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Sess0811 new - Lecture 8-11 Capital Budgeting Reading RWJ...

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FIN 3715 - Fall 07 - Kayhan 1 Lecture 8-11: Capital Budgeting Reading: RWJ Chapters 2 and 3 Chapters 9, 10, and 11 Outline : Separation Principle. Net Present Value (NPV) Determining Project Cash Flows Project interactions Other Investment Rules
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FIN 3715 - Fall 07 - Kayhan 2 Corporate Objective Suppose you are at a GM shareholder’s meeting. Three shareholders in particular are quite vocal about what the firm should do. An old man wants a safe return on his money: he wants GM to focus on existing business and stop developing new cars A little child’s trust fund representative wants money a long way in the future: he wants GM to invest in developing electric cars. A mother concerned about her child’s education wants money at some specific time in the future (say 10 years): she wants GM to build small cars because experts forecast a sharp rise in oil price during this time. What do you think GM’s managers should do?
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FIN 3715 - Fall 07 - Kayhan 3 Capital Budgeting and the NPV Rule Capital budgeting is the process of determining which projects (real assets) to invest in. The NPV rule states that managers should consider ONLY the NPV and accept ALL projects with positive NPV in making capital budgeting decisions.
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FIN 3715 - Fall 07 - Kayhan 4 Why the NPV Rule? The NPV rule maximizes firm value and shareholder wealth NPV tells us, in today’s dollars, the extent to which a projects expected cash inflows surpass the expected cash outflows. All positive NPV projects create wealth. That is, in present value terms, they are worth more than they cost.
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FIN 3715 - Fall 07 - Kayhan 5 Why (just) Maximize Shareholder Value? Shareholders are concerned about three things: 1. Increasing their wealth 2. Timing their consumption 3. Managing their exposure to risk Shareholders can use capital markets to address (2)-(3), leaving the corporation to focus on (1). Consumption timing handled via borrowing and lending. Risk adjustments handled via portfolio selection.
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FIN 3715 - Fall 07 - Kayhan 6 A Word of Caution The NPV rule depends on the assumption of a perfectly competitive capital market, specifically, no barriers preventing access to the capital market no distorting taxes and frictions individuals can borrow and lend at the same rate. Although the assumptions are not exactly satisfied, the NPV rule provides a benchmark for further analysis there is reliable evidence that the U.S.capital market functions fairly well.
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FIN 3715 - Fall 07 - Kayhan 7 Capital Budgeting Steps The main ingredient of capital budgeting is project valuation. We value projects just like we value everything else (e.g., bonds and stocks): 1. Estimate the cash flows (inflows and outflows). 2. Determine the appropriate cost of capital (i.e., the discount rate).
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