Question

Respond to the following in a minimum of 175 words: Capital Budgeting Decisions Describe the six models of a capital budgeting decision, which are typically defined as a 'go or no-go' decision. These are -

1. Payback period (standard)

2. Discounted payback period (modified from payback period)

3. Net present value (NPV) (standard)

4. Internal rate of return (IRR) (standard)

5. Modified internal rate of return (MIRR) (modified from IRR)

6. Profitability index (PI) (modified from NPV)

In reviewing these, which one(s) is appropriate for small projects and which one(s) is appropriate for larger projects? Or all they all necessary for any capital budgeting decision? Please choose one of these models and provide an example by showing the model's calculation in action.

Answer 1

SOLUTION:-

The six models are as described below:-

1). Payback Period:

The period is the number of years required to recover the funds invested in a project from its net, after-tax cash flows. The payback period is one of the oldest & simplest capital budgeting techniques being used.

For example, consider a project having year-end total cash flows as given below (starting from year 0 to year 3):

Total Cash Flow

$ -50,000

$ 29,900

$ 57,200

$ 9,555

In year 0 i,e., beginning of the project, we are investing $50,050. In the first year, we are recovering $29,900 after which we need $20,150 more to fully cover our initial investment of $50,050. This will come in 2nd year as a function of the year since full 2nd year is giving a cash flow of $57,200 we assume that cash flow of $20,150 will be completed in a fraction of 2nd year i.e., 20,150 / 57,200 = 0.35 years. So total payback period, in this case, becomes 1+0.35 = 1.35 years

2). Discounted payback period:-

The problem with the payback period is that it does not consider the time value of money- Cash flows from all future years are given equal weight which is not correct as cash flows earned today have more value than the same cash flows in the future. Discounted payback is the solution to this flaw-In this technique, the future cash flows are first discounted at the WACC & those discounted cash flows are then used to find the payback period just as we did in above example.

3). Net Present Value:

NPV is probably the most used capital budgeting method currently in the industry. The equation of NPV is a sample to understand as shown below:

It simply means that each year's cash flows are first discounted at the WACC rate to present value & then all those present values are added together The resulting value is the NPV & it describes the net addition to shareholder's wealth that the project is expected to make. Any positive NPV project can be taken whereas projects with NPV<0 are usally discarded.

4). Internal Rate of Return :

The IRR is defined as the discount rate that would force the PV values of a project's future cash flows to exactly equal the initial investment. So, in other words, we may say that it is the rate that would make the NPV=0.

Mathematically we can write it as :

This equation can either be solved manually or using the IRR function in a financial calculator or software like Excel to find the IRR. An IRR greater than WACC is generally desired for a project to be accepted.

5). Modified IRR :

One problem with IRR as described above is that for some projects whose cash flows keep chaging from positive to negative or vice versa during the project life, the IRR equation is given above can yield more than one IRRs as mathematically it is just a polynominal equation that can yield multiple roots. Moreover, IRR is based on the assumption that the project's cash flows can be reinvested at the IRR rate itself but this assumption is generally incorrect.

These issues are resolved in the MIRR model which assumes that the project's cash flows can be reinvested at the WACC rather than the IRR. This gives a better idea of the project's true return. To calculate MIRR we can first compound each year's cash floe at WACC rate to the terminal year & add all the resulting terminal values. Then we find that rate which would cause the PV of the terminal value to equal the costs exactly. That rate is the MIRR.

6). Profitability Index :

It is defined as the ratio of PV of future cash flows to the initial investment i.e.

PI of 1.0 is the minimum acceptable & higher PI projects are preferred over lower PI projects as they are likely to add more value to the firm since the PV of their future cash flows is higher.

Generally, all of these methods of capital budgeting are used together since they are all very easy to calculate so it does not make sense to not consider any of them as each one of them usually provides a different viewpoint & insight to the project's value addition to the firm. For very small projects sometimes people may only consider the payback period or IRR, but generally, for any reasonable project, all of these measures are considered.

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