MGMT_130_Lecture_8_Notes

MGMT_130_Lecture_8_Notes - MGMT 130 Lecture 8 Net Present...

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MGMT 130 Lecture 8 Net Present Value and Capital Budgeting Decision Rules
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NPV Analysis The recommended approach to any significant capital budgeting decision is NPV analysis. NPV = PV of the incremental benefits – PV of the incremental costs. When evaluating independent projects, take a project if and only if it has a positive NPV. When evaluating interdependent projects, take the feasible combination with the highest total NPV. The NPV rule appropriately accounts for the opportunity cost of capital and so ensures the project is more valuable than comparable alternatives available in the financial market. NPV analysis has “value additivity”. The value to the firm is the sum of all the NPV projects it undertakes.
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NPV Analysis Key attributes of NPV: 1.NPV uses cash flows. Other decision rules sometimes use earnings, which are not as useful as cash. 2.NPV uses all of the cash flows for the project. Other rules ignore some cash flows. 3.NPV properly discounts the cash flows.
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Internal Rate of Return Definition: The discount rate that sets the NPV of a project to zero is the project’s IRR. Conceptually, IRR asks: “What is the project’s rate of return?” Standard Rule : Accept a project if its IRR is greater than the appropriate market based discount rate, reject if it is less. Why does this make sense? For independent projects with “normal cash flow patterns” IRR and NPV give the same conclusions. IRR is completely internal to the project. To use the rule effectively we compare the IRR to a market rate.
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IRR – “Normal” Cash Flow Pattern Consider the following stream of cash flows: Calculate the NPV at different discount rates until you find the discount rate where the NPV of this set of cash flows equals zero. That’s all you do to find IRR. 0 1 2 3 -$1,000 $400 $400 $400
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IRR – NPV Profile Diagram Evaluate the NPV at various discount rates: Rate NPV 0 $200 10 -$5.3 20 -$157.4 At r = 9.7%, NPV = 0 -200 -150 -100 -50 0 50 100 150 200 250 0 10 20 Discount Rate NPV
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The Merit to the IRR Approach The IRR is an approximation for the return
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MGMT_130_Lecture_8_Notes - MGMT 130 Lecture 8 Net Present...

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