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FM11 Ch 10 Show - 10 1 Chapter 10 The Basics of Capital...

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10 - 1 Chapter 10: The Basics of Capital Budgeting: Evaluating Cash Flows Overview and “vocabulary” Methods Payback, discounted payback NPV IRR, MIRR Profitability Index Unequal lives Economic life
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10 - 2 What is capital budgeting? Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to firm’s future.
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10 - 3 Steps in Capital Budgeting Estimate cash flows (inflows & outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows.
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10 - 4 What is the difference between independent and mutually exclusive projects? Projects are: independent , if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive , if the cash flows of one can be adversely impacted by the acceptance of the other.
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10 - 5 What is the payback period? The number of years required to recover a project’s cost, or how long does it take to get the business’s money back?
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10 - 6 Payback for Franchise L (Long: Most CFs in out years) 10 80 60 0 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback L 2 + 30/80 = 2.375 years 0 100 2.4
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10 - 7 Franchise S (Short: CFs come quickly) 70 20 50 0 1 2 3 -100 CF t Cumulative -100 -30 20 40 Payback S 1 + 30/50 = 1.6 years 100 0 1.6 =
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10 - 8 Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the TVM. 2. Ignores CFs occurring after the payback period.
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10 - 9 10 80 60 0 1 2 3 CF t Cumulative -100 -90.91 -41.32 18.79 Discounted payback 2 + 41.32/60.11 = 2.7 yrs Discounted Payback: Uses discounted rather than raw CFs. PVCF t -100 -100 10% 9.09 49.59 60.11 = Recover invest. + cap. costs in 2.7 yrs.
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10 - 10 ( 29 . 1 0 t t n t r CF NPV + = = NPV: Sum of the PVs of inflows and outflows. Cost often is CF 0 and is negative. ( 29 . 1 0 1 CF r CF NPV t t n t - + = =
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10 - 11 What’s Franchise L’s NPV? 10 80 60 0 1 2 3 10% Project L: -100.00 9.09 49.59 60.11 18.79 = NPV L NPV S = $19.98.
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10 - 12 Calculator Solution Enter in CFLO for L: -100 10 60 80 10 CF 0 CF 1 NPV CF 2 CF 3 I = 18.78 = NPV L
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10 - 13 Rationale for the NPV Method NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
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10 - 14 Using NPV method, which franchise(s) should be accepted? If Franchise S and L are mutually exclusive, accept S because NPV s > NPV L . If S & L are independent, accept both; NPV > 0.
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10 - 15 Internal Rate of Return: IRR 0 1 2 3 CF 0 CF 1 CF 2 CF 3 Cost Inflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.
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10 - 16 ( 29 .
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