Chapter 09 IM 10th Ed

Chapter 09 IM 10th Ed - CHAPTER 9 Capital Budgeting...

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CHAPTER 9 Capital Budgeting Decision Criteria CHAPTER ORIENTATION Capital budgeting involves the decision making process with respect to the investment in fixed assets; specifically, it involves measuring the incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project's costs. This chapter focuses on the various decision criteria. CHAPTER OUTLINE I. Methods for evaluating projects A. The payback period method 1. The payback period of an investment tells the number of years required to recover the initial investment. The payback period is calculated by adding the cash inflows up until they are equal to the initial fixed investment. 2. Although this measure does, in fact, deal with cash flows and is easy to calculate and understand, it ignores any cash flows that occur after the payback period and does not consider the time value of money within the payback period. 3. To deal with the criticism that the payback period ignores the time value of money, some firms use the discounted payback period method. The discounted payback period method is similar to the traditional payback period except that it uses discounted free cash flows rather than actual undiscounted free cash flows in calculating the payback period. 4. The discounted payback period is defined as the number of years needed to recover the initial cash outlay from the discounted free cash flows. 226

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B. Present-value methods 1. The net present value of an investment project is the present value of its free cash flows less the investment’s initial outlay NPV = t t n 1 t k) (1 FCF + = - IO where: FCF t = the annual free cash flow in time period t (this can take on either positive or negative values) k = the required rate of return or appropriate discount rate or cost of capital IO = the initial cash outlay n = the project's expected life a. The acceptance criteria are accept if NPV 0 reject if NPV < 0 b. The advantage of this approach is that it takes the time value of money into consideration in addition to dealing with cash flows. 2. The profitability index is the ratio of the present value of the expected future free cash flows to the initial cash outlay, or profitability index = IO k) (1 FCF t t n 1 t + = a. The acceptance criteria are accept if PI 1.0 reject if PI < 1.0 b. The advantages of this method are the same as those for the net present value. c. Either of these present-value methods will give the same accept-reject decisions to a project. 227
C. The internal rate of return is the discount rate that equates the present value of the project's future net cash flows with the project's initial outlay. Thus the internal rate of return is represented by IRR in the equation below: IO = t t n 1 t IRR) (1 FCF + = 1. The acceptance-rejection criteria are: accept if IRR required rate of return reject if IRR < required rate of return The required rate of return is often taken to be the firm's cost of capital. 2.

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Chapter 09 IM 10th Ed - CHAPTER 9 Capital Budgeting...

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