Capital Budgeting Topics

Capital Budgeting Topics - Finance 4310 Capital Budgeting...

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1 Finance 4310 Capital Budgeting Topics Define Capital Budgeting “Capital” implies long term projects with Capital implies long term projects with lives greater than one year. • “Budgeting” implies making forecasts about future cash flows.
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2 Significance of Capital Budgeting to the Firm Capital projects typically involve large • Capital projects typically involve large investments. • Capital projects typically affect the firm for long periods of time. • Capital projects may fundamentally alter the way the firm does business. Capital Budgeting Techniques Payback • Payback •IRR •NPV •EVA
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3 Problems with the Payback Method 1 Does not consider cash flows that occur 1. Does not consider cash flows that occur after the payback period. 2. Does not consider time value of money. 3. Risk is not directly considered. Payback Examples Example 1: Initial Investment: $10,000 Year Project A Project B 1 $5,000 $2,000 2 $5,000 $2,000 3 $2,000 $50,000
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4 Payback Examples Example 2: Initial Investment: $10,000 Year Project A Project B 1 $9,000 $1,000 2 $1,000 $9,000 Normal Cash Flow Pattern • The project’s cash flows are used to calculate its NPV and IRR. A project that requires a single initial • A project that requires a single initial investment that is followed by a stream of inflows would have normal cash flows, that is, a single outflow followed by a stream of inflows. • Since outflows are negative and inflows are positive, the signs would be: - ++++++++++………. .+
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5 Independent Projects Projects are independent if acceptance or • Projects are independent if acceptance or rejection of one does not affect acceptance or rejection of the other. Mutually Exclusive Projects Mutually exclusive projects are not • Mutually exclusive projects are not independent. Acceptance of one precludes acceptance of the others. An example would be alternate methods of accomplishing the same task. If one is chosen from the group of competing projects, no others will be selected.
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6 NPV vs IRR If projects are independent and their cash • If projects are independent and their cash flows are normal, both NPV and IRR will yield a correct investment decision. • If projects are mutually exclusive and/or cash flows are non-normal, IRR may not yield a correct investment decision. NPV Profile NPV Cost of Capital IRR 0
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7 NPV Profiles for Mutually Exclusive Projects Project A NPV K X Project B IRR B Cost of Capital IRR A Slope of the NPV Profile A steep slope of the NPV profile is characteristic of a project with large cash flows late in the project. These large cash flows are penalized most by high discount rates because the discount factor has a large exponent.
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This note was uploaded on 02/24/2010 for the course FINA 4310 taught by Professor Impson during the Spring '10 term at North Texas.

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Capital Budgeting Topics - Finance 4310 Capital Budgeting...

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