Lecture Note 3 (Ch6) - LectureNote3 Chapter6...

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    Lecture Note 3 Chapter 6
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    Some alternative investment rules From this handout we will start learning  “capital budgeting”, the decision-making  process of accepting or rejecting project. The most useful decision rule is the net present  value (NPV) rule where project is accepted  when the net present value of the cash flow of  the project is positive, and rejected if it is  negative.                                       See next page
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    Some alternative investment rules  (contd) Although NPV rule is our preferred rule, there  are other investment rules that are used in  practices. These alternative investment rules  had been used for several reasons: These  alternative rules may be easy to calculate, may  be easy to understand, or may be used simply  because it have been conventionally used.
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    Some alternative investment rules  (contd) In this handout, we will learn some  alternative investment rules. - First, this handout summarizes some reason  we may prefer NPV rules. Then, it will  explain 1. Payback Period Rule 2. Average accounting return rule 3. The internal rate of return 4. Profitability Index
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    Why use Net Present Value? A basic investment rule is to Accept the project if the NPV is greater than  zero Reject the project if NPV is less than zero.
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    Why use Net Present Value?  (Contd) First reason we prefer NPV rule is that accepting positive  NPV projects benefits the stockholders. Suppose that a firm  has a productive asset worth $V and has $100 of cash.   Consider the following two strategies. The market interest  rate is 0.06 (1) Use $100 of corporate cash to invest in the project. The  $107 dividend will be paid as a dividend in one year. (2) Forgo the project and pay the $100 of corporate cash as a  dividend today.                            See next slide
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    Why use Net Present Value?  (Contd) If the firm takes strategy (1), the value of the firm  today will be                  $V+$107/1.06=$V+$100.94                                      If the firm takes the strategy (2), the value of the firm  today will be                  $V+$100  Clearly the firm value for strategy (1) is greater than  the firm value for strategy (2) by the amount equal to  the net present value of the project ($0.94). Thus,  accepting the positive NPV project will benefit the  shareholder.
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    Why use Net Present Value?  (Contd) Second reason we prefer the NPV rule is that,  the firm value will increase by the NPV. This  can be seen from the example in the previous 
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Lecture Note 3 (Ch6) - LectureNote3 Chapter6...

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