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Course 2: Capital Budgeting Analysis
Chapter 3: Three Economic Criteria for Evaluating Capital ProjectsWe have completed our three main stages of capital budgeting analysis, including the calculation of discounted cash flows. The next step is to apply some economic criteria for evaluating the project. We will use three criteria: Net Present Value, Modified Internal Rate of Return, and Discounted Payback Period.
Net Present ValueThe first criterion we will use to evaluate capital projects is Net Present Value. Net Present Value (NPV) is the total net present value of the project. It represents the total value added or subtracted from the organization if we invest in this project. We can refer back to our previous example and calculate Net Present Value.
If the Net Present Value is positive, we should proceed and make the investment. If the Net Present Value is negative (as is the case in Example 10), then we would not make the investment.
Modified Internal Rate of ReturnBesides determining the Net Present Value of a project, we can calculate the rate of return earned by the project. This is called the Internal Rate of Return. Internal Rate of Return (IRR) is one of the most popular economic criteria for evaluating capital projects since managers can identify with rates of return. Internal Rate of Return is calculating by finding the discount rate whereby the Net Investment amount equals the total present value of all cash inflows; i.e. Net Present Value = 0. If we have equal cash inflows each year, we can solve for IRR easily.
If the Internal Rate of Return were higher than our cost of capital, then we would accept this project. In our example, the IRR (6.43%) is less than our cost of capital (12%). Therefore, we would not invest in this project. One of the problems with IRR is the so-called reinvestment rate assumption. IRR makes the assumption that every year you will be able to earn the IRR each time you reinvest your cash inflows. This assumption can result in some major distortions between Net Present Value and Internal Rate of Return. We will correct this distortion by modifying our IRR calculation.
In order to eliminate the reinvestment rate assumption, we will modify the Internal Rate of Return so that the reinvestment rate is our cost of capital. This will give us a more accurate IRR for our project. Fortunately, we can use spreadsheets like Microsoft Excel to calculate Modified Internal Rate of Return.
Discounted Payback PeriodThe final economic criteria we will use is the Discounted Payback Period. Payback refers to the number of years it takes to recover our net investment. In our previous example (Example 6), we could use a simple payback calculation as follows:
$ 24,100 / $ 5,788 = 4.2 years
However, this method does not recognize the time value of money and as we previously indicated, we must consider the time value of money because of inflation, uncertainty, and opportunity costs. Therefore, we will use the discounted cash flows to calculate the payback period (discounted payback period).
Under the Discounted Payback Period, we would never receive a payback on our project; i.e. the total to date present cash flows never reached $ 24,100 (net investment). If we had relied on the regular payback calculation, we would falsely assume that this project does payback in the fourth year.
In summary, we use economic criteria that have realistic economic assumptions about capital investments. Three economic criteria that meet this test are:
- Net Present Value
- Modified Internal Rate of Return
- Discounted Payback Period
Chapter 3 pointsNet Present Value
Modified Internal Rate of Return
Discounted Payback Period