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Ch 11 - Chapter11 TheBasicsofCapital Budgeting...

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  1 Chapter 11 The Basics of Capital  Budgeting:  Evaluating Cash Flows
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  2 Topics Overview and “vocabulary” Methods NPV IRR, MIRR Profitability Index Payback, discounted payback Unequal lives Economic life
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  3 What is capital budgeting? Analysis of potential projects. Long-term decisions; involve large  expenditures. Very important to firm’s future.
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  4 Steps in Capital Budgeting Estimate cash flows (inflows &  outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows.
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  5 Independent versus Mutually  Exclusive Projects Projects are: independent, if the cash flows of one are  unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one  can be adversely impacted by the  acceptance of the other.
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  6 Cash Flows for Franchise L  and Franchise S 10 80 60 0 1 2 3 10% L’s CFs: -100.00 70 20 50 0 1 2 3 10% S’s CFs: -100.00
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  7 NPV: Sum of the PVs of all  cash flows. Cost often is CF 0 and is negative. NPV = n t = 0 CF t (1 + r) t . NPV = n t = 1 CF t (1 + r) t . - CF 0 .
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  8 What’s Franchise L’s NPV? 10 80 60 0 1 2 3 10% L’s CFs: -100.00 9.09 49.59 60.11 18.79 = NPV L NPV S = $19.98.
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  9 Calculator Solution: Enter  values in CFLO register for L. -100 10 60 80 10 CF 0 CF 1 NPV CF 2 CF 3 I = 18.78 = NPV L
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  10 Rationale for the NPV Method NPV =  PV inflows – Cost  This is net gain in wealth, so accept  project if NPV > 0. Choose between mutually exclusive  projects on basis of higher NPV.  Adds  most value.
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  11 Using NPV method, which  franchise(s) should be accepted? If Franchise S and L are mutually  exclusive, accept S because NPV s  >  NPV L  . If S & L are independent, accept both;  NPV > 0.
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  12 Internal Rate of Return:  IRR 0 1 2 3 CF 0 CF 1 CF 2 CF 3 Cost Inflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.
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  13 NPV:  Enter r, solve for NPV. IRR: Enter NPV = 0, solve for IRR. = NPV n t = 0 CF t (1 + r) t . = 0 n t = 0 CF t (1 + IRR) t .
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  14 What’s Franchise L’s IRR? 10 80 60 0 1 2 3 IRR = ? -100.00 PV 3 PV 2 PV 1 0 = NPV Enter CFs in CFLO, then press IRR: IRR L = 18.13%. IRR S = 23.56%.
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  15 40 40 40 0 1 2 3 -100 Or, with CFLO, enter CFs and press IRR = 9.70%. 3 -100 40 0 9.70% N I/YR PV PMT FV INPUTS OUTPUT Find IRR if CFs are constant:
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  16 Rationale for the IRR Method If IRR > WACC, then the project’s rate  of return is greater than its cost-- some  return is left over to boost stockholders’  returns. Example: WACC = 10%, IRR = 15%. So this project adds extra return to  shareholders.
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  17 Decisions on  Projects S and  L per IRR If S and L are independent, accept both:   IRR S  > r and IRR L  > r.
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