AEM324 - Capital Budgeting Ch4_Notes

# AEM324 - Capital Budgeting Ch4_Notes - Capital Budgeting As...

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Capital Budgeting As agents of the owners, managers should seek to increase stock price; however cash flows are even more important -as an expression of economic value of the shareholders’ stake in the firm, the stock price represents the markets’ consensus opinion of the present value of cash flows they are entitled to by virtue of their equity participation -firms should evaluate investments on the basis of prospective cash flows (differ with regard to timing and riskiness) Three basic cash flow patterns -conventional (-+++), an expenditure followed by a series of cash inflows -loan (+---), a receipt of funds followed by a series of cash outflows -non-conventional (-++- or +--+), at least two sign changes Measures to Evaluate Investment Acceptability 1. Payback -for a conventional investment, payback is the time when the sum of all preceding cash inflows equals the initial expenditure Absolute value (CF at time 0) = Sum of CF at time t, t <= t of payback Advantages: Easy to understand, can serve as a control (a large payback period can act as a warning signal) Disadvantages: It ignores the timing of cash flows and the cash flows after the payback period 2. Discounted Payback -for a conventional investment, discounted payback is the time when the sum of the present values of all the preceding cash flows equals the initial expenditure Absolute value (CF at time 0) = Sum of CF at time t/(1+r)^t, t <= t of discounted payback 3. Average Accounting Return -usually calculated by dividing some measure of average net income over the life of the project by some measure of average book value of assets of the life of the project 4. Net Present Value -the sum of the present values of all the investment cash flows; the present value of the cash inflows net of the present value of the cash outflows NPV = CF at time 0 + CF1/(1+r) + CF2/(1+r)^2 + CFt/(1+r)^t

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