Chapter 9

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© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter 9
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9.2 Learning Objectives of Chapter Nine Be able to describe the capital budgeting process Be able to distinguish between independent and mutually exclusive projects, and between conventional (normal) and unconventional (non-normal) project cash flows Be able to compute and interpret a project’s net present value (NPV), and to explain the NPV’s strengths as a decision tool Be able to compute and interpret regular payback (PB), and to explain its usefulness and its shortcomings Be able to compute and interpret the internal rate of return (IRR) Be able to explain the strengths and weaknesses of the IRR, Be able to explain why a decision made with the IRR rule might conflict with a decision made by the NPV rule Be able to compute and interpret the modified internal rate of return
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9.3 Investment Selection Techniques Chapter 9 begins a two chapter section on capital budgeting. Most of chapter 9 is devoted to examining and comparing a variety of techniques used to select from among alternative investments. Chapter 10 deals with cash flow estimation and some special applications of capital budgeting We begin by briefly examining the process of capital budgeting.
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9.4 Capital Budgeting Capital budgeting – the process that firms go through to select investments in long-term assets, such as property, plant, equipment, and product lines. In capital budgeting, projects are selected on the basis of their expected return and perceived risks The Capital budget – summarizes the funding requirements of all the investments selected by the firm
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9.5 Capital Budgeting Basic Steps in Capital Budgeting: Identify appropriate investment opportunities Estimate the relevant cash flows Assess the riskiness of the expected cash flows in order to select an appropriate discount rate Evaluate the potential investments by applying one or more capital budgeting decision techniques Make a decision about which, if any, of the investments under consideration to select
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9.6 Criteria of a Good Capital Budgeting Method Primary vs. secondary decision methods A primary capital budgeting decision method (or technique) should meet the following four criteria : Does the technique consider all relevant cash flows ? Does the technique take into account the time value of money ? Does the technique consider risk ? Does the technique indicate whether the
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Two Important Distinctions The following two distinctions are important for project evaluation: 1) First, independent versus mutually exclusive projects Alternative projects are independent if the selection of one does not affect the decision to select others Projects are mutually exclusive if selecting one project rules out selecting others. Projects tend to be mutually exclusive if they are alternative ways of doing the same task. e
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