Session 20 - Accounting 102 Session 20 Capital Budgeting...

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Accounting 102Session 20
Capital BudgetingEvaluating Investment Opportunities
Capital BudgetingAn important element of capital budgeting involves choosing which, from among a group of long-term investments opportunities, should be undertaken and how those (that) selected investments should be financed. From financial economics we know that, in general, the investment decision should be separated from the financing decision. And, we are concerned only with the former. From economics we know that, in these cases, the selection criterion that satisfies the shareholders’ economic objective (of profit maximization) is: Maximize net present value ("shareholder value") by accepting positive net present value (NPV) projects and rejecting or terminating negative NPV projects.
The Investment DecisionThe most appropriate method to evaluate long-term investments and to choose among them is Present Value or Discounted Cash Flow (DCF) Analysis.1)Estimate the amounts of future cash inflows and outflows (CFt) for each alternative2) Discountthose future cash flows to the present using the firm's cost of capital(r) and sum them. (The discount rate is the cost of capital, i.e., the required rate of return to the firm's assets.)3)Choose from among the alternatives using the Net Present Value (NPV) criterion+=ttrCFNPV)1(a)For a single project, choose if and only if its NPV is positive; b)For several mutually exclusive alternatives, choose the alternative with the highest NPV.Clearly, using the NPV criterion is equivalent to choosing projects that maximize shareholder value.
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Are There Other Criteria That Can Serve in Place of NPV?

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