Lectures8and9 - LECTURES 8 & 9 INTRODUCTION TO NET PRESENT...

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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 8.1-8.4 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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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 long-term 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.
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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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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.

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Lectures8and9 - LECTURES 8 & 9 INTRODUCTION TO NET PRESENT...

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