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Ch 10 Slide Show

Ch 10 Slide Show - Chapter10 TheBasicsofCapital Budgeting 1...

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1 Chapter 10 The Basics of Capital  Budgeting 
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2 Topics Overview and “vocabulary” Methods NPV IRR, MIRR Profitability Index Payback, discounted payback Unequal lives Economic life Optimal capital budget
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Project’s Cash Flows  (CF t ) Market interest rates Project’s  business risk Market risk aversion Project’s debt/equity capacity Project’s risk-adjusted cost of capital  (r) The Big Picture: The Net Present Value of a Project NPV =                  +                +  ···  +                    Initial cost CF 1 CF 2 CF N (1 + r ) 1 (1 + r) N (1 + r) 2
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4 What is capital budgeting? Analysis of potential projects. Long-term decisions; involve large  expenditures. Very important to firm’s future.
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5 Steps in Capital Budgeting Estimate cash flows (inflows &  outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows.
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6 Capital Budgeting Project  Categories 1. Replacement to continue profitable  operations 2. Replacement to reduce costs 3. Expansion of existing products or markets 4. Expansion into new products/markets 5. Contraction decisions 6. Safety and/or environmental projects 7. Mergers 8. Other
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7 Independent versus Mutually  Exclusive Projects Projects are: independent, if the cash flows of one are  unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one  can be adversely impacted by the  acceptance of the other.
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8 Cash Flows for Franchises  L and S 10 80 60 0 1 2 3 10% L’s CFs: -100.00 70 20 50 0 1 2 3 10% S’s CFs: -100.00
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9 NPV: Sum of the PVs of All  Cash Flows Cost often is CF 0  and is negative. NPV =   Σ N t = 0 CF t (1 + r) t NPV =   Σ N t = 1 CF t (1 + r) t – CF 0
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10 What’s Franchise L’s NPV? 10 80 60 0 1 2 3 10% L’s CFs: -100.00 9.09 49.59 60.11 18.79 = NPV L NPV S = $19.98.
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11 Calculator Solution: Enter  Values in CFLO Register for L -100 10 60 80 10 CF 0 CF 1 NPV CF 2 CF 3 I/YR = 18.78 = NPV L
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12 Rationale for the NPV Method NPV =  PV inflows – Cost  This is net gain in wealth, so accept  project if NPV > 0. Choose between mutually exclusive  projects on basis of higher positive  NPV.  Adds most value.
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13 Using NPV method, which  franchise(s) should be accepted? If Franchises S and L are mutually  exclusive, accept S because NPV s    > NPV L . If S & L are independent, accept  both; NPV > 0. NPV is dependent on cost of  capital.
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14 Internal Rate of Return:  IRR 0 1 2 3 CF 0 CF 1 CF 2 CF 3 Cost Inflows IRR is the discount rate that forces PV inflows = cost.  This is the same as forcing NPV = 0.
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15 NPV:  Enter r, Solve for NPV = NPV   Σ N t = 0 CF t (1 + r) t
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16 IRR:  Enter NPV = 0, Solve  for IRR = 0   Σ N t = 0 CF t (1 + IRR) t IRR is an estimate of the project’s rate  of return, so it is comparable to the  YTM on a bond.
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