INSTRUCTOR MANUAL
Instructor’s Manual for Principles of Finance
03/21/22 1
, Instructor’s Manual for Principles of Finance
Chapter 16
How Companies Think about Investi ng
Chapter Summary
Capital budgeting is the process by which firms make capital expenditure decisions. This
chapter concerns itself with what methods and criteria are used by firms to make those
decisions.
Lecture Outline
16.1 Payback Period Method
Capital expenditures involve an investment up front (a negative cash flow) followed by positive
cash inflows (representing the benefits of the investment).
To calculate an investment’s payback period, take the initial investment and accumulate the net
cash flows from the investment year by year: net the negative cash flows and the positive cash
flows cumulatively until you can determine when the cumulative cash flows turn zero.
This would be the amount of time it will take for the investment to pay back the initial
investment. Sometimes this calculation generates fractional years.
Issues with Using the Payback Method
The payback method appeals to one’s intuition in terms of what they believe a good investment
should look like. It does have its flaws:
The payback method does not take into account Time Value of Money. Future dollars
are given the same weight as present-day dollars.
The payback method does not provide an objective way of determining when the
payback is adequate.
The payback method ignores cash flows generated after the payback and will favor
investments with strong up-front cash flows as opposed to those that generate more
cash flows further out.
16.2 Net Present Value (NPV) Method
The net present value method sums the present values of all investment cash flows (both
negative and positive) over the project’s lifetime and generates a value that is either negative
or positive.
NPV =PV ( Cash Inflows )−PV ( CashOutflows )
Sum the present values of the individual future cash flows at a chosen discount rate, netting
positive and negative cash flows.
The i, or discount rate, is determined as the minimum acceptable rate of return for the
investment. The resultant sum is the net present value of the investment.
The decision to invest in the project or not is determined by the value of the NPV.
03/21/22 2
Instructor’s Manual for Principles of Finance
03/21/22 1
, Instructor’s Manual for Principles of Finance
Chapter 16
How Companies Think about Investi ng
Chapter Summary
Capital budgeting is the process by which firms make capital expenditure decisions. This
chapter concerns itself with what methods and criteria are used by firms to make those
decisions.
Lecture Outline
16.1 Payback Period Method
Capital expenditures involve an investment up front (a negative cash flow) followed by positive
cash inflows (representing the benefits of the investment).
To calculate an investment’s payback period, take the initial investment and accumulate the net
cash flows from the investment year by year: net the negative cash flows and the positive cash
flows cumulatively until you can determine when the cumulative cash flows turn zero.
This would be the amount of time it will take for the investment to pay back the initial
investment. Sometimes this calculation generates fractional years.
Issues with Using the Payback Method
The payback method appeals to one’s intuition in terms of what they believe a good investment
should look like. It does have its flaws:
The payback method does not take into account Time Value of Money. Future dollars
are given the same weight as present-day dollars.
The payback method does not provide an objective way of determining when the
payback is adequate.
The payback method ignores cash flows generated after the payback and will favor
investments with strong up-front cash flows as opposed to those that generate more
cash flows further out.
16.2 Net Present Value (NPV) Method
The net present value method sums the present values of all investment cash flows (both
negative and positive) over the project’s lifetime and generates a value that is either negative
or positive.
NPV =PV ( Cash Inflows )−PV ( CashOutflows )
Sum the present values of the individual future cash flows at a chosen discount rate, netting
positive and negative cash flows.
The i, or discount rate, is determined as the minimum acceptable rate of return for the
investment. The resultant sum is the net present value of the investment.
The decision to invest in the project or not is determined by the value of the NPV.
03/21/22 2
