AF3313 - Lecture 3

# AF3313 - Lecture 3 - AF 3313 – Business Finance Lecture 3...

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AF 3313 Business Finance Lecture 3 Investment Rules

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1 Some decisions to be made Remember in Lecture 1, we learned that there are three decisions that every financial manager has to make: 1. Capital Budgeting 2. Capital Structure 3. Working Capital Management Let s first consider Capital Budgeting . What is the aim of a capital budgeting decision? How can we make the best capital budgeting decision?
2 Good Decision Criteria We can consider a capital budgeting decision as some kind of project selection decision. To select the best project, we need to ask ourselves the following questions when evaluating capital budgeting decision rules 1. Does the decision rule adjust for the time value of money? 2. Does the decision rule adjust for risk? 3. Does the decision rule provide information on whether we are creating value for the firm?

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3 Investment criteria There are several methods we can select project with: 1. Net Present Value (NPV) 2. Payback Period 3. Discounted Payback Period 4. Average Accounting Return (AAR) 5. Internal Rate of Return (IRR) 6. Profitability Index (PI) Each methodology has its own advantages and disadvantages, but which one do you think is the best?
4 An Example You are looking at a new project and you have estimated the following cash flows: Year 0: CF = -165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000 Your required return for assets of this risk is 12%.

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5 Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment.
6 NPV Decision Rule If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

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7 Computing NPV for the Project NPV = 63,120/(1.12) + 70,800/(1.12) 2 + 91,080/(1.12) 3 165,000 = 12,627.41 Do we accept or reject the project?
8 Decision Criteria Test - NPV Does the NPV rule account for the time value of money? Does the NPV rule account for the risk of the cash flows? How? Does the NPV rule provide an indication about the increase in value? Should we consider the NPV rule for our primary decision rule?

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9 Payback Period (Undiscounted) How long does it take to get the initial cost back in a nominal sense? Computation Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Rule Accept if the payback period is less than some preset limit
10 Computing Payback Assume we will accept the project if it pays back within two years.

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