3 Calculation of the Payback Period for Rashid Company's Two Alternative Investment Projects:

Project X Project Y
Initial investment $10,000 $10,000
Year Operating cash inflows
1 $5,000 $3,000
2 5,000 4,000
3 10,000 3,000
4 100 4,000
5 100 3,000
Payback period 3 years 3 years
REVIEW QUESTIONS

Q9.2 What is the payback period? How is it calculated?

Q9.3 What weaknesses are commonly associated with the use of the payback period to evaluate
a proposed investment?

Net Present Value (NPV)

Because net present value gives explicit consideration to the time value of money. It is considered
a sophisticated capital budgeting technique. All such techniques in one way or another discount
the firm's cash flows at a specified rate. This rate—often called the discount rate, required return,
cost of capital, or opportunity cost.

The net present value (NPV) is found by subtracting a project's initial investment (CF0) from the present
value of its cash inflows (CFt) discounted at a rate equal to the firm's cost of capital (r).

NPV = Present value of cash inflows — Initial investment

𝐶𝐹𝑡
𝑁𝑃𝑉 = ∑𝑛𝑡=1 (1+𝑟)𝑡 − 𝐶𝐹0 .......... (9.1)

= ∑𝑛𝑡=1(𝐶𝐹𝑡 𝑥 𝑃𝑉𝐼𝐹𝑟, 𝑡) − 𝐶𝐹0 ........... (9.1a)

When NPV is used, both inflows and outflows are measured in terms of present dollars.

Decision Criteria
When NPV is used to make accept—reject decisions, the decision criteria are as follows:

• If the NPV is greater than $0, accept the project.

• If the NPV is less than $0, reject the project.

If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action
should increase the market value of the firm, and therefore e wealth of its owners by an amount
equal to the NPV.
We can illustrate the net present value (NPV) approach by using the Bennett Company data
presented in Table 9.1. If the firm has a 10% cost of capital, the net present values for projects A
(an annuity) and B (a mixed stream) can be calculated as shown on the time lines in Figure 9.2.
These calculations result in net present values for projects A and B of $11,071 and $10,924,
respectively. Both projects are acceptable, because the net present value of each is greater than
$0. If the projects were being ranked, however, project A would be considered superior to B,
because it has a higher net present value than that of B ($11,071 versus $10,924).

Figure 9.2 Calculation of NPVs for Bennett Company’s Capital Expenditure Alternatives
Time lines depicting the cash flows and NPV calculations for A and B

Project A End of Year

5
NPVA= $11,071

Project B End of Year

O 5
$45,000 $28,000 $12,000 $10,000 $10,000 $10,000

$55,924

NPVB=