Ch 11-12 - Chapter 11 The Basics of Capital Budgeting...

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Generating ideas o Firms create capital budgeting projects and have a major influence on their projects’ results o 1 st forecast a set of cash flows, and then find the present value of those flows, and make the investment only if the PV exceeds the investment’s cost o A firm’s growth depends on the constant flow of new ideas o Strategic business plan- long-run plan that outlines in broad terms the firm’s basic strategy for the next 5-10 yrs o If a firm has capable and imaginative exec.’s and employees and its incentive system works properly, ideas will be advanced Projects- proposals are not costless operation o Replacement needed to continue current operations- worn-out or damaged equipment, should operation continue and if so, use same? simple decision o Replacement with cost reduction- results lower costs, discretionary with a fairly detailed analysis o Expansion of existing products- increase output or expand retail outlets, more complex decisions that require a forecast of growth in demand o Expansion into new markets- involve strategic decisions that could change the fundamental nature of the business o Safety/environmental- comply w/ gvt. Net Present Value - estimates how much a potential project will contribute to shareholder wealth o A direct measure of the project’s contribution to shareholder wealth o If two projects are mutually exclusive, whichever has higher NPV should be accepted (can only accept one or none) o Independent projects- whose cash flows are independent of one another o CALCULATE: NPV= enter cash flows with correct signs and the r=I/YR as the cost of capital If exceeds 0, then increases firms value and if negative, reduces Internal Rate of Return- discount rate that forces the project’s NPV=0 o Useful to know investment’s most likely rate of return o CALCULATE: IRR= enter cash flows o IRR is the expected rate of return If exceeds the costs of funds, then the excess goes to stockholders If less than the cost of capital, the stock price declines Comparing o Can provide conflicting recommendations when used to evaluate mutually exclusive projects Sometimes better to chose a project with a low IRR over an alternative with a high IRR o NPV valued better, but IRR is familiar in industries and with executives o Net present value profile- graph showing the relationship b/w a project’s NPV and the firm’s COC X-axis is % COC and Y-axis is the $NPV
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This note was uploaded on 02/22/2011 for the course BMGT 340 taught by Professor White during the Spring '08 term at Maryland.

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Ch 11-12 - Chapter 11 The Basics of Capital Budgeting...

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