# Lecture 3 - UGBA 103 Lecture 3 Capital Budgeting Cr iter ia 1 NPV Rule 2 Alternatives to NPV Rule i Payback Period ii Internal Rate of Return iii

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Unformatted text preview: UGBA 103 Lecture 3 Capital Budgeting Cr iter ia 1. NPV Rule 2. Alternatives to NPV Rule i. Payback Period ii. Internal Rate of Return iii. Book Rate of Return 2 Net Pr esent Value (NPV) Rule • Net Present Value (NPV) = Σ t PV ( CF t ) for t =0,1,.. n * = Total PV of future CF’s + Initial (t=0) Investment • Estimating NPV: 1. Estimate future CFs: how much? and when? 2. Estimate discount rate based on time and risk of CFs 3. Estimate initial costs • Acceptance Criteria: Accept if NPV > 0 • Ranking § Criteria: Choose project with highest NPV * n stands here for the life of the project § Ranking makes sense only if the projects are mutually exclusive 3 Why Use Net Pr esent Value? • Accepting positive NPV projects benefits shareholders ( it replicates their decision-making process ) NPV takes time value of money into account Decisions based on NPV depend on CFs and on their time and risk characteristics, and on nothing else * NPV has additivity property : NPV(A+B) = NPV(A)+NPV(B). This property facilitates analysis in terms of smallest economically viable components. Examples: Outsourcing of payroll, HR, functions etc NPV enables management to exercise its judgment about the risk of CFs in a rational way by using an established paradigm *From a financial perspective, CFs and their time and risk characteristics are the only determinants of value; everything else is extraneous. 4 NPV and Cash Tr ansfer s • The decision on whether or not to invest in a project affects the flow of cash to the firm as follows Cash Investment opportunity (real asset) Firm Shareholder Investment opportunities (financial assets) Invest Alternative: pay dividend to shareholders Shareholders invest for themselves The cash that the firm has can be either invested in a project or paid out as dividend 5 Alter natives to NPV Rule • Firms have traditionally used a number of different criteria for: – Deciding whether to accept a particular project or not – Ranking mutually exclusive projects (MEPs) • In the following slides, we shall: – Describe how these alternative rules are used – Compare these to the NPV rule, particularly in terms of whether or not they have properties described earlier on slide 3 (time value of money, exclusion of extraneous factors, additivity property, and use of an established paradigm for considering risk) 6 Payback Per iod Rule • The payback period ( PB ) of a project is the number of periods it takes for the cumulative forecasted cash flow to equal the initial outlay...
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## This note was uploaded on 04/30/2010 for the course L&S 101 taught by Professor Chow during the Spring '10 term at University of California, Berkeley.

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Lecture 3 - UGBA 103 Lecture 3 Capital Budgeting Cr iter ia 1 NPV Rule 2 Alternatives to NPV Rule i Payback Period ii Internal Rate of Return iii

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