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

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Accounting 102 Session 20
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Capital Budgeting Evaluating Investment Opportunities
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Capital Budgeting An 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.
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The Investment Decision The 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 (CF t ) for each alternative 2) Discount those 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 + = t t r CF NPV ) 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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Example : A project has an initial cash outflow of $90. It yields cash inflows of $55 at the end of the first year and $60.50 at the end of the second year. The firm's cost of capital is 10%. Should the firm accept the project? > 0 10 = (1 +0.10) 2 (1 +0.10) 1 60.50 + 55 + – 90 = NPV Accept project
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Are There Other Criteria That Can Serve in Place of NPV?
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For the preceding example, Internal Rate of Return (IRR) The internal rate of return is the discount rate which equates the NPV of a stream of cash flows to zero. + = t t IRR CF ) 1 ( 0 If the IRR can be determined, then choosing IRR > r leads to the same decision as choosing NPV > 0 . The IRR criterion is useful for choosing among projects with the same NPV. 18% = IRR (1 + IRR) 2 (1 + IRR) 1 60.50 + 55 + – 90 = 0 > 10% Accept the project
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Payback Period : Length of time required for total cash inflows to equal total cash outflow. Decision Rule:
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This note was uploaded on 10/06/2010 for the course FNCE 100 taught by Professor Jaffe during the Spring '10 term at UNC Asheville.

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

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