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BCOR 2200 Chapter 8

BCOR 2200 Chapter 8 - Chapter 8 Net Present Value Other...

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1 Chapter 8 Net Present Value & Other Investment Criteria
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2 We’re starting a new section of the Course: Section 1 – Overview Ch 1: Intro Section 2 – Financial Statements and CFs Ch 2: Financial Statements and CF definitions Ch 3: Ratios Section 3 – Valuation of future CFs Ch 4: Intro to TVM (Single CFs) Ch 5: More TVM (Multiple CFs) Section 4 – Stocks and Bonds Ch 6: Bonds Ch 7: Stocks Section 5 – Capital Budgeting
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3 Capital Budgeting is… Budgeting the firm’s capital Spending the big money Not small, short-term money The light bill, salaries, office supplies… But BIG, long-term money Which are called capital expenditures This is the “I” in GDP = C + I + G +(X – M) So if a firms sells stocks, sells bonds, retains earnings… What does it do with the money?
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4 Here’s the idea: Capital budgeting is about ADDING VALUE to the firm To pay for capital investments, a firm can sell stocks, sell bonds or retain earnings. But SHOULD a firm sell stocks, sell bonds or retain earnings? Does it have something worthwhile to do with the money? Does it have good capital projects? If not, don’t sell stocks, don’t sell bonds, don’t retain earnings. (Pay dividends instead) Capital Budgeting is all about “ Net Present Value " Called NPV
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5 Here’s how NPV analysis works: The decision rule: If the Net Present Value is positive Then the project adds value So invest the capital (or “budget” the capital) NPV is: The PV of all the project’s future cash flows – CF 1 , CF 2 , CF 3 , … Discounted at the proper discount rate Plus the initial, time 0 cash flow Call this CF 0 If the PV of the cash flows is greater than the cost: Then the NPV > 0 The project adds value Spend $100 for something worth more than $100 (in PV terms) The do the project
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6 More about how to think about NPV: Think about paying $1,000 today for “something” (a bond, an annuity, a truck, a machine…) That “something” will pay a net of $400 per year for the next 3 years The proper discount rate is 10% So pay $1,000 now for $400 at time 1, 2 and 3. Is it a good deal? First we have to get all the CFs to the same time period (we will use time zero) So take the PV of all the CFs Since all CFs are the same, use the TVM function: N = 3, R = 10%, PMT = $400, FV = 0, PV = $995 So pay $1,000 today to get CFs that are worth only $995 We would be loosing $5 in present value terms NPV = -$5 So don’t do it!
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7 Chapter Outline: 1. Net Present Value How to calculate NPV How to interpret NPV 2. Other Rules: Payback Rule Average Accounting Return Internal Rate of Return (IRR) Profitability Index 3. Why the other rules suck: Really why the other rules are “flawed” 4. Positive CF rules (used only for start-ups): Debt service rules: Sell enough to pay our interest expense?
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