ch.11 notes - CHAPTER 11 The Basics of Capital Budgeting...

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CHAPTER 11 The Basics of Capital Budgeting Fin 300 E. Johnson Should we build this plant?
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What is capital budgeting ? Analysis of potential additions to fixed assets. (replacement projects, cost- reduction projects, expansion of product lines, new products projects, new areas,etc…) Long-term decisions (5 to 10 years); involve large expenditures. Very important to firm’s future.
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Steps to capital budgeting Estimate CFs Assess riskiness of CFs. Determine the appropriate cost of capital. Find NPV and/or IRR . Accept if NPV > 0 and/or IRR > WACC .
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What is the difference between independent and mutually exclusive projects? Independent projects – if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.
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What is the difference between normal and nonnormal cash flow streams? Normal cash flow stream – Cost ( one negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal cash flow stream Two or more changes of signs . Most common: Cost (negative CF), then string of positive CFs, then cost to close project. (e.g. Nuclear power plant, strip mine, etc.)
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Net Present Value ( NPV ) A method of ranking investments proposals using the NPV, which is equal to the present value of future net cash flows , discounted at the cost of capital Sum of the PVs of all cash inflows and outflows of a project: = + = N 0 t t t ) r 1 ( CF NPV
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Rationale for the NPV method NPV = PV of inflows – Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are
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This note was uploaded on 05/10/2008 for the course FIN 300 taught by Professor Cindychen during the Spring '07 term at CSU Long Beach.

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ch.11 notes - CHAPTER 11 The Basics of Capital Budgeting...

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