Jack Welch Era

In: Business and Management

Submitted By arrambidmj
Words 1643
Pages 7
2/19/2014

Methods of Evaluating Capital
Budgeting Projects

Capital Budgeting Decision
Criteria







Net Present Value (NPV)
Internal Rate of Return (IRR)
Modified Internal Rate of Return (MIRR)
Profitability Index (PI)
Payback Period (PB)

Evaluate a Project with the
Following Cash Flows

Net Present Value
• NPV is the present value of all project cash flows

Year

Cash Flow

0

(100)

1

25

2

75

3

25






Discount at weighted average cost of capital (WACC)
Assumes cash flows are reinvested at WACC
NPV varies inversely with WACC
Decision Rule:
• Accept if NPV ≥ $0
• Reject if NPV < $0

– NPV represents change in the value of operations from accepting a capital budgeting project
• Thus, NPV accrues to shareholders and creditors

WACC = 10%

Net Present Value
Year
0

Cash
Flow
(100)

1

25

2

75

3

25

N

CFt
NPV = CF0 + ∑ t 1 t =1 ( + r )
NPV = (100 ) +
= $3.49

25
75
25
+
+
(1.10 )1 (1.10 )2 (1.10)3

Internal Rate of Return
• IRR is the discount rate making NPV = 0
– Assumes cash flows are reinvested at IRR
– Single IRR for a project (assuming normal cash flows)
– Decision Rule:
• Accept if IRR ≥ WACC
• Reject if IRR < WACC

– IRR represents the return on a project, while
WACC represents the cost of financing a project. WACC = 10%

1

2/19/2014

Internal Rate of Return
Year
0

Cash
Flow
(100)

1

25

2

75

NPV Profile

NPV = CF0 + ∑

CFt

t
1
t =1 ( + IRR )

=0

$30.00
$25.00
$20.00
$15.00
$10.00

3

NPV Profile

NPV ($)

N

0 = (100) +

25
75
25
+
+
= 11.95%
(1 + IRR )1 (1 + IRR )2 (1 + IRR )3

25

Accept
Region

$5.00

NPV
IRR

$0.00

WACC (%)
0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

-$5.00

20%

Reject
Region

-$10.00
-$15.00…...

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