L11_Capital+investment

L11_Capital+investment - Financial Management Fall 2010...

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Financial Management Fall 2010 Lecture 11: Capital Investment (I) Professor Erica Li Ross School of Business
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Last class NPV: the only decision rule that is consistent with value maximization under all scenarios IRR For a single project: IRR gives correct decision for conventional cash flows. But you need to distinguish “investing” and “financing” like cash flows IRR does not work for non-conventional cash flows For mutually exclusive projects: IRR may give a wrong decision if projects have different scales or projects have different risk levels Even if the projects have the same risk level, if their NPV profiles cross-over at some point, there is no simple decision rule
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More example on cross-over rate Which project to choose if the required return for both project is 5%? What if the required return for both project is 15%? Project A Project B A-B t=0 -1000 -1000 0 t=1 700 100 600 t=2 500 300 200 t=3 300 500 -200 t=4 100 900 -800 IRR 30.46% 20.59% 9.14%
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NPV Profile NPV Discount rate (%) .
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Summary If the required return < 9.14%, choose project B; otherwise, choose project A NPV of project B is larger when the discount rate is low because project B has greater total cash flow but it pays back more slowly, that it, most of its cash flow occurs later Conclusion: IRR rule can be misleading when comparing mutually exclusive projects even if those projects have the same risk level
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Roadmap for today Forecast the UCFs of a project How to determine relevant cash flows of a project Sunk costs Opportunity costs Side effects How to deal with the following cash flow components Net working capital Depreciation Salvage value Use a mini case to illustrate all of the above
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Stand-alone principle Analyze each project in isolation from the firm’s existing asset by focusing on the project’s incremental cash flows.
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8 Relevant cash flows The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted These cash flows are called incremental cash flows Any and all changes in future cash flows which are a direct consequence of taking the project
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Identify the relevant cash flows Ask the right question: Will this cash flow occur ONLY if we accept the project? If the answer is “ yes ”, it should be included in the analysis because it is incremental If the answer is “ no ”, it should be not be included in the analysis because it will occur anyway If the answer is “ part of it ”, we should only include the part that occurs because of the project
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Sunk Costs Costs that have already been incurred in the past and cannot be recovered no matter whether the project is taken
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L11_Capital+investment - Financial Management Fall 2010...

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