Case Study - 11-23

# Case Study - 11-23 - 125 250 375 125 250 375 500 400 100...

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× 1/1.10 × 1/ (1.10) 2 × 1/ (1.10) 3 18.1% × 1/1.181 × 1/ (1.181) 2 × 1/ (1.181) 3 10 15 20 25 10 20 30 40 50 0 - 10 Crossover Rate 1 9% IRR S = 23.6% IRR L = 18.1% WACC (%) Project S Project L NPV (\$) 5 10 15 20 25 10 20 30 40 50 0 - 10 Crossover Rate 1 9% IRR S = 23.6% IRR L = 18.1% WACC (%) Project S Project L WACC = 10% × 1.10 × (1.10) 2 10% 125 250 375 - 125 - 250 - 375 500 400 100 200 300 500 0 125 250 375 - 125 - 250 - 375 500 NPV (Thousands of Dollars) r (%) 100 200 300 500 0 125 250 375 - 125 - 250 - 375 500 400 ALLIED COMPONENTS COMPANY 11-24 BASICS OF CAPITAL BUDGETING a. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? Capital budgeting is the process of analyzing fixed assets additions. It is important because the fixed asset decisions chart a company’s course for the future. In addition, the capital budgeting process is relatively identical to the same decision making process by individual investors. Listed below are the same steps used by both processes: i. Estimate the cash flows ii. Assess the riskiness of the cash flows iii. Determine the discount rate based on the riskiness of the cash flows as well as interest rates. This process is called the project cost of capital. iv. Find the PV of the expected cash flows/the asset rate of return. v. If the inflow is greater than the outflow of the PV (meaning the NPV is greater than zero), or if the IRR is higher than the project cost of capital, you would accept the project. b. What is the difference between independent and mutually exclusive projects? Between projects with normal and nonnormal cash flows? Projects are independent if the cash flows of one are not affected by the acceptance of the other. Therefore, two projects are mutually exclusive if acceptance of one affects adversely the cash flows of the other; that is, at most one of two or more such projects may be accepted. Projects with normal cash flows have outflows, or costs, in the first year (or years) followed by a series of inflows. Projects with nonnormal cash flows have one or more outflows after the inflow stream has begun.

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c. (1) Define the term net present value (NPV). What is each project’s NPV? The NPV defines the present values of a project’s cash flows: NPV =. Project L’s NPV is \$18.79: 0 1 2 3 | | | | -100.00 10 60 80 9.09 49.59 60 .11 18 .79 = NPV L NPVs are easy to determine using a calculator with an NPV function. Enter the cash flows sequentially, with outflows entered as negatives; enter the WACC; and then press the NPV button to obtain the project’s NPV, \$18.78. The NPV of Project S is NPV S = \$19.98. (2) What is the rationale behind the NPV method? According to NPV, which project(s) should be accepted if they are independent? Mutually exclusive? The rationale behind the NPV method is direct by definition meaning if a project has
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## This note was uploaded on 12/16/2010 for the course FIN 510 taught by Professor Garvin during the Fall '10 term at Davenport.

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Case Study - 11-23 - 125 250 375 125 250 375 500 400 100...

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