chapter4 - Chapter Four Capital Budgeting: Competing...

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1 Chapter Four Capital Budgeting: Competing Criteria MGMT 109 Managerial Finance Professor Lu Zheng Topics Covered Decision Rules in Practice • NPV (Net Present Value) • The Payback Period • The Book/Accounting Rate of Return • Internal Rate of Return • Profitability Index Net Present Value The natural (and correct) rule for project evaluation is the “net present value” (NPV) rule. NPV is defined as the present value of the project’s cash flows, or alternatively as the sum of the present values of the individual cash flows: where I0 is the investment cost of the project and Ci is the cash flow in period i. () n n r C r C r C I NPV + + + + + + + = 1 ... 1 1 2 2 1 0
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2 Interpretation of NPV NPV can be interpreted as the dollar value of the project. Taking a project with an NPV of $1 million, will add $1 million to the value of the firm. As such, NPV represents the addition to the market value of the firm from undertaking the project. – Moreover, it corresponds with the objective of the firm to maximize its value. The NPV Decision Rule (1) For independent projects, accept a project if NPV>0. (2) For mutually exclusive projects, take the project with the highest NPV. Discount Rates Synonyms • Discount rate • Required return • Opportunity cost of capital • Hurdle rate
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3 Cost of Capital Capital is expensive because there are always other alternatives for the investment of that capital. Instead of undertaking a project, a firm can always return the capital to investors. The appropriate discount rate is the rate of return that could be earned by investors on an alternative investment of equal risk. Characteristics of Disc. Rates • Discount rates (opportunity costs of capital) are project specific • The discount rate increases with the risk of the cash flows Decision Rules Capital budgeting decision rules are used for two things: 1) To determine if a project is acceptable 2) To rank mutually exclusive projects
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This note was uploaded on 01/17/2011 for the course MGMT 107 taught by Professor ? during the Winter '08 term at UC Irvine.

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chapter4 - Chapter Four Capital Budgeting: Competing...

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