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MGMT310_lecture18

# MGMT310_lecture18 - Last Lasttimewediscussed investment a b...

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Last time we discussed… How can managers determine whether a project is a good investment? Various decision criteria: a) Net present value (NPV) b) Payback period (PB) / Discounted PB period c) Profitability index (PI) d) Internal rate of return (IRR) e) Average accounting return (AAR) f) Etc! From here on out, (unless you’re told otherwise) assume that capital budgeting decisions are made based on the NPV rule budgeting decisions are made based on the NPV rule.

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Review Questions Calculate the following (occ = 15%) 1. PB period 2. Discounted PB period Year 0 1 Project A 300,000 20 000 Project B 40,000 19 000 3. NPV 4. IRR 2 3 4 20,000 50,000 50,000 390 000 19,000 12,000 18,000 10 500 5. Profitability index 6. If the two projects are mutually exclusive, which will you choose? 390,000 10,500
What should we use as the occ (i.e., discount rate)? The expected return on the overall stock market is 11% and the riskless rate is 4%. A firm with average risk is considering an investment of 100 in a project that is certain to pay off 106 one year from now one year from now. Should the project be taken or not? Why? Hint: recall brief discussion on why we call it the “ opportunity cost of capital

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Investing in a financial security Suppose the firm is thinking about buying shares of stock X. What is the NPV of this investment? Hint: recall that the price of a financial security is the present value of its expected future cash flows (in an efficient market)
Big picture Earlier in the class (i.e., many weeks ago), we did pro forma statements to determine whether certain levels of growth were feasible Now, we want to evaluate specific projects to see how to best achieve this desired growth In the last lecture, we used simple examples where the incremental net cash flows werejust given to us Now we must figure out how to get these numbers, and take into account things such as tax shields, changes in NWC, etc…

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Incremental cash flows Want to know the incremental cash flows of a project i.e., any and all changes in the firm’s future cash flows that are a
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