slides16 - 16. Capital budgeting: Decision criteria Recall...

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Unformatted text preview: 16. Capital budgeting: Decision criteria Recall that there are three main issues in corporate finance: capital budgeting capital structure working capital management In this chapter we begin to look at the issue of capital budgeting. Introduction Given limited resources, a firm must decide whether a particular investment is worth undertaking. There are various approaches to assessing potential investments: Net present value Internal rate of return Payback rule Discounted payback Average accounting return Profitability index Each has its own advantages and disadvantages. 2 Net present value Computing NPV: Take all estimated cash flows for the investment (both costs and revenues) Compute present value of each Add them up Accept project if NPV is positive. This approach is also known as discounted cash flow val- uation . The choice of discount rate can be used to adjust for risk Often regarded as the best approach. 3 Example Agroproducts Corp. is considering investing in a new fertilizer fac- tory. They estimate Initial investment is $30,000 Cash revenues of $20,000 per year Cash costs (including taxes) of $13,000 per year After 8 years, after-tax salvage value of factory is $2000 What is the NPV (use 15% discount rate)? Is this a good investment? 4 Example continued Year Cash flow-30,000 1 7,000 2 7,000 3 7,000 4 7,000 5 7,000 6 7,000 7 7,000 8 9,000 NPV = 5 Remarks Positive NPV means that accepting the project will add value to the firm and thus increase the wealth of the own- ers. Since the goal of the corporation is to increase owner wealth, NPV is a direct measure of how well this project will ac- complish that goal. Once the cash flows and discount rate have been determined, the mechanical job of computing NPV is easy. The important (and difficult) part of the task is coming up with realistic estimates for the cash flows and an appropri- ate discount rate. 6 In the real world ... Although NPV is a valuable tools, care must be exercised in its use, since there are many important factors that are difficult to quantify . Recall that in a perfectly competitive economy there should be no positive NPV projects!! Therefore, positive NPV projects must be predicated on some market imperfection . It is a good idea to try to identify the imperfection and think about how realistic the NPV projections are. 7 Market imperfections Examples of potentially exploitable market imperfections include: the firm has patents or proprietary technology (e.g., drug companies, software companies) first entrant into a market with a product meeting some previously unidentified need exceptionally well-organized, well-trained, or well-motivated work force 8 Internal rate of return The IRR is the discount rate at which NPV=0. Accept the project if the IRR is greater than some target....
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This note was uploaded on 03/31/2008 for the course FNCE 3010 taught by Professor Donchez,ro during the Fall '07 term at Colorado.

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slides16 - 16. Capital budgeting: Decision criteria Recall...

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