PPT Ch 4 Capital Budgeting

PPT Ch 4 Capital Budgeting - Capital Budgeting Investment...

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Capital Budgeting Investment Decision Rules and Capital Budgeting in Practice
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Capital Budgeting 0 Capital Budgeting Capital budget: lists all of the projects that a company plans to undertake during the next period. Capital budgeting: the process of analyzing investment opportunities and deciding which ones to accept.
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Capital Budgeting 0 Net Present Value (NPV) How much (net) value is created from undertaking an investment? Most firms measure values in terms of NPV– the difference between the market value of a project and its cost Or: required return should reflect the risk level of the project NPV = PV (Benefits) – PV (Costs)
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Capital Budgeting 0 NPV and Goal of Financial Management A project with positive NPV means the project is expected to add value, therefore increase the wealth of the shareholders Since the goal of financial managers is to increase the wealth of shareholders, managers should accept all projects with positive NPV, if resources allow Take the alternative with the highest NPV (competing projects) if resources are limited Reject negative-NPV projects
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Capital Budgeting 0 Using the NPV Rule A take-it-or-leave-it decision: A fertilizer company can create a new environmentally friendly fertilizer at a large savings over the company’s existing fertilizer. The fertilizer will require a new factory that can be built at a cost of $81.6 million. Estimated return on the new fertilizer will be $28 million after the first year, and last four years. The company’s cost of capital is 10%.
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NPV of Fredrick’s New Project Capital Budgeting 0
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Alternative Decision Rule: Internal Rate of Return The NPV depends on cost of capital. Based on this data the NPV is positive only when the discount rates are less than 14%. At 14%, NPV =0 IRR: rate of return s.t. NPV = 0 IRR helps determine how sensitive NPV analysis is to cost of capital estimate IRR decision rule: Take any investment opportunity where IRR exceeds the opportunity cost of capital; turn down any opportunity whose IRR < cost of capital. Capital Budgeting 0
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Capital Budgeting 0 Weakness in IRR In most cases (stand- alone projects with negative cash flows preceding positive cash flows) IRR rule agrees with NPV. In other cases IRR may disagree with NPV.
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