C 15/1: Economic Feasibility Studies Capital Budgeting Techniques Pathways to Higher Education 19 Chapter 2: Capital Budgeting Techniques Introduction The Net Present 2.2 The Net Present Value Method Value Method Estimating NPV 2.1 Introduction In order to assess the feasibility of any investment project, some capital budgeting techniques should be used to evaluate that project. This part illustrates the most common techniques and the advantages and disadvantages of each one of them. The primary capital budgeting method that uses discounted cash flow techniques is called the Net Present Value (NPV). Under the NPV net cash flows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts is referred to as the NPV. The interest rate used to discount the future cash flows is the required rate of return (will be discussed later). A project is accepted when the net present value is zero or positive. The Net Present Value (NPV) Rule Net Present Value (NPV) = Total PV of future CF's - Initial Investment 2.2.1 Why To Use Net Present Value? Accepting positive NPV projects benefits shareholders, for the following reasons: NPV uses cash flows NPV uses all the cash flows of the project NPV discounts the cash flows properly, and 2.2.2 Estimating NPV Three variables should be considered: 1. Estimate future cash flows: how much? and when? 2. Estimate discount rate 3. Estimate initial costs Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPVC 15/1: Economic Feasibility Studies Capital Budgeting Techniques Pathways to Higher Education 20 Good Attributes of the NPV Rule The Payback Period Rule The Discounted Payback Period Rule 2.2.3 Good Attributes of the NPV Rule 1. Uses cash flows 2. Uses ALL cash flows of the project 3. Discounts ALL cash flows properly Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate. 2.3 The Payback Period Rule The payback period answers the question of; how long does it take the project to "pay back" its initial investment? Payback Period = number of years to recover initial costs The shorter the payback period the more attractive the investment. The reasons are that: The earlier the investment is recovered, the sooner the cash funds can be used for other purpose. The risk of loss from obsolesces and changed economic conditions is less in a shorter payback-period Minimum Acceptance Criteria: set by management Ranking Criteria: set by management Disadvantages: Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria An accepted project based on the payback criteria may not have a positive NPV Advantages: Easy to understand Biased toward liquidity 2.4 The Discounted Payback Period Rule How long does it take the project to "pay back" its initial investment taking...
