part II lecture notes 374 RWJFALL2010 - Part II of lecture...

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Part II of lecture notes Capital budgeting Cost of capital Raising capital Capital structure Dividend policy 1
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Net Present Value and Other Decision Criteria (Chapter 9) The question: Do we accept or reject a potential investment project? Value comes primarily from the left hand side of the balance sheet (assets). Examples: * Does a hotel corporation build new hotel in a given location? * Does a hospital buy new diagnostic machine? * Does a steel corporation invest in more efficient equipment? * Does a real estate company build a parking lot or office building on a parcel of land? * What type of pollution control equipment does a chemical factory buy in order to meet regulations? Successful corporations find good projects and reject bad ones. Creativity, entrepreneurship, and understanding how markets work all part of the process …. We need to identify possible projects in the first place! 2
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Types of projects: (1) revenue increasing (e.g., a new product) (2) cost decreasing (e.g., new and more efficient equipment) A good project has a positive net present value (NPV) of future cash flows. It adds value to the corporation (increases stock price). Positive NPV: PV of cash inflows > PV of cash outflows (3) required (e.g., pollution control equipment) Choose required projects with least negative net present value. The discount or interest rate used to calculate the NPV is called the “cost of capital” (the cost of capital is a required return such as 15%/year). The cost of capital represents the required return of the corporation’s suppliers of long-term funds (stockholders and bondholders). Keep the investors happy! Expected project cash flows usually: 3
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0 1 2 3 4 -$ +$ +$ +$ +$ Negative at “time 0” and then positive. For now … given the cash flows and the cost of capital, how do we make the accept/reject decision? Later … we show how to find the cash flows and the cost of capital. (This is the hard part in reality.) Cash flows should be incremental after-tax cash flows from project …. Net Present Value Rule It is always an appropriate decision rule (it is theoretically sound). Example: 0 1 2 3 4 -$100 +$50 +$40 +$40 +$15 If the cost of capital is 15%, the NPV is +$8.6: 4
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The NPV is positive so accept the project. A positive NPV project adds value to the corporation. A positive NPV project earns a rate of return greater than the cost of capital. Other decision rules …. Sometimes used, but each has problems. Payback Rule Calculate how many years until the cumulative cash flow after year 0 exceeds the initial investment. If this is less than the acceptable payback period (for example, 3 years) accept the project. What is the payback period in the previous example? (How many years until we get back the $100 investment?) Cumulative cash flow 1 2 3 4 ? ? ? ? 5
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Payback period is between year 2 and 3. We could say 2 + $10/$40 = 2.25 years to be “precise.” The $10 is amount we need to get to $100 (from $90), $40 is the year 3 cash flow.
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