Chapter12 - Chapter 12 Capital Budgeting: Decision Criteria...

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  1 Chapter 12 Capital Budgeting:  Decision Criteria
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  2 Topics Overview and “vocabulary” Methods Payback, discounted payback NPV IRR, MIRR Profitability Index Unequal lives Economic life
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  3 What is capital budgeting? Analysis of potential projects. Long-term decisions; involve large  expenditures. Very important to firm’s future.
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  4 Steps in Capital Budgeting outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows.
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  5 Independent versus 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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  6 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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  7 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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  8 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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  9 Strengths  and Weaknesses  of Payback Strengths: Provides an indication of a project’s risk  and liquidity. Easy to calculate and understand. Weaknesses:  Ignores the TVM. Ignores CFs occurring after the payback  period.
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  10 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 PVCF t -100 -100 10% 9.09 49.59 60.11 = Recover invest. + cap. costs in 2.7 yrs. Discounted Payback: Uses  discounted rather than raw CFs.
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  11 NPV: Sum of the PVs of all  cash flows. Cost often is CF 0 and is negative. NPV = n t = 0 CF t (1 + r) t . NPV = n t = 1 CF t (1 + r) t . - CF 0 .
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  12 What’s Franchise L’s NPV? 10 80 60 0 1 2 3 10% L’s CFs: -100.00 9.09 49.59 60.11 18.79 = NPV L NPV S = $19.98.
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  13 Calculator Solution: Enter  values in CFLO register 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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  14 Rationale for the NPV Method NPV =  PV inflows – Cost  This is net gain in wealth, so accept  project if NPV > 0. Choose between mutually exclusive  projects on basis of higher NPV.  Adds  most value.
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15 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; 
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This note was uploaded on 04/27/2008 for the course FINC 3333 taught by Professor Melissawilliams during the Spring '08 term at UH Clear Lake.

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Chapter12 - Chapter 12 Capital Budgeting: Decision Criteria...

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