FIN202 “Financial Management II”

Chapter 4 (Capital Budgeting Techniques)

TA: Salma Ashraf

1. Payback Period (Time or Years)

PP

*We use this rule if the numbers are fixed

Ex 1:

1
We can calculate the payback period for Basma’s Company projects A and B
using the data in Table 8.1.

• For project A, which is an annuity, the payback period

= 3 Years

• 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 US$28,000 of its US$45,000

initial investment.

– By the end of year 2, US$40,000 (US$28,000 from year 1 +

US$12,000 from year 2) will have been recovered.

– At the end of year 3, US$50,000 will have been recovered.

– Only 50% of the year-3 cash inflow of US$10,000 is needed

to complete the payback of the initial US$45,000.

= 2.5 Years

• The payback period for project B is therefore 2.5 years (2 years +

50 percent of year 3).

Decision criteria:

• The length of the maximum acceptable payback period is

determined by management.

• If the payback period is less than the maximum acceptable

payback period, accept the project.
2
 • If the payback period is greater than the maximum acceptable
payback period, reject the project.

2. Net Present Value ($)

If the firm’s cost of capital is 10% solve based on the above problem

Project A
) )
+ )
) ) )

Project B=
) )
+ )
) ) )

= $ 55,924

Decision criteria:

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

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

3
 3. Profitability Index (Ratio)

Project A=
) )
+ )
) ) )

Project B=
) )
+ )
) ) )

= $ 55,924

When companies evaluate investment opportunities using the PI, the

decision rule they follow is to invest in the project when the index is
greater than 1.0.

4
 4. Internal Rate of Return (%)

Use the CASIO calculator to find X as shown below:

(1) Copy the above equation of NPV on the calculator

(2) Press Alpha + X to set X on the equation

(3) Press Alpha + CALC + 0 + shift + CALC

(4) Wait a moment to receive the result of the IRR

Project A=
) )
+ ) = 42,000
) ) )

= 19.9%

Project B=
) )
+ ) = 45,000
) ) )

= 21.7%

Comparing the IRRs of projects A and B given in Figure 8.3 to Basma

Company’s 10 percent cost of capital, we can see that both projects are
acceptable because

• IRRA = 19.9% > 10.0% cost of capital

5
 • IRRB = 21.7% > 10.0% cost of capital

Comparing the two projects’ IRRs, we would prefer project B over project A
because IRRB = 21.7% > IRRA = 19.9%.

Decision criteria:

• If the IRR is greater than the cost of capital, accept the project.

• If the IRR is less than the cost of capital, reject the project.

Ex 2:

A company is considering whether to purchase a new machine.

Machines A and B are available for $80,000 each. Earnings after
taxation are as follows:

Required: Evaluate the two alternatives using the following: You should
use a discount rate of 11%. Comment on each requirement.

(A) Calculate each project’s payback period.

(B) Calculate each project’s Net Present Value (NPV)

(C) Calculate each project’s Profitability Index (PI)

6
 (D) Calculate each project’s Internal Rate of Return (IRR)

Answer:

(A)

PP (A) = 24,000 + 32,000 = 56,000

= 80,000 – 56,000 = 24,000

= 24,000 / 40,000 = 0.6

PP (A) = 2.6 years

PP (B) = 8,000 + 24,000 + 32,000 = 64,000

= 80,000 – 64,000 = 16,000

= 16,000 / 48,000 = 0.33

PP (B) = 3.33 Years

(B)

Project A=
) )
+ )
) ) )

= $ 102,145
= $ 102,145 – 80,000
= 22,145

Project B=
) )
+ )
) ) )

= $ 100,693
= $ 100,693 – 80,000
= 20,693

7
(C) Project A=
) )
+ )
) ) )

= $ 102,145
= $ 102,145 / 80,000
= 1.27

Project B=
) )
+ )
) ) )

= $ 100,693
= $ 100,693 / 80,000
= 1.25

(D)

Project A=
) )
+ ) = 80,000
) ) )

Project B=
) )
+ ) = 80,000
) ) )

Use the CASIO calculator to find X as shown below:

(1) Copy the above equation of NPV on the calculator

(2) Press Alpha + X to set X on the equation

(3) Press Alpha + CALC + 0 + shift + CALC

(4) Wait a moment to receive the result of the IRR

IRRA = 21.97% IRRB = 19%