11 The Basics of Capital Budgeting

11 The Basics of Capital Budgeting - 11 - 1 CHAPTER 11 The...

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11 - 1 Should we build this plant? CHAPTER 11 The Basics of Capital Budgeting
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11 - 2 What is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future.
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11 - 3 Steps 1. 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.
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11 - 4 An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river.
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11 - 5 Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.
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11 - 6 Inflow (+) or Outflow (-) in Year 0 1 2 3 4 5 N NN - + + + + + N - + + + + - NN - - - + + + N + + + - - - N - + + - + - NN
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11 - 7 What is the payback period? The number of years required to recover a project’s cost, or how long does it take to get the business’s money back?
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11 - 8 Payback for Project L (Long: Most CFs in out years) 10 80 60 0 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback L 2 + 30/80 = 2.375 years 0 100 2.4
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11 - 9 Project S (Short: CFs come quickly) 70 20 50 0 1 2 3 -100 CF t Cumulative -100 -30 20 40 Payback S 1 + 30/50 = 1.6 years 100 0 1.6 =
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11 - 10 Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the TVM. 2. Ignores CFs occurring after the payback period.
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10 80 60 0 1 2 3 CF t Cumulative -100 -90.91 -41.32 18.79 Discounted payback 2 + 41.32/60.11 = 2.7 yrs Discounted Payback: Uses discounted rather than raw CFs. PVCF
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This note was uploaded on 04/24/2010 for the course FIN 4414 taught by Professor Staff during the Spring '08 term at University of Florida.

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11 The Basics of Capital Budgeting - 11 - 1 CHAPTER 11 The...

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