Review for midterm exam
Cost of Capital and Capital Budgeting
Capital Budgeting
This topic and cost of capital as we will see go together. In order to calculate the Net Present
Value (NPV) of a project we will need the cost of capital to plug into the NPV equation. But I get
ahead of myself – let’s start at the beginning.
In this chapter I am concerned with the three major ways of deciding whether or not a
company should do a costly project: simple payback, net present value (NPV) and the internal
rate of return (IRR). Each has pros and cons and often a company will use all three, starting
with payback (the simplest and fastest to calculate) and if the project passes that test, the
company will go on to the more sophisticated models, NPV and IRR. Why both NPV & IRR? I’ll
discuss this more in a bit, but for now: NPV gives a $ answer, whereas IRR gives a % answer.
Often management will want to know both.
Payback:
You are considering two machines, A & B. They both do the same job and they are “mutually
exclusive”. THIS IS IMPORTANT! (Your text has a good discussion of this by the way.) Mutually
exclusive projects means that you will do ONE not both regardless of how nice both are! Why?
Because you can only use one. If you need one new conveyor system you might look at several,
but no matter how nice they all are – you only need one. OR: you are considering three
manufacturing projects. You have enough floor space in the plant to house one and only one.
All three projects would be profitable, but since you only have room for one – you pick project
“A” and that automatically eliminates all other projects.
This (mutually exclusive) concept is the opposite of “independent” projects. With independent
projects accepting one has no effect on considering the others. You will do as many of these
independent projects as possible. By that I mean , all projects that pass your screening
(payback, NPV or IRR).
1
, Going back to just two projects, A & B, machine A costs $21,000 and machine B costs $40,000.
The profit from A has been estimated to be $7,000 per year; the profit from B would be $5,000
per year. Which to buy?
The payback for A = $21,000/$7,000 = 3 years. B = $40,000/$5,000 = 8 years.
All other things being equal you would select A because it has the shortest payback.
Let me add one other piece of information. Machine A has a useful life of 4 years; machine B
has a useful life of 59 years. Using payback would you change your decision?
NO! Payback clearly has as its decision – pick the one that pays you back the fastest, and that’s
clearly A.
This illustrates one of the two major problems (cons) using payback: it ignores anything that
happens AFTER the payback period.
Let’s take another example: machine A costs $30,000; machine B also costs $30,000. Machine
A is easy to use while machine B is more complex but once the operator gets the hang of it – it
goes very fast – faster than A.
The profit from A will be $10,000 each year but the profits from be will be different each year,
in part due to that learning curve. B’s profits are: year 1 = $5,000, year 2 = $8,000, year 3 =
$17,000. Which to buy?
If you look closely at the numbers, BOTH have a payback of three years! (Add up the $ - they
both = $30,000). Soooo, using payback you would be indifferent – flip a coin. BUT YOU KNOW
something about the TIME VALUE OF MONEY. Waiting to get that last $17,000 takes three
years for B. In the third year A is generating $10,000 (A has more $ coming in sooner – in years
1 & 2). Conclusion using present value: A IS superior to B. But you wouldn’t make that
decision if you were only using payback and this gets us to the second major problem (con) with
p[payback: it ignores the time value of money!
Well if payback has these two fairly major problems, why use it at all? Two reasons: it’s fast
and it’s easy to understand (even your boss could get it). If you ever try to explain present
value to someone who has never had it – good luck!
So payback is often used as a first, quick test of a project, but how? The company will have a
rule that might say, “we will consider any project that has a payback of 5 years or less”.
Therefore any project that meets that 5 year rule will go one for additional scrutiny – it will now
meet NPV.
2
Cost of Capital and Capital Budgeting
Capital Budgeting
This topic and cost of capital as we will see go together. In order to calculate the Net Present
Value (NPV) of a project we will need the cost of capital to plug into the NPV equation. But I get
ahead of myself – let’s start at the beginning.
In this chapter I am concerned with the three major ways of deciding whether or not a
company should do a costly project: simple payback, net present value (NPV) and the internal
rate of return (IRR). Each has pros and cons and often a company will use all three, starting
with payback (the simplest and fastest to calculate) and if the project passes that test, the
company will go on to the more sophisticated models, NPV and IRR. Why both NPV & IRR? I’ll
discuss this more in a bit, but for now: NPV gives a $ answer, whereas IRR gives a % answer.
Often management will want to know both.
Payback:
You are considering two machines, A & B. They both do the same job and they are “mutually
exclusive”. THIS IS IMPORTANT! (Your text has a good discussion of this by the way.) Mutually
exclusive projects means that you will do ONE not both regardless of how nice both are! Why?
Because you can only use one. If you need one new conveyor system you might look at several,
but no matter how nice they all are – you only need one. OR: you are considering three
manufacturing projects. You have enough floor space in the plant to house one and only one.
All three projects would be profitable, but since you only have room for one – you pick project
“A” and that automatically eliminates all other projects.
This (mutually exclusive) concept is the opposite of “independent” projects. With independent
projects accepting one has no effect on considering the others. You will do as many of these
independent projects as possible. By that I mean , all projects that pass your screening
(payback, NPV or IRR).
1
, Going back to just two projects, A & B, machine A costs $21,000 and machine B costs $40,000.
The profit from A has been estimated to be $7,000 per year; the profit from B would be $5,000
per year. Which to buy?
The payback for A = $21,000/$7,000 = 3 years. B = $40,000/$5,000 = 8 years.
All other things being equal you would select A because it has the shortest payback.
Let me add one other piece of information. Machine A has a useful life of 4 years; machine B
has a useful life of 59 years. Using payback would you change your decision?
NO! Payback clearly has as its decision – pick the one that pays you back the fastest, and that’s
clearly A.
This illustrates one of the two major problems (cons) using payback: it ignores anything that
happens AFTER the payback period.
Let’s take another example: machine A costs $30,000; machine B also costs $30,000. Machine
A is easy to use while machine B is more complex but once the operator gets the hang of it – it
goes very fast – faster than A.
The profit from A will be $10,000 each year but the profits from be will be different each year,
in part due to that learning curve. B’s profits are: year 1 = $5,000, year 2 = $8,000, year 3 =
$17,000. Which to buy?
If you look closely at the numbers, BOTH have a payback of three years! (Add up the $ - they
both = $30,000). Soooo, using payback you would be indifferent – flip a coin. BUT YOU KNOW
something about the TIME VALUE OF MONEY. Waiting to get that last $17,000 takes three
years for B. In the third year A is generating $10,000 (A has more $ coming in sooner – in years
1 & 2). Conclusion using present value: A IS superior to B. But you wouldn’t make that
decision if you were only using payback and this gets us to the second major problem (con) with
p[payback: it ignores the time value of money!
Well if payback has these two fairly major problems, why use it at all? Two reasons: it’s fast
and it’s easy to understand (even your boss could get it). If you ever try to explain present
value to someone who has never had it – good luck!
So payback is often used as a first, quick test of a project, but how? The company will have a
rule that might say, “we will consider any project that has a payback of 5 years or less”.
Therefore any project that meets that 5 year rule will go one for additional scrutiny – it will now
meet NPV.
2
