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ORIE 3150 December 3 2009 Notes

# ORIE 3150 December 3 2009 Notes - ORIE 3150 Capital...

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ORIE 3150 Capital Budgeting The process of making capital expenditure decisions is known as capital budgeting. We will focus only on screening decisions: whether a proposed project meets some standard of acceptance. In contrast, preference decisions relate to selecting between several courses of action. This is more complicated, and will be left for other courses. We will cover only two simple topics: 1. Payback period 2. Net Present Value (NPV) method Payback Period The payback period simply measures the number of periods necessary to recoup the original investment. The time value of money is ignored. Thus, it is best used for short payback periods (like 2 years or so). The shorter the payback period, the better. While it is certainly not a sophisticated technique, it is easy to use. Often businesses require that investments in cost-saving devices pay for themselves in 18 months, for example. That is, they must have a payback period of 18 months. Net Present Value In the majority of situations, net present value (NPV) is preferred. NPV – the value at time zero that is the equivalent to the cash flow series of a proposed project. We know what cash today is worth. The value of cash flows in the future is more difficult to assess! NPV - Assumptions 1. Cash flows are end-of-period, except for first costs and prepayments that occur at t = 0. 2. Cash flows are deterministic. Even though they occur in the future, we assume they are known exactly. 3. The interest rate is given. Since this affects the NPV, choosing the appropriate rate is very important. 4. The problem’s time horizon, n, is given. Usually we look at this for several years, most often 10 or more! When to use NPV 1. Evaluating a project when the investment is given. The investment occurs at t = 0, and we get future cash flows. 2. Calculating the equivalent value for an irregular series of cash flows (usually for the sake of comparison of several alternatives) Salvage Value At the end of the project horizon, we close the project and sell the assets for salvage. Consider comparing buying a Ford Explorer vs. a Toyota 4Runner. We consider the costs over 5 years. But we must consider the resale value at the end of the project horizon, 5 years. Note, however, that the inattentive and brainless layman will attribute

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full value to the difference in salvage values.
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ORIE 3150 December 3 2009 Notes - ORIE 3150 Capital...

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