Comm298-Week8-NPV_and_capital_budgeting-wit

Comm298-Week8-NPV_and_capital_budgeting-wit - Com298: Week...

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Com298: Week 8 Net Present Value and Capital Budgeting Learning Objectives: Focus on the following: Capital budgeting decision criteria. NPV: best decision criterion. Payback and discounted payback period. IRR: strength and weaknesses. Profitability index and capital rationing. Capital Budgeting Decisions Role of capital budgeting decision: Once a firm has decided on its strategic business 1
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decision e.g. offering new product lines or competing in new markets, it will have to make its capital budgeting decision. Capital budgeting decision is about whether a firm should accept or reject a proposed investment project in some long term fixed assets. Implications: Once an investment project is accepted, the firm will commit its scarce resources to certain types of long term fixed assets. This will determine the nature of a firm’s operation and products in years to come. Investment Decision Criteria Good investment decision criteria usually involve the following: Takes into account the time value of money and risks of the projects. 2
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Provides information about whether the project will create value for the firm and its shareholders. A firm focuses on the cash flows to decide on whether to accept or reject the proposed project. Four investment decision criteria: Net present value (NPV) rule. Payback and discounted payback rule. Internal rate of return (IRR) rule. Profitability index (benefit-cost ratio). Net Present Value (NPV) Rule Definition: The NPV is the difference between the PV of the future cash inflows and the cost of the investment project. The NPV is a direct measure of how well the project will meet the firm’s goal. 3
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The NPV rule: If the NPV > 0, accept the project. If the NPV < 0, reject the project. The NPV rule is the most appropriate method, so long as the objective is to maximize value. Example: A project with NPV = $10,000 implies that shareholders’ wealth will increase by $10,000 if the project is accepted. Drawback to NPV: it relies on estimated cash flow and discount rate values that may not be certain. Example: Using the NPV Rule Suppose a firm has to decide whether or not to launch a new product line. Based on the projected sales and costs, the cash flows over the next 5 years life of the project are as follows: $2000 in the first 2 years. $4000 in the next 2 years. $5000 in the last year of the project. 4
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Investment cost = $10,000. Discount rate = 10%. Using the NPV rule: PV = 2000 + 2000 + 4000 + 4000 + 5000 = 12,313 (1.1) (1.1) 2 (1.1) 3 (1.1) 4 (1.1) 5 NPV = 12,313 – 10,000 = 2313; accept the project. Calculator Approach:
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Comm298-Week8-NPV_and_capital_budgeting-wit - Com298: Week...

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