Chapter 9 - 1 BA 3341 Business Finance Nataliya...

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Unformatted text preview: 1 BA 3341 Business Finance Nataliya Polkovnichenko, Senior Lecturer 2 • The role of financial managers is to make capital budgeting (investment) decisions (spending money) and financing decisions (raising money): – How does the manager decide whether or not to invest in a particular project/real asset? – How is the investment decision made when the manager is faced with several projects and limited resources? • These issues will be dealt with in Chapters 9, 10 . 3 • Northwest Airline buys 6 new planes at $60 million per plane. • Marriott plans to invest $30 million in a new hotel in Paris. 4 Common Methods to Evaluate Investment Projects: – Net Present Value (best evaluation method ) – Internal Rate of Return (IRR) – Payback Method (discounted Payback Rule) • Capital Rationing (when resources are limited) • Project Interactions (when acceptance of one project might affect another one) 5 Capital Budgeting – Basics • Four Steps in the Capital Budgeting Process: – Forecast cash flows of the project. Essential step. – Select an appropriate discount rate. – Apply an evaluation technique. – Determine the selected alternative and implement. • For now we will focus on the last two steps and evaluate various techniques. • We will have more to say about the first two steps later in this course (ch10). 6 • Opportunity Cost of Capital (OCC) is the discount rate used to find the present value of cash flows from the project. • Definition – The expected rate of return offered by other equally risky investments • It is the expected rate of return given up by investing in the project. 7 • Depending on the application, the discount rate is referred to by many names. When valuing bonds the term used is Yield to Maturity . When valuing stocks the term used is Expected/Required Rate of Return . When valuing projects the term used is Opportunity Cost of Capital/Required Return . 8 • Generally, the more uncertain the cashflows of a particular project/security the higher the risk . • The higher the risk , the higher the opportunity cost of capital. • Restated, the riskier the cashflows of a security or a project, the larger the value of the discount rate. • Therefore, riskier projects/securities have lower present values than less risky projects/securities with the same expected cash flows. • Measuring or estimating risk will be covered in later chapters. For now we will merely specify the required 8 • Generally, the more uncertain the cashflows of a particular project/security the higher the risk . • The higher the risk , the higher the opportunity cost of capital. • Restated, the riskier the cashflows of a security or a project, the larger the value of the discount rate....
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This note was uploaded on 11/24/2009 for the course BA 3341 taught by Professor Polkovnichenko during the Fall '08 term at University of Texas at Dallas, Richardson.

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Chapter 9 - 1 BA 3341 Business Finance Nataliya...

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