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Unformatted text preview: 1 Chapter 8 Net Present Value & Other Investment Criteria 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 3 Capital Budgeting is… • Budgeting the firm’s capital • Spending the big money • Not small, shortterm money – The light bill, salaries, office supplies… • But BIG, longterm 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? 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 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 • 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 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! 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 startups): – Debt service rules: Sell enough to pay our interest expense?...
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This note was uploaded on 03/17/2009 for the course BCOR 2200 taught by Professor Tomnelson during the Fall '08 term at Colorado.
 Fall '08
 TOMNELSON

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