Lecture 4: Capital Budgeting and Investment Rules (Part A) Flashcards
What is capital budgeting?
Capital budgeting is the process that companies use to select the projects/ investments that add value to the company
Capital budgeting is the process used to take an investment decision
What are Independent projects ?
Independent projects can be selected independently from others
The selection of one project does not affect the selection of others
Firms can invest in more than one projects
i.e. Starbucks opens new stores in Southampton and Portsmouth
What are mutually exclsuive projects?
Mutually exclusive projects cannot be chosen independently from other projects.
- The selection of one, precludes the selection of the others
- Only one project is selected
- i.e. A Starbucks store decides to purchase coffee machine A than B
what is the decison criteria for investing in a project using NPV for both independent and mutually exclusive projects?
Decision criterion using NPV
For independent projects: Accept those with NPV > 0
For mutually exclusive projects: From all projects with NPV > 0, select the one with the highest NPV
What is the disount rate to use in npv calculations?
The discount rate to use for a NPV calculation is the return of the best alternative investment (e.g. with same features)
What is the payback period?
Payback period is the minimum length of time, k, such that the sum of the cash flows exceeds the initial investment
CF1 + CF2 + … + CFK > I0
What is the decison criteria using the NPV?
Decision criterion using the payback period
- For independent projects: Accept all projects with k ≤ t where t is a threshold
- For mutually exclusive projects: Among all project having k ≤ t , accept the one that has the lowest k
What are the shortcomings of the payback period method?
Shortcomings:
No discounting, so the time value of money is ignored.
A dollar five years in the future is considered to be the same as a dollar today, according to the payback period.
Cash flows after the payback period are ignored.
Does not consider the project as a whole
Project’s risk is ignored
Why do people use the payback period?
So why do people still use the payback period?
Simple concept to understand and communicate
Easy to calculate
It provides an idea of the liquidity of the project
Managers sometimes think that investing in more liquid projects means quicker promotion
What is the discounted payback period?
Discounted payback period, in words, is the minimum length of time, k, such that the sum of the discounted cash flows exceeds the initial investment
What is the decison criteria for using the discounted payback period?
Decision criterion using the discounted payback period
For independent projects: Accept all projects with k ≤ t where t is a threshold
For mutually exclusive projects: Among all projects having k ≤ t , accept the one that has the lowest k. k is the payback period
What are the pros and cons of using the discounted payback period?
Advantages
Discounted payback rule solves the major problem associated with the simple payback rule as it Considers the time value of money
Disadvantage is that it ignores the cash flows after the optimal cut off period
