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L
ECTURES
8
9
I
NTRODUCTION TO
N
ET
P
RESENT
V
ALUE
AND
C
APITAL
B
UDGETING
Reading: Chapter 7, Section 7.1
Chapter 8, Sections 8.18.4
Homework: Online problems, supplemental readings, study for
midterm.
Objectives:
Understand the Net Present Value Criterion and its importance
in evaluating corporate investments
Identify the information that is required to compute NPV
Identify the relevant, incremental cash flows of an investment
proposal
Evaluate an investment proposal using the NPV criterion given
a discount rate
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View Full Document W
HAT IS
C
APITAL
B
UDGETING
?
Capital budgeting is the decision making process for investment
decisions, i.e., deciding how much and what to invest in.
The most important decisions a corporation can make involve the
acquisition of longterm assets. (Sometimes called capital
budgeting
or strategic asset allocation.)
In what lines of business or activities should we invest?
What types of equipment should we acquire?
Should we replace our plant or equipment?
What other companies should be buy?
To make these decisions, we apply the valuation principle and law
of one price.
What is the market value of the project’s benefits?
What are the
costs?
If the benefit is bigger than the cost, we do it.
Net Present Value
is a dollar measure of the market value of an
investment's benefits less its costs.
Put another way, the net present value is the amount by which an
investment will increase the market value of the firm.
If a project has an NPV of $100,000, doing it would increase
the market value of the firm by $100,000.
W
HAT DOES
N
ET
P
RESENT
V
ALUE MEASURE
?
The market value of all financial claims on a firm equals the present
value of all current and future free cash flow.
Free Cash Flow
is the cash flow the firm generates that is
available to pay out to
all
investors, including
stockholders,
bondholders,
banks
and other creditors.
...
)
1
(
)
1
(
)
1
(
3
3
3
2
2
2
1
1
1
0
+
+
+
+
+
+
+
=
r
FCF
r
FCF
r
FCF
FCF
Value
Firm
Net present value measures the present value all of the changes in a
firm's current and future free cash flow.
Δ
means "change in"
Δ
(Firm Value)=
...
)
1
(
F
)
1
(
F
)
1
(
F
3
3
3
2
2
2
1
1
1
0
+
+
Δ
+
+
Δ
+
+
Δ
+
Δ
=
r
CF
r
CF
r
CF
FCF
NPV
Δ
FCF refers to incremental free cash flows.
(
Δ
FCF represents all
the changes in the firm's free cash
flows that result from the investment.)
r is the required return (or discount rate or cost of capital)
r
is the return that could be earned in the financial market
for investments with the same risk
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View Full Document EXAMPLE
You own a company that operates 5 Arby’s Roast Beef Sandwich
shops in Seattle.
The company generates free cash flow of $100,000
per year, and you expect to close your stores in 5 years.
Today
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This note was uploaded on 12/02/2009 for the course FIN 350 taught by Professor Schonlau during the Spring '08 term at University of Washington.
 Spring '08
 SCHONLAU
 Finance, Net Present Value

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