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Chapter 6
Case: NETCO
Definition of capital budgeting
The justification for net present value
Independent vs. mutual exclusive projects
Simple net present value example
Payback example
Problems with payback
Internal rate of return (IRR)
Problems of IRR with independent projects
Borrowing vs. lending
Multiple rates of return
No internal rates of return
Problems of IRR with mutually exclusive returns
Timing
Scale
Replacement chains
Profitability index
Value additivity
implies that the contribution of any project to a firm’s value is the NPV
of the project.
When calculating NPV, you compare the interest rate of a project to the interest rate of an
equally risky investment (e.g. stock market or real estate)
Opportunity Cost
in these cases is the discount rate of an equally risky project
The key to NPV lies in three attributes (p. 146)
Payback Method
Counts number of years until initial investment is recovered, ignoring the time value of
money.
Noted: (-50 k, 30 k, 20 k, 10 k) where each of the positive numbers are inflows and the
negatives are outflows.
The commas separate inflows and outflows between consecutive
years.
Payback period rule
says that all investments taking more than x years to recover the
initial investment are rejected and within x years accepted.
Problems with

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